Derivatives market challenges

• Increased margin requirements and revenue compression for traditional industry participants driven by slower-than-expected growth, reduction in proprietary trading and other risky businesses, and proliferation of technology that removes information asymmetry required to generate alpha.
• Rising cost pressures from manual processes and legacy technology infrastructure, multiple intermediaries, unnecessary data reconciliations, and complex layer of handoffs within the ecosystem.
• Increased regulatory pressures, including the use of more central counterparties for clearing and settlement, reporting requirements, and higher capital buffer requirements.
• The proliferation of data available across multiple platforms but few programs in place to harness its potential and use its knowledge to better serve clients.

Market participants should begin to pursue bolder opportunities to shift the cost curve and deliver target returns on equity. There are three key factors that can help organisations define success in this area:

1. Industry standards to facilitate the adoption and migration to sustainable digitisation.
2. Technology to support new digital business models and processes.
3. Regulatory certainty.

State of the derivatives and financial markets industry

Efforts to undertake large-scale technology transformation to modernise infrastructure usually suffer from cost overruns and delivery risk. Additionally, as market structures evolve and business strategies shift, human capital, application, and hardware spending costs tend to “creep back in,” primarily due to legacy business architecture and processes. To facilitate a path to a future-state vision for derivatives infrastructure, the industry needs to agree on a simplified target state and develop data and process standards to realise it through technology enablers.

Post-trade – why standards matter

Traditional cost-reduction methods, such as outsourcing, offshoring and reducing headcount, will likely yield diminishing marginal returns going forward. Business, IT, and operations leaders face significant challenges to serve clients, support new product development, meet regulatory requirements, and adapt to the evolving market structure while keeping costs in check to deliver an acceptable return on capital to shareholders.

It is imperative for business and infrastructure leaders to focus on shifting down the cost curve for post-trade infrastructure. Historically, the derivatives industry and the wider capital markets players have attempted, at least to some degree, to mutualise costs related to non-differentiated functions within the post-trade ecosystem allowing them to focus on areas to realise competitive advantage—namely pre-trade functions. The idea of true cost mutualisation has failed because this would require industry alignment on standardising how derivatives are managed throughout their life cycle, beginning with trade execution and ending with clearing and settlement. Standards development and implementation require broad consensus among market participants, often making them slow to implement. However, standards can yield widespread benefits that can lead to improved economics, reduced risk, and improving liquidity. Interestingly, the derivatives industry is familiar with similar efforts to agree to and implement standards.

Common domain model (CDM) – the value proposition

In October 2017, the International Swaps and Derivatives Association (ISDA) introduced its CDM to create a standard blueprint for an end-to-end post-trade lifecycle. This blueprint will deliver common standards for data formats, reference data, transactional data, and business processes. CDM is meant to be technology agnostic yet at the same time can be leveraged with emerging technologies, such as smart contracts and distributed ledger technologies (DLTs).

A consistent model that defines all lifecycle events and processes for traded products can position firms to achieve simplification and scale in post-trade while preserving freedom of technology choices and interoperability between technology solutions.

With the advent of blockchain and smart contracts, the inefficiencies and costs in derivatives trading due to multiple handoffs and complex processes were supposed to decrease. However, before banks and industry participants can rely on any distributed ledger as the new Holy Grail or “single source of truth,” better standardisation is required. Most participants today use a complex set of processes, data structures, and reporting formats to track trade lifecycles in order to satisfy internal and external regulatory and compliance norms. Thus, without a common language or format, it may not make sense to adopt a common ledger.

Future outlook

The derivatives market ecosystem faces challenges from a sub-scale post-trade infrastructure marred by inadequate risk controls. Traditional cost-saving opportunities have already been fully explored, and new solutions don’t effectively address the end-to-end process. Current pain points will likely magnify over time, increasing stress on operational processes and risk management, as well as leading to the need to retrofit innovative financial technology solutions with inherent workarounds. A standard blueprint for the entire post-trade can significantly reduce inefficiencies. However, real digital transformation is only possible through common underlying standards.

To find out more about the report and how it applies to UK firms, please contact one of our UK Capital Markets team listed below.