Rashad Kurbanov, Head of Advisory, Investance, explores how the trend towards the futurization of swaps may impact market participant’s business, product evolution and operational processing.
Three years on from the signing of the Dodd Frank Act and EMIR, derivatives markets are abuzz with the new term. The “Futurization of Swaps”, which refers to the transformation of OTC Derivatives to become more like listed futures. This concept seems to offer a way to get around some of the more onerous capital and compliance requirements brought about by the new regulatory regime while offering new ways to trade risk between market participants.
Some players have already taken tentative steps in this direction. Energy market participants have been moving from trading swaps to futures on exchanges such as the CME and ICE and the volume increases is significant. In addition Eris Exchange –predicted to be one of the 25 most influential firms over the next five years – is rapidly growing its product offering and signing up liquidity providers.
Is “Futurization of Swaps” the way forward for OTC derivatives? What are the implications for market participants in terms of regulations, business and product evolution and operational processing?
In the US the Commodity Futures Modernization Act, signed into law at the end of 2000, came at the end of a decade-long debate about the extent of regulation of the derivatives markets, particularly OTC derivatives. The Act stipulated that since most OTC derivatives transactions take place between “sophisticated parties”, they would not need to be regulated as “futures” or as “securities” under the existing regulations. Instead, market participants would continue to transact in OTC Derivatives and be supervised by their regulators under general “safety and soundness” standards.
The CFTC as the main regulator of derivatives markets in the US argued unsuccessfully for more stringent regulation and was left with few tools to effectively regulate OTC markets. International regulations followed the same model and approach to a large extent. The financial services industry lobbied very hard a decade ago to make swaps different to futures and it won!
Needless to say this created a fertile environment leading to rapid growth in the OTC derivatives markets. At the onset of the credit crisis in 2007, global volumes of OTC derivatives stood between $600-$700 trillion in notional terms according to the Bank for International Settlements (BIS).
OTC Derivatives seemed to offer endless possibilities for the packaging, trading and managing of financial risks through ever more sophisticated mathematical models and financial engineering. Major dealers focused on product innovation and increased leverage through which they were able to achieve substantial profits. New business models emerged that focused on origination, packaging and distribution of new financial instruments.
However, this growth came at a price. The focus on product innovation, model sophistication and the complexity of OTC derivatives required dealers to invest heavily in their front office applications and processes. The mantra was “profits are high and we are prepared to pay the required operational price to support the business growth”.
Most dealers’ operations were organized in relatively narrow product siloes with little commonality between them. Exotics were processed on a different platform than flow derivatives, rates separately from credit or equities, and all were separate from listed futures. While OTC derivatives were mostly processed on proprietary systems, futures were processed on vendor platforms. Straight-through processing (STP) and process automation rates for OTC derivatives were low, resulting in a high cost per trade.
Anyone who has been following the evolution of the OTC markets will recognize that the fragmented operational infrastructure and high costs associated with it are simply not sustainable. Regulators globally, are pushing to move OTC derivatives to be traded via Swap Execution Facilities (SEFs) and Organized Trading Facilities (OTFs), clear through central counterparties (CCPs), be reported to Swap Data Repositories (SDRs) and margined using either CCP or regulatory approved models.
To respond to these changes, dealers recognized that the only way to succeed in the new environment is to streamline and rationalize their front-to-back platforms. However, the major challenge for the industry is to determine with some certainty how the market will evolve before committing to major investment to upgrade their infrastructure. Opinions differ on whether the OTC Derivative markets will simply shrink under the weight of additional capital and reporting requirements, resulting in lower volumes and notional or if the markets will evolve to become more like listed markets with significantly higher volume of smaller trades. There are many possibilities somewhere between these extremes.
However, a few things are becoming clear and all of them point in the direction of the “Futurization” of Swaps:
1. Listed derivative exchange operators like CME and ICE, having been given a mandate from regulators to operate CCPs, are making a strategic push to lead the innovation in the OTC derivatives markets. Given the breadth of their products in the futures and options markets, they are in a prime position to offer the industry substantial relief from the capital requirements through cross-product margining and by designing new products that optimized for the current regulatory regime. For example, while collateral requirements for cleared swaps are based on a 5 day close-out period, futures only require 1 day margin. Any evolution of swaps toward futures will bring this potentially significant benefit to all market participants.
2. Trading venues such as Bloomberg, TradeWeb and others are marching to register as SEFs aiming to draw more and more volume onto their platforms, effectively taking away the bi-lateral trading relationships from the dealers. Although many Dealers are currently providing liquidity to these platforms, as more users of OTC derivatives migrate to these platforms, bi-lateral trading will become less important in the overall client relationship. On the other hand, trading venues will seek to standardize traded products in order to gradually move from RFQ to something that resembles a Central Limit Order Book. This can be achieved only by making OTC derivatives act more like listed futures or options.
3. Apparent conflicts between the new OTC market regulations such as SDR reporting or the Volcker Rule and existing laws covering privacy and confidentiality are likely to lead the fragmentation of the OTC derivative markets along national lines. Dealers will need to adjust their services depending on their client’s jurisdiction. As global markets fragment, OTC derivative users will see less and less difference between listed and OTC derivatives.
4. The last and perhaps most important consideration is that the users of OTC derivatives will see very little difference between listed and OTC derivatives once SEF trading and CCP clearing are fully implemented. Although investors will continue to increase their asset allocation to various derivatives in search of enhanced returns, they will be making investment decisions taking into account transaction costs and operational efficiency. Clients will demand superior client service, from trading through to post-trade support and be looking for near real-time cross-product risk management and reporting as key requirements.
In light of the above the cost of evolving of the front to back platform is likely to be high, both in terms of new investments and retiring of the old platform and processes. Dealers must focus on their operational infrastructure as a priority or risk being left unequipped to operate in the new markets.
A few key themes are likely to dominate the evolution of dealers’ front to back environments:
• Scalability. As OTC derivatives become more standardized and start acting as listed instruments, it is likely that trading volumes will increase and trade size will decrease. The institution’s ability to process trades in large orders of magnitude will become important to ensure acceptable levels of support costs and operational risk.
• Vendor and utility integration. Dealers will have to integrate many more industry utilities and vendor packages into their processing environment. Whether it is mandated integration with SEFs, CCPs, SDRs or the integration of industry solutions such as AcadiaSoft, Dealers will have to focus on ability to integrate more than their ability to build in-house. Furthermore, if OTC derivatives become more like futures, established vendor solutions such as SunGard GMI or Rolfe & Nolan will become more appealing to support certain operational processes.
• Functional alignment and rationalization. Dealers will have to break product silo based processing environments and move to functionally aligned platforms. The move of OTC derivatives to the futures model will make certain functions such as collateral management, reporting and settlements virtually indistinguishable between various product types.
Of course we can only speculate on the way the OTC derivative markets will evolve. Back in 1995 it would have been almost impossible to predict the evolution of the Equities markets. However, based on what we can observe today, lessons learned from other asset classes and the direction of the markets, it is safe to say that a step change by Dealers is required to maintain their market share and presence. Whatever form OTC Derivatives take, the regulatory and market environment will push them much closer to listed futures model than where they are today.
