More end-users should focus on the hows of connectivity to CCPs.
The relevant legislation isn’t yet signed but still it’s never too early—and perhaps already too late—to consider the systems impacts of OTC derivatives reform.
As the reforms enter the all-important next stage where regulators will add meaning to the key terms set out in the legislation and set forth guidelines for implementation, end-users should consider carefully their impact on potential connectivity solutions. For example, connectivity to clearing platforms that is based on open standards, interoperability and unrestricted access will make a transition to the new rules easier and less expensive than if connectivity remains closed, proprietary and restricted. How this shakes out will be largely determined by how regulators respond. Lobbying by the various constituents will be fierce.
Even corporate end-users that win exemptions from centralized clearing of their derivatives should care about the outcome. Ultimately the cost of hedging going forward will depend greatly on how connectivity to clearing platforms evolves—regardless of whether treasurers deal with exchanges and their clearing platforms directly, via custodial banks, broker-dealers or some other intermediaries. Unfortunately, many more corporate end-users have spent time fighting for exemptions than thinking about what comes later in processing derivatives trades once new rules kick in. Here are few issues to think about:
Access. Various brokers and their associations have already been complaining that efforts to centralize derivatives clearing are skewed, thanks to high capital requirements and strict trading eligibility rules, to the existing large, dealer-banks. If smaller brokers are worried about direct access, then most end-users don’t have a chance and will end up paying their dealer-banks as gatekeepers along with everything else. While this is not directly a technology question, if platforms are wired up to cater to a small number of primary dealers, it will be more difficult and more expensive for end-users to connect up directly later—purely from systems standpoint. Further, pressure for open standards, interoperability etc. will be lessened if fewer players are in the mix. Given the technology investments that will need to be made by the sell-side in response to the new rules, it is easy to see how they might also want to lock-in clients to help offset their investments.
Ease of integration. If the various CCPs are encouraged to build their platforms using common standards and to maximize interoperability, then end-users can be freer to go for the best price and counterparty without concern for a loss of STP on trade processing, for example. Interoperability also would ease the process of moving trades should a derivatives clearing vendor run into trouble or go down. To the extent that integration and interoperability is open on the back-end, this enables similar opportunities on the front-end to trade derivatives with a wider variety of counterparties, be it with legacy OTC dealers, exchanges, electronic trading platforms, or end-user to end-user directly. The same can be said about the middle, where end-users may need to upgrade to new applications for collateral management, documentation and valuation checking.
What to do in-house vs. outsource? Looking at their volume of derivatives trades, many treasurers will find they are better off outsourcing connectivity to someone with the volume to justify investment in the necessary technology. Indeed, most early pioneers in the corporate treasury space are going with custodial banks. Seeing the similarities with access to SWIFT, using custodial banks as service bureaus for access to CCP networks should not stop treasurers from pursuing access rights and open standards, along with better integration with their supporting systems in-house.
Next steps: End-users should have a list of technology vendors that are, or at least thinking about, catering to them with regard to derivative clearing and trade processing. Corporate treasurers’ needs are different than fund managers’, for instance. Where the outsourcing option is chosen, corporate treasurers should press outsourcing service providers to get the functionality that meets their needs into the systems they use. As many treasurers are in the process of upgrading treasury management systems, or considering this, now is also a good time to include a question or two in the RFP to get a feel for how the vendor is preparing for the derivatives trading environment that’s coming.