European transparency rules for over-the-counter derivatives have given regulators a Gordian knot of a problem: how to make sure firms understand when their off-venue trades must be publicly disclosed?

And just as, according to legend, Alexander the Great simply cut through the intricate knot, rather than try to untie it, the European Securities and Markets Authority has come up with a bold solution. Rather than try to clarify a fuzzy concept that currently governs reporting obligations, it wants to just do away with it and start requiring large dealers to publish details of all of their swaps trades.

But some market participants doubt this new approach will win Esma the prize of greater transparency, as it will simply increase the quantity of trade data without improving its quality.

“I don’t think it helps to just provide the marketplace with even more data if you’ve got fundamental problems already, in terms of the identification of derivatives and the data not being useful,” says Matthew Coupe, director of market structure at Barclays. As a so-called systematic internalizer (SI), the bank will have to disclose more of its OTC derivatives trades if Esma’s plan goes ahead.

“It is squashing more data in there without hitting the objective,” Coupe adds.

Others oppose Esma’s proposal for a different reason: they worry that other firms could use the newly available information to trade against them.

The proposal is one of a number of recommendations for the European Commission, detailed in a March 30 final report, on amendments to the reporting requirements of the second Markets in Financial Instruments Directive. Firms regulated under Mifid II must disclose the price and volume of certain trades to the public, as well as further details to regulators.

As part of its recommendations, Esma suggests removing the obligation to report publicly on off-venue OTC derivatives trades if they have “the same reference data details” as the derivatives traded on a trading venue—that is, transactions captured by the somewhat counterintuitive “traded on a trading venue” (TOTV) concept. Instead, Esma proposes that SIs—dealers that trade large amounts outside of a venue—disclose all relevant OTC derivatives transactions.

This means that firms that are SIs in a given derivatives product would have to report transactions undertaken in any derivatives belonging to the same sub-asset class. For example, a bank that regularly internalizes substantial amounts of fixed-to-float cross-currency US dollar/euro 10-year swaps would have to disclose all fixed-to-float cross-currency swaps, regardless of their currencies and maturities.

The European Commission tells WatersTechnology’s sibling publication Risk.net: “We are currently engaged in a cross-cutting impact assessment on how to improve the trading experience in the [European] Union’s equity, bonds and derivatives markets. The Esma recommendations will certainly feed into that review.” 

It’s raining Isins

Many dealers chime with Coupe at Barclays, arguing that issues with existing post-trade data need to be fixed before the scope of the reporting rules is expanded.

One quirk that has made public trade details hard to use is a proliferation of International Securities Identification Numbers, or Isins—unique codes that must be used under Mifid II to identify various OTC derivatives.

Users of the data and others in the industry say multiple Isins are often used for the same instruments. There are several reasons for this but one in particular has long been a source of complaints: interest rate swaps with different maturities are given different Isins, whereas market participants say the tenor is more relevant for these instruments. The result is interest rate swaps are issued with a new Isin every day.

This means an investor looking for price data on, say, five-year fixed-to-float euro-denominated swaps has to search for it by multiple Isins and then aggregate the prices, as opposed to building an overall picture from a single Isin.

Although Amir Khwaja, chief executive of data vendor Clarus Financial Technology, supports Esma’s proposal, he too acknowledges the challenge posed by mushrooming Isins.

“We can solve it, but it adds costs and unnecessary work because you have to access a database with 56 million Isins to write code to decipher the Isins into something meaningful,” he says, referring to the total number of Isins generated to date.

Even if post-trade data on OTC derivatives were made easier to use, publishing more of it as Esma suggests would not necessarily improve transparency, dealers say. That is because many of the additional trades that would then be caught are bespoke.

Coupe at Barclays argues these trades do not affect the prices of any other derivatives.

“I don’t think this data is actually usable or relevant for the end-investor,” he says. “There is customization in these bespoke agreements, which doesn’t make it price-forming or help the end-investor understand what is going on in the marketplace.”

A regulatory policy expert at a European investment bank that also runs an SI in derivatives agrees, saying prices for bespoke OTC derivatives are affected by a variety of factors, such as the probability of the client not being able to make contractual payments.

Isins that correspond to few trades in practice, Khwaja adds, make it harder to make sense of aggregate Isin data.

“The vast majority of those [existing] Isins—possibly more than 80%—will have one or no trades,” he says. Some instruments are created for a single trade and others are created but not traded for a while, if ever.

Deciphering post-trade data would become even more difficult if details of more customized derivatives started feeding into it.

“If you are applying the generation of Isins to all bespoke products, then you will have the generation of more Isins for products that are traded once,” says Benoit Gourisse, a senior director of European public policy at the International Swaps and Derivatives Association.

No peeking

While the merits of mandating greater disclosure are debatable, some market participants fear actual harm from the change.

Two non-financial corporations say Esma’s proposal means more of their trades with banks would be revealed to the public. As derivatives trades involving corporates are typically customized, they tend to fall outside of the current scope of the post-trade transparency rules.

A financial risk management executive at one of the two companies explains that the newly available information could be used against it by more sophisticated players.

He gives the example of derivatives activity in the lead-up to a cross-border corporate acquisition. To build up the requisite holdings of an illiquid currency, a corporate often has to conduct multiple large trades in OTC foreign exchange derivatives over a period of time—sometimes a month. If post-trade data on these transactions were published, other investors might anticipate further such trades and move the price of the currency against the corporate before it returns to the market.

“In those times of unusual events, I feel the transparency the regulator is looking for could have a harm on our activity,” says the risk management executive, adding that another example would involve illiquid commodity derivatives, such as those based on rhodium. “Normal activity won’t be affected but in extraordinary [cases] I could definitely see it happening.”

The regulatory policy expert at the European investment bank shares this concern, saying that other market participants could use the new information to spot a position the bank needed to exit or hedge.

In those times of unusual events, I feel the transparency the regulator is looking for could have a harm on our activity

Financial risk management executive at a non-financial corporation

Coupe at Barclays agrees with the logic of the argument, though he says that for now Mifid II data is unlikely to be exploited in this way given its underlying problems.

“The data isn’t being used [at all],” Coupe says.

Damaging pre-emptive action by other investors will be more of a risk if the quality of the data is improved in the future, he adds.

Fear of such actions is compounded by worries over another possible legislative change, recommended by Esma in a separate final report in September.

In the example of the cross-border acquisition, the buyer would benefit from a delayed disclosure of its trades, and currently the publication of the price and volume of a large or illiquid trade can be deferred by up to four weeks in many EU jurisdictions. But in the September report Esma suggested that the delay should be shortened to two weeks for volume data and that all prices should be published in real time.

The corporate risk management executive says: “Those kinds of amounts for large acquisitions you don’t do it in a fortnight, it takes definitely longer.”

The second company that spoke to Risk.net has come up with a simple solution. A corporate treasurer there says the company is lobbying regulators to exempt trades that involve bespoke OTC derivatives and are executed for corporate hedging from post-trade transparency requirements.

Eyes on the prize

Reactions to Esma’s March proposal have not all been doom and gloom.

Buy-side groups and non-bank market-makers had criticized the murky TOTV concept, saying it left room for different interpretations by different firms and could be leading to many trades that should be disclosed slipping through the net.

“We’re pleased to see that Esma is running with our suggestion that all OTC derivatives trades involving SIs should be subject to post-trade reporting,” says Adam Jacobs-Dean at hedge fund lobby group the Alternative Investment Management Association. “We’ve made the point a number of times that the concept of TOTV isn’t working properly when it comes to having a meaningful amount of trading in OTC derivatives markets being subject to post-trade reporting.”

As a result of the Esma recommendation, buy-side firms and smaller dealers would also become exempt from the post-trade transparency rules for OTC derivatives, as the obligation to report would now apply only to SIs.

Saxo Bank, which would benefit from the exemption, welcomes the tweak. Gary Chia-Hsing Li, head of regulatory affairs at the bank, says extending the reporting requirement to all relevant OTC derivatives trades would impose more work on reporting firms, which would be justified only for SIs.

“They are big enough to affect the market,” he explains.

The European Commission have a strong wish to build a consolidated tape … They want to create a consolidated tape for everything—that is the final goal

Gary Chia-Hsing Li, Saxo Bank

Further down the line, Jacobs-Dean sees another gain from a greater amount of derivatives trading data: he says it could help create a consolidated tape. Investors could monitor this stream of the latest prices and volumes to see whether they can obtain better quotes than those offered by their dealers and where such quotes are available.

The European Commission has not yet committed to creating a consolidated tape in derivatives, though it is planning to push ahead with a tape in equities and bonds.

“At the moment, a derivatives consolidated tape is quite low on the agenda,” says Gourisse at Isda. “In October 2020, the European Commission published a report on the feasibility of the consolidated tape, and the report only focuses on equity and bonds. So it may come in the future but not in the short term.”

Li of Saxo Bank echoes that.

“The European Commission have a strong wish to build a consolidated tape similar to the US [one],” he says. “They want to create a consolidated tape for everything—that is the final goal—but they are starting simple with equity.”

The regulatory policy expert at the European investment bank would welcome a consolidated tape for standardized OTC derivatives but not for bespoke OTC derivatives where terms vary significantly.

A usable consolidated tape, though, will require not only more trading data but better data too. So in pushing for a higher quality and a bigger quantity of public information, big banks and the buy side seem to be working towards the same ultimate goal.

Editing by Olesya Dmitracova