The Oxford English Dictionary defines 'challenge' as the “move from one system or situation to another”. It is a word Toby Corballis, CEO of Rapid Addition, believes, all too easily describes the financial turmoil of the past six months. With a particular focus on EMEA, Corballis examines these challenges and the associate risks facing firms and software vendors across the financial marketplace over the coming 12 months.
Given the continuing volatility of global markets, large-scale movement of people, data and systems, challenge looks set to be the order of the day. Or, in the words of Robert Zimmerman, 'The Times They Are A-Changing', in the world of electronic trading, like many others, 'movement begets change and change begets risks'. Over the following year, the industry looks set to face a series of challenges, change and risk.
Change #1: Consolidation of software
With apologies to any egg-sucking grannies, once upon a time, to attract order flow, the sell-side gave away various software packages to the buy-side. It was the same kind of logic applied by proponents of the ubiquitous loyalty card, and buy-side firms saved money, as they didn't have to pay for their software upfront. Actually, costs were partially hidden in sellside fees and partially realised through the inconvenience of having to use a multitude of different solutions that did more-or-less the same thing but connected to different counterparties.
This may seem trivial, but it represents a seismic shift in the way systems make it to market. Money for these systems will no-longer flow from the sell-side to the software vendors. The relationship is now owned by the buy-side. No one wants to pay for something that used to be free, so it's unsurprising that there are mutterings in the corridors. Expect this crescendo to peak as many existing 'free' contracts expire, creating a drive to consolidate on as few solutions as possible. This consolidation carries a number of risks to all sides of the financial Rubik cube.
Buying software requires an understanding of the software procurement process, a process that is itself currently the subject of change. Questions like, “how long has the vendor been trading?” are likely to matter less than “who is the ultimate parent?” and “how solvent are they?”. Ownership is likely to say much about the chances of software being able to support your requirements later on. Where safety in numbers was once seen as good (vendors had more clients so less chance of going under), it doesn’t work so well if you’re in a long queue of creditors to a failed business.
Knowing who the ultimate parent of a company is gives other insights. Do the company's principals really understand my industry (they need to if you want some assurance that your system will change to keep up with the times)? Do they have a reputation for innovation? What is their commitment to Research & Development?
Change #2: Increased regulation as a by-product of political oratory
Politicians love to claim credit, deflect blame, and be perceived as tough guys. A quick scan of the local media is enough to see that the current political culture is very much one of blame. Fallout from political rhetoric tends to materialise in legislation which almost always beats the drum for “greater transparency and accountability”. What is actually meant, of course, is greater auditability, or the ability to recreate a moment in time so as to prove that the course of action taken was fair and in the best interest of the client. This is all good and there are many ways to achieve it, however it would be hard to argue that computer records were anything other than the most accessible of these.
Imagine trying to model all of the Credit Default Swaps (CDS) contracts into which Lehman’s entered. One problem is that a CDS could be created in so many ways: phone, instant messenger, and so on. Finding and recreating all of these would be a nightmare. That there is an appetite by the regulators for things to be more auditable is evident in recent speeches by Charlie McCreevy, the European Commissioner, who has been looking to introduce legislation to create more on-exchange trading of CDS trades.
If more assets are traded on-exchange that implies that more software connections are required to connect venues with participants. That, in turn, implies more trading platforms and more capacity to handle increased transactional volumes by the participants.
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.
FIX has grown rapidly from the historic base of cash equity product, and pre-trade and trade business process support, to a point where it now supports a broad range of product types; Fixed Income, Foreign Exchange, Equities and Derivatives. This organic growth has been driven by the business benefits of FIX, and a dynamic user and vendor community. JP Morgan’s Andrew Parry explores the technical aspects that will take FIX to the next level, in particular in relation to global derivatives.
The success of FIX, to date, is supported by a simple premise. It is useful, provides valued business outcomes, and has an active user, vendor, and consultancy community, rather than trying to be the most beautiful possible technical solution.
To expand FIX further we need to continue the lines of work opened up in FIX 5.0 so that we can continue to provide valued business outcomes with what is, by now, a far larger model in terms of data and function support than when FIX began.
These lines of work such as correctness, machine readable business rules and process rules – discussed below – should improve the core of the FIX model, and increase the ease of use, both for software tool makers, and our end users.
Companies such as Google and Apple provide a good example of this approach. The end user of Google maps does not have to understand the technology behind it, whereas application developers are provided with a Google Maps API. We should approach the FIX model in the same spirit.
An analysis: Service Packs FIX 5.0 onwards supports a service pack model, which supports the addition of minor changes within a matter of months'. This approach has particular value for the derivatives industry, which has a high rate of business driven change, and increasing regulatory requirements.
By adopting the service pack model, we promote standardised additions, instead of customised user extensions, which are commonly required in the absence of a timely way to make contributions. We will go on to look at how the service pack model has been used to a wide range of features to support derivatives in FIX 5.0 onwards.
Building Blocks The service pack approach has been used to provide business correct building blocks, which can be re used. Taking an example from FIX 5.0-SP2( Service Pack 2), which has provided timely support for the business requirements and regulator demands of credit derivative contract specification standardisation and central clearing in America and Europe.
EP83 – Enhancements for Credit Default Swaps Clearing. “The following new fields were added to the Instrument Block … AttachmentPoint (1457), DetachmentPoint ( 1458 )”.
These fields are in support of CDS index tranches, which give investors the opportunity to take on exposures to specific segments of the CDS index default loss distribution. For example the “0% to 3% tranche” with attachment (0% ) and detachment (3%) is the lowest tranche, known as the equity tranche, and absorbs the first 3% of the losses on the index due to defaults.
Correctness The percentage data type used for AttachmentPoint and ExhaustionPoint should only allow values between 0% and 100% (inclusive) to be business correct. The attachment and exhaustion points are always between 0% and 100% of the notional amount. This is data type correctness.
Where a tranche is being modelled, both AttachmentPoint and ExhaustionPoint should be used, otherwise the tranche is unbounded. This is model structure correctness.
AttachmentPoint should always be less than ExhaustionPoint, otherwise the Tranche would have zero or negative width. This is business rule correctness.
Where we have standardised tranches, such as “0% to 3%” we should have a way of tying back to a reference data source to confirm that this is indeed one of the standard tranches. This is reference data correctness.
Extending FIX implementations to support OTC trading and clearing
FIX is becoming a viable protocol for the trading and clearing of OTC products, as regulators usher the OTC world toward transparency and standardization. Credit Default Swaps (CDS), FX forwards and FX swaps are the latest set of financial instruments to experience a move toward standardization and are fitting nicely into the model provided by FIX while, the OTC energy market has been leveraging FIX for several years. In response, the industry is starting to see clearing service providers offer new trade confirmation and clearing solutions that allow FIX implementations to be extended from vanilla equity and listed derivatives products to standardized OTC products. CME Group’s Matt Simpson explains that this has the potential to allow significant savings for participants who can likewise extend their existing FIX implementations to support OTC trading and clearing.
Clearing houses make stride
Over the last 18 months regulators have aggressively pushed OTC markets toward standardization in order to achieve price transparency and eliminate bilateral counterparty risk. Clearing is a key component of this plan. Central counterparties such as CME Group, ICE Clear and the London Clearing House (LCH) provide clearing services which can greatly reduce the risk of default and systematic failure across the markets as well as the major players who are the investment banks, asset managers and hedge funds.
Central counterparties run clearing houses which set policies for settling markets and limiting risk. Clearing houses offer a safe harbor from this risk by ensuring that OTC markets are sufficiently collateralized and that in the unlikely event of a default the market impact is minimized. The clearing process involves carefully setting margin rates which are high enough to protect the market but not so high that trading is squashed. Margin is held in the form of collateral which can be called on in case of default. Additionally, clearing members must contribute to a default fund over and above basic margin requirements which also serves as a buffer should a default occur.
Beyond providing a safety net for the OTC high wire act, clearing houses perform other critical day to day functions that are necessary for ensuring stable markets. Valuation (also known as mark to market), cash flow calculations, and settlement price determination are part of an overall clearing service that allows all trades and positions to be fully settled each day. Taking CDS as an example, clearing houses calculate what is referred to as variation margin which is a combination of the change in the market value of a CDS position as well as the coupon accrued on a daily basis. Clearing houses hold variation margin until the CDS position matures or a coupon payment date is reached. Other types of cash flows include the full payment/receipt of a coupon on a quarterly basis and the handling of the upfront amount that is included with trades. All such cash flows are immediately banked rather than being held on a collateralized basis.
Daily settlement price
Determination is a critical process which underlies all functions of the clearing house. Without it, trades and positions could not be valued or margined. For OTC products, this tends to be a democratic process which involve “voting” on the value of a financial instrument by key participants in the form of price submission. Both bids and asks are submitted. The clearing house receives these prices, removes outliers, converges on the settlement price and publishes them to the market.
Another area worth a mention that is specific to CDS clearing is the handling of credit events. A credit event occurs when the issuer of a bond on which a CDS instrument is based fails to make payment. In effect, this is the fundamental purpose of a CDS instrument; to protect the buyer of a bond from exposure to default by the bond issuer. When this happens the clearing house must ensure that the CDS buyer is made whole and receives the unrecoverable portion of the amount held. Likewise, the clearing house must also ensure that the CDS seller delivers on the unrecoverable portion. The recoverable portion is determined by an ISDA auction. Generally, this transaction is cash settled.