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

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.

The future is here

The pressures are well known in banking and the capital markets. Each month there are front page articles of scaling back, overhauling, reorganizing, or closing major bank lines. A continued reworking, a forging of a new business is occurring. Old models are shrinking and being replaced by new business models or being cast aside. Since the 2008 crisis, wave after wave of pressure has made this perfectly clear. Capital constraints, on-going regulatory pressures, and an ultra-low interest rate environment have all struck hard at the existing banking & broker/dealer system. Nearly all players-big and small- are rethinking the very core of their businesses. And this is a multi-threaded problem across all businesses: equities, FX, fixed income, and derivatives. Banks and broker/dealers are trying to balance their existing franchises against the pressures they are facing to create a lean profitable business that supports their clients. There are no easy answers, given the strong interdependence between the wealth, asset management, and capital markets businesses across all products. Many of the solutions are moving from efficiency, or cost-cutting to effectiveness. Costs are being cut-there are improvements in risk, compliance, processing. The cost side is getting better but the challenge remains on the revenue side. This drive for effectiveness is driving business models that support internal and external clients from a compliance, transparency, regulatory, fairness and cost perspective are driving more automation and electronic trading solutions. Celent will be discussing the evolving landscape of innovation in automation and technology at two upcoming roundtables. On September 15th in London we will be looking at changes in the US and European fixed income markets and how new technologies are driving change. Then on September 22nd in Zurich, we will be looking at wealth management and the capital markets and the many changes that are occurring in Swiss banking.

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.

Operations challenges for APAC asset managers

The global capital markets have been going through a turbulent recovery phase in the last few years. Asia-Pacific is no exception to this rule and the region’s asset managers will come up against a set of operational issues and constraints to be addressed in a difficult market environment. Addressing regulatory pressures, be they from within their own jurisdiction, or from without, will be paramount in the mind of asset managers. It is important for managers to consider the various KYC and AML requirements internationally and how they affect their respective jurisdictions. This is not an isolated enterprise, and must be undertaken along with the task of upgrading the operational capabilities, and if required, acquiring the necessary platforms or systems to address these concerns. As much as possible, asset managers must try and use a comprehensive solution, underlining a desirable holistic approach to the issue. Most asset managers will meet their various operational requirements by using a mix of in-house and third party services. Outsourcing is nothing new to the industry, but can still be challenging. It has its own set of risks which need to be considered and mitigated for successful operations. Firms have to ensure a strong integration of the outsourced services with the in-house operations. Another challenge is the complexity of products being utilized by asset managers to meet their clients’ needs. With more choices available and structured products becoming popular again in leading Asian jurisdictions, firms have to ensure that their risk management systems are capable of handling greater product complexity. These are only some of the issues asset managers need to keep in mind, and overall they would be well served with taking a more holistic approach to operations management, and ensuring they make sufficient investment in their systems to help them handle the various challenges.

Evolution of trading technology for exchanges in the Asia-Pacific

Several Asian economies and capital markets have witnessed rapid growth in the last few years. This has led to an expansion in the market infrastructure and a string of notable investments by the leading regional exchanges in trading platform technology. The exchanges in Asia-Pacific have adopted varying strategies to meet their technology requirements. Some exchanges have used their in-house capabilities to develop trading platforms. Others have used a mix of in-house platforms and technology from third party providers. Finally, some have relied mainly on outside technology, using best-of-breed solutions. The objective has been to modernize exchange infrastructure and ensure that the exchange remains competitive in the face of pressure from leading global players as well as other regional exchanges. An interesting feature of the Asia-Pacific markets has been the linkages and tie-ups between the regional exchanges, as well as those with leading global exchanges. The market is exhibiting a unique mix of cooperation and competition. The most notable recent inter-linkages have been the Shanghai-Hong Kong Stock Connect and the ASEAN Trading Link. Both are still in early stages of being set up and there are some inevitable glitches before we see significant volumes. But what is important to note is that this kind of connectivity is spurring other exchanges to also try and increase access to their products from outside markets and exchanges. While there are certain advantages for exchanges in the Asia-Pacific, there is nevertheless room for improvement. There is potential to turn the market data function into a significant profit center. Some exchanges are already successful in this, but others need to follow suit. Also, there needs to be greater emphasis on market surveillance and tighter regulation in what is a fast-evolving market landscape. I have been working on an upcoming research report that looks at the issues discussed here in further detail.

Analyst day: Capgemini

I recently had the opportunity to attend the analyst day at Capgemini in Chicago. It was certainly time well spent, as it provided me interesting insight into the functioning of a leading capital market technology firm. It was also useful as I was able to step back from my day to day work in technology related to capital markets, and understand some of the latest trends in technology for both the overall financial services and also for non-financial firms such as energy companies, retail firms and even firms in the entertainment industry. Having such a perspective allowed me to contextualize the recent innovations and technological developments in the capital markets that I write and consult about, and which we discuss on a day to day basis with our clients and other industry participants. We often forget the potential for cross-fertilization of ideas across all industries, and also the deep impact that some of the technological changes have on our day-to-day lives. The analyst day also provided me an understanding of the evolution of Capgemini as a technology firm and how it has matured as one in the last decade or so. From a firm that used to meet the bespoke IT needs of its clients, it has moved onto becoming a system integrator and then even a business partner for many of its clients in the new initiatives that they have planned related to technology. It is an interesting example of how the entire industry has evolved and how IT firms are becoming much greater risk-takers and partners in new technological initiatives, as opposed to being mere service providers they were earlier. With regard to their capital market capabilities, there was an interesting discussion of a recent derivatives trading system implementation, where Capgemini helped to integrate and streamline the trading systems of their client, while upgrading the same in the process. It highlighted Capgemini’s capability to manage and enhance vital IT platforms as a strategic partner for its clients.  

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.

Exchanges and innovation

I recently attended the 2014 IOMA/WFE conference in Moscow. An interesting panel debate was on the role of innovation in the exchange universe. Some observations: • While not all innovation begins at the product level, exchanges tend to focus energies there consistently • Exchanges seek early feedback from customers on product needs, particularly any products that offer risk hedging • In some geographies innovation must involve a wide array of stakeholders including regulators • Exchanges also concentrate on innovation along the value chain; seeking and filling gaps In summary, the current state of innovation at exchanges appears to be fairly customer-centric when launching new products (e.g. index options or futures products). To get beyond product innovation at exchanges, one must consider technology innovation. Since only a few exchanges think of themselves as technology vendors, technology innovation is difficult, but some exchanges may focus on driving down latency, improving capacity or delivering technology to a community of users. Collaborative innovation may be on the rise, as exchanges look outside their walls for partnerships. For example, CBOE plans to invest in Tradelegs, a developer of advanced decision-support software.

Will There Be Another Financial Crisis? Yes

Note: I posted this, but it was written by Axel Pierron, Senior Vice President, Securities & Investments. – JC On the occasion of the fifth anniversary of the collapse of Lehman Brothers, people are asking whether there will be another financial crisis. The answer is: yes. Therefore the question is: Are we ready for the next crisis? The major regulatory push has been to address the issue of OTC derivatives trading, which was perceived as the source of the Lehman default, and the AIG bailout. However, with OTC derivatives being centrally cleared, we are raising the level of systemic risk by implementing a common process/infrastructure across the various asset classes. The first rule I learned in grad school was: to minimize your risk, you need diversification.  If you take the analogy of Darwin’s theory of the origin of species, the most adaptive species are the ones that survive. Mother Nature does not put all her eggs in one basket. Today, regulators are doing the opposite; hence the next crisis could be much more dramatic.  My overall concern is that the regulations will ensure that a minor crisis does not spread across the industry.  However, we are ill prepared for a “black swan,” and as we have known since 2007, black swans do exist. It’s a balancing act for regulators between leveling the playing field (for example, by syncing effort between the US and the EU to avoid regulatory arbitrage) and allowing some level of diversification and customization. Nevertheless, some fundamental questions have not been addressed, and we are not questioning how the crisis was handled. Maybe Lehman should have been bailed out as well? Or perhaps there should not have been any bailout? Capital markets are based on risk and reward; one could argue that the bailout program has removed the risk element and sent the wrong signal to the industry and the public. In summary, regulators are working to create a framework to avoid a 2007-like  crisis. However, while crises are integral to the functioning of financial markets (we call it a crisis, but in fact it’s a readjustment), their detonators are always a surprise to most people. It would be better to  learn from our experience to  develop a framework to respond (e.g., chain of command, bailout or not, synchronization of central bank policy, etc.), because crises are inevitable. The current regulatory approach reminds me of the French army in the 1930s leveraging their experience of World War I and building the Maginot line, when in fact World War II would be fought with tanks and airplanes. The last battle is over, and we need to prepare for the next one.