With the structure of global OTC markets – particularly OTC derivatives – going through some fundamental changes at the moment, it is perhaps not surprising that the main focus of many firms in the industry right now is on how to comply with all of the new regulations that impact their business.
But just complying with rules and regulations and doing no more than that is never going to give a firm a competitive advantage. Those operating within the OTC landscape and evolving from a manual to a more automated trading environment need to increase efficiency, increase profitability and increase “stickiness” with their own clients, in order to stay ahead of the game. So rather than just looking at how they are going to comply with regulations like Dodd-Frank and EMIR, the question they should ask themselves is, how can they do it in a way that also helps them increase their business?
It is a fact of life that some markets and some types of OTC deals, particularly those involving the more complex type of transaction, lend themselves more to voice broking than electronic trading. That is how deals are structured and that is the way business gets done. The challenge is how to capture everything electronically, so that firms can still make use of the voice element but also build on it, while still satisfying the regulators.
The evolution of hybrid trading is addressing this challenge. The combination of voice and electronic trading into a single evolving platform enables users – whether market operators or market participants – to get the most out of both, by augmenting voice trading rather than replacing it.
With hybrid trading, dealers can still perform trades via voice, but all of the price discovery action happens on the screen. The key thing is that the dealers have all of the information they need at their fingertips to be able to negotiate the deal. They don’t need to call around to see where there is a price, what that price is, how much volume is there, and so on. This allows them to make more informed trading decisions, more quickly. And because everything is captured electronically, the reporting needs of the regulators are met.
In the wake of Dodd-Frank and EMIR, the OTC landscape is moving towards a more standardised, centrally cleared environment, so is likely to become more fragmented and more competitive. This means that banks, inter-dealer brokers and market operators will need to think long and hard about how to attract – and keep – liquidity. What do they need to do in order to satisfy the needs of market participants?
In the more established electronic exchanges such as equities, futures and options markets, central limit order books have long been the standard. But the new market operators might want to consider how volume matching or time-based matching periods can help grow their liquidity.
An example of this might be where a bank uses a volume-match function to set up auctions at certain periods of the day, to attract volume and liquidity at specific times. A bank operating a Hong Kong-based convertible bond market for example, might have a better chance of attracting liquidity for the Japanese, Korean, Hong Kong and Singapore markets by running auctions for each of those markets at specific times of the day. In a fragmented, low-volume market, these periods become a lot more interesting for the participants if, for example, there are different levels of transparency during different trading periods. The market operator might want to show best bids and offers for an initial period followed by a secondary period in the auction where nobody sees anything, then after the session is over there is an algorithm that allocates volume to participants who put in the best prices and/or more volume.
By having this degree of control, from complete transparency to complete opacity, and by having the ability to set those levels at different times of day – or based on a range of different parameters that they can design and define themselves – banks, IDBs and market operators enable their matching sessions to become more focused, which enables them to target specific types of liquidity. This level of configurability enables a different way of trading than a standard, central limit order book where participants place bids and offers and everybody sees what’s going on all of the time.
Compliance with new regulations is of course essential. But firms need to think beyond pure compliance. They need to ask themselves where the opportunities are in this new environment, and what they will need in order to capitalise on these new opportunities, in terms of technology, processes and business strategy.