An Exclusive Global Trading Roundtable
Outsourcing clearing can provide capital efficiency and access to liquidity as well as ensure that brokers are compliant with new regulations and accommodate the latest technologies, according to a thought-leadership discussion.
Many Asia-Pacific markets are implementing significant changes to their trading infrastructures, while new regulations, products and technologies are transforming their clearing and settlement practices.
The changes are not homogenous across jurisdictions, which add further complexities and risks to brokers’ operations.
In this environment of dynamic, diverse and rapid evolution, firms are being forced to question whether their historic models of self-clearing are competitive and cost-effective, or if recourse to third-party clearing (TPC) is a more viable and efficient alternative.
TPC has already been widely embraced in Europe where more than 85% of equities clearing is now outsourced, but Asia-Pacific offers unique challenges – as well as opportunities – to its successful provision and adoption in the region, agreed participants at a GlobalTrading roundtable discussion sponsored by BNP Paribas Securities Services on 9 May 2018.
Managing liquidity in Asia-Pacific offers particular challenges. Investors selling a security in one market are required to go through an FX transaction to cover a trade settling in another market which causes a delay in funding and affects intraday liquidity requirements.
Similarly, brokers may need to move funds from market to market to ensure the timely settlement of transactions with their clients.
One solution is for brokers to seek intraday liquidity from their banking partners. This needs to be flexible enough to cover any peak activity that can come from rebalancing periods for their clients, while not creating significant fixed costs that can hit profitability. For instance, the banking partner may request collateral from the broker to provide a necessary credit line.
Liquidity in fragmented markets
Alternatively, TPC can provide intraday liquidity solutions to the broker on an uncommitted, undisclosed basis to assist in the coverage of their daily activity or, at an extra cost, on a committed or overnight basis to add more certainty.
Compliance with the standards and rules governing custodial, clearing and settlement services is critical, but it imposes an expensive and time-consuming burden on a self-clearing broker to invest and adapt to regulatory adjustments and to infrastructure alterations.
TPC offers flexibility and efficiency as an alternative to legacy account-operator models. It can reduce capital expenditure on back-office systems and staff hires as well help streamline the clearing and settlement process, taking care of project expenditure on operations and IT, thereby freeing up the broker to focus on its core business.
TPC can deliver other cost savings. Although IT expenses are hard to quantify – and it can be difficult to prioritise post-trade operations as budgets are constrained – freeing up capital could save hundreds of millions of dollars if a broker moves its clearing to a TPC. Payment of margin calls and contributions to the default fund are passed to a TPC partner, who also takes on the responsibility of preparing for future changes to market infrastructure.
In Hong Kong, the Financial Resources Rules (FRR) imposes strict and onerous capital regulations for clearing, providing a substantial incentive to choose TPC. Brokers can now include receivables in their liquid assets but cannot net them off against payables (although the Securities and Futures Commission is considering the possibility), which means brokers are wasting capital by not using TPC. If they do not clear trades through a third party, brokers are better off setting up affiliates elsewhere in the region to book trades.
However, arguably it makes little sense for a broker to switch to TPC if, as is largely the case now in Asia-Pacific, the service can only be provided for cash equities. Unless a comprehensive, multi-asset service is offered, then a broker will still need to dedicate resources to back- and middle-office clearing and settlement functions – for example for fixed income transactions – which might negate the cost-benefits of moving to TPC and might even increase operational complexities within a firm.
Although it is a challenge to TPC providers to cope with the diverse jurisdictions, market infrastructures and regulations in Asia-Pacific – especially in order to facilitate cross-market transactions – it is also a tremendous opportunity.
Fragmentation might make the task daunting, but it will be rewarding to those TPC providers who can solve the complexities.
One concern is that the continual changes underway make it difficult for brokers to evaluate outsourcing propositions. It is tough to plan and make long-term commitments when the future regulatory environment is so unclear. It is also hard to justify jettisoning legacy systems built up during the past 10-to-15 years to meet the requirements of market evolution successfully and outsourcing (and ceding control of) those settlement and clearing functions to an uncertain future.
If current clearing models are working well, then why take the risk and suffer the inconveniences that the disruption and complexities of switching to TPC entail? Perhaps, it is premature to move to TPC when you don’t know what’s around the corner. In addition, there is concern that vendors might miss new regulation and fail to make necessary adjustments to their systems, leaving brokers exposed to financial penalties and reputational risk.
On the other hand, a skilled and experienced TPC operator can provide clients access to its technological expertise, saving them the effort of developing, maintaining and upgrading in-house technology, or the aggravation of finding a vendor to outsource their technology needs.
Compared to self-clearing’s high fixed costs such as capital for collateral, staffing and compliance, outsourcing the service can lead to lower and more manageable variable costs and reduces the monitoring required by an international broker for every change in each local market.
There are also concerns among brokers that a rival bank – one that offers a TPC service but nevertheless competes for investor trading business – might have access to the broker’s transaction data. A “utility” TPC, with several banks contributing to its funding, might be a more attractive model to brokers worried about client confidentiality breaches.
The creation of such a model is probably a long way off, as TPC is likely to remain a revenue-earning service and continue to provide a commercial edge for individual banks for the foreseeable future. Moreover, if competitors come together in such a joint venture, disputes about who is benefiting or paying the most are perhaps unavoidable.
Yet, regulatory changes and the introduction of technological innovation indicate that Asia-Pacific is moving towards adopting new practices. For instance, exchanges in Hong Kong, Singapore and Japan are assessing the merits of blockchain technology following Australia’s lead. Meanwhile, India and Malaysia, among other Asia-Pacific markets, are considering adopting SWIFT’s ISO 20022 messaging format, which could replace legacy systems connecting to central counterparty clearing houses and central securities depositories.
Moreover, global investors will have access to a large slice of China’s $7 trillion market following MSCI’s decision to include China A Large Cap stocks in its benchmark emerging markets Index; and late last year HKEX announced major changes to its listing rules and procedures in a bid to gain a bigger share of the global IPO market.
These and other factors present a significant opportunity to investors keen on diversifying their portfolios in Asia-Pacific and benefiting from the region’s growth story, while brokerages should expect to play a major role in facilitating the process.
During a period of rapid developments in regulation and technology, brokers that do not review their revenue models are risk. Some might choose to maintain the status quo, but they should at least examine the viability of existing models and assess the opportunities of TPC.