Market infrastructure in flux – use of market models (off & on-book) is changing

Electronification and the need for increased transparency and regulatory compliance are driving a shift in market infrastructure. Currently both on-book (CLOB) and off-book (selective RFQ platforms, call around and OTC) models co-exist but their roles are changing as these industry trends alter how market participants use and engage with these market models. Randolf Roth, Member of the Board at Eurex, explores the evolution of this space and specifically how market participants can harness tools and technology to strike a balance between risk and return when trading via both market models.

Growing buy-side demand for efficient electronic execution is driving a shift in market structure in the derivatives space. Many sell-side firms reduced their proprietary derivatives trading as post financial crisis capital requirements rendered it less profitable. This reduction in volumes in the industry is one major driver for the buy-side to look for greater electronic execution in multilateral venues rather than going through one prime broker. Further drivers of buy-side firms’ interest in electronic execution is their need for efficient processes, front to back, to help meet regulators’ expectations around best execution. Furthermore, Phases 5 and 6 of the Uncleared Margin Rules (UMR), which go into effect in 2021 and 2022, will further increase demand for central infrastructures like clearing via central counterparties (CCPs). 

Buy-side firms can trade derivatives electronically via the Central Limit Order Book (CLOB) or bilaterally with a selective Request-for-Quote (RFQ) model. Currently, around 50% of total Eurex options volume go through the CLOB, and Eurex would like to see that grow to increase efficiency in the marketplace. The CLOB gives firms greater price transparency and protection against regulatory risk, but the downside is firms risk signalling their intentions to the market when the order size is large. The buy-side usually trades large orders and the transparency available in those open order books creates a bigger market impact. Larger orders are more electronic than they used to be, but the CLOB cannot absorb all of these. As an alternative, selective RFQ platforms allow firms to direct their requests to one, two or even three parties they trust will not leak the position to the market or front run them. Eurex has built Eurex EnLight for this purpose.

Eurex EnLight offers on-exchange, off-book price discovery in large-scale orders for transparent and efficient off-book trade negotiations and execution. It took some time to establish Eurex EnLight as a new way of doing business. However, in the last 2 months we have seen a more than tripling of the activity, despite significant competition among similar platforms. By the end of October more than 5 million contracts have been traded since the launch of the RFQ platform in March 2018.

Strengthening the CLOB

Derivatives traders are becoming more sophisticated and buy-side firms today are coming up with thousands of strategies for trading derivatives, also deploying third-party smart algorithms. As an exchange, one of Eurex’s challenges is to attract a wide range of buy-side interest to highly standardised products where they are served by deep liquidity to make it worthwhile for clients. Eurex has various market structure elements that aim to strengthen the CLOB, enhance the price discovery process for buy-side and sell-side firms, and to bring off-book price formation on-exchange. With Eurex Improve and Passive Liquidity Protection (PLP), two major new features have recently been added.

The reduction in commissions is a major trend affecting market participants with many buy-side firms now looking to access markets directly. The cost to banks of providing market access is sometimes too great to be profitable and they are looking for ways to interact with the client flow in the order book electronically. Eurex Improve enables members to provide their end-customers full executions of any trade quantity capped at the minimum block trade size at the best available market price. The service is fully integrated in the CLOB. The end client is participating from the full competition of the order book, while the bank guarantees a price at which the order is executed. This reduces buy-side concerns about slippage, and they are able to execute at the given price no matter what the market impact. Banks benefit from the opportunity to interact with their client flow while the overall market benefits greatly from the fact that all customers orders will be executed fully in the order book and everyone can participate.  

Latency is a key feature for the open order book. Low latency enables liquidity providers to offer good prices to buy-side firms; however, some providers fear they could be outmanoeuvred by more technology-sophisticated market participants hunting their (just outdated) quotes at times of market movements. Eurex developed Passive Liquidity Protection to address the speed disadvantage that some liquidity providers have in the CLOB versus certain aggressive super-fast strategies, thus strengthening their focus on the needs of end-clients such as institutional investors. 

Looking ahead

This year, markets have dealt with a perfect storm in terms of unforeseen economic actions and health issues creating massive economic impact. This makes me very optimistic about the future. The overarching trends of increased electronification of the derivatives markets and the increased push for the standardisation of processes, especially as the next phases of UMR come into force, will continue to drive a shift in market structure and, specifically, how market participants engage with market models.

This article was first published on DerivSource on 18 November 2020.