Isda publishes equity derivatives transparency study

The first paper describes the structure, participants, products and existing forms of pre- and post-trade transparency for equity OTC derivatives. This is complemented by a quantitative study which analyzes differences in pricing amongst dealers and between dealers and end-users.

The paper shows that the link between listed stock and options exchanges and the OTC market currently provides significant pre-trade transparency and price discovery mechanisms. Overall, the paper reports that the industry is evolving towards increased post-trade regulatory transparency via trade repositories, electronic reporting and centralized clearing.

The statistical study, which included analyzing a large dataset and live quote experiments, indicates that, between dealers, (i) price to fair value discrepancies are found to be within one or two bid-offer spreads (95% confidence) and (ii)transactions involving end-users are not further away from fair value than analogous dealer to dealer trades on average. This finding, that the end-users trading with dealers are not at an informational disadvantage, is confirmed by the live test.

"These studies add to the growing body of research and work that ISDA has conducted on transparency as part of our focus on making OTC markets safe and efficient," said Conrad Voldstad, CEO, ISDA. "The studies' findings highlight the different types and amounts of transparency currently available in the OTC equity derivatives markets, as well as the importance of understanding the benefits and costs of transparency, particularly with regards to how it may affect liquidity."

Similar to the two previous studies on CDS and IRS -- which were all conducted by Finance Concepts -- the reports on equity derivatives found that it is key to distinguish between informational transparency and regulatory transparency.

While informational transparency creates a level playing field for equity derivatives traded on exchanges, it may not serve well the OTC markket where dealers and clients negotiate large, customized trades, the study finds.

The studies find that the measures adopted by the industry for the past few years have enhanced transparency and will increase post-trade transparency for the regulators while maintaining the same flexibility and privacy that make OTC markets attractive to their participants.

The reports also conclude that due to the large variety of products, some of which are highly customized, standardization and central clearing may not be suitable or feasible across all OTC equity derivatives.

The studies are the latest in a series of studies on transparency in the OTC derivatives markets that ISDA has conducted over the past year. Late last year, ISDA published two other independent studies on transparency with respect to credit default swaps (CDS) and to interest rates swaps (IRS). For CDS, the study found that increased transparency may affect large and small trades differently and suggests it may be necessary to consider different transparency requirements for large trades. The move towards central clearing of standard CDS contracts, the study states, will increase the level of transparency as will reporting of CDS trades to data repositories.

For the IRS market, trade sizes are large in notional terms but the number of trades tends to be smaller than other markets such as equity, and trades are more customized to meet clients' hedging needs. The study finds that the industry would benefit from improving transparency in key areas, including considering the "end-of-day dissemination of anonymized, composite post-trade indicators for the interest rate market either based on current trades going through electronic platforms or those registered in trade repositories," as this may be more effective and easier to implement than moving IRS to exchanges.

In November 2010, ISDA and an independent risk advisory firm conducted a blind test among market participants on the liquidity, price transparency and competitiveness of the "plain vanilla" US Dollar and Euro for the IRS markets. The IRS Test results demonstrate that the market is extremely liquid with excellent price transparency and competitiveness for standard-structure swaps between active market participants and major dealers. The study also highlighted that a high level of price transparency can be provided by dealer screens.

ISDA's survey of end-users in the OTC derivatives markets, published in October 2010, showed a great degree of satisfaction with the level of pre-trade transparency for the largest asset classes and satisfactory levels of transparency for less frequently used products.