Increasing efficiency has been a constant theme in the history of financial markets. The fallout from the subprime crisis has increased the need to keep a tight lid on costs, but not at the expense of business expansion.
After a decade of unprecedented growth, the exchange-traded derivatives (ETD) industry was subject to a sharp correction during the global financial crisis. Volatility increased and contract volumes plunged. Now though, the future is already looking much brighter, even if there is, as Kevin White, lead partner for financial services at Ineum Consulting UK, claimed a ‘do more for less’ challenge facing everyone.
White made his assertion while moderating a panel session on ETD post-trade processes. In his opening remarks he stated that many believe the future will see increased growth. White listed some reasons for this, including: an increase in the number of exchanges; 24-hour, round the week trading; higher volumes flowing from algorithmic trading; and the continued switch of over-the-counter (OTC) business securities processes to the central counterparty (CCP) model.
White asked the panel to first state what they regarded as their key operational challenges. Kim Lennen, global head of futures and options post-trade technology at JP Morgan, said it was “keeping the boat afloat while steering ahead” at a time of focus on capacity during an upsurge in volumes while accommodating new controls.
Didier Dos Santos, derivatives business development manager at BNP Paribas Securities Services spoke of the “tremendous switch and increase in emphasis to risk management” and concerns on the matching side, due to the higher level of volatility, and a shift to close-to-real-time matching from overnight. These he said, were producing a “major stress on our systems and people.”
Mark Mills, director of futures and options at Merrill Lynch, echoed this, and noted the enormous upsurge in interest and scrutiny aimed at the ETD market following the 2008 financial crisis. “Everybody wants your expertise on how exchanges and their margin calls works now”, he claimed.
Patrick Tessier, head of European ETD operations at UBS, said that, “contract volumes may be down, but transaction volumes have not tailed off by as much.” He marvelled at the novelty of being asked to help clients with risk management and straight-through-processing [STP] developments, as they reassessed broker relationships and credit.
White then focussed attention on risk management issues. Tessier began with the perennial problem of brokerage being impacted by volatility, and the industry not being fully geared to intraday settlement, which requires real-time position monitoring.
Intraday margining
Mills added that the frequency of exchange margin calls had risen, and brokers were no longer happy or able to ‘swallow’ these overnight anymore. Instead they want to clear and match margin calls with their clients intraday. Lennen agreed: “The demand now is how fast can you recompute margin and cash exposure intraday…it’s almost moving from a T+1 to T+0 basis, and that’s a challenging environment,” he said. This requires the full end-to-end process, “from execution to books and records”, to be completed in minutes. Dos Santos concurred and added that collecting margin and collateral from clients was a key challenge, but at least do-able because of industry automation.
He added: “Operationally speaking, the biggest area of risk has always been around deliveries and options exercise.” As a result, this had been identified by BNP Paribas Securities Services as a key area for investment as it sought further automation.
Mills picked up on the communication issues involved in this: “STP from client to exchange around expiration is going to be extremely beneficial for us…to mitigate risk issues”. Tessier agreed but mentioned a major stumbling block. “Interaction with exchanges is still often too manual on big expiration dates, when thousands of trades need attention all at the same time,” he pointed out. Add to this the new flex products now cleared through CCPs, and all this puts the human links between clients, brokers and exchange systems under immense pressure, he claimed
Dos Santos said that he could not agree more, and questioned how can you deal effectively and manage the risks with clients that give you manual instructions right up to the time limit for action? It may be fine with one client, but, “how do you deal with it if you have 20 different clients with 20 strategies in the market, and all waiting to process within a minute of the deadlines? At the moment the answer is to throw human resources at it, but that isn’t either efficient or risk-less,” he stressed. His answer is to work with IT vendors and exchanges to prompt fuller automation of the investor side of the business.
White then asked the panel to move on to considering the general outlook in the ETD world now; noting that in 2008 there was a widespread general media and public perception that derivatives were bad and dangerous things.
More products and more regulation
Tessier noted that the steady move from OTC to CCP/exchange models for many derivatives means that there is inevitably more regulatory oversight, which further increases back office workloads. Mills added that since the SocGen rogue trader issue, the amazing Volkswagen stock volatility and the Lehman’s collapse there have been massive additions to workload and pressures to monitor positions and activity. “Data has to be there, correct and timely,” he said.
Mills thought the market had reacted well to the problems, and that the derivatives industry does not get the full credit it deserves for the way it functioned and applied necessary changes. However, Dos Santos partly disagreed: “The Lehman crisis saw the whole market move in 24 to 48 hours, and the [ETD] model already in place was proved to be right.”
The panel finished up considering technology development issues, with first listing known current areas of concern: the effect of new asset classes moving on to exchanges; the surge in volumes; the break up of silos and a move to horizontal operating models. All require infrastructure re-engineering from end to end, said White, but getting funding currently is a massive challenge.
Tessier thought IT vendors are meeting many of these challenges, and added that there was additional regulatory and political pressure on the street-side to move more processes from OTC to more easily monitored exchanges. He also called for a move away from processing futures and swaps separately – as greater inter-operability was required between units to benefit both the clients and brokers treasuries.
The panel was split down the middle on their immediate IT wish list. Mills and Dos Santos wanted more automation of option management systems, whilst Lennen and Tessier both called for extra automation of the intraday process. But Lennen added a telling caution: “No matter what the sell-side houses do, if clients are poorly automated it will still mean problems in managing expiry, margin and risk,” he warned.
So there was much cautious optimism to be drawn from the session. ETD post trade processing teams had faced up to the immediate operational challenges of the 2008 crisis, and according to the panellists, they coped rather well. Intraday processing has developed into a major concern for end-to-end automation and data processing, as has the remaining manual parts of the STP chain and risks around major expiration dates. But with improved automation from clients to exchanges, these are issues the industry is confident it can overcome.
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