You can't change the past, but to protect the future, NASDAQ OMX’s Brian O’Malley argues, the financial services industry needs to partner with the regulators to evaluate what went wrong, which market mechanisms worked and which did not. Best practices risk management controls, O’Malley argues, must be put in place, and followed.
The current financial crisis could be described as a disaster waiting to happen. At too many institutions the basic tenets of good long term risk management were being ignored in favour of short term profits. A lack of transparency meant many investment bank boards and executives did not fully understand the risk their firms were assuming with complex new instruments. As a result, they were not able to properly assess the return they were getting for them.
At the same time, trillions of dollars worth of risky OTC contracts were being traded and cleared bilaterally around the globe without proper risk management controls, and the regulators have been accused of being asleep at the wheel.
Opinions vary, but most observers agree on one thing. If regulated exchanges and clearing houses, with proven risk management practices, had a role in the OTC derivatives markets, the crisis would not have been as severe. Therefore, these organizations must be part of the solution.
Exchanges and clearing houses assume and manage counterparty and clearing risk. The members put up capital, and collateral is collected from the counter-parties in the form of initial margin. The exchange measures and manages intra-day risk. When market volatility increases, a variation margin call is made. The positions of firms that cannot meet the margin call are liquidated. When the circumstances require it, the exchange can tap into the shared capital and the clearing corporation’s capital.
This system worked extremely well, even during the worst days of 2008. So the question is: should OTC contracts be migrated to exchange trading and central counterparty clearing?
There are precedents for central counterparty clearing in the OTC markets. CLS Bank operates the largest multicurrency cash settlement system, eliminating settlement risk for over half the world’s foreign exchange payment instructions. In the US, fixed-income marketplace, Fixed Income Clearing Corporation, processes more than US$3.7 trillion each day in US Government and mortgage-backed securities transactions.
For the last few years, the London Clearing House has operated a clearing facility for interest rate swaps. The International Derivatives Clearing Group (IDCG) recently started clearing and settling US dollar interest rate swap futures, and Liffe’s Bclear, which already clears OTC equity derivatives, started clearing credit default swaps (CDSs).
Role of risk-mitigating technologies Creative use of technology can also play a big role in mitigating risk. For example, a large NASDAQ OMX technology client is leveraging technology to minimize pre-trade risk. Its customers wanted a system that could automatically validate a counterparty’s collateral and filter out bids and offers from unacceptable trading firms. In practice, this meant, traders could only see bids and offers from firms with whom they had open credit lines. Considering the number of versions of the order book that need to be sent out, the challenge was to create a system that was robust but not overly expensive or complicated.
The NASDAQ OMX solution was to allow the client to send an order book to all its customers in a single encrypted message. Users have a decryption key that determines which view of the order book they are permitted to see. The client has been using this technology in Europe to help handle pre-trade risk in securities lending.
Despite these examples, some Wall Street firms are resistant to the idea of trading OTC instruments on exchanges and clearing them centrally. They argue that OTC contracts are far more flexible than standardized, exchange-traded contracts. Bilateral trading allows them to retain anonymity. OTCs can be traded electronically or by voice, and typically the larger the deal, the more likely it is to be executed over the phone. Moreover, many OTC instruments are off balance sheet products. If they are centrally cleared, they would have to put up collateral, such as treasury bills, to meet margin calls, and these would be would be an on-balance-sheet item.
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.