A recently published whitepaper by Fidessa entitled “You Only Live Twice, examines how FCM business models are changing as a result of new financial regulation. Fidessa’s Steve Grob explains the challenges FCMs face as they adapt workflow and technology to align with these new business models.
Q. What were the main drivers behind the report?
A. The paper assesses how futures commission merchants (FCMs) will need to make considerable changes to their business models in order to meet the challenges of impending derivatives regulation. This is a realisation that started to emerge at the back of end of last year and has only grown stronger in 2013. We believe it will be one of the main themes of 2014. One of the problems is that many FCMs have business models that are based on old market structures and are reliant on being able to simply intermediate between clients and liquidity. However, the move to multi-lateral trading and central clearing in swaps means these old business models will not work in the future. There was a hope that markets would have returned to normal but I think there is now a recognition that this will not happen.
Q. What have been the main reasons behind the trends?
A. Regulation such as Dodd Frank, EMIR, MiFID II are the main reasons behind these changes. They are all in different ways trying to make the Over-the-Counter (OTC) world look more like the exchange-traded derivatives (ETD) world. However, what the regulators have overlooked is that the OTC and ETD workflows have evolved differently and as a result, many market participants have multiple internal and external systems, which do similar things due to a rush to win clearing mandates in the past. FCMs also run multiple desks with different trading application, which can add significant expense.
It hasn’t though just been about the regulatory reforms. FCMs would have been forced to change their models because the interest rate environment has changed and doesn’t look like it will be rising significantly in the near future.
Q. Given this backdrop, what are the biggest challenges facing the derivatives industry?
A. The cost of running these various disparate systems with different trading applications are some of the biggest challenges. FCMs have ended up with a hodgepodge of systems that do not talk to each other. There is no place for this historical accident and legacy technology not only because it is expensive but also difficult to monitor from a compliance and firm wide risk perspectives. FCMs need to adopt a more centralised and integrated approach to business. They need to develop a business model that lowers cost but remains flexible enough to take advantage of the change as well as meet all the new regulatory challenges. Technology in and of itself is not necessarily the answer. The goal is to create a workflow approach that provides a single centralised spine connecting the different parts of the firm together provides the only really workable solution.
Q. I read in your paper that convergence and aggregation are the buzzwords. Why?
A. Although it is difficult to predict what the outcome will be, the industry is likely to evolve towards a broader spectrum of standard and custom contracts that will be accessible by all. Flexibility as well as the ability to discern the real themes from the bright shiny toys will be key. It looks like the agency model versus direct access will be one such theme as the buy side will soon tire of accessing liquidity via a multitude of separate SEF deployed screens.
Aggregation will also be important. I am not just talking about an aggregated view of liquidity but also risk and margin from a clearing efficiency perspective. The battle lines will be drawn in the middle office and its integration with clearing houses, credit hubs and clients.
Q. What about algos?
A. I think we will see a different and more holistic way of thinking about algos. There is likely to be a greater proliferation of algos working across multiple pools of liquidity which will mean transaction cost analysis will play an increasingly important role. Buy-side firms will use it to assess and select their brokers while FCMs will need it in order to prove their value.
Q. What should FCMs aim for?
A. The goal should be to develop resilient, high-performance back-bones that centralise functions while leaving enough flexibility to meet clients’ needs. They should ensure they understand their intellectual property and look to outsource areas which don’t give them a competitive advantage. Last but not least, the ability to implement a seamless workflow across asset classes and desks will also be essential to competing once the many regional reforms to derivatives trading have been completed.
Q. What are the benefits of a complete workflow system?
A. Aside from the cost of having disparate systems, each one adds another layer of compliance stress because data is held in separate locations and often in incompatible formats. A single platform creates a single audit trail. In addition, FCMs can use their technology as a competitive advantage, For example, they can show they have the capabilities to route incomplete orders seamlessly between desks and can effectively trade across an increasing number of liquidity pools.
Q. Should they outsource or build the platform themselves?
A. Building an entire stack is an expensive proposition especially when so much of the picture is unclear. Outsourcing is not only more cost effective but it can also be more effective in delivering economies of scale and replacing a fixed cost with a variable cost. It also provides the FCM with scalability and flexibility.
Q. Was there anything that surprised you in the findings?
A. Yes the fact that FCMs have moved on from complaining about regulations and the low interest rate environment. They have accepted that we are in a new world order and that they have to adapt and change the way they have done business. The focus is now on developing a new workflow model infrastructure to meet these new requirements.
