Derivatives at the dawn of MiFID II: Do the challenges also hold opportunities?

In an age when any investor can trade stocks and bonds electronically via a smartphone app or web portal, it surprises many that the trade settlement process – the behind-the-scenes matching and reconciliation processes necessary to complete a transaction – still includes manual processing and can take up to three days to complete.

Even more surprisingly, many of the trade execution steps occur in a black box, out of the view of investors, regulators and even the financial institutions handling the trades.

However, the days of this antiquated trading process are numbered. The potential dangers that lurk in this black box became obvious in the 2008 global financial crisis, prompting the birth of Dodd Frank in the US and the inception of the Markets in Financial Instruments Directive, aka MiFID II, in the European Union (EU).

The impact on derivatives trading

But if the dangers associated with traditional stock and bond trades are so severe, how dire are the potential consequences of trading non-traditional and very high value instruments, such as over-the-counter (OTC) derivatives?

The majority of OTC derivatives are still traded offline in a dark corner of the black box – the asset class has started trading electronically in the US via Swap Execution Facilities (SEFs), but the rest of the world is just starting to enter the electronic trading age via new markets such as “organised trading facilities” (OTF).

This shift to electronic trading has been front of mind as EU regulators have debated MiFID II. Despite the recent delay in its implementation to January 2018, derivatives traders are paying close attention to the new regulations coming down the pipe.

MiFID II will require the trade execution black box to be broken open across markets and asset classes – including derivatives – with enhanced trade transparency via real-time trading, clearing and reporting becoming mandatory rather than a “nice to have”.

Real-time reporting – cost burden or advantage?

The benefits of real-time reporting of derivatives trading activities are clear from a regulatory perspective. It will enhance insight to derivative and margin positions and facilitate compliance across many areas.

These benefits, however, come with potentially massive costs for buy- and sell-side financial institutions. Indeed, virtually none of the current platforms employed by these companies can deliver real-time clearing and settlement – most can only report data at the end of the trading day and some not until the next morning!

While financial institutions with a US presence are likely closer to meeting the requirements of MiFID II due to the need to comply with Dodd Frank, most other securities firms worldwide will need to undertake expensive updates of their middle- and back-office infrastructures to enable real-time trade settlement.

However, the advent of real-time reporting will also deliver new business opportunities and potentially significant cost savings to these same financial institutions. By dragging non-traditional asset classes such as derivatives out of the black box and into the electronic trading age, MiFID II is likely to drive a significant increase in trading volume, boosting market liquidity for the buy side and enabling brokers to collect additional commissions and fees.

At the same time, real-time clearing and settlement will enable potentially significant savings by facilitating efficient capital management, particularly in terms of margin requirements for derivative positions, and simplifying regulatory compliance.

Meeting the cost challenge

Where individual financial institutions will fall on the spectrum of cost of compliance with MiFID II regulations versus advantages has yet to be seen.

Smaller firms with limited resources may ultimately have to exit some asset classes due to the upfront cost of upgrading trade infrastructure to enable real-time reporting. Larger companies with deeper pockets, on the other hand, should be better positioned to meet the cost burden of compliance with MiFID II.

However, all of these firms might want to think twice before initiating complex and costly infrastructure upgrade projects. Indeed, the advent of distributed computing and leaps forward in cybersecurity mean that financial institutions – both large and small – no longer have to pay upfront for trade infrastructure that may become quickly out-dated due to constant regulatory changes, the emergence of new products and technologies, or increases/decreases in their own trading volumes.

Firms may also want to consider a multi-tenant managed services model for trading and clearing infrastructure. For smaller firms, this has the advantage of avoiding potentially crippling upfront facility investments, by implementing a solution that delivers real-time capability across asset classes, essentially making them MiFID II-compliant overnight.

Larger firms can also derive significant benefits from the managed services approach. In addition to dramatically cutting upfront infrastructure investment costs, the scalability of the model eliminates the need to maintain large in-house IT systems that are under-utilised much of the time.

Getting ahead of the curve

Many financial firms were already pushing the limits of antiquated in-house trade infrastructure before Dodd Frank and MiFID II. As the latter’s January 2018 implementation date approaches, the requirement to deliver real-time trade information means that these legacy systems can no longer be “patched up” to meet the needs of modern electronic trading.

The market continues to echo with protest against the regulatory burden that MiFID II places on securities firms and implementation has been delayed. However, the changes are coming and firms will either have to deliver real-time trade clearing and settlement or exit some asset classes completely.

Those that take the initiative to do so early, whether via costly and complex in-house upgrades or the adoption of a scalable and cost effective managed services solution, have the potential to capture significant derivatives trading market share. Those who do not are only delaying the inevitable.

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