OTC automation could spur cross-asset crashes

12 December 2011

Dr Richard Bentley,
Industry Vice President,
Banking & Capital Markets

Regulators in Europe and the US are grappling with how to make over the counter (OTC) markets more transparent and easier to monitor. Automation is the key and the mandated use of swaps execution facilities (SEFs) and central counterparty clearing houses (CCPs) will revolutionise OTC derivatives trading. They will also enable them to be traded electronically. This, in turn, could lead to the increased risk of a massive cross-asset class "splash crash" with contagion reaching into the swaps markets.

Electronic trading was born on 27 October 1986, when the ‘Big Bang’ in London took place. Equities and futures trading moved from exchange floor to screens, opening the door to cross-border trading for the masses. Today it is hard to imagine that equities and futures were ever not automated, so smoothly do they flow around the world.

But there is still a rather large elephant in the automated trading room - OTC derivatives. OTC derivatives trading continues to grow; the latest figures from the Bank for International Settlements (BIS) puts notional amounts of outstanding OTC derivatives at nearly $708 trillion for the first half 2011 (1). This is an 18 per cent increase over the same period last year, making the elephant an ever-growing concern.

New regulations mandate making OTC markets more transparent and easier to monitor. In principle the answer is automation, but in practice it is tricky. Derivatives are necessarily complicated in structure, often bespoke or customised for one client. Most OTC derivatives – like credit defaults swaps and interest rate swaps – are traded bilaterally between banks or sold by banks to other corporate businesses as hedging tools. Profit margins are generally high because of the lack of transparency, which means the financial industry is fighting against automation.

Dodd-Frank and MiFID

The EU Markets in Financial Instruments Directive (MiFID II) and the US Dodd-Frank Act both call for regulating OTC derivatives. In the US the Dodd-Frank Act wants OTC swaps to be cleared in order to increase transparency, liquidity and efficiency, and to decrease systemic risk. Rules defining how derivatives will trade and be centrally cleared under the Dodd Frank Act are currently being written by the US Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). SEFs are defined as trading systems or platforms where multiple participants can make bids, offers and trades.

MiFID II's Markets in Financial Regulation section (MiFIR) will require central clearing houses (CCPs) to clear financial instruments. CCPs are mandated to be non-discriminatory and transparent, regardless of the trading venue on which a transaction was executed. This would enable independent trading platforms access to existing CCPs that are currently vertically integrated via exchanges. Rules regarding SEFs are expected to be defined early next year, while MiFIR will likely not come to the implementation stage before 2015.

Enter the algos

Just like Reg NMS and MiFID I cleared the path for multiple trading venues in equities and futures markets, Dodd-Frank and MiFIR lay the groundwork for the same thing in OTC derivatives. As SEFs and CCPs proliferate so does the opportunity for arbitrage. Traders will need smart order routing plus the ability to aggregate trading venues and customise pricing strategies. Enter the algorithms; and where there are algorithms there will be high frequency trading.

HFT provides market benefits such as liquidity and tighter spreads but, as we discovered after the 6 May flash crash, it can also cause excessive volatility. If a flash crash can spread across asset classes from equities to futures to OTC derivatives, the potential for damage becomes exponentially greater. High speed trading requires high speed controls. Monitoring and surveillance are crucial to avoiding a cross-asset flash crash, and for preventing market abuse. No matter what the asset class.

Luckily there are responsive and intelligent algorithms available that can sense and react instantaneously to market anomalies and anticipate interruptions to liquidity. These rapid response algorithms could help to prevent a splash crash by alerting risk managers of impending issues, or by changing trading strategies to accommodate market glitches.

On top of smarter algos, there are a few other splash crash prevention measures:

- Diligent backtesting – using historic data and realistic simulation to ensure many possible scenarios have been accounted for. A backtesting process needs to be streamlined– as getting new algos to market quickly is key.
- Real-time risk monitoring - just as a network firewall stops anomalous network packets reaching your computer, so a risk firewall could stop anomalous trades from getting to market.
- Real-time market surveillance - even if trades do not breach risk parameters, they may breach compliance rules, regulations or may be perceived as market manipulation by a regulator.

Everyone needs to be proactive in using the correct tools to monitor algorithmic trading. Sensing and responding to market patterns before the aberrations or errors have a chance to move prices is the right thing to do - in all asset classes. The detection of abusive patterns must happen in real-time, before any suspicious behaviour has a chance to move the market. This approach should be taken on board not just by the regulators, but by the industry as a whole.

1. OTC derivatives market activity in the first half of 2011

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