You Only Live Twice: Creating the FCM of the future

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