The trading of credit derivatives has downshifted in recent months but trading volumes of derivatives has grown overall. Eric Bernstein of Sophis explains current trends in trading volumes and technology needs of firms during the credit crisis.
What types of derivatives are financial institutions trading now? Has there been a shift towards other asset classes as a result of the credit crisis?
There has certainly been a reduction in Over-the-Counter trading in the last several months but we have also seen trading volumes of derivatives increase overall.
Generally product lines have maintained their volumes, or actually increased, although the growth in volumes we see today is mostly due to increased trading of non-credit derivatives such as listed derivatives and commodities. More specifically, trading volumes of credit derivatives has decreased, volumes of interest-rate derivatives has grown and we are also beginning to see a tremendous amount of equity-based derivatives trading. In fact, the trading volumes of some of our forward-looking clients have grown across the board (by 10 to 15% for some) as these firms get into other financial products such as equity-oriented or equity-valued products.
With OTC derivatives, we have definitely also seen a downshift in the trading of certain kinds of OTC derivatives most particularly the credit backed financial products, however some of the more opportunistic firms are taking advantage of the market opportunities and the intraday volatility. In the last few months especially we have seen more firms beginning to dip their toes back in the waters.
What factors are driving these changes in trading volumes? How do impending regulatory and market-wide operational changes contribute to tese trends in investment strategy?
Liquidity risk is a big issue and some firms are being optimistic and taking advantage of bargain basement prices in the market, but they also want to be able to get out of these products at some point. Liquidity risk is one reason why we see a flight towards listed derivatives and more transparent financial instruments.
Also, the drive for more transparency and imminent changes in regulation and post-trade processing will greatly impact an individual firm’s middle and back office operations and many firms are worried about their ability to keep up to speed with these expected changes. Historically, anytime there has been regulatory or market-wide operational changes the impact on small firms, or firms that don’t have significant technology, is pretty dramatic. These upcoming market-wide changes are a significant contributing factor to the reduction of trade volumes among some financial institutions and their move towards the trading of more transparent instruments.
How have market initiatives impacted volumes and post-trade operations?
New regulation and market-wide operational changes such as the central clearing of credit default swaps, is greatly affecting trends related to both volumes and technology needs in that many firms are aware that they will have to build a post-trade operation that is more standardized than it is today and there is an obvious cost to do this.
With regards to central clearing of credit derivatives, there is still a tug of war going on among the many players involved – both exchanges and government agencies. I think the industry is still not as close as we want to be as far as clearing credit derivatives via a central counterparty is concerned. However, it is difficult to instigate change quickly and when it concerns a large number of firms and counterparties. This is especially true if such a change is a significant departure from how things were done even a year ago. We are not talking about a little change but dramatic regulatory and operational changes that will affect the entire financial market.
In my opinion, I think we are about a year away from really seeing where the impact will be. In our evaluation of our clients and how their staff is handling these changes we have seen that most of our clients are preparing for the market changes, but not doing it yet.
How are financial institutions handling these market changes?
So there are two big areas to focus on when it comes to middle and back-office operations – staff and technology, and both areas are reliant upon each other. Recent reductions in staff have had an impact on a firm’s ability to keep up with market changes but some firms, from a technology perspective, are also not prepared for new challenges. In other words, a financial institution with sufficient staff might be able to afford to have technology that is a bit behind while a firm with state of the art technology can have less staff; the combination of reduced staff and less functional technology is a very troublesome scenario.
How have the changes in volumes and market-wide initiatives impacted the technology needs of your clients?
From a volume perspective, the firms that are trading a lot of volumes require technology to support large volumes, and by large I mean thousands of trades a day versus hundreds. So, we are definitely seeing the prospect base of our clients looking at robust solutions that handle heavy volumes and the ebbs and the flows in the business now and in the future. For instance, a firm trading equity derivatives today may want to trade commodity futures in six months and at a much smaller volume. Financial institutions need technology that can manage such a shift in both investment strategy and volumes.
We are also seeing a shift towards the management of risk in real time. Pre-credit crisis, many firms monitor risk on a T+1 basis and manage this risk using methods such as Value at Risk (VaR) models and manual comparison of exposures, but this approach of risk management is changing. Now risk managers are looking at real-time risk management and are evaluating Profit and Loss (P&L), the Greek-based risk models or conducting real-time stress tests on portfolios so they can better assess the impact on a portfolio if the market moves or if liquidity dries up. Honestly, I do not see VaR coming back as the primary risk measurement anymore, I think its going to be a secondary measures and the primary measure will be real-time stress testing analysis and use of Greek models.
From a technology perspective, pre-credit crisis financial institutions had systems integrated and feeding other systems data in a semi-periodic data flow (once a day), but now firms are looking to either aggregate the data into a single system or connect systems in a real-time fashion to support more frequent risk monitoring procedures. Use of disparate systems does not allow a firm to easily assess all the current risks and potential impact of market movement on a portfolio from a macro level. And in the last several months financial institutions have started to realize this and are centralizing data and systems to support their need to measure a variety of risk exposures and stress test a portfolio based on a multiple factors simultaneously.
I also anticipate a major shift in the ways firms report to the prime brokers, administrators and investors. I think we will see a lot more real-time reporting and more frequent periodic reporting to investors and not only holdings but risk exposures. What every player wants and is beginning to ask for is much more transparency from the front end all the way to the investor, event potentially to the individual investor.
What are some of the enhancements to your current product offering that you’ve made recently to respond to new client needs and those specifically related to recent market trends?
We saw a tremendous demand about a year ago for equity finance and specifically total return swaps, contract for differences (CFDs), and stock lending, and so we developed a module to support these equity finance needs. We also just released a second version of this equity finance functionality to enable clients to better measure and handle the changes in the underlying in the baskets being traded because doing so is a laborious task for operations and current systems often cannot do this efficiently.
We have also developed a market risk monitoring tool which is a graphical user interface that allows users to enter risk parameters and run real-time stress tests. We have always offered a great VaR and real-time risk measurements functions, including end of day Monte Carlo and historical VaR functionality, but we recognized that the market is changing fast enough where clients need a very easy and intuitive way of looking at and monitoring risk. As consequence, we developed this new risk monitoring user interface and launched it in February. We are getting a lot of traction on this new tool.
Additionally, we have also made enhancements to our technology to handle newer or trendier asset classes like bank debt and other products. For example, we built out our commodities trading support more in the last year. We’ve had commodities businesses trading on Sophis for six to eight years but we continue to invest in our technology and in this asset class because we see greater demand for it, and particularly around the commodities hedgers and the connectivity to downstream systems and exchanges. There has also been significant client uptake on this functionality already.
What do you think we should expect in the next year in terms of volumes of OTC derivatives?
Without question, with market turmoil financial institutions tend to sit on the sidelines and tend to get into the more transparent, easier to measure and therefore safer investment strategies, but I think there are plenty of firms still playing ball. With the stress testing of banks and gradual stabilization of the market we will start to see firms being trading more OTC instruments again – maybe not at the same rate they were over a year ago, but certainly there will be a growth in volume from the level of volumes today.
And also, I think we will see firms getting back into credit and in mortgage-backed securities and loan products with the loosening to degree of credit in the market. Of course, there will be some firms, those that got badly burned by the credit crisis, who may stay away from specific OTC instruments permanently and instead opt for strategies that are more transparent and are easier to report on for investors. I think in a year we may see the market volumes of OTC trades back to the levels of three years ago.
