As the EU considers changes to its Markets in Financial Instruments Directive and regulation (MIFID II/MIFIR), new ISDA research on derivatives trading in the region shows some interesting trends.
Importantly, it confirms the post-crisis commitment of the Group-of-20 nations to move standardized over-the-counter derivatives to electronic trading platforms or exchanges where appropriate has largely been achieved in the EU.
According to ISDA analysis, about 64% of total interest rate derivatives (IRD) traded notional reported in the EU in the fourth quarter of 2021 was executed on trading venues (TVs) – that’s higher than the 57.4% of IRD traded on swap execution facilities in the US. Significantly, EU participants are choosing to execute on TVs even when they don’t have to: just 44% of the total $6.3 trillion executed on TVs in the EU was subject to the derivatives trading obligation.
In comparison, a much smaller proportion – 27.9% of total IRD reported in the EU – was executed by liquidity providers known as systematic internalizers (SIs). These trades are typically highly customized to meet the specific hedging needs of individual counterparties and tend to be larger in size than the more standardized transactions executed on TVs.
According to the ISDA analysis, about half the fixed-for-floating interest rate swaps (IRS) executed by SIs in the fourth quarter of 2021 had non-standard features, including settlement currency, tenor and floating leg reference index. Average size of fixed-for-floating IRS executed by SIs was $97.4 million versus $73 million on TVs.
This data underscores the importance of the waivers and deferrals from pre- and post-trade transparency requirements under MIFID II/MIFIR, particularly for SIs. These entities use their own balance sheets to facilitate customer trades, so they rely on the waivers and deferrals to avoid the risk that other market participants will use the disclosed trade information to take positions at their expense before they can hedge the exposure. Most important of these is the size-specific-to-the-instrument (SSTI) threshold, which gives SIs the comfort to offer customized hedges in large size to EU firms at a competitive price.
As part of the review of MIFID II/MIFIR, EU legislators are currently discussing revisions to the pre- and post-trade transparency regime. The most recent proposals include scrapping the pre-trade transparency regime for non-equity instruments, including derivatives executed on request-for-quote and voice systems (the trading protocols typically used for derivatives), and a change to the post-trade deferral rules. We think the former is a positive step – end users gain little benefit from the pre-trade disclosure of quotes that are tailored to the specifics of each trade, the credit risk of the counterparty and other idiosyncratic factors. This is also in line with the approach favored by UK regulators.
The proposed changes to the post-trade deferrals regime are more problematic, however. The European Commission had proposed ditching the post-trade SSTI threshold and cut the deferral period to a maximum of two weeks. This deferral period would apply to volume reporting only – price information would have to be reported by the end of the trading day. The more recent iterations of the MIFIR text, following discussions among EU member states presided over by France in the first half of 2022, have barely eased the concerns of liquidity providers in the derivatives market over the length of deferrals. There is an acknowledgement that the discussion on deferrals has focused on bonds, with little consideration of the appropriate approach for derivatives.
We think the post-trade framework should be more flexible, with a variety of deferral periods based on a more granular determination of the size and liquidity profile of the derivative. Making the deferral period too short will expose liquidity providers, particularly SIs, to undue risk that would need to be reflected in the price offered to end users, reducing the competitiveness of EU capital markets.
Liquidity providers need adequate time to hedge the risks they assume in facilitating client hedging. As ISDA data shows, the majority of derivatives in the EU are executed on TVs. The smaller proportion executed by SIs are less liquid, larger in size and more customized. It’s important the EU transparency regime recognizes these nuances and ensures the deferrals regime gives liquidity providers the scope to offer optimal pricing to clients, whether trading on venue or with SIs.
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