-Today we will discuss FINCAD’s annual research findings where we polled our global client base. There were three primary areas covered within this survey; these included forecasted derivatives usage, business and regulatory trends across both the buy-side & sell-side, as well as technology investment.-These are three widely expansive range of topics. We gave further context to the polls based results that provides an even greater depth to these finding-This session will take about 30 minutes and afterwards we will open up the Q&A, as time allows.s. And as Scott mentioned, we will be sharing both the full research report as well as a presentation after today’s webcast. We will also go through the full list of questions should there be any unanswered ones and provide that as well.
We thought it would be useful to provide a broad overview of our survey process so that it can give more of a context to our findings. We conducted our research by polling thousands financial institutions and for the purposes of today’s webcast. The emphasis of today’s ession is to focus on the results for both the buy-side & sell-side institution type.
And on the buy-side alone we have 404 firms that responded to our poll.The largest proportion of these buy-side firms included are traditional asset managers. Other represented buy-side institution types include hedge funds, fund administrators, pensions, and insurance companies. 10% of those who responded also didn’t fall into one of the previously mentioned categories.If we look at the graph present on the screen. we can see the break-down as I have just mentioned. And lastly, the responders were from a global pool to provide a diverse geographical representation of our survey findings.
In total, there were almost 700 sell-side banking institutions who responded to our global survey. The largest percentage was commercial and investment banks, collectively representing more than half.Other segments included private banks, broker-dealers, and regional banks.Overall the survey findings are based on the percentage of firms responding such that the overwhelming weight of one segment in number is not always correlated with the magnitude of the specific survey topic area.
We will first take a look at the projected trends in the volume of over the counter derivatives. We try to step back sand interpret some of the broader trends in the derivatives market place. The primary emphasis is within OTC derivatives but we look at the broader derivatives industry as a whole.
The first area within our survey results is the projected usage of derivatives instruments on a forward looking basis.These graphs on the screen represents the combined response across both the sell side market segments.We can see from this high level overview that the majority of responders are forecasting either an increase or constant usage of OTC derivatives. We believe that we are seeing this perceived growth for a few reasons & thus we need to consider a few factors. The first is the landscape of the responding firms to this survey By nature, this represents a broad number of global financial institutions. This covers the spectrum ranging from regional banks integrating derivatives into their business as a growth area for additional return generation and/ or as a way to mitigate risk. On the other end of the spectrum are the tier one investment banks, who have been using derivatives for many years and have deep legal & quantitative teams analyzing all pending derivatives legislation in earnest to see the potential impact on their business. One important factor to look at is the time frame. Financial institution may have different time lines for phasing in or phasing out derivatives instrument used, based on project and budget timelines. These initiatives could either be short, medium, or long term with regard to the usage of different types of derivative instruments for cost and benefit implications.Additionally, when looking at the impact of changing regulation, we can see that institutions would be best served to evaluate both cost & benefit when looking at various financial instrument types. Once implementing derivatives strategies, the comparison will be on the usage of over the counter or centrally cleared alternatives. The decision will be driven from liquidity, funding, and ease of migration with regard to different financial instrument types. A potential example is the complex analysis of instrument alternatives across different tenors as they will have different breakeven points and different haircuts applied to them, all impacting the overall trading costs. The practical considerations amongst all possible tradable alternatives will vary significantly.
Across both the buy-side and the sell-side 17% of responders indicated that they will be decreasing their usage of Over the Counter derivatives, though did not specify the precise time line. Some of the most influential reasons are highlighted in the graph on the screen. This 17% captures composite of different institution types. And as we look at all 4 of these factors, it is evident that they are all facets of the same underlying issue, of the sentiment shift to greater risk controls. Time will tell if there will not be a regulatory shift into the other direction again but it is currently a more risk aware mindset. One such example that is evidenced and impacting many entities is the potential impact and risk in cost resulting from increased margin requirements as required under Dodd-Frank. The logic as risk is priced into trading activity more effectively than it was several years ago, a significant change required is the additional cost from insuring trading activity, through the mechanism of posting margin. And we can see from the graph that these are all highly interrelated.The increased regulatory reporting requirements resulting from the cost of using over the counter derivatives in favor of centrally cleared instruments, such as new types of futures based alternatives is another example.
One area we questioned financial institutions on within this survey was related to their greatest business challenges. The graph on the screen represents these challenges as seen from the vantage point of the sell-side. The majority response was in favor of accurate regulatory compliance. The second largest percentage was the ability to provide independent pricing/ valuation. This is largely due to the changing regulatory landscape now requiring an increased granularity of firm wide portfolio exposures as well as a detailed understanding of how their risk assessment could change in different market conditions.When taking a more in depth look at the risk strategies and more effectiveness assessment methods being deployed by the sell-side, some of the major areas covered included an increased awareness of model risk as well as an increased usage of stress testing and scenario analysis to track exposures. The (as an example the requisite margin calculations).There is also split data on the requirement for intra-day risk for firm wide exposures. More than anything this requirement has varied depending on individual firm dynamics. Many institutions are utilizing batch risk processes that are run end of day whereas other firms are adopting the mind-set that intra-day / on demand risk based calculations are a better alternative from a best practices point of view. And it obvious that most firms would agree but some firms are making technology investments to get there.
When we analyze the sell-side requirements stemming from regulatory compliance in a little bit more detail we get a better sense for the type of risk analysis they are seeing as the most critical to their business.Most of the regulatory compliance drivers have an underlying theme that speaks to enhanced risk analysis. There is a growing appetite for improved risk processes and procedures and we are also seeing a growing technology investment in this area, which we will come to in a few slides.One of the most important areas, focus on Model risk & independent valuation. This is an area where we are seeing continual resource investment. The primary emphasis being to invest in the firm’s ability to ensure their approach to model financial instruments and portfolio risk is robust and can be validated as well as illustrating how valuation differences can be driven from modeling changes. Many internal audit teams are being set up (and expanded) to validate that front office pricing and back office risk procedures are sound and can be corroborated through model validation & audit teams. Model risk here can be thought of as the ability to test pricing and risk assumptions with different models and to decompose model attributes such that firms can better understand risk factors. And also have a defensible independent analysis of the model for increased transparency.We are also seeing an increased usage of stress testing & scenario analysis. Much of this is regulatory driven, such as the 5 day historical var calculations used for initial margin calculations but we are also seeing a shift to embrace industry best practices and that manifests itself here through the performing scenario analysis across a broad set of financial instruments.These most important areas were related to increased stress testing and scenario analysis as well as a more defined approach to model risk. And when looking at the regulatory landscape on the sell-side it is apparent that very few firms (in terms of percentage) are confident with their compliance with risk based and pricing based regulations. This uncertainty is possibly resulting from over-lapping regulations as well as the geographical nuances in different areas of the world.It is obvious that there is far more readiness for Basel III compliance by the sell-side than the regulatory changes under Dodd-Frank. This is primarily due to the greater clarity of the final regulations.It should also be considered that there are many facets to both Dodd-Frank and Basel III and for the purposes of this survey we are looking more at the pricing & risk measurement related areas of the regulation.This is largely due to the change in regulatory landscape requiring an increased granularity of firm wide portfolio exposures as well as a detailed understanding of how their risk assessment could change in different market conditions.
We then polled the buy-side to capture the biggest challenge that is impacting their business. And from what we have seen is that these buy-side firms have indicated that their challenges stem from independent pricing (not relying on broker or sell side quotes) as well s accurate regulatory compliance. One common reason we are seeing this challenge is firstly related to the emergence of a growing buy-side in terms of the number of asset management firms. This growing base of firms will be required to comply with the same regulations and to have the infrastructure in place for independent pricing and valuation but may lack the significant amount of infrastructure, which could be based on implementation and support resources that may span quantitative, technological and back office support. The second most prevalent issue is related to the ability to provide independent pricing and valuation calculations and also the improvement of risk measurement capabilities, primarily cross both an accurate risk assessment at the portfolio level and the ability to perform scenario analysis under a variety of market conditions. Some of the other common challenges faced by the buy-side include intra-day risk reporting, and the ability to implement for flexible product modeling capabilities (inclusion of more exotic product payoffs) as well as increased transparency in their financial reporting.And on the chart on the right hand side we can see that there is still a fairly split response between a significant impact and a minimal impact on the respondent’s buy-side business area.
Here is one of the interesting slides from the CEB Towergroup conference that took place in Boston two months ago. This is a great illustration of the different regulatory obligations that are being mandated in a global setting. We can see that there is an regulatory enormous change, and this is more prevalent today than ever before. This is another way to help explain the significant amount of risk related technology spending we are seeing. There are significant requirements in complying with these regulations to remain a competitive & operational financial institution.
When we begin to take a closer look at the risk related calculation requirements we see that the ability to quantify the risk related to counterparty credit risk exposure & the valuation adjustment resulting (credit value adjustment) is being increasingly considered as the de-facto standard for the calculation of credit risk. This is again, the result of regulatory requirement. This has also increased in importance over risk measures that have been traditionally used, such as Monte Carlo VaR. One of the primary differences here is that the Value At Risk calculation has historically been performed by risk departments whereas CVA calculations are being performed by quasi trading/risk management teams that are sitting on the trading floor as part of CVA desks. The ability to calculate Credit Value Adjustment was also seen as the greatest contributor in the business requirement for an enhanced derivatives pricing and risk measurement solution. This also can be thought of as the manifestation of the change in business practices resulting after the financial crisis starting 5 years ago that has flowed down into the specific trading and risk management processes.Another commonly used risk measure, within risk management teams, focuses on potential future exposures calculations and the calculation of expected positive exposure. Other main areas of focus include scenario analysis, VaR, and Portfolio level risk visibility all represent some of the greatest focus areas.
This graph helps to better understand some of the key drivers when implementing new or improved pricing & risk systems & tools.The ability to calculate Credit Value Adjustment was also seen as the greatest contributor in the business requirement for an enhanced derivatives pricing and risk measurement solution. This also can be thought of as the manifestation of the change in business practices resulting after the financial crisis starting 5 years ago that has flowed down into the specific trading and risk management processes.We may see some of these smaller percentage categories increase in the coming years. As an example, CVA may be the current largest issue on the sell-side but issues like intra-day risk might be more of an ideal than a near term achievable goal for many institutions yet it might increase in importance in the years ahead.Additionally, pre-trade margining is a newer and growing issue that we expect to see more sell-side (and buy-side) institutions concerned with in the years ahead.
And when analyzingbuy-side related risk requirements, some of the most critical functionality is based on a comprehensive level or risk measurement to analyze in granular detail the impact of varying market conditions on different portfolio allocations and how to effectively hedge and rebalance under these varying market conditions.These most important areas were related to increased stress testing and scenario analysis as well as a more defined approach to model risk. Model risk here can be thought of as the ability to test pricing and risk assumptions with different models and to decompose model attributes such that firms can better understand risk factors. And also have a defensible independent analysis of the model for increased transparency.
It is interesting to see the importance of different types of risk calculations as we compare the buy-side and the sell-side. Whereas the sell-side emphasis is on the calculation of counterparty credit risk & Credit Value Adjustments, we are still seeing the need for a Monte Carlo VaR calculation as the most important single calculation of risk for buy-side firms. We are seeing other calculations of risk that will project firm wide exposures on a forward looking basis. These are important and have been regulatory requirements for a number of years and continue to be important. The trend with many of these risk calculations required for the buy-side is that they are based on a comprehensive level or risk measurement to analyze in granular detail the impact of varying market conditions on different portfolio allocations and how to effectively hedge and rebalance under these varying market conditions.
When we polled the buy-side to capture the impact that regulatory compliance is having on their business they indicted the following information. We are seeing the proliferation into enhanced risk procedures as mandated globally but when we take a more detailed look at individual firm types we see the regulatory impact is not shared equally among firms. One specific example is through the SEC registration requirement under Dodd-Frank that is impacted hedge funds. Due to the small size of many funds the equivalent regulatory compliance burden is not always felt equally as not all firms have the same resource pool, infrastructure, and technology to implement them equally.The majority of institutions are being significantly impact by regulatory changes. That being said, These regulatory changes are having a different impact on different financial institutions in different ways.
We touched on several important areas thus far that are related to financial instrument / derivatives usage, business challenges, and the regulatory landscape across both the buy-side and sell-side. We will now take a look at the technology and implementation context for this discussion. This graphic illustrates an overall poll of the most pressing system implementation needs, across both the Buy-side & Sell-side.There are competing interests within different institutions but the greatest amount of technology resources is currently related to a portfolio level risk measurement system. And this certainly supports the high level trend of improved risk measurement & risk management. And we have seen these best practices evolve into a multi-faceted risk analysis frameworkThe most important, again, are related to portfolio level risk calculations to provide more visibility to aggregate and drilled-down exposures and it is through scenario analysis that they are able to understand the greatest impact in a variety of market conditions.We are seeing the metamorphosis from a tradition risk management and risk measurement approach to a more multi-faceted and richer risk analysis that is more comprehensive in nature.We are also seeing that there is a continual evaluation of the short term cost to evaluate the cost of project implementation vs. a longer term effective implementation that will be more of an investment for the financial institution.
The next question set within our survey was related to the technology spending trends across a broad set of financial institutions. What we are seeing is that there is expected to be greater than 80% growth in financial services There is increasingly a prioritization of budget resources for implementing projects, and this budget is not only captured under the front office trading teams but is also more and more frequently being allocated across different functional roles within the middle office and back office functions. Many of them focusing on different facets of risk management and risk measurement. And to add a little bit more detail, what we are seeing percentagewise, the overwhelming majority for technology spending will be related to risk management systems instead of treasury management, trading, or asset liability management systems. Some of the most critical functionality within these tech spends was the requirement for full documentation, transparency, and ease of implementation.
And in terms of technology usage and the prevalence of 3rd party specialist vendors being utilized, we are seeing that (and it probably isn’t a surprise) but the majority of the responders are already using 3rd party analytics tools. Any we are seeing that there isn’t necessarily a single point solution capable of capturing all of the specific needs, that range from pricing/valuation, trade execution, risk analysis, regulatory, messaging, market data, position database, and the list goes on.We are seeing in the market place that there is a growing appetite to leverage specialist vendors and outsource a greater amount of technology initiatives & software. One of the drivers for the decision is due to substantial changes to the financial market place, especially with increased regulatory and risk analysis process enhancements where many institutions lack sufficient ability or inclination to implement all functionality completely independent of external resources. The magnitude of regulatory requirements across the pricing and risk assessment landscape are so numerous, that all, save the largest institutions, have sufficient resources and infrastructure in place to build out all systems internally that comply with the numerous regulations impacting the global market place. It is for this reason that we see a continually evolving landscape and willingness to embrace more external add-ins & systems.
FINCAD Annual Buy and Sell-Side Survey Results Webinar