Challenging times for the post-trade industry: improving efficiency and achieving stability amidst growing complexity

Challenging times for the post-trade industry: improving efficiency and achieving stability amidst growing complexity
The challenges facing the CCPs and CSDs are manifold. Not only are they having to adapt to the downstream effects of changes in the trading environment, they are also presented with unique challenges impacting their business and operating models. Celent just published a research study titled “Challenging Times for the Post-Trade Industry: Improving Efficiency and Achieving Stability Amidst Growing Complexity” analyzing the global, regional, and local developments impacting the CCPs and CSDs. The changing regulatory environment is the dominant force impacting post-trade industry players. Several key regulations such as Dodd-Frank, Basel III, CRD IV, MiFID II, EMIR, CSD Regulations, and AIFMD are having impact on the way CCPs and CSDs perform. At times there is a lack of clarity and co-ordination among regulators in different jurisdictions; this results in lack of synchronization and standardization of some of the key regulations, creating confusion and making the job of responding to the changes difficult for industry participants. In addition to regulatory changes, market structure related changes  (such as T2S in Europe and shortening of settlement cycle across the world) are having significant impact on post-trade players. Though not traditionally very competitive, the post-trade industry is likely to become more competitive. Europe is leading the way in this regard, with CCP interoperability already in place and T2S and CSDR likely to do the same among the CSDs. Learning from the European example, other markets are considering introduction of competition in their CCP space by allowing international players in domestic markets. Post-trade players have been laggards compared to other parts of the capital market value chain when it comes to adoption of technology. Driven by regulatory and market forces, as well as emerging concerns around cybersecurity, they are now undergoing major reviews and upgrades in their technology and operations. We identified 12 key markets across the globe for this analysis including the US, UK, Germany, Czech Republic, Japan, Australia, Hong Kong, China, India, Brazil, Mexico, and Chile. This research is part of Celent’s ongoing coverage of the post-trade industry and was commissioned by Nasdaq , while Celent kept full editorial control. To complement Celent’s post-trade knowledge base from our existing and ongoing research, this research greatly benefitted from detailed discussions with representatives from 17 major industry participants representing different types and categories of players across the world. Find out more about the report at Celent or Nasdaq’s website.

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.

Smaller buy side firms and regulation

Smaller buy side firms and regulation
Increased regulation has become a way of life in the financial markets. Buy side firms are also devoting a lot of time and energy to meeting regulatory requirements. The share of expenditure for regulation and compliance has also risen accordingly. Firms are often building their IT strategies around the various requirements arising from Dodd-Frank, MiFID II, FATCA, Basel III, EMIR and so on. In this environment, smaller buy side firms are possibly in a tougher position than some of their larger asset management and hedge fund counterparts. The reason is that they do not have the same financial and technological capability and hence have to often adopt a more piecemeal approach to regulation and compliance. Their IT systems and platforms are also not geared fully to meet these needs, and streamlining the same is often beyond the capacity of many such small firms. An interesting development that has resulted from the spate of regulations post-financial crisis is the reduced participation or even effective withdrawal of the banks from different types of risk-taking activities. This has been accompanied by the effort by buy side firms to fill some of these needs. While this is an important area of opportunity for buy side firms, it is also something they should be cautious about. The reason is that the increase in buy side activity has to some extent moved the sell side risk to the buy side. This is accompanied by some liquidity problems due to the declining sell side activity. While smaller buy side firms are probably affected less by this issue than some of the largest asset managers, nevertheless they need to ensure their risk management systems are capable of bearing any new and additional stresses that the larger systemic role of the buy side might bring. Celent is currently conducting a lot of research looking at the various requirements of buy side firms, and I am about to publish a report that discusses the specific needs of smaller buy side firms when it comes to regulation. This research would also look at some of the ways in which these firms can cope with their pressing demands, and discusses how it is important for them to stand back and take a more holistic approach to regulation.

Big Banks’ exodus from Commodities

Big Banks’ exodus from Commodities
Goldman Sachs, Morgan Stanley, Barclays and JP Morgan used to be the biggest traders of commodity among banks. However, this space has witnessed many of the big banks exiting the business line in recent times. JPMorgan recently decided to exit physical commodities trading business by selling its raw-materials trading unit to Mercuria Energy Group Ltd. Morgan Stanley decided to sell its physical oil business to Russia’s Rosneft. Barclays decided to exit some of its commodities business. Deutsche Bank said it would exit dedicated energy, agriculture, dry-bulk and industrial-metals trading. Bank of America Corp. said it would dispose of its European power and gas inventory. UBS decided to shrink its commodities business sharply. Goldman began a process to sell part of its physical trading operations. This retreat of the big banks from commodity business has been driven by tighter regulation, stricter capital requirements, increasing political pressure and lower profitability in recent times. Key regulations impacting banks in commodity trading include Basel III, Dodd-Frank, and the Volcker Rule. Rules brought in to address the financial crisis of 2008 (Basel III, Dodd Frank) require banks to hold more capital than in the past against trading operations, which has made holding commodities more expensive for the banks. New charge for credit valuation adjustment (CVA) – which requires higher charge for longer dated trades with lower rated counterparties – is likely to have significant impact on hedging practices of longer dated trades. Further, regulators are pushing for over the counter trades to the public exchanges, which is likely to significantly reduce profitability of such trades for the banks. Volcker rule, aimed at banning banks from trading with their own capital, is another catalyst in this regard. Anticipating this rule many banks have already scaled back or spun off their proprietary trading desks. Politicians have also exerted pressure on banks to cut back their commodities business. Regulators and some senators have expressed concerns about banks being in the business of natural resources. This has been largely prompted by events like Deepwater Horizon oil spill, complains from other industries and associated media coverage. Policy makers are now seeking comment and exploring ways to limit banks’ role in trading of commodities.The U.S. Federal Reserve is considering new limits on trading and warehousing of physical commodities. Policy makers suspect that there are conflicts of interest when the same entity is involved in the physical market and also in trading derivatives on the same underlying. Commodity Futures Trading Commissions (CFTC) is investigating the effect banks are having in the commodities markets, as it has been argued that banks played a major role in the rising commodity prices, including that of agro-prices, in the latter part of the last decade. Lacklustre market conditions are another driver behind many banks’ decision to shrink or wind up their commodity business. While regulatory burdens have added to cost side of the business, less volatility in commodity prices have hit top line. Combination of these factors has resulted in lower revenue from the business. Industry estimates suggest commodity-trading revenue for the ten biggest banks shrunk by over 67% in 2013 compared to peak levels attained in 2008. This trend of falling revenues holds good for not only the commodity business, but also to the FICC (Fixed income, currency and commodity) segment in general. Forced by this, some banks are shrinking or winding up their Fixed Income business as well. These developments are making commodity trading an inefficient use of capital at a time when other markets, such as equities, are showing signs of recovery.

Taking the temperature on e-fixed income trading in the US

Taking the temperature on e-fixed income trading in the US
I participated in a Trade Tech West panel a week or so ago on e-trading and it was a good time to take the temperature of the adoption and attractiveness of electronic trading in US corporates by the buyside. The panel consisted of a couple of buysides and me so it was objective in terms of a real status check. The panel agreed that the major themes were as follows: 1. Bond markets remain split between continuous (odd lot mostly) and discontinuous market models (round lots or institutional trades) 2. Dealers are increasingly moving to a facilitation role 3. Inventories- still flat to down….and still an issue (pun intended) 4. Capital requirements remain onerous 5. The job description of a Fixed Income sales/trader is impossibly broad- making e-adoption something on a laundry list of other functions to support besides normal client service 6. The buyside is getting up to speed on the array of options out there- that being said, Bloomberg and MarketAxess came up a lot. Admittedly, this was an equities audience so they would not be familiar with all the other options out there, so the panel mentioned the market leading multi-dealer MD2C platforms. The tools in high demand will depend on the rate of market adoption and successive changes in market structure, but the laundry list remains: Smart order routers Aggregation tools OMS/EMS functionality My thoughts that I conveyed to the panel were that, for the buyside, order books developed for odd lots can be used to supplement liquidity- some of these EOBs are slowly allowing the buyside to be price setters (Bonds.com is an example). Also, whole the market will increasingly become interconnected over time, this is a major problem at the moment. As for best execution, it is a concept but not a pervasive business practice. For dealers, they are rolling out innovative D2C technologies, including crossing (with some capital commitment), fuzzy matching and other utility models for liquidity seekers. Balance sheet optimization remains a major theme for dealers, as does the informational balance sheet, which is a concept we will explore going forward.

Lehman Anniversary Musings and Wish Lists

Lehman Anniversary Musings and Wish Lists
There are a multitude of Lehman Brothers anniversary stories going around, and perspectives can get lost. Hence, I decided to let a week pass before I commented on the fifth anniversary of the infamous collapse of Lehman. I promise to make these points short (and hopefully sweet). What have we really learned from Lehman and the last crisis? Apparently the financial industry is unable to regulate itself, so is it really a surprise that it now needs to be externally regulated? We have opened Pandora’s Box. Virtually every sector within financial services is facing heavy regulations. But the problem I have is that the current paradigm of external regulation is expensive for everyone (expect perhaps regulators, lawyers, and consultants), compared to a scenario where the industry can learn to govern itself appropriately. So, what can we take from five years ago? Many lessons have been identified around short-term funding concentrations, leverage, mispricing of risk, misaligned incentives, lack of governance at both board and industry levels, complexities in the valuation of “hard to value” assets, and the potentially fatal interplay of various risks.   Will we have another crisis? Despite the changes the industry has made, one gets a sense that the consequences — the unpalatable prospect of capital and liquidity shortages, negative impact to the cost of funding for banks, corporates, and small businesses; and the ongoing threat of counterparty failures — all linger in various guises today. By that token, you could say that we have treated the symptoms but not the causes. The “virus” of inappropriate culture, failing to govern (e.g., treating risk management as a formality), and not using the right information to make risk-adjusted business decisions are still in the blood of the industry. A new crisis may emerge before we know it. Some observations: In the last year, corporate earnings have failed to track recent market rises. Yet US equities are up 30% over the past 18 months, while earnings have only risen 6%. Has the investment community become trigger-happy to trade while ignoring fundamentals? How soon did significant operational risk failures and conduct incidences happen after the firms, regulators, and governments supposedly “learnt the lessons” of 2007/2008? Unfortunately, not long after. We are still seeing market trading failures (Knight, Nasdaq), whale trading losses, LIBOR rigging, and product mis-selling.  We have observed (and here, regulators and policymakers are not exempt) how L/ZIRP (low or zero interest rate policy) created a bubble in commodities (which has burst). It created a bubble in emerging markets (which has deflated), and it is creating a bubble in bond markets — all of which may pose a major risk in the event of rise in rates or aggressive QE tapering. The boom and bust dynamic seems to be rearing its ugly head again. Old habits die hard.   What does the Holy Grail of risk management look like? I will answer in terms of outcomes I would like to see, rather than how the mechanics of risk management need to look like. I will know that the Holy Grail has been found when: 1. Regulators and firms embrace the right rules and the right tools to spot future financial bubbles. 2. Frontline personnel that pursue risks (and rewards) within organizations are directly compensated (based on both soft and hard incentives) according to the risks they are taking. 3. We have resolved the “too big to fail” problem, and taxpayers no longer need to bail out firms they are not responsible for.   For me, the longer-term questions are: Has the industry taken the right medicine? We know that there were bitter pills prescribed, but were they the right ones? Are we still taking the medication, or have we forgotten? We need to follow through; if the lessons of the last crisis do not improve our ways to anticipate, prevent, or manage the next crisis, then what have we really achieved? Undeniably, stringent capital, collateral and liquidity requirements are some mechanisms that can preserve stability and mitigate risks during crisis scenarios, but these are not necessarily preventive in nature. In the end, perhaps cultural astuteness about risk-taking within financial firms and a better understanding of the collective behavior of capital markets globally are the most effective medicines to avert systemic failures. For now, my advice would still be: Buyer beware!

Risk decisions that matter: What financial firms can learn

Risk decisions that matter: What financial firms can learn
Recently, at a seminar I was presenting at, I had the privilege to hear from a person, for which risk management is likely to be the most important aspect of his livelihood. The person is Sir Ranulph Fiennes, the British adventurer described by The Guinness Book of Records as “the world’s greatest living explorer” – not to be confused with Ralph Fiennes, the actor – who is a cousin of his. The title of Sir Ranulph’s talk was “Risk Management in Life and Death Situations”, and it centers on the lessons learned in pushing himself to the limits, and examines his life-and-death risk decisions. I have summarized (in certain cases, paraphrased) the risk management dimensions which I gleaned from his witty, humourous and sometimes, soul cringing presentation. The principles are as follows:

1. Know your team up members close and personal. For big life and death expeditions, although the motivation and incentives of the team are important, these are not sufficient elements in order to reach your end goals. You need to discern and understand the character of the individual members of the team, or face the risks of failure, or worse endanger the team’s lives if there are serious weaknesses in a team member’s character. Hence select your sojourners very carefully.

2. Be of “one mind” – The team who are going to take the risks, is the same team who assesses the risks, is the same team who reaps the rewards – you need to plan, operate and execute with “one mind”

3. Assess your routes and research the terrain you are trying to conquer very carefully, especially the danger zones, pitfalls and hidden crevices

4. Ensure you have the proper tools suitable for the terrain

5. Face (and expect) adverse conditions, resistance and ‘boring waiting periods’ by maintaining discipline and endurance, with a unrelentless focus towards the end goal

6. Adaptibility and innovation is required (without compromising point 5)

7. Big picture plans and detailed tactical steps are equally important to execute towards the goal – don’t underestimate either

8. Use political levers to get past road blocks, rough terrains or to cut journey time (without compromising point 5)

9. Ensure timely monitoring mechanisms to gauge progress, safety checks to measure critical (team and personal) healh indicators, and landmarks to determine closeness to target destinations

10. Plan against big risks: Try to avoid or go around these altogether rather than face it

  … if there is one place risk management matters, this is it: when your life and death depends on it!   How much can financial instiutions learn from these principles? I believe, a lot. And for some organizations, its life and death may indeed depend on executing to these principles in the coming years ahead.  

Safe heavens and investment hells

Safe heavens and investment hells
Reported through the Wall Street Journal yesterday, the Germans have issued a bond (a German treasury note known as Schatz) with a zero coupon. This is unprecedented in some ways. What it says is that investors are so desperate that they are willing to forfeit any yield for the privilege of parking their funds for two years in what they see as safe assets, as the escalating debt crisis in the euro zone continue to play out in contagious and unpredictable ways. What’s driving demand? Between insurance companies and pension funds that offer products with ‘guaranteed returns’ or conservative fund portfolios that place an emphasis on value preservation; financial institutions hunting for sources of liquid, high quality collateral for regulatory purposes, repo and OTC derivative markets; and CCPs demanding more stringent margin requirements, one can expect this race to compete for a share of acceptable safe assets to grow. Investors that have been burned over the past few years are saying capital preservation remains a paramount objective for them. For me, financial markets are so dislocated at the moment that perceived “safe havens” are elevated to “safe heavens” by investors in their flight to safety, whilst distressed entities/sovereigns are condemned to investment hell (so to speak). However, such polarization between the two extremes of ‘elevated heavens’ and “investment hells” perhaps point to me that the market is running out of options for safe assets. It also begs the question of whether this is an illusion that is too good to be true. At the moment, not even favored safe haven assets such as gold, investment grade government and corporate debt, and covered bonds are necessarily immune to the shaking that is rippling through the markets. In this instance of German treasuries, zero yields in theory means that it is completely ‘risk free’, for which there is no such thing, not in terms of absolute safety anyway. Germany may be the strongest economy in the Eurozone but contagion effects are difficult to predict. There are a few points of caution here: First, the growing concentration of capital flows into these perceived safe assets is in itself a risk and (arguably) creates a bubble effect. Secondly, the polarization dynamic between the haves and have nots create large imbalances that will amplify structural volatility. Thirdly, current (and emerging) regulatory regimes like Basel 3, Solvency 2 and Dodd Frank/central clearing are almost, in tandem, sucking in and ‘consuming’ safe assets. It creates a backdrop for these effects to continue. Is this an unintended consequence that we do not want or need in the longer term?

SEF malaise- the calm before the storm?

SEF malaise- the calm before the storm?
Market participants are frustrated. Swap Execution Facilities (SEFs) in the US market should have been a reality by now. Instead, we have faced numerous delays and await SEF registration rules, likely in April. After that point, more debate and comments will occur until probably near the end of the year. Electronic trading of swaps on SEFs (acting as actual SEFs) may occur by the end of the year, but only for largest and most sophisticated market participants and only in select swap instruments (the most liquid CDS contracts for example). A far cry from what was envisioned when the G-20 reforms and Dodd-Frank were created and put forward. However, despite the malaise, is this the calm before the storm? Will we see an explosion of SEFs? Stay tuned for more Celent research soon, but here is a quick preview of our thinking: 1) SEF status is a rite of passage and not a guarantee of success in any fashion 2) Becoming a SEF is more than just taking an existing platform and layering on top connectivity to clearing and SDRs…oh, so much more and 3) To rather awkwardly quote the voice in the Kevin Costner film Field of Dreams, the key question for incumbent and challengers in the future SEF marketplace is “If you build it, will they come?” i.e. will liquidity migrate to new innovative platforms offering new protocols or just existing platforms with minor tweaks? Will it be enough to justify the return on investment, or is it just a new cost to be passed on to the buyside for largely the same market structure plus central clearing for standardized swap instruments? ….stay tuned.

SEF is the new black

SEF is the new black
Swap Execution Facilities (SEFs) are the top fashion item of the season and conference sessions including SEFCON II are packed with attendees. What remains to be seen is whether SEF rollouts in 2012 will match the hype. A quick word on the new lexicon: The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), the European Market Infrastructure Regulation (EMIR), and the Markets in Financial Instruments Directive (MiFID, MiFID II, MiFIR) have introduced several new acronyms to our market lexicon, two of which are SEF and OTF. Swap execution facilities fall under the regulatory purview of the US, while organised trading facilities fall under the purview of European regulators. In a new report, Swap Execution Facilities and Organised Trading Facilities: A New Market Structure Emerges, we examine the emerging SEF/OTF market structure and provide some clarity for those firms engaged in 2012 strategic planning and beyond. We also assess the likely IT impact across the range of market participants and derivatives systems components. A future report will assess where firms are with SEF/OTF rollout and ultimate compliance and what remains to be done. Much will depend on regulatory clarity in 2012 and everything ultimately depends on the volume of trades and liquidity. The swaps market is a product-by-product market and adoption of SEFs/OTFs depends not only on the rules, but also the participant (i.e., small bank vs. large bank, small buy side vs. large buy side, small corporation vs. large corporation). All told, we believe SEFs will be a good force for competition in the market, but overly prescriptive rules or a lack of flexibility could lead to a market structure where nobody wins, including both users and dealers.