Lynn Strongin Dodds explores the trends that will have the most impact on derivatives markets this year according to a recent report on derivatives market infrastructure.
The call to increase efficiency is nothing new in the derivatives world. However, the voices have grown louder as markets combat the ongoing headwinds of regulation and ride the tailwinds of turbulence. It is not just about mitigating the twists and turns but also leveraging the opportunities.
Trends for 2024
These are the findings of a new report –Derivatives Market Structure 2024: Focusing on Capital and Workflow Efficiency – from Coalition Greenwich in partnership with the Futures Industry Association.
It was released at the FIA’s International Futures Industry Conference in Boca Raton, Florida, an event that gathers over 1,200 industry leaders from over 20 countries to discuss the dynamics of the global derivatives market.
The report, which canvassed 210 derivatives market participants, revealed that almost 70% believe the derivatives clearing business needs to enhance capital efficiency to generate additional capacity and support future growth. Respondents ranged from end users such as asset managers and hedge funds to intermediaries-brokers, dealers, clearing firms – and infrastructure players including exchanges and clearinghouses.
As Stephen Bruel, senior analyst at Coalition Greenwich Market Structure & Technology and author of the report, said, “Derivatives are an integral component of the financial and asset management ecosystem and the potential for increasing volatility in an environment of elevated interest rates and economic uncertainty has shined a spotlight directly on the market structure that supports these instruments.”
More stringent capital requirements
While many of the concerns identified in the report are recurring, the order had changed this year with more stringent capital requirements moving to top of the list. Around 50 % of overall participants, expect them to have the greatest impact on derivatives trading and clearing in the near future.
Last summer, the US Federal Reserve published the Basil III endgame which is one of the last chapters of the international post global financial crisis framework. It introduces extensive changes, especially in the calculation of risk-weighted assets (RWA) which will significantly impact business models, compelling banks to reconsider their capital allocation strategies.
The changes provoked widespread criticism across the industry. In a letter, the FIA said if enacted, these rules would make it far more expensive for banks to provide their clients with clearing services for futures, options, and OTC derivatives. This in turn could impair access to these instruments by a wide range of companies that use derivatives to hedge their risks or manage their investments.
In addition, they would have the unintended consequence of increasing systemic risk by reducing the capacity to move customer positions out of a clearing firm in case it goes bankrupt. In hard cold numbers, these provisions would increase capital requirements for client clearing at the six largest US banks by more than 80%.
EMIR 3.0
The Basel III endgame though is not the only regulation in the hot seat. The report found that 45% of respondents are worried about the various initiatives swirling overhead, most notably EMIR 3.0. It is its final stages of negotiation and will require European derivatives users to clear a portion of their interest-rate futures and swaps denominated in euros to clearinghouses on the continent.
Last year. a joint statement was issued by European trade associations including AIMA, EFAMA, BFPI Ireland, EACB, FIA EPTA, Federation of the Dutch Pension Funds, Finance Denmark, Nordic Securities Association, ICI Global, FIA and ISDA, urging EU policymakers to delete the proposal and instead focus on streamlining the supervisory framework for EU CCPs across member states. They noted that incentivising measures would offer sustainable growth for these market infrastructure players while maintaining competitive and open markets.
Current drivers
Overall, the derivatives market is poised to expand with 35% of respondents pointing to macroeconomic uncertainties, and volatility as the main engines. Although the latter can be seen as a risk, derivatives often come into their own as effective tools for not only managing risk via hedging but also achieving investment goals by adding duration, for example. Moreover, the report notes market turbulence, albeit not too bumpy, can be a huge driver of volume, which benefits intermediaries, exchanges and clearinghouses the most.
There is less consensus on other reasons with 25% of end users and 37% of infrastructure providers believing retail participation hold the key to the future, while only 12% of intermediaries do. This reflects the historical institutional focus of the futures industry although the recent increase of retail interest in US securities markets, particularly equity options, may signal a change in direction.
By contrast, the report said there is more agreement about the impetus from China and India. The latter country’s exchange-traded derivatives market has exploded in size in recent years, fuelled by massive retail trading of equity options. However, foreign participants will be less familiar with its market structure and regulatory environment., The retail business is dominated by local brokers who offer mobile trading platforms, while the top global brokers support hedge funds and principal trading firms that have flocked to this market because of the arbitrage and market-making opportunities.
Technology takes centre stage
Against this backdrop it is no surprise that technology will be a linchpin. There will continue to be a critical need for optimising margin and collateral management. Operational challenges, particularly in reporting, allocations, and give-ups, were identified as significant obstacles needing immediate attention. Innovations such as standardisation and tokenisation in collateral management were seen as pivotal developments capable of revolutionising trading and clearing workflows.
AI was also mentioned but it is more on the wish list in terms of improving exception handling and performing complicated data analysis. For now, as in many sectors, AI will be used mainly in research to perform complex searches with plain language with compliance and surveillance being the main areas, particularly for the heavily regulated brokers, clearing firms and other intermediaries. Many compliance programmes still include labour intensive and time-consuming manual processes.
As Bruel noted, a sizable minority of market participants believe generative AI is on the brink of transforming derivatives trading and clearing workflows, but the most impactful solutions could be much simpler. “Accommodating additional volumes and complexity requires an improved operating environment. In a high-volume/low-margin business rife with manual intervention, both intermediaries and their clients are keen to increase straight-through processing. For intermediaries in the derivatives market, the development and adoption of operational standards at the global level would be a game changer,” he said.
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