Running to Stay in Place: Listed Derivatives Still Beset by Challenges

Author Name: Nick Ronalds

The news in early April that all former customers of MF Global would soon be returned all the money they were owed turns the page on one of the industry's worst traumas. It was a welcome piece of news to an industry still beset by challenges. Listed derivatives volume was up last year, but only modestly following one of the worst volume declines in decades in 2012.

Some challenges this year include problems with trade data repositories and a nascent SEF industry. But the biggest challenge looming is an environment in which both capital and collateral are scarce. These twin scarcities will keep the pressure on the industry and likely drive further consolidation. On the brighter side, getting much more efficient in using capital and collateral should spur innovation in clearing and collateral management as exchanges, service providers, and clearing firms seek better ways to cope.

Volume Bounce 

The good news is global futures and options volume was up last year by about 3%, according to World Federation of Exchanges statistics. The bad news is that 2012 was the worst year in decades and the modest bounce provided little relief from the intense legal, compliance, and capital pressures still weighing on the industry. Regionally, North America staged a modest comeback with an increase of 9.9% compared to a decline of 2.9% for Asia Pacific and 0.8% for Europe Middle East Africa. This knocked Asia back behind North America after surpassing it for the first time in 2012. 

By product commodity was the big winner, up 24.4%, equities the biggest losers, down 5.3%. Interest rates came back from their worst year since the start of financial futures 40 years ago (down 15% in 2012) with an increase of 13.5%. 

The two biggest exchange groups, CME Group and InercontentialExchange Group, were the biggest gainers, up 9.3% and 15.7% respectivelyThe Korea Exchange, whose Kospi option had kept it in the No. 1 spot for over a decade to 2011, has fallen to ninth place because of a combination of a quintupling of the option contract size and restrictions in the warrant market introduced in early 2012. 

The Mainland Chinese exchanges were on a tear for their second year in a row, with the Dalian Exchange up 10.7% (+119% in 2012), Zhengzhou up 51.3% (-14.6% in 2012), Shanghai futures Exchange up 75.9% (+18.5%), and CFFEX, the China Financial Futures exchange, was up 84.2% in 2013 after an eye popping 108.4% in 2012 on the back of its phenomenal stock index contract, the CSI 300. 

In the early years of this millennium derivatives exchanges were growth stocks. Released from the constraints of physical floors, products multiplied and volume exploded in the transition to the digital era of screens and algos. Although the years of easy growth are past, exchanges will likely have some good years ahead, as a more normal interest-rate environment revives interest-rate products and the current focus on law and compliance eventually gives way to the need for better risk management in a volatile world.

Cleared OTC on the Rise 

Because central clearing requirements took effect in phases during 2013 it may not be surprising that cleared OTC products saw substantial increases. LCH Clearnet led the charge with cleared IRS notional value of $282.6 trillion, according to FIA statistics, an increase of about 46% from 2012. Their cleared foreign exchange volume more than doubled to $446.1 billion. 

CME group's IRS volume soared over sixteen-fold to $15.1 trillion, while CDS volume rose a more sedate 16% to $226.7 billion. IntercontinentalExchange's ICE Clear Credit remained the leader in cleared CDS volume, which rose over 25% to $7.7 trillion in 2013.

China Still Rising 

While China's economy is shifting down, its derivatives exchanges and products could still have plenty of growth ahead. China has yet to list any options, which are typically among the most popular equity derivatives in other markets. The gap may be filled this year with the launch of an option on the CSI 300 index. CFFEX has been running mock trading sessions since last year, but approval for options has to come from the highest levels and when that will happen is guesswork. In addition, the two Chinese stock exchanges are hoping for a green light this year to launch single-stock options. Chinese commodities may also get their turn this year. If so, it will be the with the most active contracts, such as Soymeal futures at Dalian, Rapeseed Meal futures at Zhengzhou, and copper at Shanghai that get the nod. However, concern about the readiness of FCMs and clients to cope with the more complex risk management challenges of options is making regulators cautious so far. 

CFFEX launched its second contract, a bond future, last September, with disappointing results so far. Volume has been bouncing around the 2000 contract mark, demonstrating after years of eye-popping success of one contract after another that there's no guarantee of success even for Chinese futures products. (For more on China's bond futures contract, see "T-Bond Futures with Chinese Characteristics" in the September issue of FOCUS.) One reason for the lackluster action is that the biggest holders of bonds, Chinese banks, don't yet have approval to trade from the China Banking Regulatory Commission. 

The silver lining of China's disappointment with bond futures is that the industry has learned that success isn't a given. Measures to nurture liquidity, for example via market-making schemes and good marketing, are important. This lesson may help China's prospects for options, where the multiplicity of option series creates challenges to maintaining liquidity.

Trade Data Struggle 

A major goal of the G-20 meeting in 2009 that kicked off global financial reform was to make financial markets radically more transparent by requiring market players to report their trades to data repositories. In the U.S. the reporting requirements for different assets rolled out in stages starting in December 2012. In Europe the EMIR requirements went live in February of this year. The mandate's objective was to make it possible to take a snapshot at will of global derivatives exposures for market participants. The effort is beset by challenges, not to say confusion. 

One problems is that the U.S. requirements cover a smaller number of major players and requires only one side to be reported, while the European rules require both sides to report and in principle cover all dealers as well as users. A second problem is that the asset classes aren't consistent across regions. A third is that at least a half-dozen service providers are in the game of collecting the data; with information spread across multiple providers, who will see the big picture, and how? It doesn't help that there are no standards or consistency in formatting, creating a Tower of Babel for all involved—the service providers who collect, store and redistribute the data, regulators who have to interpret it, and especially for the financial institutions, who have to collect, format, and disseminate the data to multiple regulators and service providers. An ambitious effort to solve on part of the puzzle is the initiative to develop a global Legal Entity Identifier (LEI) system so that global exposures of affiliated entities can be pieced together into a single picture. Progress has been made but so far only a fraction of companies that transact in financial markets have been issued LEIs, so further work lies ahead. 

Having a detailed picture of all global counterparty exposures is doubtless a worthy goal for regulators, but clearly quite more work needs doing before that goal is realized.

SEFs Launched 

Mandatory trading on Swap Execution Facilities kicked off in February a product of the U.S. regulatory response to the financial crisis. Volume so far has been so-so, bouncing around the $2 billion notional level on a weekly basis. Fifteen SEF providers were in the game at last count, with the lion's share of volume going to ICAP, Tullet Prebon, BGC, and Bloomberg. Post-execution processing—the implications that SEF trades have for downstream processing—has been a struggle and pain point. The FIA has set up "SEF Tracker", a tracking service that provides detailed statistics on all the platforms and their products. End users are entering the market cautiously, so more time is need for a fair assessment of these new platforms.

Capital Crunch 

The rising cost of capital looks like the next great challenge to the global derivatives industry. Though it's received less attention to date than the mandates flowing from Dodd-Frank and EMIR, it's likely to prove more costly than either and to force major reassessments of business models for FCMs, providers of clearing services, and the broader financial industry. 

As a response to the financial crisis, the Basel Committee of Banking Supervisors, the international body that sets capital standards for banks, is calling for phasing in increased capital levels for almost all types of assets. It's a truism of finance that more capital—all else equal--makes an individual company stronger and the financial system more stress resistant and less susceptible to crisis. But what makes the issue complicated is that a firm's level of capital by itself conveys little without knowing about the riskiness of its assets. Controversy arises because the additional safety from higher capital levels comes with a price tag. Excessively high capital requirements for a given level of assets depress returns, potentially to the detriment of the industry and broader economy. There's only one sure-fire way of bumping returns back up: shed assets and become smaller. (Another way would be to increase profits, but if that were easy presumably banks would already be doing it.) The broader economic impacts follow from that: shedding assets means calling in or selling of loan portfolios and reining in other banking activity. And that's another way of saying credit gets tighter and businesses have a harder time financing existing businesses and growing. 

Adding to the complexity is that regional and country regulators have developed their own capital standards, which may be even more stringent than the Basel rules. CPSS/IOSCO has published default fund principles for CCP and other financial infrastructure entities. In the U.S. the Fed, the Comptroller of the Currency, and the Federal Deposit Insurance Corp are all in the act. Since the financial crisis the largest 18 U.S. banks have had to add more than $500 billion in high-quality capital to achieve capital ratios of 5%, according to the Fed. In early April the three U.S. regulators announced that the eight largest U.S. banks will need to add another $68 billion in extra capital by Jan. 1, 2018. Some European regulators are proposing even higher ratios—between 6% and 10% in the case of the Swiss banks, for example. 

The January 2018 deadline for complying with Basel III rules doesn't provide the breathing room it appears to. Derivatives can have expirations 5, 10, or even more years into the future, so pricing and return calculations have to take into account today the cost of capital stretching years into the future. 

For the clearing business it gets worse. In the cleared derivatives space, the new "Basel III" standards will require banks to hold more capital against the counterparty risk of derivatives, including futures and cleared swaps. This is a major reversal of the previous model in Basel II, which regarded cleared derivatives as embodying essentially no counterparty risk hence required no capital. Without changes in the economics of the clearing business higher capital requirements inevitably mean lower returns in an industry that has already been squeezed by falling volume and rapidly rising legal and compliance expenses. It's hard not to conclude that one industry response will have to be further consolidation to achieve economies of scale. 

While the clearing business itself will call for more capital, another Basel III standard requires exchanges to increase the size for their default funds—typically funded by member contributions. Default funds and the "risk waterfall" structure of CCPs have come under scrutiny recently after a default at the Korea Exchange in December took a bite of the KRX default fund and required clearing members to kick-in new payments. 

In addition to the risk-based capital requirements the Basel standards call for reduced leverage ratios, or less debt relative to capital on the liability side of the balance sheet. What the ratios will be is still unclear, because national prudential regulators are developing their own standards which are not necessarily consistent with those of the Basel Committee. The impact, however, is in the same direction: more capital on the balance sheet depresses returns, all else equal.

Next Innovation Frontier? 

The huge costs at stake have kicked off a round of new services in the industry for banks and other players. In the exchange space the challenge is more than just a shortage of capital. Because of margin requirements, collateral has become a scarce resource. Derivatives exchanges and vendors are using their know-how in collateral and risk management to offer services to make more efficient use of both scarce resources, such as compression services and cross-margining. Compression means taking a portfolio of OTC derivatives and netting it down into a much leaner portfolio with the same economic characteristics but much-reduced credit exposure—and capital. When derivatives exchanges traded futures and options compression was irrelevant because those products net automatically. Now that a rapidly growing share of OTC products is getting cleared, compression is a business opportunity. 

LCH Clearnet has offered compression services for a while but announced expansions to its services in March. CME Group is launching "compression via coupon blending" for OTC interest-rate-swaps in May, and ICE Clear Credit, Intercontinental Exchange's OTC clearing unit, provides compression services as well. Eurex Clearing is developing an integrated cross-product model for netting, default fund and collateral efficiencies such as securities financing and lending, collateral pooling, portfolio margining, and so on. Other exchanges have such services on the drawing boards. 

In Asia, SGX is getting in on the act by offering cross-margining benefits as it rolls out more currency futures this year. For example, a portfolio of Nifty futures and Rupee forwards could expect a 30% margin reduction relative to the requirement for the individual positions. 

Risk doesn't stop at borders, which helps explain why exchanges are reaching across them to develop solutions. ICE acquired the Singapore Mercantile Exchange last November and the CME is reportedly in discussions with ASX for a mutual offset arrangement allowing customers to hold collateral in Australia or the U.S. The CME has experience with such ventures as it pioneered the Mutual Offset System (MOS) with Singapore' futures exchange, Simex, 30 years ago. (SIMEX since merged with the stock exchange to form SGX.) Eurex has announced plans to set up a clearinghouse in Singapore. 

For exchanges it's not just about launching clever new trading products anymore. In past years the race favored product innovators who brought out new instruments for trading and portfolio management. In the next few years the race may favor those who can help squeeze ever-more productivity out of scarcer capital. 

Nick Ronalds, CFA, is Managing Director, Equities at ASIFMA, an independent, Asian trade association with over 60 member firms comprising a diverse range of leading financial institutions from both the buy and sell side, including banks, asset managers, law firms and market infrastructure service providers. Before joining ASIFMA he had various senior roles in the financial and derivatives industry, including Operations Manager in the CME Clearing House and Managing Director of the CME's first Asia Office. He can be reached at [email protected].

---