Commodity brokers, facing a loss of business from a shift of derivatives trading onto exchanges, are seeking a reprieve under European proposals letting them maintain control of less transparent niche markets.
Energy derivatives that don’t trade continuously, such as swaps and options in Dated Brent crude and carbon permits, should be treated differently than other asset classes such as equities, Alex McDonald, chief executive of the London Energy Brokers’ Association, said in an interview last month. Rules being considered by European lawmakers will help determine which contracts are traded through Organized Trading Facilities, or OTFs, where brokers wouldn’t need to disclose bids and offers.
The global credit freeze and record oil prices of 2008 prompted regulators around the world to shift more trade onto exchanges such as ICE Futures Europe in London and Nord Pool ASA in Oslo, increasing transparency. The rules for OTFs would allow brokers including GFI Group Inc. to retain trades that might have moved to the more-regulated markets. The exchanges oppose this, saying they’ll be shut out of the $2.6 trillion non-exchange commodity derivatives business.
“In markets where trading is not continuous, one-size-fits-all solutions don’t work,” said Matt Woodhams, London-based head of eCommerce at GFI Group, a brokerage headquartered in New York that employs 1,300 people. “Not giving discretionary powers to OTFs could jeopardize the existence of these markets.”
As the rules stand, derivatives contracts, including those for energy, will be divided across three categories and traded on different platforms depending on how active, or liquid they are, according to proposed amendments to the EU’s Markets in Financial Instruments Directive, or MiFID. EU legislators have yet to detail the rules.
MiFID is intended to bring bilateral over-the-counter derivatives trading onto transparent platforms that require data disclosure both before and after the trade takes place. Part of this regulatory push creates the new category of trading venue, OTFs, used by inter-dealer brokers such as ICAP Plc and Tullett Prebon Plc. OTFs are needed most in markets where trading is sporadic, brokers say.
Brokers Will Switch
“There simply isn’t this stack of bids and offers in all energy derivative or forward contracts,” said McDonald, who is also the chief executive of London-based Wholesale Markets Brokers’ Association representing inter-dealer brokers across 30 countries.
Contracts may also be traded through two other types of venue: exchanges and so-called multilateral trading facilities, or MTFs, where pre-trade disclosure is required. Brokers, which also operate in interest rate, credit, equity and foreign exchange markets, already operate about 35 MTFs, according to the WMBA. There are 146 listed on the website of the European Securities and Markets Authority, a Paris-based financial markets regulator for the EU, including Nasdaq OMX, JPMorgan Cazenove and NYSE Euronext.
The value of the commodity derivatives market was $2.6 trillion at the end of June 2011, according to data from 60 banks in the G-10 countries plus Switzerland compiled by the Bank for International Settlements, based in Brussels.
What would distinguish OTFs from MTFs is less pre-trade transparency, which the exchanges see as creating an uneven playing field. “Certain venue operators will change their multilateral trading facility license to an OTF license as this trading venue will be subject to lighter rules,” the Federation of European Securities Exchanges, a lobby group representing 46 bourses including ICE Futures Europe, said in a response to an official questionnaire from Markus Ferber, German lawmaker and the European Parliament’s lead negotiator on MiFID.
Trading screens would need to be adjusted for any OTF requirements, Dan Smith, head of corporate development at Trayport Ltd., whose software acts as an aggregator of energy broker prices, said in an e-mail on March 6. “From a trader’s perspective they should notice little difference, they will use the same screen as today, in the same way.”
Energy companies that are producers or suppliers of energy argue that they are trading derivatives to manage commercial risk and, as such, shouldn’t be subject to MiFID rules.
Vattenfall AB, Sweden’s biggest utility, says physically-settled derivatives contracts should be exempt.
‘Brokers Will Switch’
The OTF category “could have significant impacts on liquidity of the energy wholesale market,” Vattenfall, said in a corporate response to the consultation led by Ferber. “Physically-settled products will have to comply with burdensome and unnecessary rules, possibly leading to less trading activity in these products.”
MiFID is being debated in the European Parliament.
“OTFs are likely to be one sticking point,” Ferber said by telephone from Brussels on March 5. If the rules are agreed on in their current form, brokers will switch their MTFs into OTFs, limiting any improvements in transparency, he said.
“We are discussing if non-equity derivatives will be separated out onto OTFs,” he said.
The European Parliament’s economics committee plans to vote on the MiFID proposals before July, followed by a full parliament vote in September, Ferber said. Discussions are also going on in the European Council. The European Commission said it expects political agreement to be reached by the end of this year.
“The creation of the OTF does potentially bring in new competition,” said Adam Jacobs, an assistant director in charge of EU regulation at the International Swaps and Derivatives Association. “It potentially changes the landscape.” ISDA based in New York represents 818 companies trading over-the-counter derivatives.
Regulators are under pressure from policy makers to show they have better control over behavior in financial markets, including energy and commodity trading which until recently enjoyed exemptions from MiFID. The bloc’s regulator proposed on Oct. 20 that the rules should extend to energy and commodities as well.
WMBA’s McDonald said he rejects an assertion by the exchange lobby, FESE, that OTFs will encourage so-called dark-pool markets at the expense of more transparent ones. FESE, the Brussels-based exchange lobby, will hold a briefing on OTFs with journalists in London on March 26.
“We would say quite the opposite; when combined with clearing, multilateral platforms such as OTFs will facilitate an evolution away from purely bilateral markets,” McDonald said.
Regulators probably will need to indicate which contracts will be eligible to be arranged on the OTFs, McDonald said. As with other EU rules on clearing, “I think it will get quite granular” as the ESMA stipulates which of the products offered by the platforms should be traded where. Most contracts deemed eligible for an OTF will have waivers from ESMA for some pre-trade transparency rules, he said.
Making it the responsibility of an EU-level body like ESMA to decide the necessary levels of pre-trade transparency will allow for a consistent application of the rules, ISDA’s Jacobs said. “Determining the level of pre-trade disclosure for these contracts is one of the big challenges for regulators,” he said.