Regulatory asymmetry, capital efficiencies and risk management are key drivers of industry changes says Object Trading ceo, Steve Woodyatt.
Improving transparency and reducing overall market risk have been key goals of regulatory reform. As compliance with the Dodd Frank Act, Basel III, EMIR, MiFID II and more continues to drain resources, buy and sell side firms look to escape the continually rising costs of maintaining business as usual. Firms of all sizes are rethinking their trading and risk management systems, and entire business models, to not only meet the regulatory obligations, but more importantly, remain alive while they innovate and discover how to deliver value in an environment that demands new solutions to old problems.
Whereas some market participants are struggling to cope with the industry’s changes in “velocity” – meaning the effects of fragmentation – others are recognising that reacting to the changes in unique ways is the key to growth and innovation.
While working closely with both buy and sell-side firms globally to access liquidity as it moves, we have identified a few key trends that will continue to shape the $710 trillion global derivatives market.
Pre and Post-trade collateral efficiency
While exchange and clearing platforms continue to seek to introduce new cross-margined products to assist maximising trading returns, buy-side firms still look to their FCMs to help optimize their collateral commitments. FCMs are competing for clients by offering capital efficiencies, which requires real-time risk management capabilities. FCMs need to be able to evaluate risk exposures across products, markets, and clients on a pre-trade basis to successfully provide margin efficiencies on a post trade basis.
A Single View of the Truth
Achieving a pre-trade view of exposures across markets and specific to client flows has proved to be an industry-wide challenge. Since the 2008 onset of the Global Financial Crisis, having a better oversight of systemic risk has been on top of regulators’ agenda. Then, the 2010 US “Flash Crash” focused regulators’ attention on the other end of the spectrum – the pre-trade risk controls. Meanwhile, competition amongst exchanges has driven both product and liquidity fragmentation, making aggregating exposure data like nailing jelly to a wall. As a result, market participants are struggling with scattered regulation, siloed trading systems and increasing collateral friction.
Sell-side firms are challenged to provide risk constraints on client flows across asset classes and markets, while maintaining low latency execution. And from the buy-side perspective, the old days of the one stop broker shop has long gone – necessitating a complex web of risk controls in a multi-broker environment.
This situation necessitates different views of pre-trade risk for different participants – the sell side views pre-trade risk across their clients and the buy side views risk across different brokers; yet the ability to access the same normalized, real-time view of position and exposure data for any single flow from any point of view is critical to managing risk while maintaining the trading counterparty relationship.
The Rise of Non Bank FCMs
Regulations intended to govern how firms trade locally are forcing firms to seek trading profitability globally. Decreased trading volumes and low interest rates coupled with increased transaction costs have suffocated business models that have worked for years, even decades. In 2014, we saw a resulting shuffle of players as a number of banks quietly backed away from the clearing business as they felt the squeeze of leverage ratio and capital requirements.
In 2015, we will see the further rise of non-bank FCMs, as they don’t have banking licenses to protect. These firms are specializing in access to regional markets, and providing specialized bespoke solutions to buy-side firms that continue to seek alpha in new markets and asset classes.
Building West, Buying East
Despite concerns over slowing economic growth, cultural differences and regulatory hurdles, global operators are eager to expand their footprint into Asia (as Asia is to access the world). Investors have long been eyeing the volatility and record breaking stock rallies in the emerging markets. Proprietary traders and market makers find new sources of profitability in supporting the launch of new exchanges and exchange products. And alpha-seekers need the volatility that has slowly drained from the North American and European markets. Many market participants are also worried that taxation on derivatives products in Europe would further push the business to other more vibrant markets where greater innovation and competition are encouraged.
The Shanghai-Hong Kong Stock Connect share trading scheme has significantly increased foreign access to China equities and created new investment opportunities. In Derivatives, new trading firms on the scene show sustained interest in new products such as Dubai Gold and Commodities Exchange’s Indian Rupee futures products and Hong Kong Futures Exchange’ new products in metals. The complexity of new markets and products presents new profit opportunities for firms with scalable and flexible technology infrastructure to quickly access liquidity without costly up-front investment. Although the Asian markets are still working toward data standardization, collateral optimization and trade reporting, the opportunity has attracted global brokers and the foreign investment community in capturing flows.
But both buy and sell sides face specific resource challenges when dealing with global distribution and high complexity specialist deployments. Market participants no longer have the resources to reach emerging markets by building what worked in the West. Scaling the necessary skills and infrastructure internally has become unsustainable. Therefore reaching the East will require specialist third party services to build, design, and operate the unique demands of competitive market access platforms.
