DERIVING PROFITS FROM ELECTRONIFICATION.
By Anna Pajor, Principal Consultant, GreySpark Partners.
The traditional OTC derivatives market is shrinking as widespread market regulation has rapidly transformed the normal trading environment. OTC derivatives are now increasingly traded digitally, and the remainder of non-electronic trades will be transformed into standardised contracts to be traded, en large, electronically. The ongoing regulatory activities will require multiple short- and long-term changes, such as the updating of client-facing tools, which may appear daunting to market participants. Despite its many short-term challenges, electronification, which is a consequence of those regulations, will ultimately create beneficial opportunities for market participants.
The term ‘derivatives’ covers a broad spectrum of instruments, from standardised, exchange-traded futures and options (F&O) to structured, complex OTC derivatives. Over 90% of listed F&O are currently traded electronically, with execution and clearing functions completed through exchanges. There are currently two main options to access listed F&O liquidity: single-bank platforms in the form of white-label solutions and FIX connections. Screen trading of listed F&O contracts is preferable when the relevant trades require extra discretion, while firms utilising high-frequency trading (HFT) and automated trading systems favour FIX exchange connections. In contrast, complex OTC derivatives are mostly traded non-electronically yet some elements of pricing negotiation can be completed via a single-bank platform. However, due to the bespoke nature of the most complex OTC instruments, it is easier to capture all the nuances and details of their contracts during ‘voice’ transactions, rather than through standardised trading platform interactions.
The ongoing wave of global and regional regulatory initiatives has forced OTC derivatives to standardise and move onto trading platforms. Regulations including Basel III, Fundamental Review of the Trading Book (FRTB), the Dodd-Frank Act, and the European Market Infrastructure Regulation (EMIR) have subjected non-centrally cleared contracts to higher capital requirements with the expectation that the increased standardisation of contracts will not only lead to healthier operational processes and greater liquidity, but also better price formation, exposure calculation, and risk management. However, the higher levels of complexity and risk associated with relevant instruments makes them more expensive to trade. Compliance has therefore transformed multiple bespoke OTC contracts into a more expensive hedging tool than a standardised set of exchange-traded derivatives could provide. In some cases, these contracts are too expensive to justify the hedging activity itself. As a result, the overall derivatives market is shrinking. Recent data from the Bank for International Settlement verifies this observation, as figures indicate that the volumes of exchange-traded derivatives are not increasing in a similar manner to the drop in OTC activity.
The standardisation of OTC derivatives is enabling electronification, indicating that OTC derivatives are likely to follow the same path to electronic trading as other instruments. As the share of trading done via digital channels rather than by voice trading is consistently increasing across all products, asset classes have been following the same evolutionary path towards electronification, albeit at different speeds. First, as the number of electronically traded derivatives increases, commissions and margins are compressed, driving buyside participation and further investment in e-commerce. ‘Voice’ traded, marginally electronic trading is typically characterised by low volumes of large-size, large-margin tickets. Here, banks and broker-dealers are still attempting to build consumer demand by focusing on research, pre-trade functionality, and analytics. Specifically, banks start offering the instrument through single-bank platforms to support servicing clients. As a result, the number of tickets increases, but the notional amount of each ticket remains rather large, therefore preserving margins. While the volumes traded are rapidly increasing, ticket sizes and margins are dropping proportionally. Only the largest tickets are dealt with by voice, and multi-dealer platforms take an increased share of the price discovery and execution flows. As electronification progresses, the market moves into a ‘utility model,’ where the focus shifts to the industrialisation of processes, cost optimisation, and efficiency. Electronic trading becomes the primary means of execution through a combination of exchanges, open platforms, and dark pools. During this final stage, the primary focus is on client relationships, with banks and broker-dealers competing fiercely for customer ‘mind share’ by trying to offer differentiated and value-added propositions.
There are still challenges facing the electronification of complex OTC derivatives. The following three factors will delay, and in some cases, even prevent the full electronification of complex derivatives:
- Complexity of the instruments – the challenge to codify the most complex structured products may be greater than the benefit from electronification of trading. Each product has different parameters and variety in how it was structured, and even the best attempts at standardisation cannot capture its full complexity.
- Legal T&C – bespoke derivatives typically require oversight and advice from the legal team to ensure consistency of the terms and compliance with relevant rules around servicing clients and trading derivatives.
- Pricing, discretion, and negotiations – firms typically have the ability to choose and moderate pricing models, levels of risk, and levels of margin for each product. Many banks will want to maintain their discretion by keeping the decision-making process manual rather than automated for complex, ‘premium’ instruments.
Organisations must also prepare for all potential consequences of the new rules surrounding OTC derivatives. While many of the most immediately visible changes and consequences appear to be negative in nature, organisations must keep in mind the long-term positive re-orientation of systemic risk the rules will bring about. Indeed, emerging electronification will usher in the following opportunities for all types of market participants:
- For the Buyside – With the increasing availability of electronic trading for complex derivatives, the buyside will gain better visibility on the pricing of those instruments. With supportive electronic tools for price discovery and price and risk modelling, the time to find an optimal structured product can be shorter than in ‘voice’ negotiation.
- For the Sellside – Electronification provides the sellside the opportunity to improve access to clients, attract new ones, and streamline the servicing of all clients.
- For Trading Venues – With the standardisation of contracts, execution will increasingly move towards the organised venues. To benefit from this change, venues need to ensure that mechanisms are in-place to make additional instruments available to trade, whenever need requires them.
- For Technology Vendors – With any form of electronification, vendors receive the opportunity to provide tools for client and market connectivity and execution management. Additionally, in the case of derivative instruments, vendors can provide tools for pricing and risk modelling. Therefore, the market size for tools supporting trading of all derivatives should grow beyond USD 1bn within the next ten years, from USD 450m in 2014. This new market for specialist trading tools will become highly attractive for existing providers of trading tools since the market is already saturated with tools for cash equities and listed derivatives trading tools.
While ongoing regulation of OTC derivatives poses myriad challenges to market participants, it is important to keep the long-term opportunities in sight. Market participants stand to benefit greatly from the resulting electronification – addressing the short- and long-term challenges in a transparent and efficient manner will help them do so quickly.