Exchanges draw battle lines in regulatory crunch year
Competition between derivatives exchanges is intensifying, giving rise to a rash of product and platform launches in 2015, as well as geographical expansion. But 2016 will be dominated by regulatory deadlines for electronic trading. As Dan Alderson reports, exchanges that best prepare market participants to meet these requirements will be the ones that will win out.
Volatility returned to financial markets in 2015, with the expectation of US interest rate rise accompanying several months of Greek political stand-off and mounting concerns about a Chinese stockmarket crash.
Causes of volatility are likely to become only more frequent and pronounced this year. While this presents new challenges and opportunities for traders, exchange operators believe it puts a heavy focus on their businesses.
“With the uncertainty around a Fed move, geopolitical events and economic issues evolving throughout Asia and other parts of the world, we saw yet again the absolutely critical need for customers to manage their risks,” says Terry Duffy, executive chairman and president of CME Group in Chicago. Duffy predicts that this year investors will continue trying to pre-empt volatility. “What we see is a drive for efficiency, as our clients try to manage their risk in the most capital-efficient way possible.”
In 2016, market participants in derivatives will face two big issues in meeting this aim: finding liquidity and complying with regulation.
“Liquidity is critically important in times of volatility, so buyers and sellers can get in and out of the market and properly manage risk,” says Duffy. “That’s an absolute imperative, not just for our industry, but for the real economy.”
This was underscored in August, when there was a jump in market volatility. But at the same time, some exchanges such as CME reported record volumes, as two‑way flow kept trading markets tight. Duffy believes this is very encouraging for his exchange and demonstrates the benefit liquidity brings to market users.
A classic need for liquidly traded risk management products came in the second half of 2015, when China’s capital markets slumped in June, July and August.
“This clearly impacted risk management volumes throughout last year,” says Michael Syn, head of derivatives at Singapore Exchange (SGX), “and we have seen evidence of continued market uncertainty, with increased volumes of SGX products linked to China, including the FTSE China A50 equity index futures, iron ore futures and USD/CNH futures.”
Eurex sees a similar trend in Europe, but believes operational costs and efficiency will determine where trading activity concentrates.
“The landscape in European options markets is changing and liquidity is not as sticky as it used to be,” says a senior spokesperson at Eurex in Frankfurt. “Liquidity is progressively moving away from local exchanges to one single European platform, in part driven by companies’ needs to maximise their collateral utilisation. Exchanges and their associated clearing houses that feature netting between large numbers of products are at an advantage.”
A call to arms
Amid this shifting landscape, market participants are striving to prepare them-selves to meet 2016’s impending regulatory targets, such as the introduction of compulsory clearing of certain products under EMIR (starting with some interest rate swaps in March) and compulsory exchange trading of liquid products under MiFID II.
The second of these is the more challenging, since all products going through an exchange also have to be cleared. In November, ESMA and the European Commission threw a roadblock in front of the European parliament’s plans when they agreed it would be best to put back MiFID II, perhaps by up to a year, from its planned January 2017 roll-out, saying many technology systems would not otherwise be ready in time.
Despite this, bankers stress that regulatory delays should galvanise the industry’s push to comply with mandatory clearing, rather than encourage complacency.
“Regulation will play a big part in the conversation around exchanges and clearing in the coming year,” says Silas Findley, EMEA head of OTC clearing, futures and collateral at Citigroup in London. “Even if MiFID gets delayed, it will only be because there is so much to do. We will continue working on the premise that it won’t be delayed and would advise clients to do the same.”
Nor are these concerns limited to Europe, since any setback in regulatory progress will put it at odds with the oversight of electronic trading regimes in the US and Asia.
“The main challenges will be handling the consequences of Basel III, together with the uncertainties surrounding the implementation of MIFID II,” says Syn at SGX.
The cost of clearing
Mandatory clearing goals are not just a logistical challenge for banks and their clients. They bring rising operational costs that will change the structure of derivative markets and has prompted some banks to reassess how they do business. Credit Suisse decided in October to scale back its interest rates business, in part because of clearing costs.
“The cost of clearing will have the biggest impact on what banks are able and willing to do in derivatives markets,” says Findley. “We have already seen a number of high profile exits from the space. It’s all about balance sheet. Banks have to think about their cost of capital, but also the investment needed to stay competitive. With ever more products and clearing venues, it all becomes very expensive.”
This has caused tension between trading parties in the industry, says the head of clearing at another bank. Clients want a commitment from dealers to continue supporting derivative markets. But banks have struggled to convince some clients that they will have to pay more towards the rising costs.
In this Catch 22 situation, derivatives exchanges and clearing houses can help the market and themselves. For example, says Findley, the ability to offer cross-product margining of both listed and OTC derivatives will be increasingly advantageous.
“We’ve developed a portfolio margining service that is of great benefit, particularly to our bank clients who use this service for margin offsets,” says Duffy. This, he says, has produced initial margin savings of over $3bn to date, including $1.8bn from dealer banks.
SGX also offers cross-margin operational and capital efficiency benefits across equity, currency and commodity asset classes, says Syn.
Expanding the types of collateral clearing houses accept will help markets, say bankers, as will increasing minimum cash requirements. This should reduce the impact on exchanges during times of stress.
In another drive for market efficiency, CME has worked with TriOptima on cycles of multilateral compression, and was the first exchange to launch coupon blending. Its recent compression reduced nearly 45,000 line items, with nine interest rate swap clearing members taking part.
“We have produced nearly $15tr in notional reduction through coupon blending, and we generated $2.2tr in tear-ups through our September multi-lateral compression cycle,” says Duffy.
But another narrative has also emerged in recent months. Clearing bankers are increasingly calling on exchanges to act as advocates in the market about the impact of clearing on bank balance sheet and capital costs.
“That definitely could advance the cause,” says Findley. “Exchanges haven’t been as visible on this in the clearing broker space as they could have been. There is an opportunity here to get some expertise in the field from players who are more neutral.”
The widening push for market share
Regulatory challenges will be compounded in 2016 by the geographical diversification of market participants. More exchange customers want exposures across all regions and increasingly base trading strategies on global benchmarks.
“Geographical expansion will be key for exchanges in 2016,” says Findley. “China and LatAm in particular offer a lot of additional opportunities. It’s no surprise that exchanges are increasing their connectivity to those regions with recent initiatives.”
In August, CME entered into a joint venture with China Foreign Exchange Trade System and National Interbank Funding Center (CFETS), to open up renminbi markets to foreign investors. Earlier in the year it began clearing Brazilian real interest rate swaps.
SGX sees increasing competition from global derivatives exchanges as one of its biggest challenges ahead. But Syn believes this also confirms the growing demand for risk management products in Asia, where SGX has helped develop the market.
For exchanges, the main buzzword for the year ahead is “innovation” rather than competition.
“The derivatives space is highly competitive and you don’t see many natural monopolies,” says Syn. “There are certain artificial monopolies established by governments in their desire to retain control of capital flows, but the market always finds a way around such restrictions, particularly in the OTC space. Our mission is to create greater transparency and accountability as well as better risk mitigation by bringing these OTCs to our central order book and central counterparty.”