The LMAX Exchange report Restoring Trust in Global FX Markets notes that OTFs are the latest venue to introduce elements of exchange-style trading into the traditional over-the-counter (OTC) model, pushing less liquid FX products – such as non-deliverable forwards and FX swaps – onto regulated trading facilities with centralized clearing and reporting.
The OTF essentially captures intermediated voice-based trading and ensures a largely level playing field in terms of transparency, access and reporting requirements across different modes of execution, observes Ben Pott, head of European regulatory affairs at Icap.
“The defining element of an OTF is the discretion that the system operator exercises in bringing about the execution of the trade – either discretion in placing an order or discretion in matching a set of orders,” he explains.
“Fundamental to that discretion is human interaction, which differentiates an OTF from an MTF or a regulated market.”
Cordium managing consultant Jonathan Wilson notes that OTFs are permitted to exercise discretion when deciding to place or retract an order on their venue and when deciding not to match a specific client order with other orders available at a given time, provided it is in compliance with specific instructions received from a client and with its best-execution obligations.
According to Dan Marcus, global head of strategy and business development at Tradition, greater clarity has emerged over recent months as to how OTFs will be implemented and the impact this will have on FX market participants.
“The new rules increase pre- and post-trade transparency in line with current standards adopted by MTF venues and require derivatives subject to mandatory EMIR clearing to be traded on at least one venue,” he says.
“One of the primary differences between an MTF and an OTF is the ability for the latter to utilize discretion in line with Financial Conduct Authority business conduct rules. In exercising discretion, OTF operators must be able to demonstrate objective proof of best execution under Article 27 of Mifid.”
Cordium’s Wilson observes that Mifid II puts in place measures designed to ensure the OTF operator remains neutral, including trade transparency obligations and access requirements which are broadly equivalent to those of an MTF.
“Regulators will be monitoring this area closely so I think we should expect to see transparency,” says Greenwich Associates market structure analyst Richard Johnson, while Javier Paz, an analyst at Aite Group, adds that there is confidence in the market that OTF will represent a more realistic and transparent version of trading than what takes place in an OTC setting.
When asked for an indication as to whether a sufficient number of operators will build OTFs given the cost of developing new platforms, Paz suggests there will be firms that will register as OTFs so as not to lose out on the type of trading encouraged by Mifid II.
“Most likely they will register in the UK unless Brexit becomes a reality, in which case mainland Europe applications could begin to emerge, probably based in Frankfurt,” he says.
“In practice, these entities will have scant traction until OTC participants have no other choice but to trade in either a regulated market, an MTF or an OTF.”
Pott confirms that Icap will build an OTF alongside its existing suite of MTFs, and Alex McDonald, CEO of the Wholesale Markets Brokers’ Association, says a number of his members intend to build out OTFs.
According to McDonald, the fact they don’t need to be set up as separately capitalized and staffed legal organizations means they can be established relatively inexpensively. “In addition, conduct of business rules are not onerous compared to the normal business of broking,” he says.
However, Greenwich Associates’ Johnson adds that while there are vendors who can provide the necessary technology, market participants will be cognisant of the experience of SEFs in the US. “Many operators rushed to build swap execution facilities after Dodd-Frank, but the uptake by the market has been lower than expected,” he concludes.