Moving towards a more stable and healthier OTC derivatives market

Moving towards a more stable and healthier OTC derivatives market

The Bank for International Settlements (BIS) recently reported that there was a decline in the cost of replacing outstanding OTC derivatives, the first since the financial crisis. There was a similar decline in the gross notional amount outstanding as well. While this indicates the tough regulatory regimes worldwide in the aftermath of the crisis, it also a sign of a healthier and more resilient OTC derivatives market. Due to the rising regulation-related costs of trading, market participants are looking to make their OTC derivatives trading more efficient. Tools such as trade compression and collateral optimization are being used for this purpose. So the decline in outstanding is also an indication of more efficient trading due to compression. Another sign of the efforts to reduce systemic risk is the rise in volumes of OTC derivatives that are being centrally cleared. The greater use of clearing houses is something that regulators have been espousing for some time, and an approach that most market participants and observers agree with. Besides the internal factors, external economic ones such as interest rates and exchange rates also explain some of the decline in value of OTC derviatives trading. Again, these are a sign of market fluctuations and do not necessarily represent any market decline. In our view, the BIS numbers are indicative of both the changes that regulators have put in place over the last 7-8 years and of a global economy that is still recovering from the financial crisis and the following economic challenges.

Run, hide, partner, or buy: Fintech, automation, and disruption in wealth management and capital markets

Run, hide, partner, or buy: Fintech, automation, and disruption in wealth management and capital markets

Readers of a certain age may remember Frankfurt's aspirations of surpassing London as the world’s leading banking center. While that vision has not come to pass, Frankfurt remains a powerful hub for global finance. Home to Deutsche Bank, the European Central Bank and the Deutsche Börse exchange among others, Frankfurt’s importance is reinforced by its location at the very heart of Europe.

With this in mind, Research Director Brad Bailey and I are excited to bring the next Celent Wealth and Capital Markets roundtable to Frankfurt on Tuesday, May 10th. Of particular interest will be the role played by fintech firms in disrupting an ecosystem long dominated by large financial institutions. Brad and I will share ideas and examples from recent research, while senior executives with banks and asset managers and other large institutions from Germany, Switzerland, the UK and Italy will offer their perspectives on the disruption and the technology strategies they have adopted in response.

To maximize the participatory nature of this event, Celent is capping attendance at 20 individuals. At present, we have a few seats still open and would love to hear from other clients interested in joining us.

What comes first, OTC derivatives trading volumes or the CCP?

What comes first, OTC derivatives trading volumes or the CCP?
In a couple of recent discussions about central counter-party clearing for OTC derivatives in the global capital markets, we have come across the view that the move towards central clearing has not been as comprehensive as expected earlier. What this is referring to is the fact that the number of central counter-parties (CCPs) has not changed significantly when we look at the global markets. In the developed markets in the US and Europe, the presence of existing CCPs and the difficulty for new CCPs to break into the market has been an important reason. In the case of emerging markets, the fact that the volumes of OTC derivatives traded are quite low means that only CCPs in large markets such as Brazil and China are expected to be viable. Hence, not too many CCPs are going to crop up in the smaller emerging markets. This belief is understandable, but we must take into account the fact that the maturity of capital markets in these regions is low. As the emerging markets evolve, the presence of CCPs would encourage more trading in OTC derivatives products and allow for greater innovation and also standardization in the long run. These could be factors that increase volumes for OTC derivatives trading in smaller markets in regions such as Latin America and Asia-Pacific. Also, until recently,  the emphasis for the respective regulators and governments with regard to derivatives trading  has been on exchange-based trading. The presence of a local CCP and the greater transparency that ensues in OTC derivatives trading would encourage both regulators and governments alike to allow for more trading and clearing of these products due to better oversight. Hence, this is a virtuous circle and decision-makers who are looking mainly at current OTC derivatives volumes before they decide whether to have or not have a CCP in their domestic market should also look at the potential for trading of OTC derivatives products in the long run. Similarly, the market participants also should take a positive view towards CCPs in smaller markets, as initial focus should not be whether the CCP would be profitable and competitive regionally and globally, but whether it fosters safer trading and clearing of OTC derivatives and allows for higher trading volumes in the region than before.

Post-trade and the clouds over Europe

Post-trade and the clouds over Europe
Europe has been dealing lately with all the issues around the Greek debt and the possibility of a “Grexit”. While the final decision on the matter would have its significant repercussions, the uncertainty that has come with the problem in the last few months is also expected to have its own associated costs. It could also impact the long-term competitiveness of the region vis-à-vis its competitors in the US and Asia-Pacific. When we focus specifically on the capital market issues. there are several significant regulatory changes happening in the European capital markets at this point in time. EMIR, Mifid II, Basel III, T2S and CSDR are all regulations at various stages of implementation. From a post-trade point of view, several of these regulations are expected to have significant impact, especially when we talk about T2S and CSDR. However, the continuing concern over regulatory implementation in Europe is that the delay and uncertainty over when the regulations come into effect could prove costly for the region overall. An example is the delay by European Securities and Markets Authority (ESMA) in providing the draft technical standards. Similarly, the recent decision by Monte Titoli to delay joining the T2S, at least for a few months has proven to be a setback for the project, considering it was easily the largest CSD to participate in the first phase and would have been instrumental in measuring the effectiveness and success of the implementation. There is a lot of ground that the regulators and industry are trying to cover in an economy that is still suffering from the after-shocks of the financial crisis. While trying to do everything in a hurry isn’t the answer, it is important to ensure that the deadlines are kept as much as possible, otherwise on-going delays will directly impact European market’s competitiveness.

Nasdaq’s vision for Blockchain

Nasdaq’s vision for Blockchain
Nasdaq has recently one become of the first leading capital market firms to consider the use of Blockchain and Bitcoin technology. It plans to use the technology in its private markets platform to begin with, with the possibility of using it in its clearing houses and CSDs at a later date. In some ways, this is the most significant commitment any large financial market firm has made to adopting Blockchain. Even more interesting is the manner in which Nasdaq has gone about the process. It has made one of its VPs an evangelist of the platform, with a strategic mandate. This is an interesting example of a tech-savvy firm utilizing an innovative approach to encourage and advocate for what it sees as the next big wave of change in the financial markets. However, the open architecture of Blockchain technology and the difficulty in controlling the kind of transactions that could happen through it make it complex to use, and there are some resultant security concerns as well, which is why large banks are normally reluctant to adopt such a technology. So the industry would have to put checks in place before there can be widespread adoption of Blockchain in capital markets. There are already some existing provisions with Blockchain to address these requirements, and we can expect more effort in this regard as time goes on.

OTC derivatives regulations in US and Europe

OTC derivatives regulations in US and Europe
There has been an ongoing dialogue for some time now between the European capital markets regulator European Securities and Markets Authority (ESMA) and the Commodity Futures Trading Commission (CFTC) of the US regarding the requirements for clearing of OTC derivatives. In the opinion of market participants, the lack of agreement, over issues such as margin requirements and the period for which a transaction can be considered to be at risk, is highly detrimental to the efficient functioning of the global capital markets. The evidence has also shown that increasingly there are two separate pools of liquidity operating in the US and European markets respectively, a sub-optimal and undesirable state of affairs. However, from the point of view of the trading participants, the important thing to keep in mind for the future is that the two regulators are in ongoing discussions and the contentious issues are specific and not pervasive. There is also a great deal of respect and understanding that has been displayed by both regulators for the other’s point of view, all of which bodes well for overcoming their differences. An agreement would allow for greater liquidity and higher levels of market efficiency, and should also provide a much needed boost to global derivatives trading.

On the cusp: regional integration in Asia

On the cusp: regional integration in Asia
It’s 2015, the mid-point of the decade and a good time to start looking at major trends in Asian financial services over the next five to ten years. One of the major themes will be regional integration, which is another way of saying the development of cross-border markets. There are at least two important threads here: the ongoing internationalization of China’s currency, and the development of the ASEAN Economic Community (AEC) in Southeast Asia. RMB internalization is really about the loosening of China’s capital controls and its full-fledged integration into the world economy. And everyone seems to want a piece of this action, including near neighbors such as Singapore who are vying with Hong Kong to be the world’s financial gateway to China. The AEC is well on its way to becoming a reality in 2015, with far-reaching trade agreements designed to facilitate cross-border expansion of dozens of services industries, including financial sectors. While AEC is not grabbing global headlines the way China does, we see increasing interest in Southeast Asia among our FSI and technology vendor clients. From Celent’s point of view, both trends will open significant opportunities across financial services. In banking, common payments platforms and cross-border clearing. In capital markets, cross-border trading platforms for listed and even OTC products. In insurance, the continued development of regional markets. Financial institutions will be challenged to create new business models and technology strategies to extract the opportunities offered by regional integration. It’s the mid-point of the decade, and the beginning of something very big.

OTC Market Reforms in Asia: Presenting New Opportunities

OTC Market Reforms in Asia: Presenting New Opportunities
In another blog we discussed the issues that will have serious implications for different market participants in the OTC derivative market reform process in Asia.  Here we look at its impact on different market participants. The move towards central clearing is likely to create more demand for clearing services. Currently a small number of brokers offer clearing service in this space, and they may not be able to handle the sudden rise in demand. Some of the major international clearing firms are in the process of scaling up their operations in the region. Even though the volumes in the OTC segment are low at present, the growth prospects of the Asian economies in general, and niche areas (e.g., NDF clearing) make the region strategically important for many of these firms. However, some participants are wary about the costs of having to join many clearing houses and the issue of assuming unlimited liability in case of default. International banks have significant share in the OTC derivatives space in Asia; if these issues are not sorted out, some western banks may withdraw from some markets, or even the whole region, which would likely have an adverse impact on liquidity. Regulations mandating central clearing will create business opportunities for centralized clearing. In some markets like Singapore, the incumbent exchanges are taking a leading role in this regard. It will be interesting to see if new players will be able to enter and succeed in this business. Low volumes in the Asian markets, proliferation of CCPs and competition from international ones may result in each CCP specializing in specific niches along product lines or local currency instruments. The business models of new CCPs will come under heavy scrutiny from regulators, breaking trends from the past. As large number of OTC trades move to the CCPs, the concentration risk at some of them would be significant and national regulators would want to make sure those risks are adequately managed on a continuous basis. As CCPs replace bilateral trading, and market participants face the choice of executing trades at different CCPs, they will also need tools for managing and optimizing the use of collateral. This represents an opportunity for some market players who specialize in providing collateral management solutions. Needless to say, the kind of solutions needed and offered in this space will depend largely on the maturity of specific markets and market participants. Thus, while Credit Support Annexes (CSAs) may be sufficient for emerging countries of the region, advanced services (like collateral transformation, outsourcing of collateral management) would gain traction in the leading countries like Australia, Hong Kong and Singapore. Reporting banks would come under greater regulatory scrutiny and will have to run stress tests and ensure capital requirements on an ongoing basis.

Impact of the MF Global bankruptcy and the lessons for global regulators

Impact of the MF Global bankruptcy and the lessons for global regulators
The filing of bankruptcy by MF Global shows how interconnected the global markets really are. It also highlights the integral role and impact of the regulators and credit rating agencies on the activities of trading firms. There have been murmurs that this event could have a widespread impact on the health of global markets. At first instance, I do not believe that we are looking at an event with wide-spread impact. There certainly will be a significant local impact as MF Global is one of the largest trading firm on leading exchanges such as the CME, and its counter-parties and stakeholders would be keen on ensuring that they do not sustain long-term damage due to the event. However, as the bankruptcy has come in the wake of the recent debt restructuring in Europe and MF Global is much smaller in size then Lehman was, it is a much more ‘controlled’ event than the sub-prime crisis was in 2007-08. From a regulatory point of view, the various regulators are now better placed to be able to manage the repercussions of such an event than they were a couple of years ago. One of the worrying issues that has come up though is the possibility of deficiency in funding the customer futures segregated accounts at the firm. It is believed that there has been a shortfall of a few hundred million dollars in the segregated accounts (in which funds are kept separate from the futures broker’s own funds). In spite of the increase in regulatory oversight and pressures of trading participants to conform, MF Global has still managed to operate without adhering to the rules. The lesson to be learnt is that the regulator would have to be even more alert to the possibility of rules such as those for segregation and margining not being followed, especially as the amount of funds that is going to be kept with brokers and clearing houses is going to rise manifold once the OTC derivatives clearing moves to the CCPs. This instance can be taken as a wake-up call by regulators world-wide and reminds them that it is not sufficient to have laws in place, enforcement would also have to be stringent. Otherwise, the systemic risk might actually go up instead of reducing under the new central clearing regime.

Where is all the collateral going to come from?

Where is all the collateral going to come from?
As we move towards a scenario in which central clearing of standardized OTC derivatives becomes the norm in markets across the globe, there is one question that is on the lips of a number of practitioners in these markets. And that is, “where is all this collateral going to come from?”. The collateral and margin requirements across the various markets mean that there would be a requirement for vast amounts of (relatively) good quality collateral. The OTC market is many times the size of its exchange-traded counterpart, hence we are talking about a gigantic exercise involving trillions of dollars. What makes things worse is that the clearing houses and CCPs are not expected to provide much interest on the collateral provided to them. In effect, we are looking at a situation in which funds and securities that might otherwise have been used for trading will go out of the system. In a recent event that this author attended, the consensus was that the volumes traded in not just the OTC derivatives market but also other asset classes such as fixed income would dip sharply. It would become quite difficult for the market participants, especially the smaller firms, to sustain themselves in such an environment. Our hope is that in enforcing these changes we do not throw the baby out with the bath water.