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.

From the Celent Innovation Forum, Tokyo

From the Celent Innovation Forum, Tokyo
At Celent we have been focusing on financial services technology since our inception. Now of course all eyes are focused on fintech, which we might inversely call the use of technology to disrupt (traditional) financial services. Investment in fintech startups is significant, and the financial markets involved are huge – US$218 trillion annually in the capital markets alone. Celent recently held our latest fintech event in Tokyo to a full house, an indication of the intense interest in fintech in the Japanese market. The day consisted of two Celent presentations on fintech in the retail and institutional securities industries, followed by a discussion panel. Celent senior analyst John Dwyer presented on blockchain technology and its potential use across capital markets. Smart contracts powered by this technology could conceivably replace existing means of executing market transactions, and by enabling direct ownership might displace custodians and other intermediaries. As if this weren’t food for thought enough, governments including the US and UK are taking a serious look at putting the dollar and the pound on blockchains. Talk about fundamental disruption! Senior analyst Will Trout provided an analysis of how automated advice (robo advisory) is reshaping the wealth management industry. After the financial crisis many individuals quite naturally want to manage their assets themselves, but also require investment advice. Robo advisory, which perfectly suits the self-service, mobile lifestyle, is an answer to this dilemma. SoftBank, Nomura Asset Management and The Bank of Tokyo-Mitsubishi UFJ joined the panel discussion, bringing their respective views on cognitive computing; the potential of fintech to lure Japan’s famously reticent retail segment to participate in the markets; and how to mobilize a large organization for innovation. A fundamental question about fintech is who will ultimately derive value from these innovations: fintech startups; technology giants like Alibaba and Google; or the incumbent financial institutions? Due partly to the regulatory stance, in Japan more than in most markets financial institutions may be in the best position to end up in the winner’s box. Only time will tell, for Japan and for markets across the globe, but you can rely on Celent to continue to provide our clients with insights in the rapidly developing world of fintech.

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.

A vital utility in the OTC derivatives industry

A vital utility in the OTC derivatives industry
Leading OTC derivatives industry participants including banks and post-trade services providers are backing the creation of an creating an OTC post-trade infrastructure utility. This hub will help automate the margin management in the industry and is also expected to reduce the disputes around margining. Until recently, moving important functions to utilities was often frowned upon. In several instances, firms showed reluctance to participate in a utility unless there was evidence of widespread acceptance of its services. But now factors such as regulatory requirements and the need to cut down upon costs are creating an environment conducive for the greater acceptance and use of utilities. To that extent, the industry has reached the tipping point with several other instances of utility or near-utility services being offered, most notably for KYC requirements. This is a good sign for the industry overall. The higher cost of operation due to regulatory requirements and the ever-growing need for investment into technology up-gradation means that often it might make more sense to move such services that are either more commoditized or require industry cooperation (or both) onto a utility platform. Hence, such a step in the highly competitive OTC derivatives industry is quite significant. It will help increase automation and efficiency, reduce costs, and encourage other segments in the capital markets industry to consider the use of utilities in a more positive manner.

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.

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.

Buy side insight for Fixed Income platforms

Buy side insight for Fixed Income platforms
Time keeps becoming scarcer and we all become more selective on what conference we will attend or speak at. But yesterday, as I was by chance in Paris, I dropped by one of the potentially nth conference on fixed income, and was presently surprised by the value of its content. Congrats to Trading Screen for pulling it off. Let me share with you a few takeaways, mainly from a great buy side panel: 1) One of the buy sides (whom we all know are the ones calling the shots nowadays) summarized his selection process for choosing a new trading platform as follows: i) Who owns the platform? A bank (negative points) or a vendor (positive points if strong balance sheet). I would add exchanges (they are neutral) and interdealer brokers (for whom it is one of the only options to remain in business) to that list, but the latter will have a challenge at connecting all the buy side. I have an open question here: why wouldn’t the big buy side invest together in a platform they believe in with Equity so that they can reap the benefits of the success they will bring to it as the banks did with Tradeweb?Aren’t they in the business of investing? ii) Buy side is not an option: if the buy side doesn’t all connect together in an automated way, the success rate of the platform will be low. (c.f. who’s calling the shots). iii) The need for an independent clearing agent from ownership and/or for the functionality to choose one’s own clearing agent. Here I actually pushed the question further as a big custodian is currently rumored to be the clearing agent of a MD2C platform’s new product: should custodians be involved, should they become agent brokers since they have the assets of the AMs (and a clean balance sheet, may I add?), or be a platform? Some people in the audience laughed at that one, pretty sad considering what some of the big global custodians have in pipe, let’s assume these were brokers who have never taken the time to understand what happens “post” trade… thankfully at least two of the big buy sides in the panel actually got my point: there could be room for some innovative matching engine to team up with custodians (Algomi?). See last year’s Celent report: Innovation in Focus: The Analytics Powering Fixed Income Matching for a comparison of the functionalities of the new matching vendors. iv) Flexibility of interactivity: the buy side has to be able to choose to interact only with each other, to exclude toxic flow, to include some banks, etc. Everyday potentially in different ways. So just a switch functionality for the other side of the trade. Some new platforms thankfully already have that in their rule book/functionalities such as Bondcube or TradeCross (Trading Screen’s 2.0 version of Galaxy). In our report we actually had mentioned the “selective multicast” capability of Baymarkets for banks to select what prices to send to what client in cascades; this is an interesting adaptation for the buy side to select who to send what interest or order or request for quote to whom in cascade or not. 2) Another point that was made was that there is no first mover advantage, this is taking time to pick up as AMs are adapting to change and regulations on transparency is not final: I could not agree more as we have been having these discussions for the past 3-4 years non-stop, and the number of professionals buy and sell side interested keeps increasing. Still, at some point the big AMs will have to jump on one ship as the cost of illiquidity is becoming too expensive for their funds’ performance (nice presentation on that from an AM quant). 3) Last but not least is the cost of connectivity to all of these platforms‎, apart from the time spent to connect to them (and to convince senior management to connect to them?). This has to be corroborated also by the lack of screen space available for new entrants, the need to come in via other or incumbent screens maybe? Or via a web browser? 4) Last interesting point which is an idea we have been pushing out at Celent for a while: the buy-side could go directly to the issuers: yes, and they already do actually, for big infrastructure projects or issues whereby they already have a relationship with the issue. A platform with both and no brokers, banks to build the book and syndicate and sustain the price? CSDs and iCSDs have a role to play here: such a platform could work with Dutch auctions or even normal auction process, but it would work more in the interest of the smaller buy side than the big ones obviously, creating a level playing field… hence hard to make it pick up… SMEs and small institutions could meet on P2P lending platforms through aggregators of interest such as Orchard though. More in an upcoming report on these… As for TradeCross‎, I still need to get a demo but we already know that it will be All-to-All (but in the flexible way mentioned above, not our old definition with CLOB and level playing field), anonymous, an MTF, trading with all-in price (commission), interest and orders, multiple trading models (did they mean protocols?), spread or price or yield trading and with a web browser if need be. No go live date as of yet.

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.