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Repurposing the Business

With regulation as a driving force, the financial services industry—and most critically the OTC derivatives landscape—is facing major change. In order to be prepared for these changes, capital markets firms must consider a variety of new business and technology challenges.

Change leaders need to be appointed for business and technical domains. Fundamentally, the process should be seen as one of ‘retooling’ in order for broker-dealers to compete effectively in an agency role, alongside continuing principal dealer business, in a landscape of new connections. We look below at each of the major business processes involved in handling client orders, and the requirements for supporting systems:

  • Discovering liquidity will be more complex. We don’t predict an all-electronic transformation of the OTC markets, in fact, the mix will vary widely. Trading in some relatively simple and liquid derivatives, such as index CDS, has already gone almost entirely electronic; corporate bond markets, by contrast, are expected to move from less than 20 percent to perhaps 40 percent electronic over three to five years, while trading of bilateral derivatives will remain essentially unchanged. This said, in the electronic market segments we are likely to see techniques familiar from the equity markets, such as indications of interest, being widely deployed. 
  • Orders may be crossed in-house, electronically or manually, where regulations permit. For Europe, this remains a controversial item in the MiFID II discussions. 
  • Trading will be carried out on external electronic venues and will complement surviving traditional channels. Industry participants are reaching consensus (via the TESI initiative) on establishing standards in order to make connections and enable clients on multiple electronic platforms, as simply as possible. An important question to ask is: how far can markets in relatively illiquid assets fragment across multiple platforms, and what will be the impact of this on price formation? Some observers suggest that equity-like techniques such as smart routing and transaction cost analysis will become relevant, but at the current time we are skeptical about this prospect. 
  • Clearing is already a fact of life for most OTC derivatives, and mandated in the U.S. for SEF-traded contracts. The transition appears to have been well handled by the industry: clearing houses, brokers and FCMs have been able to leverage their listed market experience. Clearing brokers have usually been able to extend their business with listed-market clients to cover also the OTC business: the clients are thus able to benefit from CCP cross-margining across the two product sectors. 
  • Mandatory reporting, like clearing, is in place for swaps trades in the U.S., with Europe due to follow in early 2014 (the current EMIR target). There are concerns about the different and complex requirements of EMIR which will require buy-side firms to do their own reporting on a same-day basis. They will need automated solutions and sell-side firms already equipped for this may be able to help. 
  • Collateral management will no longer be just a back-office operational issue, but a vital business driver and a primary front-office concern. Availability of sufficient collateral to meet initial margin requirements, alongside current and anticipated variation margin calls, may be the deciding factor on when and how much derivatives trading gets done. As a result of these pressures, collateral optimization and transformation (in which lower-rated securities are exchanged for cash or high-rated securities) has emerged as a new service area and revenue opportunity for sell-side firms and one where balance sheet strength can also be leveraged. An obvious prerequisite for the support of collateral optimization is a common asset inventory; clearly this will be a challenge in cases where the relevant assets are managed in several different systems. This is a motivator for integrated system solutions, but where this is not possible, robust data interfaces will be required. 
  • Risk management at all levels—pre-trade, desk position and enterprise-wide—is of course vital, for both regulatory necessity and business profitability. The requirements of the CFTC and ESMA in cleared and electronic markets are now well understood and supported by most vendor products. The greater challenge lies at the enterprise level, where overall house (and, ideally, client) positions should be managed in as close to real time as possible. In the bilateral space, where credit and liquidity risk are still the key factors, an enterprise-wide view is equally important. 

The client interface to all of the functions listed above is of course particularly important. The single-dealer platform (SDP) approach remains valid in the new environment: indeed probably more so, as the relevant technologies are now maturing to the point where an integrated web front end can act as a window onto the full range of brokerage services, and to liquidity across multiple asset classes. The difference from the past, of course, is that the ‘single dealer’ role will be more complex and multi-faceted, embracing agency as well as principal dealer services. The holy grail of a fully integrated electronic client portal that can serve all asset classes will of course need investment. But the prize to be gained from approaching this goal will be considerable. Clients that can trade across asset classes at will (particularly for hedging purposes), and that are shielded from uncertainties over shifting boundaries between bilateral, cleared, OTC electronic and listed markets, are likely to be more satisfied, more loyal and more profitable.


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