19 July 2013

Derivatives Reform: Preparing for an uncertain data landscape

A shift to derivatives, coupled with the creation of swap execution facilities and the potential "futurisation" of swaps onto exchanges, will make location key for derivatives markets and brokers seeking to bolster the value of their data.

Over-the-counter derivatives represent a huge trading opportunity: the Bank for International Settlements estimated the total national value at around $650 billion as of December 2011. This placed a high value on data about that market. Previously, firms could justify the cost of OTC activity as profits were high for bespoke products. However, with Dodd-Frank and EMIR, that is all about to change.

In terms of market data, central clearing of OTC activity introduces a wider set of participants, notably swap execution facilities (SEFs), to which firms will need to connect to source data. However, the real impact will be potentially higher costs that could disrupt the market further, resulting from regulations requiring firms to up their risk management. Firms will also need to find more collateral to cover central counterparties’ (CCPs) new calls for initial margins. Some suggest these rising costs could lead to an exodus from the swaps market and drive activity towards exchanges, with swap trades transformed into futures contracts—particularly as the amount of collateral needed to trade futures is much less than swaps.

From an industry perspective, this “futurisation” of swaps could positively impact data quality and availability, with more competition driving greater efficiency and transparency. Crucially, the shift to exchanges would also increase the value of market data from those exchanges, which may offer this new data bundled with existing products or as separate offerings, leading to greater choice for trading firms, though possibly at a higher cost.

If firms exit the OTC market, the move to exchanges may prompt interdealer brokers to create futures exchanges and futures contracts—which would traditionally have been OTC swaps. This also mirrors an unintended consequence of MiFID II in the exchange market: the potential proliferation of new futures exchanges. The brokers who make the markets will essentially need to aggregate their prices into feeds that they commercialise through aggregators, presenting a valuable opportunity for brokers to offer direct feeds in competition with exchanges.

In a new data landscape, proximity and geographical reach will become the prime concerns. Firms will need both the physical proximity to data sources and the flexibility to change rapidly to new carriers or vendors. There is now a network of financial hubs that allow firms to consolidate their global network accesses to venues, vendors and brokers. These will enable firms to achieve the necessary sub-500 microsecond speeds without the astronomical costs of proprietary setups.

It remains to be seen how the derivatives market will ultimately play out. But one thing is certain: firms that prepare now for inevitable change will be best placed to adapt and compete in the new landscape.

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