The recent crisis, the regulatory framework that might come into place, cost-cutting, technology all make an impact on the derivatives industry. Newedge’s Guillaume Roux-Chabert shares his opinions.
One of my ‘hit-by-the-crisis-turned-consultant’ friends described the current environment as: “When I call a client, I just ask them if they were long this year. Then I know if it’s worth meeting them or not”.
As we look forward to 2010, and many of us would like to forget about the past year, it is worth remembering the significant number of changes and opportunities which have been presented over the course of the last 12 months. Certain voices have screamed for more regulations, some exchanges are lining ex-IRS inspectors to hunt down any user of their precious market data while others claim there is not enough competition between securities and futures clearinghouses. There have even been calls for a combination of the CFTC and SEC into one agency. So how do competitors in Asia-Pacific play a fair game when a growing part of this world appears to think: ‘Heads: Wall Street wins; and tails: the taxpayer loses’?
Regulation and its many effects
Play by the rules and watch closely how it affects the order flow! Today, as retail clients have become extremely sensitive to transparency, the brokers should be the forerunners who ensure comprehensive and consistent regulatory oversight over all derivatives. There have been requests for the Commodity Exchange Act (CEA) to be consistently applied to all derivatives, no matter what type of derivative is traded or marketed. To avoid a similar scenario every financial instrument that is directly sold to the public should be regulated. Given the call for transparency from the retail clients and the fact that the US Congress might soon mandate firms to put a framework in place to enhance transparency, retail brokers should continually repeat the following to their clients ‘A derivative is not like any financial instrument. It is not a security as it does not clear and settle within one day of trade date’.
Competition between the Exchanges will also bring about better transparency. Of the four principal segments of our financial markets system (securities trading, futures trading, securities clearing and futures clearing), we currently have strong competition among exchanges and clearinghouses in only one segment: securities trading. It is indeed interesting to note that trading fees charged by the U.S. Equity options exchange (regulated by SEC) is much lower than that charged by U.S. Futures exchange (regulated by CFTC). Even if better regulation and higher transparency are for the best of the public and its government, the smart players in the industry might like to wait and watch for the US to set their rules, and then see what Asian exchanges and clearinghouses eventually decide. Higher transparency and better regulation also means more administrative work, extra resources and higher costs.
Some clients like the ‘Sovereign Funds’ might be uncomfortable with the changes and might prefer other pools of liquidities, for instance in Asia, where they could be delivered the privacy they legitimately deserve. This plus the consistent growth of regional production/consumption as well as new Asian Commodities Exchanges could be the stepping stone in setting the material prices without having to wait for other Time Zones.
Service: Proprietary trading and Conflict of Interest
Let’s face it! No matter how high the ‘The Chinese Wall’ in a company, having both the proprietary desk and the brokerage/clearing unit under the same umbrella means we are basically combining two activities that strongly impact each other. The sales team that many a time represents both the activities might or might not make the right delivery of information to their clients.
This is definitely not an issue for pure agency clearers enabling their sales team to focus on the service, fees and technology. Yet, very few brokerage houses offer only pure brokerage/clearing services or agency/research service.
Staff and Technology: Cost-cutting measures needs finding its own limits
While some units of large investment banks were assisted by state bailouts and government help, others struggled to get through the crisis while maintaining a decent costincome ratio. Staff and technology were both deeply affected due to the cost-cutting as there were less people left to maintain more and more sophisticated infrastructure. Asia saw a huge re-shuffle of people between the different players: ISV, Exchanges, Brokers/Clearers and Investment banks.
Cost-cutting is not without its limitations. The costs of maintaining and operating the clearing IT infrastructure does not vary hugely with the number of transactions cleared. Clearing systems software are equipped to clear a large number of instruments, and although the hardware capacity increases in proportion to the number of instruments cleared thereby increasing costs, the system design and software costs are largely detached from the cleared volumes. In other words, the cost-income ratio is dramatically reduced when the volume increases. Therefore, reducing the front-office costs or revenue-driven technologies will almost directly affect the per-lot cost.
More purely on the technology side, some questions are still under debate: In-house development or Outsourced development? And what is the best integrated technology to be offered to clients who expect a competitive electronic solution? Both questions have been addressed by the securities brokerage industry and the derivatives’ world is likely to follow up. Indeed, the securities world gives a fair insight of what usually happens in the derivatives industry after a couple of years.
Most of the big securities companies don’t limit their offer only to their in-house trading screen; many have built a lean and mean FIX layer that is able to absorb Independent Software Vendor (ISV) Trading Stations as inputs. All the flow is channeled through their internal Order Management System (OMS) with the capability to deal with Dark Pools, Algo, Care and Direct Market Orders.
Their risk management and exchange access are mostly developed in-house. They are better able to integrate near real-time information such as currency rates, cash positions, and risk scenarios. With some specific changes this would somehow also be translated into the derivatives industry. For instance, the importance of the two models of shared and non-shared environment.
The Shared environment covers the infrastructure under the full management of the broker/clearer which is then pushed to the clients under trading station or FIX APIs. The non-shared or dedicated environment is the capacity for a client to trade directly to the exchange under the membership ID of the broker/clearer. The involvement of the broker/clearer is then focused on providing co-location services and having full access to a risk layer.
New battles: China and India again…
Sure, you have heard that before, and it’s really happening. Hundreds of young and skilled traders in China and India are joining trading houses to access the Global markets, where volumes are mainly generated through Commodities and Fixed Incomes products. Long time implementation and good understanding of the competitive arena is a must-have to deal with these new players. Time spent on mapping their decision process and the key actors is really rewarding. These new entrants in the industry have already re-shaped global infrastructure of the main players to provide outbound-inbound flow of orders. No doubt, it will also influence the way execution, clearing and settlement will be organized in the few years.
Concluding the Snapshot
Competition in the derivatives industry is getting fierce and will be impacted dramatically by the top-down decisions from the political world. This article aims to encourage further discussion and provide a frame of reference for industry participants.
The crystal ball reading is: the securities industry give an outlook of where the derivatives world is likely to head over the coming years. Industry performance could be greatly influenced by participants continually looking and learning from different businesses, to work towards an enhancement in one or more components of our value chain. We can also learn a lot by looking at standards outside our own industry. I like to use the luxury-hotels industry as a benchmark: if only on-boarding all Asian futures and options with low latency package solution were as simple as a check-in at an Aman Resort! Well, we may actually not be as far as we think away from that becoming a reality, if the ideas of key industry participants can be put into practice in the 12 months ahead.