Saturday, February 19, 2011

IOSCO Report on OTC Derivatives Trading Platforms Emphasizes Full Transparency

IOSCO has issued a report analyzing the benefits, costs, and challenges associated with increasing exchange and electronic trading of OTC derivative products, with recommendations to assist the transition of trading in standardized derivatives products from OTC venues onto exchanges and electronic trading platforms, while preserving the efficacy of those transactions for counterparties. The Task Force that produced the report was led by the SEC, the CFTC, and the UK FSA.

The report concludes that it is appropriate to trade standardized derivatives contracts with a suitable degree of liquidity on organized platforms, and that a flexible approach to defining what constitutes an organized platform for derivatives trading would maximize the number of standardized derivative products that can be appropriately traded on these venues. It identifies characteristics that an organized platform should exhibit in order to fulfill the G-20 Leaders’ objectives, as well as the benefits and costs associated with transitioning trading of derivatives from OTC venues onto organized platforms. It also presents a range of actions that regulators may choose to take to increase organized platform trading of OTC derivatives products.

This report provides regulators, regardless of the state of development of their derivatives markets, with an analytical tool that can inform their current and future efforts at addressing the trading of derivatives on organized platforms, and a range of actions which they can take to facilitate this.

Assuming that product standardization has increased, that central clearing is used for OTC derivatives suitable for clearing, and significant data on OTC derivatives is reported to trade repositories, the report identifies a number of benefits that can result from organized platform and mitigate systemic risk and protect against market abuse in the derivatives market. For example, there could be greater pre- and post-trade transparency, increased market competition, deep liquidity, and improved market surveillance.

In the context of trading platform regulation, platform operators are generally expected to operate in the front line to promote clean markets through market monitoring activities. This is reflected in the IOSCO Principles, which specify that there must be mechanisms in place to identify and address disorderly trading conditions and to ensure that contravening conduct when detected will be dealt with.
Under the European Commission’s MiFID proposals, the monitoring of all trading taking place on the facility with a view to identifying conduct involving market abuse would be a minimum characteristic of organized trading facilities. Similarly, a common theme of platform regulation under the Dodd-Frank Act is that the platform is obliged to monitor trading to prevent manipulation.

IOSCO notes that organized platforms can also facilitate post-trade transparency for products traded on such platforms since the same mechanisms used to match trading interest and establish terms of a trade can allow for wide dissemination of information about the trade. However, post-trade transparency may not be dependent on trading on organized platforms. For example, the Dodd-Frank Act requires post-trade transparency for derivatives transactions executed on trading platforms as well as OTC. Similarly, EU draft legislation provides for a post-trade transparency regime by type of derivative, rather than execution venue. This could result in real-time or near real-time post-trade transparency with appropriate deferrals, such as for large trades. Thus, IOSCO concludes that organized platforms would be one source of post-trade transparency.

The G-20 has stated that OTC derivatives contracts should be reported to trade repositories so that such data would be accessible by market regulators in order to review overall OTC derivatives activity, or a portion of it, based on counterparty or otherwise. Some information on OTC derivatives activity would also be made available to the public. The Dodd-Frank Act and EU legislation, and comparable initiatives in other jurisdictions, are expected to obligate market participants to report their derivatives trades to trade repositories and provide for oversight of those repositories.

The report notes that some trade repositories may be able, over time, to provide a post-trade transparency or a surveillance function. However, the IOSCO analysis has not taken into account any resulting benefits and costs from such functions because the repositories are not expected, at least initially, to have functionality beyond their core repository function and issues remain over whether that functionality could or should be extended.

IOSCO emphasized that an organized platform must have good governance and manage conflicts of interest. In many jurisdictions, obligations are placed on platform operators to identify, mitigate and manage potential conflicts of interest. The nature and scale of the potential conflicts of interest that a platform operator might face can differ according to the nature of the platform, including whether the operator is a trading participant, requiring different arrangements to ensure that regulatory standards are met. Specifically, if the platform operator is also a participant more robust conflicts of interest arrangements should be adopted.

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