This article offers a brief look back at key milestones and trends of 2023 before turning to the year ahead to discuss industry issues and initiatives that will impact the post-trade space in 2024. Areas covered include collateral management, risk, regulatory compliance derivatives clearing, post-trade processing and crypto asset reporting.
Collateral Management Trends
In collateral management, 2023 saw a pronounced shift in client priorities towards collateral cost management and the strategic allocation of available assets for collateral utilisation. High interest rates, high inflation, increased collateral demands, ongoing market volatility and escalating cash costs compelled derivatives users to reevaluate their asset portfolios and fees associated with third-party collateral management.
The LDI crisis at the end of 2022 profoundly impacted collateral management strategies in 2023, with more focus on stress-testing and forecasting future margin, collateral and funding requirements as integral components of collateral management functions.
Liam Huxley, CEO of Cassini said:
“In 2024, the collateral management landscape is expected to be significantly influenced by several key themes and industry initiatives. The surge in costs due to elevated interest rates, which is likely to be a medium-term trend, will necessitate proactive management by buy-side firms. This is essential to protect portfolio performance from potential negative impacts.
From a broader market perspective, regulatory focus on centralized and transparent margin requirements, mandatory clearing, and stress testing of margins will continue to shape collateral management practices. Additionally, the exploration of margin optimization through cross-margin arrangements is expected to gain traction. For instance, the Bank of England’s directives on stress testing post-LDI crisis, enhancements in cross-margining offerings by entities like DTCC and CME for treasuries, and the SEC’s proposal for centralized clearing of repos are indicative of an ongoing, industry-wide emphasis on margin-related issues. These developments will undoubtedly influence how margin and collateral are managed.
Furthermore, the increased funding pressures have brought into sharp focus the costs associated with derivatives trading, highlighting the importance of an efficient margin and collateral management process throughout the entire trade lifecycle. As a result, it’s anticipated that there will be a growing prioritization of technological solutions aimed at reducing costs in margin and collateral management. Such advancements are expected to significantly improve liquidity management capabilities.
In summary, 2024 will likely see a continued emphasis on regulatory compliance, cost management, and technological innovation in the collateral management space, driven by the evolving market conditions and regulatory landscape.”
The Outlook for Post-trade Processing
Beyond geopolitical impacts on financial markets and fluctuating inflation rates, several regulations impacted the post-trade derivatives space in 2023: trade regulatory reporting (e.g., CFTC Rewrite, EMIR Refit), Central Securities Depositories Regulation (CSDR), ISO 20022 for cross-border settlement, ESG reporting, and the USD LIBOR cessation, to name just a few. These regulations necessitated a massive overhaul of internal processes and technology upgrades.
Many firms were also still trying to get to grips with the shift to SA-CCR in 2023. While much of the derivatives market already goes through central clearing, there are still pockets that are not cleared – such as cross-currency swaps. Bi-lateral FX products incur settlement risks and are more capitally intensive for banks under SA-CCR and banks have been caught between deciding to swallow up the capital costs that come from either trading cross-currency swaps bi-laterally or shifting more FX derivatives into central clearing. Even in the case of FX NDFs, the cleared volume falls well short of the total volume. All this has led to more and more banks seeking a post-trade optimisation model that seeks to minimise their total FX exposure, a trend that will likely continue in 2024.
Cybersecurity—or lack thereof—and third-party risk management moved centre stage in the way the capital markets post-trade infrastructure is thought of and reviewed by regulators and internal compliance departments. And what could be termed re-emerging assets, such as carbon certificates trading driven by increased needs by financial institutions to manage energy markets, also impacted the post-trade derivatives landscape. It often required new technology to support specific processes.
Related reading: Cybersecurity in Derivatives: Emerging Regulation
Basu Choudhury, head of Strategic Initiatives at OSTTRA said:
“In addition to continuing to overcome capital cost challenges under SA-CCR, financial institutions will also be confronted with heightened demands to vigilantly monitor, manage, and reserve against intraday settlement exposure in 2024 – as funding and liquidity challenges will not go away in the New Year.
Short-term funding intricacies coupled with liquidity scarcities, epitomised by credit bottlenecks, will culminate in elevated costs and suboptimal execution prospects. This puts an even greater emphasis on monitoring and managing liquidity positions to ensure that sufficient funds are available to meet payment obligations. Having access to backup liquidity sources in case of unexpected funding shortfalls will be increasingly important, as will the efficient collateral management to cover intraday exposures and mitigate counterparty credit risk.
Ultimately, it’s crucial that financial institutions look to adapt and evolve their risk management practices in response to these changes in market conditions. Regular reviews and updates to risk management policies and procedures are essential for staying resilient in an evolving post-trade landscape in 2024.”
Marc Natale, global head of Presales, Marketing & GTM at Murex said:
“The key theme for post-trade in 2024 will be how financial institutions transform their technology infrastructure. Regulations introduced in the last few years, such as SA-CCR and BCBS 239, are really starting to bite into post-trade activities. There are also new regulations on the horizon, in particular the Basel III “endgame,” which will add more cost and resource constraints to banks. The Digital Operational Resilience Act, or DORA, is expected to consume a large part of technology spending in years ahead. We see 2024 as a pivotal year for transforming post-trade technology, making it an enabler for growth as well as a means to optimize resource-intensive processes. Large investments in data management, optimization and monetization will continue to drive IT spending, fueled by even larger investment in AI.
Digitalization of pre- and post-trade processes, seen by many as a prerequisite for client retention and acquisition, will also continue to drive firms’ investments. Leveraging further cloud services, DLTs, selected third-party vendor business process as a service, and modern, interoperable APIs are expected to deliver further value to clients in 2024.
Financial services firms will leverage their own technology further to make it available to their customers, ultimately enhancing their user experience for better investment decisions guidelines, increased what-if scenario capabilities, faster trade execution and near real-time reporting capabilities.
So how can market participants achieve this? It would be tempting to think that banks can perform a one-and-done approach to transform their technology on their own, but this would be too resource intensive. At Murex, we believe the answer lies in a process called “urbanization,” defined as a process to organize the gradual and continuous transformation of an information system. It has a lot to teach us when it comes to transforming post-trade infrastructure at financial institutions.”
Brian Steele managing director, president, Clearing & Securities Services, DTCC said:
“2024 will be a significant year for DTCC, as we prepare for important changes to US market structure. With the transition to a T+1 settlement cycle in the U.S., Canada and Mexico, along with the SEC’s recent decision to expand the use of central clearing for US Treasuries, the industry will be looking closely at their business models, technology and processes to ensure compliance. We recognize the significant effort these initiatives require, and we are committed to working with our clients to ensure a smooth transition. At the same time, as the ecosystem continues its digital evolution, financial market infrastructures (FMIs) are poised to expand how they serve the industry. At DTCC, we’re working collaboratively with the industry to move beyond traditional transaction processing to become architects of a dynamic financial ecosystem that ushers in a new way of serving clients, crossing the TradFi (traditional finance) and DeFI (decentralised finance) ecosystems. It is an exciting time for the financial markets’ digital evolution, which will bring reduced risk, increased efficiency and new capabilities, and as an FMI, we are proud to help lead this transformation alongside the industry.”
Risk Management Macro Trends
With the most significant interest rate rises in advanced economies since the last century, and a number of high-profile bank failures, mergers and defaults, 2023 was a turbulent year.
In recent years, regulators have been trying to understand the mechanics of the default and if the current regulatory capital and margin rules would protect banks from similar failures in the future. Work by Fabrizio Anfuso on Wrong Way Risk and over collateralized exposures, and Michael Pykhtin on ‘Modelling Credit Exposure to Leveraged Counterparties’ demonstrated that in the area of highly leveraged firms there is still work to be done to ensure the stability of the financial system in the future.
While some countries have been fully under the latest Basel III regulations for some time, including holding capital based on the new rules, the United States has been unique in not publishing its proposals. That changed in July 2023 with the publication of Basel III – Endgame. With a proposed compliance date in July 2025, this brings the US up to date with the rest of the world, however, also pushes it beyond the standard internationally set with substantial gold-plating of the rule set.
Stuart Smith, co-head of Business Development at Acadia said:
“As we look forward to 2024, there are several areas where banks are likely to focus to ensure they remain in a strong position. Dealing with the changes in both regulatory and market conditions, there are three things that are likely to dominate the agenda.
The publication of Basel III – Endgame proposals has clarified much of the uncertainty that has dominated significant parts of the industry. While not drawing a line under the regulatory framework in the United States, it has given a timeline for a conclusion. The arguments, both technical and political are likely to be fierce however it’s likely we’ll see a conclusion to the uncertainty which has held back decision making until now.
As banks grapple with higher interest rates and increasing labor costs, particularly in the important areas of machine learning and artificial intelligence, they are likely to look for efficiency savings in their processes, by pushing for greater automation. By reducing their dependence on manual activities, they can both control their labor costs and improve the accuracy of risk calculations. This also extends to using new tools to support analysts in understanding and analyzing trends in risk data, and being able to perform more dynamic calculations.
Both trends will be driven by an increased focus on Open-Source and Open Access solutions. Firms have for decades had to choose between in-house development and the control and transparency that it gives the firm or vendor solutions with both transparency and interoperability challenges. A new breed of solutions focused on Open-Source principals and with an Open Access model based around public APIs is providing a compelling way forwards for many institutions. This change will enable firms to have the benefits currently associated with in-house development while enjoying the scaled benefits of a vendor model.”
Central Clearing
The revival of cleared repo and the developments around the strategic autonomy agenda of the EU were essential trends in 2023. Heightened volatility driven by macro uncertainty over the outlook for interest rates saw clearing volumes sustained at elevated levels. The expiry of the clearing exemption for EU pension funds in June 2023 was also a significant milestone.
The abrupt rise in interest rates, but also the earlier than initially expected repayment of targeted longer-term refinancing operations (TLTROs), led to an increase in the funding costs on the capital markets and the need for collateral efficiencies. As a result, for the first time in many years, cash-driven repo transactions and, in particular, transactions cleared through a central counterparty (CCP) have come back into focus. Participant structures are diversifying. Even though today commercial banks, national debt management offices (DMOs), central banks, supranationals and, most recently, pension funds already participate in repo markets, there is increasing interest from other client groups such as insurance companies, money market funds or hedge funds.
Matthias Graulich, member of the Eurex Clearing Executive Board said:
“Cleared repo will definitely continue to grow in 2024. Besides the changed rates environment there are multiple developments likely to make cleared repo, particularly centrally cleared dealer-to-client repo, more attractive and relevant for market participants.
First, within the current European Market Infrastructure Regulation (EMIR) 3.0 discussion, it is suggested to remove some relevant barriers for regulated buy-side firms to effectively access cleared repo, e.g., counterparty limits. Secondly, potentially changing global systemically important banks’ (GSIB) treatment of repo exposures under the Basel regime should increase the value of central clearing. And finally, some recent publications by central banks have highlighted risks and deficiencies of the bilateral repo markets and see more repo clearing as a key tool to address these concerns. This goes as far as the Securities and Exchange Commission (SEC) suggesting a clearing mandate for treasury bond and repo transactions.
Also, capital and margin efficiencies will stay key. Through initiatives such as cross-product margining between cleared repos and derivatives, Eurex will continue to provide market participants with further efficiency benefits across products along the entire euro yield curve. I am very pleased that clients are increasingly recognizing the potential risk offsets and margin savings that arise when bundling their Euro-denominated fixed income exposures across exchanged-traded derivatives (ETD) and over-the-counter (OTC) along the Euro yield curve with us.
The benefits of cross-product margining are also an important factor when it comes to building alternative liquidity pools within the EU and reducing reliance on third country CCPs – another topic that will be high on the agenda in 2024.
In December 2023, the Council and the European Parliament submitted their respective positions to the Commission’s proposal. Even though the final details and application timeline of the incoming active account requirement are still to be decided by the final agreement between the EU institutions in the first half of 2024, it seems that the final legislation will include some type of active account requirement for EU market participants at EU CCPs for Euro swaps and Euribor Futures. Affected market participants should ensure readiness in time. Eurex supports market participants to set up such an account. We believe it to be beneficial for market participants to be ahead of the curve and use the benefits of an EU-based CCP account in a timely manner.
As Eurex, we are especially proud to have made great progress with our alternative liquidity pools in 2023. With the expansion of our Eurex clearing partnership program to the STIR segment we laid the foundation for Eurex’s STIR segment to be successful. The volumes show that we are trending in the right direction. Trading in EURIBOR Futures passed the 2 million contracts milestone since its relaunch on 1 November. And within the first 30 days. And volume in €STR Futures accelerated since then to a total of around 2 million contracts since launch in January with market shares above 50 percent in November 24 So all in all a solid foundation for further growth in the home of the Euro yield curve CCP Eurex.”
Benchmark Reform Continues
The expiry of the clearing exemption for EU pension funds in June 2023 was a significant milestone, and these schemes have adapted well to clearing their EUR swap risk at LCH’s SwapClear service. LCH was the first central counterparty (CCP) to offer clearing of USD swaps referencing the secured overnight financing rate (SOFR) in July 2018, and the firm played an integral role in supporting derivatives market participants globally to seamlessly transition away from USD London interbank offered rate (LIBOR) – the biggest transition by notional, by trade count and by number of clients, and from other legacy benchmarks, including SGD SOR and THB THBFIX, to new risk-free rates (RFRs).
Phil Whitehurst, head of Service Development, Rates, LCH:
“LCH will continue to support additional global benchmark reform efforts, including the Canadian market transition from Canadian dollar offered rate (CDOR) to Canadian overnight repo rate average (CORRA) in 2024, following consultation with market participants earlier this year. We have already seen an effective migration of liquidity to CORRA across the curve as participants have looked to actively transition ahead of the cessation of CDOR in June 2024.”
Related Reading: Clearing the Air – the Both Sides of the Active Account Mandate and The Error of Margin is Back on the Table
Risk Management Hybrid Solutions
In 2023, private equity and private credit firms increasingly demanded hybrid risk management capabilities from service providers that pair advisory and execution services with direct, real-time access to derivatives portfolio data, reporting, and analytics. Over 80 percent of private equity and private credit firms that Derivative Path spoke to expressed interest in or had a need for improvements in technology that enables efficient derivatives portfolio monitoring and reporting capabilities. Of these firms expressing technology interest, over 75 percent had legacy advisor relationships, demonstrating a clear need for technology capabilities beyond what was available in the market to date.
Brett Morrell, head of Risk Solutions, Derivative Path said:
“The past year shed light on how dry powder for new private equity investments is at an all-time high, and lending activity has been picking up on the back of easing inflation and expectations that floating rates are at or near peak levels, suggesting 2024 should be a much more robust year for new investments. Significant uncertainty remains on the future path of interest rates, as evidenced by the divergence of rate market expectations and central bank projections, which creates opportunities for hedging new investments.
Building on the trends we observed in 2023, I foresee 2024 being the year that the demand for hybrid risk management capabilities will continue to gain momentum, stemming from a mix of an expected rebound in private markets deal activity and the complexities of incorporating derivatives into private markets investment structures. Derivatives are complex financial instruments. For PE firms, they represent both an opportunity and a risk – the opportunity lies in leveraging these instruments to mitigate risks and enhance returns, while the risk exists in the volatility of the market and intricacies of managing these instruments effectively. I also predict continued focus on adding transparency to market risk management and its impact on investment performance, and continued uncertainty of future market movements as global central banks attempt to thread the needle of mitigating inflation without triggering a recession.”
Digital Tokens and Reference Data Identifiers
The year 2023 saw progress on the regulation of stablecoins and other cryptocurrencies. The European Securities Market Authority (ESMA) has been consulting market participants in recent months on the details the Markets in Crypto Assets (MiCA) regulation, which is due to come into force in 2024. The UK Financial Conduct Authority (FCA) and other jurisdictions such as Hong Kong and Singapore are also looking at stable coin regulation.
As the markets mature, digital token identifiers and standards will become the tools to help firms with regulatory reporting, data management, risk management, compliance and so on. For example, ESMA recommended including digital token identifiers (DTIs) and International Securities Identification Numbers (ISINs) for regulatory reporting. The DTI Foundation is working with the Association of National Numbering Agencies to create identifiers to cover the universe of crypto assets that are not currently covered by ISINs. Longer term, it would be desirable to have a fully operational model where a numbering agency takes on that work like Derivatives Service Bureau (DSB) does for derivatives.
Read more Identifier Update: Current Uptake and Next Steps and UPI Update: DSB Enables UPI Creation in Production Environment
Denis Dounaev, product owner of Digital Token Identifier Foundation said:
“Crypto use is growing fast and flowing from all directions. There is some positive news, some negative news, and a lot of talk about a crypto winter that may be starting to thaw.
There will be a shift in focus to tokenisation of real-world assets, including security tokens. That will be a big trend in 2024, as traditional players have started making significant investments, after initially adopting a wait-and-see approach.
However, even though that is progressing quite rapidly, the industry will remain in a transition period for some time. It will take many years for the world to become fully digital with everything being tokenized. Taking established standards and evolving them helps to bridge the gap between traditional finance and digital. But it is not like flipping a switch – it is a very organic process.”
Year in Review: Top Reads from 2023 (So Far…) – Derivsource
