Electronification of IRS Trading and dealing with the consequences

Over the last year, electronification of the swaps market has picked up significant momentum. It’s not just the number of IRS trades executed on venue, development of the MTFs has meant that there is also an increasing level of complexity that can be supported too.

As well as custom dated swaps, trading desks are also seeing requests for lists and compressions. But with more business being done in competition on trading venues – firms are having to respond with better pricing in a shorter amount of time – in fact, almost instantaneous.

Swaps trading desks are rapidly investing in technology to manage the demand for speed in pricing and that presents new challenges for these desks. Quants develop specific pricing capabilities that look at the economics requested by the client and provide an answer for the Trader so that they can pass on to their client.

Most firms, if not all, will still require a trader to push a button to send a price back to Tradeweb or Bloomberg in response to an RFQ, how can this pricing mechanism possibly be considered an algo?

To be clear, under MiFID II, algos come with significant regulatory overhead, including detailed documentation, independent testing, independent monitoring capabilities and sign off of changes at a senior level.

Regulators are starting to look at the dependency that a Trader makes on the pricing capability provided by the Quants.

This pricing capability is often an in-house developed algorithm built into a firms pricing engine involving highly complex formulae which provides a price on-demand. These engines are connected to the firms e-trading system that deals with market connectivity and RFQ management.

When a RFQ on a compression or a broken dated IRS trade comes into the firm. The stats of the trade are sent to the algo pricing engine for pricing and the RFQ is populated with a price of the trade back to the trader. The trader looks at the suggested price calculated, maybe doing a small adjustment to the price calculated by the algo before sending it of the client.

Now MiFID II defines Algorithmic Trading as:

“trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention, and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions”.

If we look the definition of algorithmic trading and set that into context with pricing a broken dated swap or a compression trade, Regulators are starting to consider these pricing engines as falling directly into the definition of Algorithmic Trading. Their argument being Traders are often highly dependent on the price provided to them by the pricing engine – and therefore only provide limited human intervention.

As the electronification of IRS trading is rapidly growing and more and more IRS trades are executed over venue together with the complexity of pricing broken dated swaps or compression trades the IRS trading falls into algorithmic trading under MIFID II and RTS 6.

So, the question that these firms need to ask now is:

• Should in-housed developed pricing engines be considered as algorithmic trading and fall under the regulations MIFID II and RTS 6? If not, what protections are the Trading Desk using to ensure that a price is checked.
• If a more compliant approach is needed, what are the obligations on the Swaps Desk?
• What is the most efficient way to implement RTS 6 without slowing down pricing innovation and competitiveness.

With recent algorithmic failures, as recent as May 2022, both the FCA and ESMA are already starting to look at how effectively MiFID II RTS 6 is being implemented. If in-house built pricing engines need to be regulated and placed under RTS 6 rules, some firms may see the regulatory burden too high which may in turn affect liquidity in the swaps market.

If you are one of these firms and would like to learn more about what qualifies as an algo and how RTS 6 can be implemented in an efficient way – get in contact with us at GreenBirch.

 

GreenBirch is an award-winning Capital Markets consultancy with business, regulatory and technical expertise in the Financial Markets and how this ever-changing sector is supported by market data, electronic trading and trade processing platforms.

Our aim is to bring clarity through consultancy: to find the relevant information amongst the increasingly complex financial and regulatory landscape, to help build our clients’ data, digital and e-business strategy and to guide the decision to choose and deliver the right technologies and services to support it.

Get in touch with us at [email protected] to learn more.