Banks, brokers and exchanges jostle over OTC reforms
LONDON (Reuters) - Europe's top banks, futures brokers and exchanges are poised to pile into the shadowy over-the-counter market once regulators shine a light on a vast industry where toxic assets change hands virtually unchecked.
Regulators want the OTC market, in which bonds, currency and financial derivatives are traded bilaterally between banks, fund managers and hedge funds, to become more like exchange-based markets where equities and futures are traded multilaterally.
The move to reform came after the collapse of Lehman Brothers in late 2008 when open trades on traditional exchanges took days to resolve, while some trades in the most complex OTC products are still unresolved three years later.
Europe's top OTC brokers are already positioning themselves as the providers of a new kind of regulated trading system for this market. But Europe's banks and exchanges are also expected to close in as regulations become clearer this year.
"The OTC market has historically been tied up between a handful of brokers and dealers but the exchanges and other new entrants will look to move aggressively into these potentially higher margin products partly because their core exchange-traded markets have become squeezed," said Simmy Grewal, a senior analyst at research house Aite Group.
Changes to European trade in financial instruments is being made via the reform of a 2007 directive known as MiFID (Markets in Financial Instruments Directive), which opened up European share trading to competition.
This week the European Commission - Europe's executive arm - opened the public debate on its planned MiFID reform.
The Commission is proposing tighter rules around controversial high-frequency trading, which uses advanced technology to trade securities, and bank dark pool systems, which anonymously match large buy and sell orders.
But it also wants to overhaul the $700 trillion OTC market by forcing it to become more transparent and easier to regulate.
U.S. authorities are working on similar OTC reforms and the comprehensive Dodd-Frank Bill will be implemented this year.
The European reforms propose three pieces of market infrastructure: a trade repository that acts as a register of trades; a clearing house, which protects firms from a Lehman-type default; and a regulated trading platform or exchange.
The implementation of repositories and clearers are less contentious. But the plan to force trading onto exchange-type platforms - known in Europe as Organized Trading Facilities (OTFs) and the United States as Swap Execution Facilities (SEFs) - has angered the largest OTC providers who feel this level of transparency will hike costs.
"There is a consensus that reporting and clearing are important measures, but there is disagreement over whether the trading function needs to be reformed," said Jeff Gooch, Chief Executive of OTC specialist MarkitServ.
Authorities like the exchange model because business is transacted centrally, on an exchange or regulated platform, which makes trading activity easier to monitor.
Though no decisions have yet been taken, OTC incumbents are preparing to make the best of what many see as a bad situation.
"Different types of market participant are looking to provide SEFs (Swap Execution Facilities) but there is still some confusion over the rules," said Gooch.
The obvious providers of these exchange-type platforms are inter-dealer brokers like ICAP (IAP.L), Tullett Prebon (TLPR.L) and Tradition (CFT.S), which already match buyers and sellers.
These brokers have launched already systems that are compatible with the rules but take-up has been slowed by lack of clarity from regulators.
"We have not yet seen the full rules and the growth of iSwap <ICAP's system> has been suppressed, which has been disappointing and frustrating," ICAP's Chief Executive Michael Spencer said this month. "All we have been able to do is make our best effort to estimate the rules and then act first."
New entrants are also looking to tap into the lucrative OTC market but timing is a challenge.
The OTC market is the world's largest derivatives industry, dwarfing the exchange-traded market, which was estimated by the Bank of International Settlements at $26.4 trillion compared with the OTC valuation of $707 trillion last year.
"There are no doubt various SEF start-ups waiting in the wings, but the way things are progressing the bulk of the regulation may not take effect until 2013," said Daniel Marcus, Tradition's head of strategy and business development. "So the question for them is at what point do they come to market and with what?"
Marcus said others hoping to offer new platforms were likely to include technology providers such as Bloomberg and Tradeweb, a fixed income platform owned by Thomson Reuters (TRI.TO) and ten banks, including Credit Suisse (MLPN.P), Deutsche Bank (DBKGn.DE), Goldman Sachs (GS.N) and JPMorgan (JPM.N).
As minority shareholders, the banks have an interest in Tradeweb doing well from the OTC reforms but Gooch sees another opportunity for them: "There could be as many as 30 SEFs coming out in the short-term, which could create a demand for an aggregator, which is where the dealers could play a role."
The biggest competition, though, could come from the world's largest futures exchanges, also waiting in the wings.
The Chicago Mercantile Exchange (CME.O), the IntercontinentalExchange (ICE.N) and Deutsche Boerse (DB1Gn.DE) have all shown a willingness to provide OTC clearing services but have left their options open on trading.
"The question for the exchanges, in a world of mandatory clearing requirements, is whether they want to embark on clearing, or clearing and trading these OTC products," said Marcus.
The Tradition MD said trading OTC products, which tend to be low volume and high value, was not compatible with the exchanges' commercial models which are more geared towards high transaction turnover.
But he added: "The exchanges may see opportunities in making available trading in vanilla OTC products and we'd be naive to think they aren't looking at that opportunity."
(Editing by Jodie Ginsberg)
(This version corrects the description of Tradeweb ownership in paragraph 23)
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