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Challenges remain in derivatives reform

Tuesday 17 January 2012 - by Eric Kolodner

 Regulators in Europe must balance the benefits of new pre-trade transparency rules with ensuring they do not adversely impact liquidity, says Eric Kolodner, managing director at Tradeweb.

Broadly speaking, derivatives reform in the US and Europe made progress in 2011.

Proposed new rules should help meet stated regulatory commitments for greater transparency, enhanced efficiency and increased competition among regulated electronic trading venues.

However, a number of reform proposals require further attention so that end-users, such as pension funds and central banks, can continue to efficiently manage their risk in the derivatives markets.

In Europe, one of the biggest concerns comes from proposed new pre-trade transparency rules. The Markets in Financial Instruments Regulation proposals issued by the European Commission last October would require trading venues to make publicly available on a continuous basis pre-trade prices and depth of trading interest at those prices.

This requirement could damage liquidity for end-users, as liquidity providers may widen their bid-offer spreads to compensate for the higher risks involved in such pre-trade information being broadcast to the entire market or, in some cases, may choose not to make markets in certain instruments.


This reduced liquidity for secondary market investors could, in turn, negatively impact government and corporate issuers by increasing their funding costs in the primary markets. Regulators in Europe must ensure that the benefits of pre-trade transparency are appropriately balanced against the impact on liquidity.

In addition, various provisions in the draft Mifir are designed to address the other regulatory goals of promoting a level playing field and enhancing competition among trading venues.

For example, the proposals would ensure that derivatives designated for central clearing are subject to the clearing mandate regardless of where they are traded.

The European Market Infrastructure Regulation requires derivative instruments to be cleared if they are traded off-exchange but not if traded on-exchange.

Mifir seeks to close this regulatory loophole by also requiring central clearing of exchange-traded derivatives. In the absence of this Mifir provision, this regulatory loophole could create an arbitrary advantage to trading on exchanges versus on other regulated electronic trading platforms, due to the costs associated with transacting through a central clearing counterparty.

Another important provision in Mifir that promotes a level playing field among trading venues requires that central clearing houses provide trading venues with non-discriminatory access to their facilities and services.

Vertical silos that incorporate both clearing houses and trading venues present particular concerns from a competition perspective. Only if clearing houses are required to provide non-discriminatory access to trading venues will market participants be able to clear their contracts with operational and cost efficiency, whilst still having access to a choice of multiple competing trading venues.


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