Associations Push for OTC Derivatives Carve-Out in EU Execution Standards

Two industry associations have responded to a consultation paper from the European Securities and Markets Authority (ESMA) that seeks to establish the effectiveness of firms’ execution policies by highlighting the “significantly different” nature of OTC derivatives and requesting these differences be taken into account.

ISDA and the Global FX Division (GFXD) stress that OTC derivatives markets are “comprised of sophisticated market participants (with very little retail client participation), which may be able and willing to trade customised contracts based on the client’s risk management needs.”

They add that the diverse nature of participants in these markets also translates into divergent counterparty risk profiles, investment and hedging strategies, and abilities to hold cash for collateralisation purposes – with implications for pricing. Equally, pricing is also “highly dependent” on a counterparty’s risk profile, as well as on an investment banks’ own balance sheet constraints, investment strategy, transaction sizes, the general market environment, and other price-forming factors.

“In addition, trading protocols, such as voice and RFQ practices, significantly differ from order book or auction procedures used in equities (or other securities) and several suggested requirements in the draft RTS, in particular the pre-selection of execution venues may not be appropriate for these types of transactions,” the associations argue.

The response also takes issue with the concept of execution venues, namely the proposal that firms assess and compare execution results across all venues that support the product. “Consider the way OTC derivatives are priced,” the associations point out. “We think that assessing best execution for OTC derivatives transactions may be problematic on the basis of comparing execution venues.”

The ESMA proposal also implies the mandatory consumption of a consolidated Tape, the associations observe, pointing out that such a Tape in OTC derivatives will not be established before 2026, or even later. “This will – by alignment with the characteristics of OTC derivatives – be differently designed to the tapes for equities and bonds. We recommend removing wording in the draft RTS which implies mandatory consumption,” they suggest.