Due to ongoing regulatory reform, the OTC derivatives world has evolved rapidly in recent years however, existing and new changes will bring greater challenges for market participants in 2016. In a DerivSource video panel, industry experts discussed the trends and changes that will impact this space in the near and long-term from execution to clearing and settlement.
Reform of the Over-the-Counter (OTC) derivatives industry continues but what is the long-game for this industry? In a recent DerivSource panel video, participants from Commerzbank, Aviva Investors UK, and Eurex Clearing examined some of the current and future challenges the market faces in light of rising collateral costs, greater regulatory scrutiny and the operational overhaul needed to comply with new and existing regulatory requirements. They explored how the market has evolved as a result of these circumstances so far, the big trends and concerns that will impact all market participants in 2016 and where the industry is heading in the long-term.
Futurisation – why hasn’t the swap futures market taken off?
The futurisation trend has promised to provide attractive alternatives to OTC trading, which is subject to rising costs and increased scrutiny. Swap futures have generated a lot of buzz—being listed on an exchange means they are transparent, and the bid/ask spread should be fairly tight—but they have yet to fully take off, despite offerings being available at various exchanges, especially in the U.S.
The main reason for this lull in uptake is a lack of liquidity. When an exchange launches a new contract, it cannot ensure its immediate success because without the underlying liquidity, and without the sell side providing the differential, the buy side has no incentive to use these products. “From a buy-side perspective, it’s very difficult to transfer into products without the liquidity being there,” says Barry Hadingham, head of derivatives and counterparty risk at Aviva Investors UK. A buy-side firm needs to know they can get in and out of contracts for its clients —they cannot afford to make up a significant portion of the market alone.
In addition, for swap futures to be attractive, the underlying OTC instrument must be accurately priced in terms of capital cost. If not this leads to differentials in the marketplace between cleared and non-cleared swaps, and between swap futures and the underlying product, says Ricky Maloney, head of buy-side relations at Eurex Clearing. Should the Basel Committee’s proposed new standardised approach for measuring counterparty credit risk exposures (SA-CCR) go ahead to change the two-day Value At Risk (VaR) for a swap future to five days, the swap future could lose its advantage, Maloney says.
Swap futures act like an OTC hedge, helping to mitigate basis risk. But it’s a bit like the chicken and the egg—you need active participation from the sell-side market makers and the buy side. Given the rising costs of clearing derivatives, there are viable alternatives to swap futures, including hedging duration with bonds, or using index-linked gilts to hedge inflation risk.
Costs of regulation including OTC clearing
CCP clearing and the associated regulatory changes have brought various costs, some of which remain unclear. Organisations have had to make significant changes to their processes and infrastructures. On the clearing broker side, that means having the people and technology in place to provide clearing services to clients on an ongoing basis. By now, these operational costs are fairly well understood and may be offset with a per-ticket fee or monthly minimums.
But there are also costs associated with pricing resources utilisation—the usage of a clearing broker’s balance sheet or risk capital—and how to price in the risk capital in terms of the default fund contribution. “Leverage ratio is another big factor—while there are clear costs associated with that in terms of the add-on, notional, margin and netting firms have to have in place, there is still uncertainty around what the rules will say in future,” says Eugene Stanfield, managing director, head of execution and clearing service, Commerzbank.
Some brokers are being conservative and pricing in the entire amount today. Others price in what they know today with the caveat that pricing might change when the regulations come into force. Both clients and clearing brokers face unknowns around the total costs of clearing, which means many firms are holding off from clearing until it becomes mandatory. 2016 should bring more clarity on that front, but implementing those changes can take time. Mandatory clearing will come into force for category one and two firms in 2016, and firms need to price for today, with an expectation the costs will go down in the future, Stanfield says.
Complexity doesn’t equal counterparty risk reduction
The high costs of operating in this industry have led to some OTC clearing providers letting clients go or exiting the business altogether. Fewer clearing brokers in the market, and fewer participants per CCP, inevitably concentrates counterparty risk—counter to the regulators’ intentions.
The new regulations could have the unintended consequence of pushing some market participants out of the OTC market altogether. As clearing brokers pull back, it becomes harder for buy-side firms—especially small ones with limited trading needs—to find a clearing member. Asset managers and pension funds are managing assets on behalf of other people. They may not have the cash or the equity capital to contribute to the default fund. “Building societies are also struggling to get coverage, which has a direct impact on the general public, as they won’t be able to get fixed-rate products, such as fixed-rate mortgages,” Hadingham says.
“Building societies are also struggling to get coverage, which has a direct impact on the general public, as they won’t be able to get fixed rate products, such as fixed-rate mortgages,” Hadingham says.
But while some brokers exit, new entrants are also coming into the market. These are smaller institutions, which are starting small. “They might clear for their subsidiaries first, and when that becomes a robust process, they will expand it out to the outside client base,” Stanfield says. Self-clearing, while yet to be put into practice, could potentially be a solution for some players, whereby banks or existing clearing members provide an agency-type service, doing the heavy lifting in the background, and avoiding the capital costs, says Hadingham.
Regulators intend well by deleveraging the marketplace. But deleveraging leads to reduced liquidity. “With reduced liquidity, any good CCP is going to have liquidity add-ons as part of that particular product. So you’ve got a contracting market with increased costs,” says Maloney. And the additional complexity that has been introduced to systems and infrastructure to comply with the new regulations builds in new operational risk, which equates to counterparty risk when things break, adds Hadingham.
It is worth mentioning that by automating the trade affirmations and reconciliations processes, clearing actually reduces operational complexity in the long run. There is a lot of cost getting the systems in place, but futurising the cumbersome OTC tradeflow, will eventually deliver cost savings and efficiencies, Stanfield says.
The real complexity comes from the collateral piece. “Dealers have been doing this for a long time but smaller counterparts may not be used to performing collateral management. Or they might only have been doing weekly collateral movement, with minimal transfer amounts in place. Suddenly they need to have funding capabilities, not just same day, but multiple times the same day, potentially, depending on their relationship with the clearing broker. It’s those elements that are adding complexity,” says Stanfield.
“Dealers have been doing this for a long time but smaller counterparts may not be used to performing collateral management. Or they might only have been doing weekly collateral movement, with minimal transfer amounts in place. Suddenly they need to have funding capabilities, not just same day, but multiple times the same day, potentially, depending on their relationship with the clearing broker. It’s those elements that are adding complexity,” says Stanfield.
Global asset managers also face complexity from cross-border transactions. When dealing with parallel rules in different regulatory jurisdictions, there is a high risk of getting something wrong. Firms might get one price here and another price there—making it difficult to guarantee best execution.
Whether participants will exit the market en masse as clearing comes into force remains to be seen. Many buy-side firms have yet to fully understand the implications for them of the new rules. Many still look to their brokers to solve the regulatory puzzle for them. Market participants need to inform themselves as much as possible about the new requirements—but even for those that are well educated on the subject, many of the costs remain unclear, which is leading to delays in CCP onboarding.
Clearing members need to be transparent about the costs today, the known unknowns, and the degree to which theses might change. Buy-side firms need to engage sooner rather than later as onboarding takes time—and once clearing brokers review who they are going to provide services to, some buy side that are late to act could be left out in the cold, Stanfield says.
Systems Challenges – Systems Are Not Fit For Purpose Yet
Across the industry, systems are not currently fit for purpose to support the upcoming changes to derivatives trading, and collateral management in particular. The sell side, as usual, is further ahead than the buy side when it comes to technology, but dealers also retain a lot of manual processes, driven by the overriding desire to be first to market. However, delays to the regulation start dates may have given them more time to make their systems fit for purpose, says Stanfield.
Systems updates come in phases. Last year, there was a heavy focus on trade reporting under EMIR. There is a lot to do still on the clearing front. In theory, buy-side firms can be set up for clearing fairly quickly—although there will be delays to onboarding, given the backlog of firms that have yet to get set up. Collateral management on day one will be mostly cash based—as they become more sophisticated and their systems more fit for purpose they will move more into non-cash collateral, says Stanfield.
With the torrent of new regulations, some of which have conflicting or duplicate reporting requirements (MIFID II, EMIR, UCITS V and AIFMD), systems could be fit for purpose for one regulation, but not for another. This is where utilities come into play, simplifying the compliance burden. “If you were to develop your operating model today from scratch, you could use OpenGamma to price pre-trade stuff, CloudMargin to deliver the margin, AcadiaSoft for the messaging, and TriOptima for compression. That model would work wonderfully,” says Maloney. However with legacy systems firmly entrenched at most firms, this model is unrealistic for many. The gap analysis to transfer to such a model alone would be very costly, let alone implementing those changes.
“If you were to develop your operating model today from scratch, you could use OpenGamma to price pre-trade stuff, CloudMargin to deliver the margin, AcadiaSoft for the messaging, and TriOptima for compression. That model would work wonderfully,” says Maloney.
Markets ability to adapt
One of the challenges with reacting to impending regulatory change is that technology moves on very quickly. For all the complaints about firms sitting on their laurels and waiting, those that react too quickly risk developing technology that has become obsolete by the time the regulations go live. Prolonged uncertainty about the content and timeline of the regulations has hampered the market’s ability to adapt to change. Firms don’t want to commit resources and funds to multi-year regulatory projects with unclear scope.
Given how much uncertainty there has been and how many firms have yet to get ready, there is an argument for European regulators to be able to issue ‘no-action letters’, like the US Commodity Futures Trade Association (CFTC). At the moment, firms are uncertain how long they have to fix any issues before action will be taken, Hadingham says.
Move towards electronic trading
As a result of mandatory clearing, derivatives trading will move increasingly to electronic platforms. In the US, firms must already trade either directly on swaps execution facilities (SEFs), or trade elsewhere and report the trade on the SEF. There are currently a large number of SEFs, some with tiny volumes, which may see a shakeout as the industry evolves. Dealers are increasingly moving from a pure broker dealer model—with sales staff pitching ideas and providing pricing for execution—to an agency broker dealer model where they may provide the idea and execution on an agency basis, charging a commission.
As Europe moves towards mandatory clearing, the industry will see increased electronification, and sell-side firms are increasingly focused on expanding their digital capabilities on both the execution and the clearing sides, says Stanfield. US developments may serve as a model for Europe, but firms will have to wait until the European mandates come into force to be sure how much they can replicate.
Increased electronification will also bring new opportunities for algorithmic and high-frequency trading (HFT). While having the option to trade electronically does not necessarily generate interest in the market to trade, it can increase liquidity as traders are able to trade in and out quickly with smaller trades leading to higher trading volumes.
What has changed so far?
Preparing for these regulations has changed the way the industry operates over the last few years. There is more engagement and interaction between financial services participants and regulators, where there used to be an “us versus them” mentality. Consultation papers receive a lot more responses than they once did. The European Securities and Markets Authority (ESMA) is becoming more involved with the drafting of new legislation to avoid the delays that come with waiting for comments after drafts have been completed. Regulators are also more forthcoming on issues they have, and when they hope to resolve them, and there is closer cooperation between global regulators such as the CFTC and the European Commission.
But there has also been a shift of focus in the capital markets from wealth generation and supporting the economy to more of a compliance culture, Stanfield says. Buy and sell-side firms have necessarily become very focused on what they have to deal with next. In addition, markets have become very fragmented—participants have gone from being able to trade anything with anyone to being effectively regionalised, says Hadingham.
Regulators, while aiming to deleverage the marketplace, have wrought unintended consequences, including the exit of some clearing members, who found their new burdens too cumbersome. The industry is in flux and it remains to be seen how much more fallout there will be from these changes. Taking a more consultative stance with users is a positive step forward for regulators and may help them mitigate some of the unintended consequences going forward.
*Watch the full video roundtable here and on DerivSource’s YouTube Channel.
