Buy-side technology

Post-crisis reform of the over-the-counter derivatives market can be boiled down to a single bet: regulators have decided to swap product complexity for structural complexity. Bilateral trades will be replaced by transactions involving executing counterparties, swap execution facilities, clearing members, clearing houses and data repositories.

There’s an emerging narrative about what this means: a combination of electronic trading and clearing will encourage more standardised OTC trades and, possibly, smaller ticket sizes; competition between venues will result in some fragmentation; bid/offer spreads will be compressed, and dealers will find it harder to compete on price.

It is not too soon, however, to look a step or two beyond that. If dealers are going to find it harder to compete on price, they will need to find some other way to stand out from the crowd – many already expect a suite of OTC trading algorithms to be a key part of their post-reform offering. And if the execution space is going to fragment, splitting liquidity along with it, there will be demand for aggregation services to knit it back together. Again, some dealers are already working on this.

So far, so good, but there are scarier possibilities, too: encouraging the bulk of the OTC market to be electronically traded also means opening the door to high-frequency trading (HFT). With it, say critics, comes the threat of a flash crash that would dwarf the collapse seen in the Dow Jones Industrial Average in May 2010.

Many argue that HFT had nothing to do with the flash crash – or suggest OTC markets would prove more resilient than stocks to a sudden, irrational collapse. Some say more efficient markets are worth the occasional rollercoaster ride. It’s hard to know who will be proved right – but it is worth thinking about the tail risks associated with regulators’ big bet on structural change.

Further reading

• Technology

All together now: the tech challenges of Sef aggregation

• 06 Sep 2011

• Trading platforms

Reforms could force OTC markets to embrace trading algorithms

• 05 Sep 2011

• Exchanges

OTC flash crash: Dealers consider risks of HFT invasion

• 06 Sep 2011