You Only Live Twice Creating the FCM of the future Published in 1964, Ian Fleming’s eleventh Bond novel describes the change in 007 from a depressed man in mourning, to a man of action ready to rise up and take on the world again. In a similar way, the global derivatives industry is undergoing the same metamorphosis. For some time now the industry has been battling against multiple headwinds - low interest rates, falling commissions and an image tarnished by the spectacular failures of some individual firms. New regulations have also tilted its entire axis as exchangetraded and OTC workflows look set to run into each other. This paper assesses the likely effect of these changes and describes how the FCM community in particular has been impacted. It also describes how some firms have already begun re-tooling and re-aligning their businesses accordingly and look set to take on the new world order with renewed vigour and appetite. Shaken and stirred - a new emphasis on convergence and aggregation Derivatives markets have operated on a 24-hour, global and highly interconnected basis for many years now and in some Steve Grob Director of Group Strategy @SteveGFidessa areas have been relatively opaque too. These factors have proved a challenging combination for regulators around the world as they pursue their global agenda of attempting to reduce risk, increase transparency and rein in the financial industry generally. land grab between the new electronic venues even before many of them have got their businesses off the ground. Lack of clarity over matching models (RFQ, CLOB, C2T) is causing another headache as different contracts have very different levels of liquidity. Dodd-Frank, EMIR and MiFID II represent different attempts to do just this on each side of the Atlantic. These pieces of legislation aim to make the over-thecounter (OTC) world operate much more like its exchangetraded derivatives (ETD) counterpart. This has led to mandates that dramatically extend centralised clearing and compel OTC trading to take place on electronic venues, rather than bilaterally as it’s historically been done. What the regulators seem to have overlooked, though, is that the OTC and ETD workflows may have evolved differently for perfectly sensible economic reasons. As a result market participants are battling not just to understand the new rules, but to implement them too. The spread between exchange-traded futures and swaps traded on swap execution facilities (SEFs) is wide and there are now a number of hybrid entrants that borrow from both. Meanwhile, the MAT concept (Made Available to Trade) is leading to an unsightly When regulators attempted to introduce similar reforms into equity markets, two uninvited guests crashed the party extraterritoriality and unintended consequences. The unique nature of the derivatives industry means that we’re likely to see these at play here too. All of this change can be summed up in two words convergence and aggregation. Workflows that previously ran along separate (but parallel) streams are now permanently intertwined. At the same time all market participants need to streamline their operations to find, process and risk manage this new liquidity effectively. The macroeconomic picture doesn’t look like it is going to help much either. Abnormally low interest rates in the Western world look set to continue, and possibly even become the new ‘normal’. So even without the regulatory reforms, the FCM’s traditional business model is in need of a serious rethink. © 2013 Fidessa group plc 01 You Only Live Twice Initial response Central clearing Greater middle office lifts broker connectivity restrictions Phase 1 Phase 2 Phase 3 Phase 4 Use what you already have in place Price sensitivity increases More efficient use of margin Mix & match contracts across the whole interest rate curve Nobody does it better – a view from the buy-side For your eyes only - the new rule book Understanding the real implications of all these changes is hard. A good starting point is to look at the response from the buy-side as this represents the beginning of the workflow food chain. The likely phases of the buy side’s response to the new rules are shown in diagram 1. All of these phases reflect the need for greater empowerment as they seek to navigate the newly converged liquidity and manage their scarce risk capital across the centrally cleared landscape. A more holistic view across their orders (whether DMA, algo or care) will be important, as will the ability to adjust their risk up or down centrally and in real time. Even as markets come ‘back to normal’ they will not be the same. Business models based on a return to high interest rates, or simply intermediating the traditional opacity between clients and liquidity, now look to have an uncertain future. The new rules simply will not support these and so the FCM of the future will need to refine its strategy accordingly. The first of these modifications is recognising that cost really is king. Another dimension will focus on margin efficiency and taking advantage of the natural offsets that emerge both within and across different clearing houses. Ultimately this may become one of the most crucial factors when selecting the most appropriate contract to trade. © 2013 Fidessa group plc Full OTC/ETD convergence Operational cost has always been high on the list of concerns for all firms, but the FCM community has had to balance this with the (in some cases, idiosyncratic) wishes of its customer base. The rush to win clearing mandates has led many firms to adopt a wide variety of internal and external systems, many of which do almost exactly the same thing. Looking forward, the idea of having multiple desks running different trading applications will be hard to make work. Not only Diagram 1 is this approach too difficult to police from a compliance and firm-wide risk perspective but, above all, it is just too expensive. This extends to the screens FCMs deploy to their trading clients too. Anachronism and sentimentality have no place in today’s FCM playbook. What is required is a more centralised approach to business workflow that supports and empowers the different desks and client constituencies that need to use it. This means that information must persist more fluidly through the entire firm and so reduce the growing compliance burden and meet the transparency demands of the regulators. The second modification required is to take advantage of the converging nature of the OTC/ETD flows within the industry. Whilst much remains unclear, it seems that the industry will evolve towards a broader spectrum of standard and custom contracts (see diagram 2) that will be accessible by all. Flexibility will be key here, as will the ability to 02 You Only Live Twice ^ ^ ^ ^ ^ FUTURES Lower margin required, less precise fit SWAP FUTURES Critical mass to achieve liquidity? ^ ^ ^ ^ FUTURES STANDARD ^ Aggregation will also be key - not just of liquidity, but of risk and margin as well - as this will enable FCMs to provide the greatest possible clearing efficiencies to their clients. The middle office and its interoperation with clearing houses, credit hubs and clients will be where this battle will be fought. It may even lead to a new form of latency war as firms seek to navigate this complex area both quickly and safely. And, finally, all this is going to require a rethink on algos and posttrade analysis. Benchmarking algos, such as daily VWAP, will provide a useful tool in the FCM’s armoury and may even grow to dominate in the way they have in cash equity markets. With greater proliferation of algos working across multiple pools of liquidity, © 2013 Fidessa group plc Higher margin required, risk of liquidity dispersion ^ ^ CUSTOM * Constant maturity futures distill the real themes from the bright shiny toys. The evolution of the agency model, as opposed to direct access, looks to be one such theme as the buy-side will soon tire of accessing liquidity via a multitude of separate SEFdeployed screens. Market acceptance? SWAPS ^ ^ ^ SWAPS CMFs* Diagram 2 transaction cost analysis (TCA) will play an increasingly vital role. Buy-side firms will need it to assess and select their brokers and FCMs will need it in order to prove their worth. A view to a kill - the power of workflow Rising to these challenges poses an interesting set of questions for the FCM, especially in how it chooses to implement technology. The goal is simple: a resilient, high performance backbone that centralises as many functions as possible and yet is flexible enough to accommodate different desk and client needs. Easy enough to say, but to really deliver on this the FCM is going to have to make some tough choices. Perhaps the first question in reaching this goal is whether to build or buy. Central to answering this is recognition of the fact that, in many ways, technology is an enabler - a mechanism to deliver a firm’s IP. This might be its reach, its balance sheet, its people, its customised algos and TCA, or some other component. The simple fact today, though, is that building this entire stack in-house is just too expensive, especially with so much of the picture unclear. When the only constant is change, buy rather than build becomes the strategic option. Not only is it cheaper, but it can be more effective too. This is especially true when the entire platform is outsourced, delivering economies of scale and replacing fixed cost with variable cost. This in turn enables the FCM to retain its optionality in how it addresses the market and develops opportunities. Another part of this debate concerns the balance between a ‘one size fits all’ approach and the potential benefits of high levels of customisation. The first is obviously cheaper but can be criticised for not always satisfying individual requirements. The answer lies in encouraging modifications where appropriate, but allowing these to be deployed and monitored centrally. 03 You Only Live Twice The value of a complete workflow system, rather than a collection of discrete disconnected pieces of technology, also comes to the fore here. Aside from cost, each different system that is added into the mix provides another compliance stress point as data is now held in separate locations, often in incompatible formats. Intelligent workflow needs to extend seamlessly across asset classes and flow easily from front through to back office. Many technology suppliers that claim to offer this capability struggle to deliver here because their workflow has essentially been put together from smaller technology firms they have acquired. Incompatible database technology, or gaps where they join, can make such technology hard to implement and a nightmare to support. The benefits of a more sensible approach to workflow technology will manifest themselves in a number of ways. The ability to route incomplete orders seamlessly between desks is just one example. In the global, 24-hour derivatives industry this capability enables both global and supra-regional firms to turn this whole area of their businesses into a real competitive differentiator. The need to trade coherently across a growing number of liquidity pools will make this even more important. Related to this is the ability to smart route orders by breaking them down, spreading them across multiple markets, and yet still maintaining the integrity of the original order. Lack of fungibility between economically similar derivatives contracts means that this linkage needs to be maintained at a system level and yet still be easily accessible to the end user. © 2013 Fidessa group plc A single audit trail is another benefit of getting workflow technology right. Making sure the systems are doing what they are supposed to do is of course vital, but even more important is the ability to demonstrate to both clients and regulators that this is the case. Algos and TCA need to be thought about carefully too. In the cash equities world most instruments remain fairly static and so can be monitored and mapped over time fairly easily. A typical derivatives position, however, will need to be rolled over a number of sequential contracts and so maintaining a single atomic view of the original trading objective is much harder. On top of this, the wide variety of underlying assets that derivatives cover means that an algo that works for one type of contract (such as STIRs) may not necessarily work for another (commodity futures, for example). Implementing technology in this way requires a partnership approach with any chosen supplier. Obviously that supplier must have the appropriate resources and structure available globally. But without the project management skills and expertise to bring these two together, the results will be mixed at best. With the 80 plus derivatives exchanges already in operation across the world about to be joined by around 20 SEFs in the US and numerous OTFs in Europe, the global picture is going to get significantly more complicated. And it’s not just about the roll-out; it’s also about maintenance – day in, day out. This requires an ongoing relationship with the supplier who must also have the global support, operating precision and experience to bring the necessary resources and structure together. Diamonds are forever - creating the FCM of the future It seems evident that derivatives markets have changed permanently and there is still a long way to go. Waiting for markets to return to ‘normal’ is not an option. Ongoing low interest rates and the regulatory momentum already underway have seen to that. The fundamental challenge for the FCM, then, is how to create a business model that lowers cost but remains flexible enough to take advantage of all this change. At the same time, getting on the front foot with compliance is essential in order to navigate extraterritoriality and the unintended consequences that are already making their mark. Technology in and of itself is not necessarily the answer; a multitude of different systems creates too many joins that drive up cost and inhibit freedom to respond to change. Instead, a workflow approach that provides a single centralised spine connecting the different parts of the firm together provides the only really workable solution. This must be flexible enough to allow customisations to be centrally deployed and managed so that each desk and each customer group is empowered to achieve its specific aims. Just as 007 found, technology is a great weapon - but only if it’s used properly. 04