RiskTech Forum

Capco: OTC Derivatives And Commodities In The Spotlight

Posted: 16 April 2013  |  Author: Tom Riesack, Ramandeep Lakhan  |  Source: Capco


Part One

Since MiFID I was introduced it became increasingly clear that certain products, particularly commodities and corresponding derivatives also needed to be regulated. There are no current rules for ‘on-market-trading’ of OTC derivatives and most commodities trading firms are exempt from MiFID when trading on their own accounts. The result, as postulated by the regulators, was rising food prices due to unencumbered speculation

The main concerns are:

Insufficient intervention powers for regulators on commodity markets, and;
A lack of transparency around OTC derivatives trading.
More stringent rules in MiFID II look to remedy these areas of concern. In this first of two blogs, we will demonstrate how MiFID II aims to ensure transparency across all asset classes, including those that were not in scope in MiFID I, and the impact on market participants.

The key reforms
The implementation of Organised Trading Facilities (OTFs) promotes a move away from the current bilateral model and towards a fortified best execution model. Standardisation of derivative contracts across trading venues means that there will be a move away from the quote driven market on which OTC Derivatives currently trade, which is associated with high counterparty risk exposure. MiFID II will build on EMIR and enforce mandatory electronic trading of OTC derivatives exclusively on: Regulated markets, MTFs, OTFs and permissible third country trading venues.

Transparency is the central theme of the MiFID II rules, which will affect a number of products including: all equity instruments, non-equity instruments, structured finance and all derivatives. Greater transparency will highlight systemic risks and cultivate control over them. It will also support more accurate internal due diligence and increased risk management. All of which seem necessary in the wake of the financial crisis and current challenges in the industry.

The impact
MiFID II will have a significant impact across the whole securities value chain, from front-office sales and trading to back-office reporting.

There are factors in the new regulation that will have a significant impact on the current OTC industry, such as:

Decrease in volumes traded;
Rising prices for OTC products;
Reconsideration on how and where contracts are executed;
Re-categorisation of all client data;
New or revised IT infrastructure that will include all MiFID rules;
Market liquidity will be impacted significantly. The finer details are yet to be finalised by the regulators, but it is an area all parties closely watched for future outcomes.
On the back of MiFID II, the market infrastructure will change considerably for certain constituents including regulators, market infrastructure providers and the buy and sell side.

With the introduction of OTFs and transparency across the board, the OTC derivatives industry and its corresponding trade lifecycle is likely to change dramatically in the coming years. All constituents affected by MiFID II, especially market infrastructure providers, need to identify the hot spots for change and then start preparing for implementation of the necessary changes from 2014 onwards.