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Jake Pugh – Derivatives Market Infrastructure – November 2013

Executive Summary

CFTC guidance on SEF access may be a game changer for OTC market infrastructure.

• Taking the OTC markets ‘all to all’ could lead to the high volume prop trading futures market participants accessing the OTC markets

• Leading to IRS spread compression, significant OTC volume increases, large flows into clearing and a re-modelling of the banks FICC businesses from prop to agency service provision

• Would represent a ‘floor to screen’ moment for the IDBs and may bring them into play as M&A targets for exchanges

• Clarity of ICE strategy and brilliance in execution puts pressure on peers to respond

Regulatory reforms

A number of significant trends have been in place since the Lehman insolvency and the G20 Leaders summit at Pittsburgh in September 2009. The G20 ‘commitments’ to reform the OTC derivatives market have been made real via the Dodd Frank and EMIR regulatory reforms.

These regulatory mandates have spelled out significant changes to the market model and the associated market infrastructure.

The key points being:

– more electronic trading of OTC derivatives to increase transparency and market efficiency. The prescriptive requirements of the OTC trading model are a feature of Dodd Frank but not EMIR. Nevertheless the market assumption has been that a more electronic model for IRS trading in the US is likely to be adopted in Europe as the large investment banks (and their customers) will wish to operate similar models in their major theatres of operations for reason of efficiency and greater operational control.

– increased use of central counter parties (CCPs) as the preferred approach to the risk management of outstanding derivatives liabilities. Quite simply CCPs are favoured by regulators and governments because they operate a more conservative and transparent risk management model than that operated by the investment banks.

Whilst higher collateral requirements arguably increase costs for certain end users, the corollary is a more ‘appropriate’ collateralisation and one that prevents a collapse of the global financial system as caused by Lehman with the attendant implications for the maintenance of stable democratic political structures and a market model one that more appropriately balances the financial services industry with the rest of the economy

– more transparency in the reporting of OTC (and in Europe listed) derivatives so that exposures are better understood and monitored; i.e. that no institution is allowed to become ‘too big to fail’

– increased scrutiny and restriction on bank prop trading activities as envisaged under the Volcker rule

– the parallel introduction of Basle 3 has also led to the higher capital requirements for holding OTC derivatives exposures

Development of new models

These combined reforms have combined to increase the cost of doing business and have caused a major dislocation in the market as all participants are required to make changes to adjust to the new model:

– Banks are coming to terms with the likely reduction in FICC revenues, more e-trading and higher capital charges as well as the uncertainties associated with the introduction of increased collateralisation and the introduction of LSOC in the US and individual segregated customer account structures under EMIR

– exchanges are looking at developing new products that reflect elements of the bespoke nature of certain OTC products but also offer the lower capital regime afforded by the futures markets (more on futurisation below)

– CCPs are preparing for the potential increase in revenues associated with more central clearing but at the same time re-platforming for new account structures, developing new risk algorithms to replace the antiquated SPAN methodology, developing OTC clearing offerings for banks and end customers and, in Europe, going through the far-reaching EMIR re authorisation process

– IDBs are adjusting to lower volumes from their bank customers and lower brokerage fees and the perennial issue of parallel voice and electronic models and the expensive legacy remuneration structures for voice brokers

– technology providers are adjusting to all the above and the proliferation of new exchanges, markets and platforms in Europe: Gmex, Aquis and NLX to mention just three. The issue of resource prioritisation has never been more profound.

Impact on market structure

Until recently however the received wisdom in the market has been that the traditional market structures and participants at the two ends of the spectrum in the fixed income derivatives market would, despite, some major re-tooling largely stay in place. THIS ASSUMPTION MAY NOW NEED TO BE REVISITED IN THE LIGHT OF EVENTS OF THE LAST WEEK OR SO.

The assumption has been that the longstanding market structure would largely remain in place; this can be characterised as:

– at one end of the spectrum, a ‘closed’/restricted access OTC derivatives market with a clear delineation between banks, customers and inter dealer brokers in which high value, low volume, more bespoke products would be negotiated between banks and their customers and then the exposure being managed via (partially) risk offsetting bank to bank transactions or through an inter dealer broker. Although the DF and EMIR reforms require more electronic trading and more central clearing, the fundamental tenets of the model remain unchanged, namely that banks talk to their customers, customers see a restricted view of liquidity and IDBs only talk to banks.

– at the other end of the spectrum sits the futures market. A market characterised by more simple or basic products, 100% electronic trading, multilateral netting and central clearing. An all to all market in which clearing members provide a purely agency service and all end users are market participants, there being no similar segmentation between the role, access and participation of different types of users. A CLOB which has transparent access rules and in which the price is the same to the largest institution or a one lot local.

– because the assumption has been that this market structure would largely remain in place (despite more electronic trading and CCP utilisation in the OTC markets) there has been an expectation of the potential ‘futurisation’ of OTC products. The issue being whether exchanges could develop products that exhibited some of the more flexible features of the OTC market whilst at the same time benefitting from the lower capital requirement of a futures contract.

The ERIS exchange in the US, Eurex’s plans to launch a similar deliverable swap future and the planned launch of Gmex represent three examples of ‘futurisation’ – I.e. the attempt to bridge the product gap between the OTC and futures market.

HOWEVER, the events of the last week may have rendered the futurisation question obsolete AND may have significant implications for investment bank FICC incomes, change the volume and profit potential of CCPs, open up enormous trading opportunities for the Futures market proprietary trading community and bring the IDBs into play as M&A targets.

Numerous SEFs that have launched have respected and maintained the traditional closed access and clear demarcation in the OTC market, namely that banks trade with other banks and end customers and that IDBs only talk to banks.

‘Guidance’ provided by the CFTC on 14 November makes clear that they wish to break open the access restrictions of the silo’d otc model and introduce an all-to-all market akin to the futures market:

This has enormous potential significance because it may allow customers to trade direct with other customers, IDBs to provide bank prices to end customers (and potentially most significantly) allow the high volume futures market proprietary trading firms to access the OTC IRS market.

An opening up of the restricted access silo’d OTC market world would

– dramatically tighten spreads in the OTC IRS markets as the prop shops trade for much tighter margins than investment banks and are more adept and experiencedin high volume, low latency, spread trading. The opportunity to trade the $ and € IRS versus Eurodollar and Euribor futures curves would provide significant new trading opportunities for the futures market day trading firms

– commensurately reduce the profitability of the investment bank IRS flow desks within the FICC divisions. These desks have been amongst the banks’ most profitable businesses in the last 25 years

– require a fundamental remodelling of the investment bank/client relationship frombeing a bilateral trading relationship to one of agency or service provision, earning transactional fess for execution and clearing rather than trading profits from dealing spreads

– CCPS could see a huge growth in cleared volumes if the high volume futures players get access to the OTC markets

– it may obviate the need for ‘futurisation’ type products as IRS spreads become tighter, thereby in part compensating for the higher collateral requirements, which may be further reduced by the concentration of closely correlated OTC and exchange trade derivatives products in a single CCP and then (cross) margined as a single risk pool

– the development is also likely to have significant impact on technology firms, especially the aggregators. The experience of regulatory change causing multiple liquidity pools (as is the case with the launch of the various SEFs) is very similar to the experience of the equity market in the US and Europe under RegNMS and MiFID.

– For both brokers/banks and end-customers, there is no desire to connect to the various platforms because of the costs and uncertainty as to which platforms would win the battle of market share. In this environment the role of the ‘aggregator’ becomes important. The aggregator connects to the various liquidity pools and reflects the various bids and offers onto a single screen; additional functionality can be added with smart routing and order execution functionality. The natural vendors to occupy this space would include ION and Fidessa. ION because of its strong position in the fixed income market and Fidessa because of its market leading role as aggregator on the equity market.

– more broadly there are significant data opportunities as SEFs or OTC platforms open up to new users (data sales and product development)

IDBs in play….?

The regulatory guidance represents a seminal moment for the IDBs and it is critical to mitigate the influential role of the aggregator by urgently migrating legacy/incumbent bank liquidity onto their SEFS.

The multiple pressures on the IDB model (lower volumes, reduced commissions and the higher operating and regulatory costs associated with regulatory reform) has forced them to consider whether and how to offer their prices to end customers.

This would completely cut across the historic IDB model and would likely have huge implications for the IDB – Bank relationship. IDBs may wish to reach the end customer but cannot be seen to be proactive in this regard as the large investment banks still represent a significant proportion of overall revenue and would likely (threaten to) ‘pull the line’.

However the CFTC guidance may force the IDBs through the operation of their SEFs to open up access to the buy-side. Migrating more of their businesses onto the screen and providing prices to the end customers would be a seminal moment for the IDBs. The scale of change would be akin to that when the futures market went from open outcry to electronic. This may be a ‘floor to screen’ moment for the IDBs.

In this environment it is likely that IDBs may become M&A targets for exchange groups.

The large exchange groups and private equity firms have frequently undertaken detailed analysis of the IDB businesses with a view to migrating the IDB liquidity onto the exchange electronic platform and then into clearing. The issue has been that many of the profitable IDB desks are still voice-broker led (and exchanges do not have the management skills and experience to ‘manage’ money brokers) and the risk for the purchaser is that the bank liquidity may not continue to be provided to the IDB if owned by an exchange (all exchanges being viewed with suspicion by the banks).

It may be that the introduction of SEFs in the US and the guidance issued by the CFTC may lead to more IDB liquidity being reflected onto electronic platforms and those platforms being made available under DMA or sponsored access regimes to end customers. This model would be very attractive to exchanges as they could then offer the OTC prices out to the hundreds of thousands of global futures market participants through existing distribution channels.

In this environment IDBs would be attractive M&A targets for the major exchange groups such as the CME, ICE, Deutsche Boerse, SGX, Hong Kong, BM&F, Nasdaq and the LSE.

ICE leads the way

There is another factor at play in the Exchange space. ICE is so far ahead of its competitors in the development and implementation of its strategy that it is leaving its peers looking slow and reactive. There is no better example recently than the fact that whilst the market assumed ICE was 100% occupied with the closing and integration of the NYSE business than ICE took advantage of the issues at MCX to acquire an exchange and CCP licence in Singapore with the purchase of SMX.

Furthermore in the high value and more complex European market, ICE will be a player in the fixed income derivatives market following the acquisition of LIFFE. The question is merely how far they will penetrate into OTC fixed income derivatives trading and clearing and how high their market share will go.

The IDBs

– ICAP – the clear market leader in terms of asset class/product breadth and geographical reach with numerous electronic platforms and other valuable post trade network and compression e-businesses such as Tri-optima, Traiana, Reset etc. The biggest prize but a more complex integration. An ex CME MD now runs the SEF….

– Tullett – good liquidity and flow in fixed income but with a limited electronic offering – potentially a real prize as little legacy technology to retire

– Tradition – reasonable e-commerce offering with Trad-X and Par FX but hard to break into the top three but with strong franchises in certain asset classes

– bgc – sold the e-Speed platform to Nasdaq and a more complex business model

– GFI – traditionally strong in credit with less to lose by being more nimble in moving to the new model (UBS and CSFB already offering DMA into the GFI SEF)

The exchanges

– CME – dominant position in the US market, excellent global distribution, strong position in OTC (IRS) clearing in the US with the cross-margining offering and strong regulatory connections. Limited success of CME Europe offering. ICAP could be their target – with otc flows cleared into their US or European clearing house

– ICE – strategically way ahead of their peers with a peerless culture and excellence in delivery. Numerous clearing houses. ICE acquisition of LIFFE is a game changer and SMX provides an Asian clearing house. They are brilliant but can they manage to digest an IDB without being distracted by the current huge schedule of work?

– DB/Eurex – the M&A hasn’t worked for them in recent years and they seem publically committed to organic business development (Gmex, OTC clearing, relaunched Euribor, Regis-TR etc) BUT they will appear even more of a German silo if their peers move. Still need a CCP in the UK.

– LSE – potentially the banks ‘champion’ and viewed more favourably than the other exchange groups. LCH will be a player. Need to fill the gap in fixed income derivatives. The last remaining London player. Strong links to UK plc. Strength of the MTS business provides opportunity to pull together a very powerful fixed income securities and derivatives offering

– Nasdaq – a rather random collection of businesses needing a stronger derivativesoffering. NLX gaining some traction but need to see how volumes develop without ‘paper’ and when the fee holiday ends. Acquisition of e-Speed put them ahead of others, in thinking at least. No credible clearing foothold.

Hong Kong – big wallet and with the LME in London but no fixed income experience. LME clearing house cannot be made quickly open for IRS clearing

– SGX – evidence of wanting an international element to their business but very limited European footprint


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