By Sanjay Awasthi, Director, Eastspring Investments**
Increased adoption of OTC derivative technology is giving buy-side traders better pricing and reduced operational risk. More technological options will only help improve systems and trading methods and styles.
For exchange-traded derivatives, including futures and options contracts, electronic trading is relatively straightforward and the markets can be accessed electronically via electronic messaging protocols and broker algorithms.
However, with respect to Over the Counter (OTC) derivatives across foreign exchange (FX) and fixed income derivatives the increased acceptance and adoption of technology are more complex and innovative. These are much larger markets and traditionally, there have been issues around transparency and pricing.
Historically, financial derivative contracts were OTC and over time, as they were standardised and gained wider acceptability, we began to see them trading on exchanges in the listed space. However, FX and fixed income derivatives continue to trade on OTC markets.
These OTC markets still work on the basis of Request for Quotes (RFQ), which require traders to ask a few counterparties, typically banks for quotes and trades are executed based on the best available price The traditional approach involves calling a broker or sending messages in chat rooms.
There are a few inherent limitations to this method.
First, it limits the trader’s ability to reach out to multiple counterparties and consequently, a buy-side trader may not get the best possible price.
Second, it is time-consuming, which is increasingly relevant as many trading desks and traders are handling multiple asset classes.
Third, this process is prone to errors as manual entry of trading particulars invites the risk of fat finger order mis-entry.
The OTC FX and fixed income derivative markets have been around for a long time and operate in this particular manner for various reasons. However, explanation of these reasons may not be germane to what we are now discussing.
The electronic RFQ platforms, be they Bloomberg, Tradeweb, FX connect, etc., facilitate ease of trading without significantly changing the way these OTC
markets operate. As a result, we are increasingly seeing new technology being implemented into Request for Quotes in the OTC derivative space.
The obvious advantages to a buy-side trading desk are as follows:
• One is able to immediately request more counter-parties for pricing. This increases the chances of getting better pricing for client mandates.
• Linking the buy-side order management systems to RFQ systems and markets electronically makes trading less time-consuming, seamless and free of obvious manual errors.
• The quotes are stored electronically and are available for assessment of trading quality on a tangible basis. Electronic records assist TCA on pricing and counter-party reviews which adds quantitative and objective dimensions to the whole process.
• Across most jurisdictions, there are increasing regulatory and compliance requirements around trading OTC derivatives. RFQ systems bring transparency in terms of electronic audit trail, controls and reporting, which in turn significantly enhances compliance and helps avoid regulatory oversight.
• The RFQ systems bring in an STP element to the OTC market which significantly reduces operational risk.
Most institutional investors have concerns around transparency in OTC derivative markets and this, in turn, limits their use of these products. RFQ systems which bring in increased transparency makes one more inclined to use OTC derivatives to achieve portfolio objectives.
RFQ systems even facilitate ease of accessing quotes in listed derivative like options, especially longer-dated relatively illiquid options.
Another area where technology will have a significant impact is in post-trade operations around these OTC contracts. These contracts being bilateral are governed under cumbersome ISDA contracts which increases operational complexity and risk. Evolution of technology which can facilitate ‘smart contracts’ as a protocol to digitally facilitate, so as to electronically record all contract conditions and performance can completely transform the OTC derivative space.
** The print version of this article incorrectly listed Sanjay’s title. It has been corrected here.