Autumn 2014

INSIDE VIEW: Lessons from the US

AmericaRegulations around trading bonds and derivatives in Asia have yet to be fully formed, but Andrew Bernard of Tradeweb says valuable lessons can be learnt from the US. Most of the jurisdictions that have already established trading regulations have focused on over-the-counter (OTC) derivatives.  This was in response to the G20 commitment that “all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties”.  The US, for example, introduced the Dodd-Frank legislation to regulate the derivatives market, and under these laws the Commodity Futures Trading Commission has now almost completely implemented mandatory trading requirements.  Regulations in Asia have yet to be fully formed, and consequently there is still a great deal of uncertainty as to what their impact will be in practice.  What we do know is that the global trading environment for bonds and derivatives will look very different in future. INNOVATION
New rules regarding market structure, transparency and the regulation of trading venues will be in place, and will significantly impact the market. As the industry seeks to adapt to the changes ahead, there will be more opportunity for product and service innovation.  Although the policy intent of regulators around the world is similar – to create safer, more transparent markets – there are key differences in the trading obligations between regions.  European rules may be characterised as broad-based while US rules are seen as more prescriptive. Brussels looks at a wide range of instruments. In addition to derivatives and fixed income securities, exchange traded funds (ETFs) are also in scope. There are both pre- and post-trade transparency requirements for government and corporate bonds.  The Commodities and Futures Trading Commission requires trading venues to operate specific trading protocols – for example, swap execution facilities offering a request-for-quote system must also operate an order book. There are no similar requirements within the European rules.  Asia’s regulators are now starting to offer more clarity – or partial clarity – on derivatives regulation.  In Japan, the Financial Services Agency (FSA) has been engaging with market participants and is already some way towards defining its rules.  Australia is also making progress in developing its proposals, and others are making strides. What remains clear, however, is that market participants will be able to satisfy their regulatory needs while trading more effectively using electronic trading platforms.  Since the implementation of the Commodities and Futures Trading Commission’s trading rules for derivatives is now largely complete, the experience in the US could provide some useful lessons for Asia.  Although electronic platforms offering derivatives trading have been available for several years, it was estimated that less than 10% of dealer-to-customer volume in the US was transacted electronically before swap execution facilities came into existence. Much of the transition towards e-trading only occurred after it was mandated. MILESTONES
One advantage of the phase-in of the made-available-to-trade obligation was that it helped the US derivatives market to adapt to the new trading landscape.  It allowed time for participants to prepare for the changes necessary, and as a consequence, there was a step-change increase in electronic volume after each of the made-available-to-trade milestones was passed.  On-swap execution facilities dollar swap volume now stands at around 53% of the market.  A more profound driver for the shift to e-trading has been the associated benefits that electronic execution provides, such as the ability to use compression tools.  The requirement to clear derivatives trades resulted in the need for institutional investors to manage effectively their line items at the clearing house, because each outstanding transaction increases both costs and risk.  Netting or terminating this risk has typically been a highly manual process, but electronic venues can offer an efficient mechanism for executing offsetting swap trades to eliminate these transactions.  This functionality proved to be particularly useful to US derivatives users after the Commodities and Futures Trading Commission’s no-action relief for packages expired – in one recent week, 25% of on-swap execution facilities volume was from compression trades.  The benefits of these types of electronic solutions for institutional investors can already be realised, even before e-trading becomes mandatory. Clients in Asia are starting to embrace electronic execution for OTC derivatives, as illustrated by the seven-fold increase in on-swap execution facilities swaps volume on Tradeweb in the second quarter of this year, compared to the first quarter, when made-available-to-trade trading started.   There is also evidence that firms are preparing for the implementation of local trading rules for derivatives. In Japan, for example, although electronic trading of yen swaps is not expected to be mandated until September next year, the first electronically-traded and Japan Securities Clearing Corporation-cleared yen swap transaction by a Japanese bank was executed in June.  Innovative technology will make managing the requirements of forthcoming trading regulations substantially easier, but electronic execution offers extra benefits.  Greater efficiency throughout the trading workflow, alongside the reduction of costs and operational risk, have all been drivers of the growth in e-trading in the fixed income markets for several years.  It is possible to streamline the entire trade cycle by integrating trading venues with internal and third-party mechanisms, such as order management systems and clearing houses.  These connections make it possible to reduce operational risk, while facilitating trade processing and reporting.  Connectivity also helps firms to prove best execution by generating audit trails of each auction, and delivering post-trade summary or compliance reports.  Buy-side investors with integrated systems have access to real-time analytics and transaction cost analysis that can be used to monitor performance.  Although trading mandates across Asia may not be delivered for some time, many buy- and sell-side institutions operating in the fixed income and derivatives markets are already preparing for future rules.  Cash bond market participants are, generally, already cognisant of, and active in, elements of e-trading, and are now looking to adjust their derivative trading functions to achieve the benefits inherent in electronic execution.  Many dealers, keen to provide a more efficient service for their clients, have responded by helping to develop their capacity to respond to electronic enquiries.  Regulation, market structure and client behaviour will continue to evolve across Asia.  This provides the opportunity for execution venues to use insight and expertise to develop innovative trading solutions, and so help the market address the challenges to come. Andrew Bernard is head of Asia at Tradeweb ©2014 funds global asia

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