The impending regulatory overhaul of the OTC equity derivatives markets will require a rapid change in direction from an industry which has so far remained wedded to voice broking. The necessary upsurge in technology will deliver unprecedented innovation in trading and processing workflows as a result.
The ability for the buy-side to harness any available liquidity across the widest spectrum of instruments will require being able to locate the right sell-side desk across under resourced silo’ed banks, while delivering “best execution” in order to meet the growing number of regulatory reporting requirements. Technology will be the crucial enabler in this process.
Changing the old guard
As the equity derivatives market has progressed from voice trading to instant messenger, the RFQ modus operandi enables market participants to recreate an “on-exchange” level of transparency and efficiency in a bilateral OTC-like environment. The move from a labour-intensive voice process to a streamlined transparent pricing workflow, including full analysis of both brokers’ performance across products is a slam dunk requirement for any buy side trader today.
As both buy side and sell side are burdened with adhering to increasing legislation, there will be a requirement for systems to adapt to the myriad of regulatory requirements emanating from Brussels in a timely manner, particularly with the implementation of the European Market Infrastructure Regulation (EMIR). This greater level of automation throughout the investment process will not only enable firms to meet regulation but analyse the true cost of investment; a task which hitherto has been laborious within an OTC environment.
Resolving inefficient usage of collateral will now become a priority.
Getting the basics right: clearing, collateral & reporting
While many market participants see clearing obligations being pushed out to 2014 and beyond, it will be the requirement for transaction reporting, in particular the aspect of timely confirmations, which will spearhead widespread uptake of automated workflows.
New levels of standardization from master agreements to templates to pre-approved term-sheets will become prerequisite. Given the stretch of workload on buy side desks, you can expect the path of least resistance; sell side brokers who are able to provide a seamless, standardized process real-time will win market share.
Basel III and European short-selling rules will require participants to find additional collateral to support their activity. An optimal way to analyse the availability of collateral will be required prior to the introduction of the clearing obligation and margin requirements for OTC derivatives in order to ensure both the ability to trade, as well as the most cost efficient manner to do so.
Resolving inefficient usage of collateral will now become a priority. Without an automated workflow process, efficient management of collateral will remain a pipedream relegated to individual traders excel spreadsheets.
EU-11 FTT: getting taxing
The current Financial Transaction tax legislation will cover transactions occurring on any venue in the world. Without increased automation in workflow processes, the ability to manage this complexity in a timely fashion is inconceivable given the global nature of trading and the number of underlying funds. The level of complexity from a workflow perspective has already impacted cash equity volumes and TABB Group predicts this to continue as the cumulative factor of the EU-11 FTT expands to equity derivatives later this year.
The Increasing Importance of Intelligence & Analysis
Irrespective of market participants trading an OTC or ETD product, as long as it remains traded on a bilateral basis, the overriding requirement for buy side traders today is the ability to analyse data, both historic and real-time, across brokers and product ranges, to establish which product to trade, with whom, where and when.
The ability to extract data in different forms across a new range of products leads to huge opportunities for those with the right technology. Harnessing the potential within this new deep analytical source will ensure efficient management of data via technology is the new modus operandi.
From incorporating actionable Indications of Interests ‘IOI’ to tracking liquidity, maximising collateral, delivering streamlined reporting; or the provision of full analytics for transaction cost analysis; a constant evolution of products within the equity derivative space will ensure continued diversification and offer significant competitive edge for those who invest.
Just as we have seen in equities trading over the last decade, the transition from a largely obscure OTC market to a highly streamlined bilateral electronic market will deliver progress and opportunity. However the path of transition will be littered with challenges along the way.
At the National Association of Pension Funds conference in February 2013, 78% of defined-benefit scheme delegates confirmed they were moving away from cash equities to a wider range of investments and more exotic products. Technology will be a prerequisite to ensure a safe arrival to the other side.
True automation is not only about speed here; the fastest may still win but only if he is running in the right direction. The winners’ edge is now intelligent analysis and astute process management. Increasing market complexity will favour firms that can scale. As even greater emphasis on monitoring data will become critical to achieving optimum execution, those who can industrialize processes will remain lean and nimble hence will have the advantage to leverage market conditions to improve their profitability.
European order flow across equity products will require a myriad of options and choices. One size does not fit all in such a heterogeneous environment. European buy-side traders need to focus on what their individual aims are and establish which tools will deliver their ability to succeed. Historical incumbent software vendors carry heavy and aging technology burdens slowing their ability to respond to new demands. Sell sides are overwhelmed by the pace of changes imposed on their traditional business model. The cost constraints with maintaining investment in this new environment will ensure valued partnerships with agile smart technology hubs in the years ahead.
Analysis will go a long way to establishing which methodology is required when, where and in which product, offering the European buy-side trader greater defense against the perils of low liquidity.
The OTC-like bilateral model some may see as a short hop from full CLOB on-exchange centrally cleared market; however the liquidity constraints and the variety that equity derivative trading provides will ensure continued innovation both in the OTCD and ETD space, keeping the bilateral model together with the RFQ workflow alive and kicking in the foreseeable future.
The deluge of regulation continues unabated and as Europe lurches from policy to policy, the ability to stay compliant with Brussels (and Washington) will remain a moving target with one common solution. Those that chose to educate themselves and utilise the new technology will be those who will have the greatest opportunity to harness dwindling liquidity and benefit from this unprecedented market evolution.
About David Sagnier
David Sagnier previously worked for JP Morgan in London as a Managing Director in charge of Flow Equity Derivatives sales for EMEA. Throughout his career, David managed businesses in both Credit & Rates and Equity derivatives in London, New York and Paris. David graduated in 1991 with a Masters degree in Financial Markets and Stochastic Models in England as well as a Masters degree in Econometrics in France.