Is Revolution the Path to Transparency?
Posted by Dan Hubscher
Revolutions are proliferating. When you watch a revolution happening elsewhere, political or otherwise, it’s a good time to contemplate the revolution in your own history, or in your future. There are few among us that can’t point to one or the other. One of the common drivers is the fear that something is happening where we can’t see it happen, and we want transparency – of process, of government – of whatever seems to be wrong.
The capital markets globally are experiencing a similar revolution now with regulatory change, and the current climate threatens to create a revolt as well. Market participants may push back on reforms to the point of creating a new state of stress. Either way, the future presents very real threats to companies that aren’t prepared. We’re observing a vast expansion of global rulemaking, and a coming deluge of data - especially in the derivatives markets. It’s very expensive and distracting to fix problems after the fact, so we need to act now. “Hope is not a strategy” – as is often said to have been uttered by famed (American) football coach Vince Lombardi.
In an open letter to Barack Obama published on January 23, 2009, Benjamin Ola Akande advised, "Yet, the fact remains that hope will not reduce housing foreclosures. Hope does not stop a recession. Hope cannot create jobs. Hope will not prevent catastrophic failures of banks. Hope is not a strategy."
Now we have the Dodd-Frank Act in the U.S., MiFID II and EMIR in Europe, all preceded by the de Larosiere Report (EC, 2009), Turner Report (FSA, 2009), Volcker Report (G30, 2009), G20 – Feb 2009 Declarations, Financial Stability Forum Report (FSF, 2009), INF Report (IMF, 2009), Walker Review (UK, 2009), Basel / IOSCO Reviews… the list goes on. And the rest of the world is watching, waiting, for another revolution. The intended scope of the most recent reforms seems to almost be panacea, and transparency is the first step.
The next Revolution is happening in Boston, fittingly. Progress Revolution 2011, from September 19ththrough the 22nd, offers the chance to learn from industry innovators on how they have successfully tackled these challenges within the capital markets. Customers including PLUS Markets and Morgan Stanley will be there to share success stories. And Kevin McPartland, Principal at the TABB Group, will be there too. I’ve included a sneak peek into Kevin’s “Path to Transparency” below.
According to the New York Times, at the Republican Convention in 2008, Rudy Giuliani once said while contemplating Barack Obama’s candidacy, “… ‘change’ is not a destination ... just as ‘hope’ is not a strategy.” Rudy will be speaking at our Revolution too. Will you be there? It will be a lively conference – I hope that you can join us!
-Dan
The Path to Transparency
By Kevin McPartland, Principal, TABB Group
Managing the vast quantities of data born into existence by the Dodd Frank Act and related regulation will present a challenge in the post-DFA environment; but collecting and producing the required data is just the tip of the iceberg. The ability to analyze and act on that data is what will separate the survivors from the winners. This is already true in many other parts of the global financial markets, but the complexities inherent in swaps trading coupled with the speed at which these changes will take place creates unique challenges. Spread this across all five major asset classes and three major geographies, and the complexities become more pronounced.
Margin calculations are proving to be one of the biggest concerns for those revamping their OTC derivatives infrastructure. In a non-cleared world, dealers determine collateral requirements for each client and collect variation margin on a periodic schedule—in some cases once a month, and in other cases once a year. When those swaps are moved to a cleared environment, margin calculations will need to occur at least daily. The result is an upgrade of the current batch process with dozens of inputs to a near-real time process, with hundreds of inputs. Whereas before major dealers could perform margin analysis, client reporting and risk management in a single system, those systems now need to operate independently within an infrastructure that provides the necessary capacity and speed.
The trading desk will require a similar seismic shift, as flow businesses will provide liquidity across multiple trading venues to an expanding client base. Most major dealers are at some stage of developing liquidity aggregation technology intended to provide a single view of liquidity across multiple swap execution venues. Creating this type of virtual order book requires receiving multiple real-time data feeds and aggregating the bids and offers in real time.
Furthermore, rather than comparing model-derived prices to the last trade price to produce quotes, inputs from SEFs, CCPs, SDRs, internal models, third-party models and market data providers will be required inputs to real-time trading algorithms once reserved for exchange-traded derivatives.
Providing clients with execution services presents other challenges. Executing on multiple platforms also means tracking and applying commission rates per client per venue in real time. Trade allocations also complicate the execution process. In the bilateral world a big asset manager can do a $100 million interest rate swap and spread that exposure across multiple funds as it sees fit. Under the DFA, the executing broker must know which funds are getting how much exposure. Account allocation in and of itself is not new, but cost averaging multiple swap trades and allocating the right exposure at the right price to the proper account presents complex challenges, especially in a near-real time environment.
Risk management, compliance and back-testing data will also require huge increases in processing power, often at lower latencies. Risk models and stress tests, for example, are much more robust than they were before the financial crisis, requiring a considerably higher amount of historical data.
Compliance departments now must store the requisite seven years of data so they can reconstruct any trade at any moment in the past. This is complicated enough in listed markets, when every market data tick must be stored, but for fixed-income securities and other swaps, storing the needed curves means that billions of records must not only be filed away but retrievable on demand. Similar concerns exist for quants back-testing their latest trading strategies: It is not only the new data being generated that must be dealt with. Existing data, too, is about to see a huge uptick in requirements.
In the end these changes should achieve some of the goals set forth by Congress as they enacted Dodd Frank – increased transparency and reduced systemic risk. The road there will be bumpy and expensive, but the opportunities created by both the journey and the destination will outweigh any short term pain.
This perspective was taken from the recent TABB Group study Technology and Financial Reform: Data, Derivatives and Decision Making.
