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 Investment Roadmap, a guide created through a collaboration between the world’s leading messaging standards, to provide consistent and clear direction on messaging standards usage was released in May 2008. A year later, FPL’s Operations Director, Courtney Doyle asked the authors of the roadmap for their assessment of its impact on the industry and how they saw its future evolution.
Courtney Doyle: What was the motivation and purpose behind this Investment Roadmap collaboration?
Genevy Dimitrion (ISITC Chair): Today, Market Practice and Standards are inextricably linked and yet for all our efforts, Market Practice exists as a mere documented recommendation. However, we see convergence between the two areas to the point where market practice can be encapsulated directly into the standards themselves. The roadmap has a role to play in this evolution, and we see it as critical for the next generation of standards. It also helps to provide future users direction on which messaging standards should be used throughout the trade lifecycle.
Jamie Shay (Head of SWIFT Standards): Our involvement was driven by clear market demand from our customers. They needed clarity about which syntax to use in which space and, more importantly, they wanted a way to make these standards interoperable. SWIFT and FIX have been working together for a number of years towards a single business model in ISO 20022. The decision to work together on an Investment Roadmap was a natural progression. It provides clear direction with regard to messaging standards usage as it visually “maps” industry standards protocols, FIX, ISO and FpML, to the appropriate asset class and underlying business processes.
Karel Engelen (Director and Global Head Technology Solutions, ISDA): Similar to SWIFT, ISDA felt it was important to map out the coverage of each of the different standards so people could get a complete view of the industry standards at a glance. We also thought it would be a useful tool for determining where we had duplication of effort or functional gaps to complete.
Scott Atwell (FPL Global Steering Committee Co-Chair): As the others have pointed out, we needed to provide greater clarity as to how the various standards ‘fit together’. We sought an approach that recognizes, leverages, and includes the financial industry standards without reinventing and creating redundant messages that generate cost and confusion for the industry. The effort was named ‘Investment Roadmap’ as its founding purpose was to aid industry firms’ technology investment decision making.
Courtney Doyle: The roadmap was released over a year ago. Is the community referring to it and using it as a guide on how to invest in standards? How should firms use it and what does it mean for them?
Scott Atwell: FPL has found the roadmap useful as a tool for standards investment. However, the roadmap benefits are multifaceted. It has driven an even greater level of collaboration and cooperation amongst our standards organizations. Discussing it often serves as a ‘conversation starter’ that leads to healthy discussion and debate. It has also served to facilitate key changes to the ISO 20022 process such as the ability for FIX to feed the ISO 20022 business model and to be the recognized syntax for the Pre-Trade/Trade model.
Genevy Dimitrion: ISITC consistently refers to the roadmap when presenting to our members as the guidelines on message standards to be used within the trade lifecycle. It has become an extremely helpful tool for our members in understanding the key standards available and how and when they should be used.
While the influence of FIX has spread rapidly in global equity trading markets, its role in broader asset classes has been less vociferous. FIXGlobal asked market leaders, MarketAxess, Tradeweb and Fidessa LatentZero for their views on the impact of FIX in the fixed income arena.
FIXGlobal: FIX4.4 was introduced back in 2003 as a version that provided strong support for fixed income trading. How successful do you feel 4.4 has been?
Bill Hayden (Tradeweb): The adoption of FIX 4.4 was slow at first as people jerryrigged their existing FIX 4.2 engines to handle data for fixed income securities. Over time, however, firms began to address issues such as support and scalability and it became obvious that using FIX 4.2 for fixed income was no longer desirable.
The big wave of adoption for 4.4 came as clients gradually upgraded or replaced their FIX engines. In many cases this was a result of an upgrade or replacement of an existing order management system.
Nick Themelis (MarketAxess): FIX 4.4 was developed to provide realtime, counterparty connectivity for the fixed income community and, since its inception, we have seen strong interest from the buy-side community. For example, 63% of our connected clients access our platform via FIX. We have built partnerships with OMS vendors who use FIX connectivity for their operations, which has further expanded FIX adoption for the buy-side community. We’ve also seen several fixed income ECNs use FIX connectivity.
FIXGlobal: Where the protocol has not been widely adopted, do you feel its been limited by technical strengths or by other business environment issues?
Hayden: In the current climate, the adage of “if it ain’t broke, don’t fix it” takes hold. Firms are not able to make strategic upgrades and are instead forced to switch into a mentality where the primary goal is to keep the lights on.
Another reason that the protocol has not reached a one hundred percent adoption rate is that in many cases fixed income takes a back seat to equities. If a firm is using FIX 4.2 for its equity business then they might not see the incentive to upgrade to 4.4 if the volume of fixed income is small.
Themelis: There is nothing technical or conceptual that prevents the fixed income community from adopting the FIX Protocol. There was a legacy investment in proprietary protocols in the early days of fixed income etrading, however as automated trading increases, clients are looking to take advantage of more efficient, more reliable connectivity technology.
Many leading STP tools now support FIX 4.4, allowing for fully electronic interaction across all functions. Pre- and post-trade processes such as order creation, negotiation and trade allocations and settlement can now be fully automated.
Additionally, there are automated, reliable tools available for market participants to get onboard and easily overcome any barriers to entry such as cost or technology development. Greenline’s suite of FIX Protocol solutions and services are designed to ease the FIX adoption process for clients looking to update their legacy systems.
There is growing interest in messaging standards like FIX 5.0 for structured products such as credit default swaps. We have supported CDS etrading since 2005 and continue to offer the technology and access to liquidity for credit etrading.
FIXGlobal: The US has a much more diverse range of fixed asset types than elsewhere in the world, and is typically an over-the-counter (OTC) market. However, some asset types are being offered in a centralized exchange market, such as the NYSE bond market. Do you see this trend towards a centralized market as a way to achieve greater price transparency in the current US economic situation?
Hayden: The primary transaction venue for client-to-dealer fixed income and derivatives trading is likely to remain in the OTC space for the foreseeable future. If we have learned anything in the recent credit crunch it is the importance of the over-the-counter market as credit becomes tight. The primary dealers play an invaluable role in creating liquidity, which leads to lower costs for clients.
The issue of market transparency is also an important driver for the continued role of the OTC model. Due to the very large size of trades, the buy-side is very reluctant to show their positions in an open exchange.
Lisa Taikitsadaporn, FPL Global Fixed Income Technical Sub-committee Co-Chair; Managing Partner, Brook Path Partners, Inc. and Hanno Klein, FPL Global Technical Committee Co-Chair; Senior Project Manager, Deutsche Börse Group talk about the Securities Investment Roadmap and the Standards Coordination Group.
For the first time, there is actual proof of the long promised commitment from standards bodies and the industry to work together under the ISO 20022 umbrella. The Standards Coordination Group, the guardian of the recently updated Securities Investment Roadmap, is steering this collaboration. It is becoming the voice of open standards, promoting it up to law makers and regulators in Washington DC and Brussels.
Because the financial community is a vast one, encompassing institutions across the globe that deal with diverse asset classes at different points in the securities trading life cycle, different organizations have traditionally been responsible for developing their own messaging schemes. Today, financial firms often combine a great range of trading activities; therefore, the messaging standards from different organizations often intersect, but remain incompatible.
Within the financial services industry, there are multiple standards being used, hence the desire to ensure some level of interoperability. It is clear to many market participants that the FIX Protocol is the de facto standard for pre-trade and trade, that FpML is the de facto standard for OTC Derivatives, that ISO is the de facto standard for settlement and payments, and that XBRL is the de facto standard for business reporting. The Industry would benefit from an approach that leverages and includes these standards into a broader framework without reinventing and creating redundant messages that increase implementation costs and cause confusion for the industry.
The Standards Coordination Group began collaborating on the Securities Investment Roadmap in 2006, publishing the first version of the Roadmap in 2008 and the latest version in October 2010. The Investment Roadmap provides market participants with consistent direction when using financial services messaging standards by visually mapping the protocols to their appropriate business processes across asset classes and it also lays the groundwork for moving towards a common business model, ISO 20022, for the securities industry.