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.

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.

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.  

Run for Regulated!

Run for Regulated!
As the European and US authorities are trying to regulate pretty much everything in the financials industry in their “Prudential Regulation” stance to prevent our economies to implode, unregulated entities are thinking about getting a regulated status.. In the news today there is rumour that ICAP, one of the leading inter-dealer broker in the OTC derivatives space, is assessing whether they should buy the Plus Market, the UK exchange for fledgling companies that is planning to close after failing to secure a buyer. Now only four companies in the UK have a regulated market status: the London Stock Exchange, the London Metal Exchange (also for sale), ICE Futures Europe and Liffe, owned by NYSE Euronext. It sounds like a safe bet, an insurance in case Dodd-Frank in the US and EMIR in Europe do not just ask for OTC derivatives trades to be cleared but also be traded on a regulated market. That’s a bit far out but you never know how crazy things can go! It’s probably going to be a matter of price for ICAP. But for many fixed income players that are eyeing the “post-new-regulation” dealer-to-client market in Europe, and assessing how to best get into it, it has become compulsory to at least get an MTF licence, maybe an OTF licence when we will really know what they will be, and why not Regulated Market status, though costs of maintenance associated with the latter have to be valued carefully, not for the faint-hearted.

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.

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.

Looking South for Inspiration

Looking South for Inspiration
What is often overlooked in the debate around derivatives reform and standardization of products in particular is that there are examples all over the world where the vast majority of contract volume takes place on exchanges and electronic platforms with central clearing, and far less on a bilateral basis. To wit, this is not a blog entry about whether Dodd-Frank is correct in its aims and implementation so far, but rather that when we move our analytical framework out of North America or Europe and take a look elsewhere in the world we can find useful market structure insights and even inspiration. In Brazil, 90% of all derivatives are standardized. Since 1994, all OTC derivatives transactions are required to be registered with trade repositories that are self-regulatory organizations. Argentina also offers useful insights. In Argentina, a 2007 regulation provided incentives for trading derivatives on exchanges or other regulated electronic platforms that offer guaranteed settlement. In 2010, about 75% of derivatives were centrally-cleared in Argentina and either traded on exchange or electronic platform, while bilaterally traded and settled derivatives comprise the remaining 25% of the market. Even more interesting, the central bank puts a microscope on these positions by closely monitoring the use of non-standardised OTC derivative products. They require institutions to provide notations in their quarterly financial statements about the use of bespoke products. As a result, according to the G20 Financial Stability Board, the market regulators and government “do not have plans to introduce mandatory central clearing requirements given the high level of standardisation, exchange and electronic platform trading and central clearing that already takes place” Clearly, other ways of conducting transactions and organizing market structure can enable a more inspired and informed debate.