Revisiting electronic swaps trading

Revisiting electronic swaps trading

By Alan Grody

Iosco report on OTC trading platforms

In October 2010, the International Organisation of Securities Commissions (Iosco) formed the task force on OTC Derivatives Regulation to follow the lead of the Financial Services Board of the G-20. Its purpose was to conduct a study of the benefits and challenges associated with exchange based and electronic trading of OTC derivative products.

The resulting report on trading of OTC Derivatives by Iosco’s technical committee<1> is an analysis of methods of increasing the use of exchanges or electronic platforms for trading in the derivatives markets.

The report noted that in a majority of jurisdictions, the legal and regulatory framework provided a number of approaches to conducting OTC trading business, reflecting highly diverse and increasingly competitive business models.

In this context, the report noted the difficulty of making distinctions between a fixed set of characteristics that is sufficient to constitute organised OTC derivatives’ trading platforms. However, as noted in the report, a distinction was made any way to “support the realisation of the G-20 objectives”.

In reporting on the different types of organised derivatives trading platforms the list included an order book system, a market maker system, a periodic auction system (sometimes referred to as a call market), a listing or bulletin board system and a catch-all, a hybrid system.

The preferred style of operating such systems  (that is to discover prices, the  first purpose of a market) were defined as limit order books (LOB’s), request for quotes (RFQ)s, and combinations of manual (voice negotiation) and electronic  (referred to as hybrid markets) under single or multiple market-maker models. 

The report noted that the rules of governance over trading functionality provides for special or modified operations to deal with particular market trading practices or events. It was often the case, it was noted in the report, that platform operators will, subject to regulatory requirements, choose to offer a range of different trading systems based on an assessment of the features of the particular product class and the different levels of liquidity within that product class.

Trading platforms as commercial businesses

We note that the features and functionality deployed by market platform operators, while providing market participants with a valuable place for buyers and sellers to meet and discover prices, are also operating the platforms as a competitive business, increasingly as publically traded shareholder owned for-profit businesses, and that market participants must be incented to place their trades into these markets.

To us this most important observation did not get fully developed as to the consequence of different types of trading platforms that may get deployed for OTC derivatives trading. It still plagues electronic trading platforms to this day as multiple versions of voice and electronic swaps execution facilities (Sefs) are deployed for competitive advantage.

This comes as regulators have missed the opportunity to first set stricter rules for a global market infrastructure to be put in place, thus allowing competition to determine outcomes before a level playing field has been established.

Regulators too have put nationalistic instincts and self-interests ahead of infrastructure rules for all. They too suffer in silos, although their silos are sovereign states not strategic business units.

For example, the majority of trading platforms in organised markets (equities, options, futures, single stock futures, exchange traded funds, bond trading platforms, et al) use market makers who provide liquidity to the market. These liquidity providers are also given special privileges to keep the shop open to all comers by making two-sided markets, when no one is interested in doing so.

This occurs when there is no natural “other side” as when there is no purchaser for a seller or no seller for a purchaser at a specific price at a specific time. For this occurrence, which happens frequently in illiquid low volume markets, market makers are usually given special “privileges” as for example, to be allowed to take a certain % of the trade before the public is given its opportunity.

Lately a ‘maker-taker’ model has arisen where those who have priced (limit orders) are paid a rebate over those who accept that price ‘at market’. Fair, of course, if you consider that someone needs to be there to take the other side of a trade, to keep the store open so to speak, or some incentive has to be provided by the market platform operator. Unfair if you are a purest about how markets should work vs. how they work in practice.

There are many other “nuances” of trading markets that are important to understand, especially as it relates to thinly trade markets (the issue at the core of choosing trading platforms for OTC derivatives) vs. robust and high volume markets, like that which we see in S&P 500 stocks, where the markets discover prices electronically without much market maker intervention. ICE’s ARCA Exchange is one such example.

Another example of other nuances in trading, especially in fixed income and swaps markets is ‘size’ trading as developed by inter-dealer brokers. This gives privilege to large volume traders who, once embarked on filling an outsized order, is given step ahead privileges ahead of others waiting in line until their entire order, or as much as they wish to execute is filled.

Finally, much has been written and discussed, argued might be a better word, about high-frequency-trading (HFT). Stepping ahead in microseconds, these speed traders have used the regulatory enabled gaps in multi-venue execution platforms to see market price changes in one venue before it is reflected in another venue. They benefit from ‘seeing around the corner’ before others, and are thus able to capture the ‘information arbitrage’ price movement advantage. 

Iosco identified trading platform characteristics

The Iosco task force identified seven characteristics of trading platforms, what I choose to call rational or framework statements, which are listed below:

1.      Registration of the platform with a competent regulatory authority, including requirements relating to financial resources and operational capability;

2.      Access for participants based on objective and fair criteria that are applied in an impartial, non-discriminatory manner;

3.      Pre- and post-trade transparency arrangements which are appropriate to the nature and liquidity of the product and the functionalities offered by the platform;

4.      Operational efficiency and resilience including appropriate linkages to post-trade infrastructure and measures to handle potential disruption to the platform;

5.      Active market surveillance capabilities, including audit trail capability;

6.      Transparent rules governing the operation of the platform; and

7.      Rules that do not permit a platform operator to discriminate between comparable platform participants in relation to the interaction of buying and selling interests within the system, whether fully electronic or hybrid.

This last point seems to fly in the face of existing mechanisms for incenting market makers, noted previously, especially in illiquid markets.

The contentious last characteristic – centralising markets

 A final characteristic had been identified by the task force as one that would provide benefits over and above the seven general characteristics described above. However, some in the task force noted that this eighth characteristic would generate additional costs above the costs generated by the other seven:

8.      The opportunity for platform participants to seek liquidity and trade with multiple liquidity providers within a centralised system.

This additional characteristic is generally associated with multi-dealer, make-available-to-trade (MAT) markets as opposed to single-dealer platforms.

The members of the task force were not in agreement as to whether this additional characteristic should be considered a minimum requirement necessary for organised platforms to achieve the G-20 objectives of improving transparency, mitigating systemic risk, and protecting against market abuse or whether the first seven characteristics were sufficient to achieve the G-20 objectives.

The report stated that many task force members believed that to achieve the G-20 objectives a centralised system was required. Such a trading platform would offer access to multiple liquidity providers.

Centralising trading, it was argued, should mitigate systemic risk by reducing the concentration of derivatives activity in a few market participants.

Additionally, such organised platforms operate independently of any one market participant and therefore promote better regulatory oversight, provide systemic risk benefits and strengthen protections against market abuse.

Other task force members believed that the same benefits can be achieved whether a particular platform offers access to multiple liquidity providers or not. These members noted that the first seven characteristics of OTC trading platforms represent a significant strengthening of current rules in the majority of Iosco jurisdictions.

Also noted was that a market consisting of a mix of single and multi-dealer platforms for standardised derivatives may also provide many systemic risk benefits, and that the additional  eighth characteristic, excluding single dealers as an element of the market structure would involve costs along with their additional benefits.

New definitions of centralised markets

It is a simple thought to contemplate, if we could only bring all trading venues together in a consolidated space and in a single point in time we would improve pricing, provide transparency and offer fairness to all in accessing market liquidity.

Can we do this, should we do this?  Why would we do this? First, definitions are important here:

  • centralising markets does not necessarily mean a fairer more transparent market – it could but best practice suggests it does not, such as  when large orders borrow prices from order books to be executed off market in other jurisdictions – the regulatory arbitrage issue;  or  when orders do not interact in public order books but rather are permitted for purposes such as internalisation (efficiency for small order processing) and market stability (stabilising price volatility for institutional sized orders)
  • a centralised order book does not necessitate a global facility housing the entire order book. It can be local order books liked through federated technology as in how we get internet information brought to our desktops from millions of computers located everywhere in the world
  • centralised markets can be multiple liquidity pools, public and ‘private’ linked together across local and/or wide-area fiber
  • centralised markets can be multiple trading algorithms linked to central order flow or quote flow or a central order book
  • centralised markets can be single or multi-asset trading venues, with single or multiple next execution cues
  • centralised markets can be integrated markets across time and space, with time and distance factors eliminated through information technology and network communication advances
  • centralised markets can offer efficiency in real-time risk management, electronic audit trails and regulatory transparency

How to Improve Electronic Trading Platforms

Here is set of possible approaches to consider in OTC derivatives trading platforms that did not get discussed in the Iosco report nor implemented as rules by regulators. Neither did any Sef operator deny themselves the short term profit motive over creating a better, fair and more orderly market.

That’s what you get when regulators call for competition over cooperation, whether by design or unintentionally:

  •         Favour overall risk management and transparency over multiple non-integrated single dealer liquidity pools. Arguments about single dealer markets eliminating single points of failure ring hollow in the face of resilient federated networks, clouds of redundant computer power and multi-location fall-over data centers
  •          Think about the possibilities of multiple trading platforms (really trading and market making algorithms) co-located  and competing  for executions around a single data pool  of real-time orders or quotes, or both – single only in concept as in joined data sets, not in physical proximity
  •          Consider the possibilities of starting up new swaps trading markets (swaps minis) or new products (consumer mortgage swaps) with a global population of Internet traders where market enthusiasm for new products is built up through social networking (goes viral as they say!)
  •          When dealers break away from sponsoring market places to specialised groups of traders or investors, and think more about broad liquid markets that come from many trading points of contact, the resilience and value of centralised markets across level-playing-field infrastructure will become apparent.
  •          If the OTC derivatives world is being shoved onto electronic trading platforms, let it think about embracing more innovative products that can be enabled by technology. Think of the innovations of S&P E-mini contracts and S&P ETFs and the increased liquidity that it brought to what had been an institutional market of trading the S&P 500 stocks in large denomination baskets.
  •          Single or multiple dealer markets, whether connected together in low-speed or high-speed no-latency communication lines, only perpetuates time and price arbitrage, even information and regulatory arbitrage. Such markets are not what liquid, transparent, fair and orderly markets are all about. Rather it is all about a time- and space-agnostic level playing field that, absence industry cooperation only regulators can bring to the table via regulatory compulsion.
  •          In a global world of anytime, anywhere, anyplace, and anyhow trading technology, protecting a product concept around a set of loyal clients is like trying to hold onto customers who always bought what you had to sell, but who now know that others sell it as well, delivered as efficiently and  perhaps even more cheaply.
  •          OTC derivatives dealers can join in demanding global regulators set level playing field rules in an infrastructure rebuild. Alternatively they can stay singularly focused in winning share of market until the end, perhaps until the next and last bonus pool day. To quote the Iosco report on promoting centralised OTC market trading structures:

 “The task force recognises that, if some jurisdictions choose to establish requirements that give effect to all eight characteristics (the eighth being ‘The opportunity for platform participants to seek liquidity and trade with multiple liquidity providers within a centralised system’) while other jurisdictions do not, the resulting regulatory disparities have the potential to influence market participants’ choice of venues in which to conduct business”<2>


To Summarise


“The difficulty lies not so much in developing new ideas as in escaping old ones”
                                                — John Maynard Keynes


The Author

Allan Grody is the president of Financial intergroup Holdings. He can be reached in New York at 917 414 3608,

Additional information is available on or at by clicking on Research.

<2> The Task Force notes the G-20 Leaders? recognition of the importance of “implement global standards consistently in a way that ensures a level playing field and avoids fragmentation of markets, protectionism, and regulatory arbitrage.” Statement No. 12, Leaders’ Statement: The Pittsburgh Summit (September 24 – 25, 2009),