Protecting transparency and liquidity in uncertain times

Following his participation in the 'renewal, rebuilding and rebirth of economies' panel at the recent 58th WFE GA&AM in Athens, Jan Boomaars, CEO, Optiver, writes about the dramatic increase of systematic internalisation and strict capital requirements that are creating an environment that threatens efficient markets in Europe.

With 2018 marking a decade after the financial crisis, it is time to take a hard look at how the present regulatory landscape is affecting the role of exchanges and central counterparty clearing houses (CCPs). This topic is especially important given the developments in Europe as a function of Brexit and new global regulatory requirements.

Since 1602 when the world’s first stock exchange was established in Amsterdam, we as a society have relied on exchanges to facilitate the capital transfer from investors to the real economy. Over centuries, vast improvements to the infrastructure have been made to reduce risk and streamline the process of buying and selling of financial instruments. CCPs were introduced to bring certainty and efficiency to exchanges and participants by taking on credit risk. Out of the need to assure that there is always a buyer and a seller, market makers stepped in to provide continuous pricing and improve the bid-ask spread, notably in the derivatives market. Together these fundamental players make up the present exchange ecosystem.

Markets function best when fair competition amongst trading members and between trading platforms is cultivated through policy. In turn, modern, developed economies benefit from healthy markets.

As part of the financial ecosystem, Optiver has worked with one mission since its founding in 1986: to improve the market. Robust markets are accessible, liquid and comprised of diverse participants. We at Optiver strongly believe that in order for markets to remain efficient and support sustainable growth, they should be transparent, multilateral and centrally cleared.

The last ten years has seen a wave of EU regulatory legislation with the aim of restoring confidence in the industry after the recession. In contrast, what we now witness is the dramatic increase of systematic internalisation and strict capital requirements creating an environment that threatens efficient markets in Europe.

Systematic internalisers (SIs)

Driven by MiFID II, many investment firms have set up new SIs or entities “trading on their own account when executing client orders on a frequent and systematic basis”. Under MiFID II, firms operating as SIs benefit from a substantial advantage where they are exempt from the tick size regime reserved for EU trading venues and have more flexibility in the timing of trade publication.

In a properly functioning exchange ecosystem, the reference price is in the lit market.

To the detriment of transparent, multilateral and centrally cleared markets, the influx of SIs has pushed increased trading volumes towards models with reduced transparency, leading to limited competition and a more fragmented landscape.

ESMA’s Steven Maijoor captured the issue well when in his WFE Annual Meeting speech he asserted that “there are concerns that the attractive environment for trading on systematic internalisers may ultimately result in changes in the market structure away from trading venues.”

Capital restrictions

New capital rules have a significant impact on the exchange ecosystem and how it finances the real economy. Capital rules drafted for banks have made it more costly for clearing members and market makers to hold positions and provide liquidity to end-investors. In a recent letter drafted by Optiver in collaboration with exchanges and competitors to prudential regulators, we highlight how options and futures markets are adversely affected.

Jointly stated, inflated capital requirements imposed by the Leverage Ratio framework are actually bolstering the OTC derivatives markets and “could increase systematic risks as a result of an expected decrease in liquidity at times when markets become volatile and volumes go up”.

Adding to concern, the latest EU prudential regime draft for investment firms proposes that firms hold more capital based on daily trading flow, effectively discouraging liquidity providers from performing trades and hedging at the volume needed for sustainability.

Healthy markets withstand volatility, but capital rules that ignore netting benefits and exclude delta-weighting of option exposures do not.

Moving ahead with disregard for the implications of this combined legislation propagates a challenging environment for new market entrance, ensuring less overall liquidity and a precarious future for the European economy.

Needed change

The legislative focus should move away from overregulation and shift towards long-term, stable growth for EU capital markets.

It is essential to evaluate the unanticipated effects of MiFID II and determine mitigating actions while there is still time to regain strength. It is Optiver’s firm belief that this assessment be made alongside the safeguarding of continued access to UK markets during Brexit negotiations. International competitive forces must also be taken into account to prevent obvious regulatory arbitrage actions. When well more than half of all European trades are executed on London based exchanges, imposing a border between EU and UK financial markets will weaken Europe’s exchange ecosystem. Failing to address this could prompt a chain reaction on a wider scale and contribute to an unbalanced global exchange ecosystem in the years ahead.