Derivatives have always been synonymous with change, but the current levels of change are unprecedented. This is due to numerous impacts on market participants and organizational functions by the derivatives transformation imposed by the regulators on the financial industry. Capco’s Samuel Ely discusses opinion of general themes and trends going far into the future and the ‘end game’ for derivatives clearing rather than commenting on the present environment.
Derivatives central counterparty clearing (CCP) and the greater transformation of the derivatives industry is now upon us and will take the next five to ten years to migrate the majority of the current Over-the-Counter (OTC) business onto clearing houses and electronic execution venues. Though this may seem far-fetched now, in the future it will be possible to clear even complex products as they can be modelled and packaged based on the component cleared products. There is a great opportunity within this transition. The changes are not just a cost and burden to the industry but also present new business opportunities. It will be necessary to fundamentally change business models to be successful in this ‘new world’. Organizations that will be most successful are those that adapt best and develop market-leading products attracting the business flows.
The changes cut through the entire organization and are not the domain of only any one area. Senior management buy-in is required to realign management structures and reporting lines, transform systems and develop processes. All departments are impacted by the changes to a greater or lesser extent including but not limited to front office, middle office, risk, collateral management, operations, technology and legal. Therefore inclusion and joined-up leadership and direction across the organization will be a determining factor to the success of businesses.
Traditionally derivatives business has been split into OTC and exchange traded derivatives (ETD). In most financial organizations the businesses have been split into silos with each being a separate division. With the arrival of CCP embracing an element of both OTC product elements and ETD clearing elements organizations will need to join together all derivatives offerings to gain efficiencies.
Short term there is the obvious transition cost to the derivatives transformation. Longer term customers will benefit from a larger pool of participants, tighter spreads and lower transaction costs, with lower barriers to entry and greater liquidity, transparency, mitigated counterparty risk and lower capital requirements where appropriate for hedged business. Capital requirements will be raised significantly for speculation, naked positions and remaining OTC positions.
The theme in operational development includes the migration of antiquated manual processes driving operational efficiency through straight-through processing (STP) and eliminating the vast majority of operational risk and substantial errors of the past.
The execution topic is an area that will become more prominent and have the biggest element of change for derivatives moving forward. Many new participants including market makers and liquidity providers, traditional custodians, electronic brokers, trading platforms and exchanges will now enter the traditional OTC domain as it migrates to electronically executed from bilateral. New considerations will include connectivity, latency, smart order routing to name but a few.
Changes Makes Way for Innovation
Such rapid industry change paves the way for more innovative solutions for use by various participants in the derivatives market.
A key theme common for both clearing providers and clearing houses going forwards will be critical mass and joined-up services with the primary business driver being portfolio margining.
This is the ability to deliver margin benefits where correlation exists between different instruments across the asset classes. The risk reduction benefit can be modelled and delivers appropriate deductions in the associated margin. By considering counterparty risk at a portfolio or legal entity level rather than for each individual instrument in isolation the reduced margin requirement will more accurately reflect the true risk. The benefit of lower margin requirements should offset some of the increased cost in terms of funding and capital for trading caused by the migration from OTC to CCP and the regulatory changes going forwards.
Fundamentally the more accurate modelling of risk rather than components in isolation will be key to managing risk better and the ultimate monitoring by all involved parties from the regulators down to the individual organizations themselves.
Going forward we may see more multi cross-product offerings by providers trying to establish a ‘one stop shop’ to enable delivery of not just operational efficiencies for participants but also greater cross-margining benefits. From large banks integrating their derivatives services to traditional custodians who are also entering the clearing space all participants will target this model for derivatives. Long-term winners will have all instruments in one place, which is applicable to all types of clearing businesses.
Clearing models for third party clearing need to develop substantially. The general theme being a transition from a vertical silo front-to-back model to more of a component service with a differentiation between the execution and clearing elements driving to a commoditized per unit cost model will succeed over free models that price in operational costs into spreads. The per unit cost model means the client pays a small fee for each transacted product.
The driving force behind the changes and the participants with mandatory uptake of OTC products which are offered for clearing will shift the attention of the regulators to the few CCP providers rather than the individual participants and it will be in the providers’ interest to list as many products as possible.
The current penetration of CCP in the credit and rates markets will continue broadening to cover more products and also expand to cover all other OTC products. Priority for new products will depend on market demand and complexity. The pace will be dictated by the speed of standardization and coverage by the clearinghouses.
Regional solutions will continue to develop as jurisdictions will impose mandates to retain control. Regulators need to be very careful when setting out rules as stand-alone solutions will not be effective and will disadvantage organizations within those regions and regulatory mandates. Interoperability between clearing houses is extremely hard to achieve and precedent is extremely limited. Without a regulatory requirement imposed on clearing houses, which would require global collaboration between regulators, such a development would not be possible. Therefore I believe that the alternative will be that exchange consolidation that was so prominent in the last decade will return. The landscape of clearing houses and exchanges will transform dramatically. Central counterparty clearing will be a catalyst and creates a business case for exchanges leading to further consolidation enabling them to deliver more benefits for their members. These include greater efficiencies delivering lower fees, standardized processes, higher STP and most importantly portfolio based margining.
Looking Forward
Moving forwards every discipline related to derivatives activity will change. Some more than others but all will be impacted. The changed dynamics of an industry unprecedented in scope will define the markets of the future. The considerations and impacts are more numerous and complex than would suggest from an outsiders viewpoint. To be properly covered all market participants need full CCP assessments and to keep up with the constant changes taking place as the derivatives market transforms both in the short and long term.
