In Hong Kong the back-office support of derivatives activity has become more complex because volumes are rising and products traded are becoming more elaborate. The capabilities of back-office organisations are being stretched and the current level of technology is not resilient enough. More ASP (application service provider) service is needed.
Key points of the session:
- The push to clear OTC derivatives is putting stresses on systems and procedures.
- Differing symbology among exchanges is creating problems for cleared trades.
- Asia has an opportunity to grab market share in the midst of regulatory uncertainty.
- But investment in compliance personnel and technology will be required.
Speakers:
- Michael Stanhope [MOD] – Moderator – CEO, Hubbis
- Albert Helmig [AH] – President, Hong Kong Mercantile Exchange
- James Drumm [JD] – Executive Director, Omgeo Pte Ltd, Asia
- John Warren [JW] – Director, Post Trade Group, SunGard
- Robb Arnulphy [RA] – Clearing and Settlement, Noble Group, Hong Kong
JW – Post-trade clearing and settlement of derivatives, over the last two years, has grown in complexity. The push for OTC products incorporation into the cleared environment has created challenges for providers, custodians, and the exchanges themselves.
AH – It is popular in the current environment, after the crisis in debt instruments, to try to clear everything. That sounds easy from a regulatory, systemic risk, scenario but there are enormous unintended consequences. It creates an enormous strain – timing issues, capacity issues, and huge cost issues. OTC derivative clearing requires enormous bandwidth for small transactions and small clearing revenue and I’m not sure the cost/benefit ratio is sound for the exchanges.
RA – We’ve seen a lot of movement in the commodity world to clear OTC swaps; we’re finding that automating these poses some challenges – certainly when you have multiple exchanges offering clearing of the same product. Selecting which exchange to clear that product on, and how you reflect that in the systems adds a certain complexity that you don’t find in the futures and options world.
Has the regulatory pendulum now swung too far to one side?
AH – Regulation is either a little too loose or way too tight. The current environment has been seen before: ’81, after the Hunt brothers, and ’87 after Drexel it looked like this – after both we saw great regulatory change. Also, after Enron in 2001/2 you saw Sarbanes-Oxley and you’re seeing a different version of that now. The situation is one of regulatory uncertainty: the lack of certainty as to how certain instruments will be margined, how they’ll be settled, what has to be cleared.
JW –The expansion of instruments changes the face of the market but the business model itself will have to change to address the issues mentioned or else we’ll see a huge drop out of participants that will not be able to keep up with the systemic requirements of this new evolving market.
RA– In the energy markets swaps can be cleared on multiple exchanges. And there can be many instrument codes among the exchanges for effectively the same instrument. Additionally, of course, the dealer will have traded in a particular quantity whereas the exchanges report cleared swaps in lots. The reconciliation problems are endless. Mapping quantity and coding is quite difficult into a system that’s geared to reconciling futures.
JW – It is not an easy solution, getting a system designed for futures and options to aggregate trades from the swaps. And, of course the symbology is an issue that everybody is struggling with at the moment. The definitions of the back-office and post-trade are being fundamentally changed by the move to clear OTC instruments.
AH – We’re talking about encoding. I think that’s an exchange job. I believe there is an exchange solution to coding – I believe that an exchange is a service bureau, there’s a service that exchanges can perform: aggregate code and folding it into execution.
As well as taking the role of a service bureau how do you see exchanges driving into the non-exchange markets?
AH – The opportunity in capital markets for financial institutions is vast. Technology will give Asia the opportunity to exploit the economic growth model that was not possible 15 years ago. There is now enough embedded liquidity in commodities and other derivative instruments in Asia to trade our own liquidity pools in our own time zone. But technology is the must-have component and whether you are a participant, a broker, or a service provider you have to be at the leading edge of technology.
JD – There is another advantage that Asia has, it doesn’t have the heavy infrastructure, no legacy systems, and it has a clean start and can learn from the mistakes of others, EMEA and the Americas.
What are the specific problems that need to be faced?
RA – As we move OTC swaps into the clearing mechanism they fall under the oversight of the regulators – the CFTC for example – and where previously compliance systems were only looking at specific futures they now have to take into account a whole raft of swaps that have been cleared in the US. That adds another layer of complexity for our compliance people: from a back-office perspective we have to make sure that not only are we monitoring the futures levels but also the corresponding OTC swaps which fall into the same position limits.
AH – The US regulatory model of position limits for commodities will force business out of the US. Exactly as what happened with precious metals in 1981-2, after the Hunt brothers, regulation changed overnight, the base metals market went to London and never came back. That could happen now in the energy market. The paperwork and regulatory burden that could occur in the US in OTC energy swaps is going to huge. If Asia provides a solution the market will vote with its feet. Another thing: when OTC clearing is talked about I don’t think it’s understood what it means to be compliant. There will be a human resource problem regarding compliance officers with experience: the industry has consolidated so much there is now a reduced talent pool.
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