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Futurisation of OTC Derivatives has been a key topic of conversation at many events and conferences I have attended over the last few weeks on a global level. Indeed, this has been the case for most of the last four years during which I have been building my business here at CLTX. Therefore, for my debut column in this publication, I have focused on this theme as I feel it is certainly something worth taking a moment to reflect on as we near the close of 2014.
So, does one size fit all? Let’s explore…
Since the advent of the G20 Regulatory Reform agenda of 2009, the CFTC and many regulators of the G20 Nations have been transforming the rules and regulations which govern the financial markets, and in particular, the OTC market. We all know the story of the three guiding pillars of reform. When it comes to OTC Derivatives those pillars are characterised as; moving derivatives on exchange - they become subject to mandatory clearing at a clearing house (CCP) and must be reported to a Trade Repository (SDR). Much of this reform has taken hold from a geographical point of view, in the US, Europe and Asia, and from a product point of view, across Interest Rates, FX, Credit Default Swaps and Commodity Swaps.
However, this reform agenda leaves a global derivatives market map of fragmentation - the US being the most advanced in its implementation of the three major principles followed by Europe and then Asia. Indeed, within the European and Asian markets there is, of course, much coordination across independent countries to align and synchronise efforts. In recent times, we see the challenges being faced by regulators in addressing cross-border jurisdiction and oversight responsibilities. Most critically, the US & European regions need to find a solution to equivalence and the recognition rules of clearing houses (CCPs). We at CLTX of course see some progress in this area, in that, the European regulator on 30th October 2014 did recognise a number of Asia-based CCPs which brings the first phase of “harmony” to at least one pillar of the G20 mandate.
This is a good example where one size does not fit all. CCPs have emerged in their own regions and their personalities and product lines very much reflect this history. Whilst many Clearing Houses, such as CME Group, LCH.Clearnet or ICE operate on a global basis, they are asked to establish operations in each region or recognition at the very least. And where their operations exist, regulatory licences in each market they operate in should be obtained. Ironically, the stand-off between the US & Europe would mean, for example, CME’s European Clearing House would not allow a US Person (Trader) to clear contracts there until CCP recognition is achieved.
So for the next wave of my questioning I ask, are all OTC contracts ready to move on Exchange and be cleared at a CCP and reported to a Trade Repository? Well, the market says an unequivocal “no”. I am being controversial, of course. Again, in the US, interest rates derivatives (IRD) have seen success in 2014, moving onto Swap Execution Facilities (SEFs) and being mandatorily cleared, reporting to Trade Repositories (SDR). Therefore, whilst the revolution for financial derivatives is seeing enforced migration to these new venues in the US, we in parallel, are seeing the unintended consequence of Dodd Frank reform. This is best encapsulated in the migration of contracts to become block trade futures on regulated markets which preserves the role of the voice execution broker, however, with the added advantage of mature futures regulation on a global basis, while incorporating the requirements of clearing and reporting. I believe that this is a very good hybrid solution, certainly for commodity markets. Therefore again, I argue there is no one size fits all for derivatives and it remains my point of view that not all derivatives should be treated the same way. Some markets such as rates and commodities do have standardised contracts, but also have bespoke ad hoc contracts. The standardised products can be executed on multiple trading venues and given up to multiple clearing houses. Additionally, differentiation and opportunity will arise through a combination of technology and operations leadership, cost, customer service excellence and innovation in contract design and the ability to operate for longer trading hours.
Of critical importance to the evolution of these OTC Derivative markets, be they swaps or futures is ‘plumbing’ - the pipes and connections that brings order and transparency to the lifecycle of the trade – from execution to clearing (and reporting!). The world has changed and is evolving at an incredible rate. Web services, open APIs, cloud computing, CTRM and agile software development are the underpinning languages of a multi-billion dollar software and services market that focuses on the opportunity to help transform the financial services market to meet the needs of the new trading rules and regulations. The tools required to enable a trader, his desk risk manager and the post trade compliance and reconciliation team to understand intraday positions in real time and ensure trades are given up for clearing and have them reconciled are the critical tools of the new world derivatives market. This becomes critical, particularly, as the next big phase of regulation will seek to strengthen capital adequacy rules (Basel III and G20 reforms) and through CCP segregation will create a more demanding realtime regime for Derivative margining.. Thus, integrated efficient systems that can satisfy portfolio reconciliation and compression will be the next battleground. These tools don’t and shouldn’t require millions of dollars of CAPEX to deploy across every line of business or desk and every process. A one size fits all technology model - held dear by a number of major software vendors in the FINTECH market - will be subject to challenge by new emerging software innovators. These solutions will and can transform mid and back office operations processes that remove risk and generate capital efficiency. The financial services market can meet upcoming rules, IT policies, compliance and reporting mandates through newer and more powerful platforms. Don’t be beholden to how it used to be.
I challenge these norms, as, for this new global market design of OTC Derivatives to be successful, it must lead to the creation of new markets, products and ultimately liquidity. The lifecycle of a trade needs to be efficient, near-error free and automated. Traders must be able to get back to focusing on trading and finding opportunities in the market. Intermediary brokers must worry less about losing the old ways of working - voice will certainly continue, but will be complemented by exchange order books. The best venues will offer the most choice, these are the tools of the job and both will be viable long term. Technology and Innovation have a significant role to play in this new world and the rate of change will only accelerate – all for the better.
Make no mistake, the new world for OTC Derivatives is here to stay, how it will evolve from here is unpredictable, however I have for some time surmised that this transformation will happen in three stages over a five year period, namely, the introduction phase, the adoption phase and the dependency phase. We are just leaving the introduction phase of global transformation (that started in 2009) and the adoption era is upon us. Dependency is some way out. Of course, I am long on regulation and to predict when this final stage will manifest itself is very much an option call. Let’s just agree to have a chat again when it has happened.
Richard Baker, CEO, Cleartrade Exchange CLTX. www.cltx.com
