VALDIPOSITION PAPER SERIESListed derivatives trading:challenges, opportunitiesand technologiesDavid Morganmarketing director, trading and client connectivity,SunGard’s capital markets business
Contents2 Introduction Market challenges 3 Client demands Regulation, regulation... How leading firms are responding4 Capacity planning and managed services Risk management5 DMA, algos and HFT Strategy trading Exploiting market fragmentation Where from here?
Introduction Market challenges2012 has seen the multi-year boom in listed derivatives Even during the years of growth, life as a futures commissiontrading suffer an abrupt reversal, with a 10%+ decline in merchant was not a bed of roses. Responding to rapid changesyear-on-year volumes. The boom had seemed to be in market conditions, such as the commodities boom, was neverindestructible, buoyed up as it was by the surge in world a cost-free exercise: capacity planning in terms of both peoplecommodity markets and growth in currency futures volumes. and systems is challenging. Also the volume growth itself led to aSeveral other factors also contributed: wider buy-side market sharpening of competitive conditions, as the major investmentawareness, particularly in emerging markets, more flexible banks used their deep pockets to fund (in some cases greatly)investment mandates at many firms, and the need to hedge expanded operations in futures and options trading. So allagainst persistent cash market volatility. Prime brokerage market participants have long had to fight hard to preserveoperations have been particularly profitable for the leading market share, and the resulting pressure on commission rates hasfirms in this field. of course been exacerbated by the volume declines of 2012. Persistently low interest rates are yet another negative factor,Now, in place of all these positive themes, market participants both reducing clients’ need to hedge and also restricting theare increasingly concerned about the volume trend, which is returns on funds held in margin accounts.already reflected in a declining number of CFTC-registeredfutures commission merchants. And there is also of course a There are also concerns on the part of derivatives market usersstill bigger issue to contend with: the looming negative cost about global market structure. The controversy aroused by(and revenue) implications of new regulation. 2011’s proposed Deutsche Börse-NYSE Euronext merger, ultimately disallowed by the European competition authorities, has focused the market’s attention on some long recognized but unaddressed issues: derivatives market concentration, restrictive intellectual property practices that preclude contract fungibility, and the prevalent vertical-silo model inhibiting competition at the clearing level. Differing contract structures mean that even to pursue an arbitrage strategy between major markets is in manyThe buy-side strategies are more broad-based cases still difficult. When one considers what open competitionand complex, often ranging across multiple between equities markets has achieved in terms of lower costsmarkets and asset classes. for trading participants, then it seems clear that similar potentialDavid Morgan exists in listed derivatives. But for now, trading and clearing costsmarketing director, trading and client for the brokerage community remain relatively high.connectivity, SunGard’s capital markets businessFigure 1: Exchange-traded derivatives average monthly contract volumes (billions).2.52.01.51.00.50.0 2006 2007 2008 2009 2010 2011 2012** January to June 2012Source: Futures & Options Intelligence24 Listed derivatives trading: challenges, opportunities and technologies
expected to create a significant growth opportunity for theClient demands listed markets: if a contract is sufficiently standardized to be cleared, then why not list it for trading?Meanwhile, commodity trading clients and the investmentmanagement buy-side are not becoming any less demanding. As the OTC and exchange traded markets become more alike,Their strategies are more broad-based and complex, often this is bound also to have significant impact on the way thatranging across multiple markets and asset classes. Derivatives brokerage firms structure themselves to address their clientsexchange businesses in many emerging markets are growing, and interface to the markets. But at present in the exchange-and the spread of connectivity required to satisfy client demands traded parts of their businesses, the primary focus is on riskis increasing as a consequence. Direct market access (DMA) management: high priority is given to timely consolidation oftrading demand continues to grow steadily, and parallel growth overall positions and the associated risks and correlations, andin the use of execution algorithms has driven the requirement for there is also increased pressure at the trading front end, bothbrokers to distribute these algos also to their clients’ workstations pre-trade and in near-real time. Exchanges themselves areand trading engines. And as the high frequency trading (HFT) responding with integration of basic pre-trade checks into theirphenomenon becomes established in derivatives markets as it central systems, but the greater onus still falls on the broker,did earlier in the equities field, it brings with it another new set of and the issue is made more important by the continuing growthrequirements – ultra-low latency, sponsored access, exchange of DMA client trading. And most important (not to mentionco-location and so on. There is no shortage of areas in which a most controversial) of all in the commodity markets, there isderivatives brokerage is forced to invest, if it wishes to capture preparation to meet the demands of position limits rules fromthe best of the new revenue opportunities. the US CFTC and in the EU’s MiFID 2. We look further at these issues on the following page.Regulation, regulation… How leading firms are respondingAs if the direct business pressures discussed above were notenough, in the wake of the global financial crisis the derivatives Many of the opportunities and challenges mentioned above aresell-side is also receiving unprecedented levels of regulatory either associated directly with changes in the technologiesattention. The largest issues are of course those associated with available to exchanges and brokerage firms, or are susceptible toglobal regulators’ drive to push OTC business onto electronic responses based on new applications of technology. SunGard isplatforms and central clearing, though there is of course one asked to work with customer firms in various ways to help themvery positive aspect of this move, at least from the point of view map their routes through this complex and fast-changing marketof the exchanges. As the OTC derivatives markets are some ten landscape. Based on our experiences with these firms, in thetimes the size of the exchange traded markets (see Figure 2), following sections we summarize what appear to be the majorfrom 2013 onwards the OTC move to clearing is widely patterns and best practices that are emerging currently.Figure 2: Global OTC and exchange-traded derivatives notional outstanding. 700000 OTC ETD 600000 500000US$ Billion 400000 300000 200000 100000 0 2009 2010 2011Source: BIS (Figures exclude commodity and single-equity derivatives) www.sungard.com/360trading 5 3
Capacity planning and managed services Risk managementCapacity planning is a nightmare in the market conditions that This former Cinderella area of business operations is nowFCMs face today. Market fashions rise and fall rapidly, and certain central, and likely to remain so for the foreseeable future, orevents (Flash Crash, Middle East unrest, Euro crisis….) can of until certain best practices become so obvious and widelycourse cause alarming volume peaks as well as price volatility. applied that they can be fully automated and once againThere are no simple answers: only experience can teach how almost forgotten (at least in normal times). We see three mainmuch spare capacity needs to be maintained, at all stages of the areas of focus:trade management process, in order to handle these peaksadequately. There is no choice in the matter – no-one can risk ›› Pre-trade risk management traps some major risks – including many erroneous and/or limit-breaking orders – at the mostsystem failure, or even slow response, at moments when prices appropriate time: before they hit the markets. Responding inmay be swinging wildly. some cases to direct regulatory demands, many firms areOne way to respond is effectively to outsource the problem, at extending and tightening their electronic pre-trade controls,least for non-core process elements, by using managed services. with latency considerations ultimately determining how muchHaving market connectivity managed ‘in the cloud’, for example, it is practical to do before sending an order to market.places the burden of ensuring adequate performance on a Guidelines published by FIX Protocol Limited, recentlytrusted supplier, as well as dispensing with onerous technical updated and extended to cover futures and options, are amanagement tasks of procuring and managing communication useful contribution to developing best practices: SunGard haslinks, and upgrading interface software as exchange platforms benchmarked the Valdi Selector pre-trade risk managementchange. There has been a rapid trend towards usage of such product against these guidelines in order to determine nextservices in recent years, which continues. We expect to see priorities (as described in our Position Paper Implementingextensions to this trend in future, with more server-based effective electronic trading risk controls, which can be read atapplications (algo and strategy trading infrastructure, for www.sungard.com/360trading). In Europe, the 2012 ESMAexample) being widely offered and accessed as managed Guidelines for automated trading engines are also relevant:services: the Software as a Service (SaaS) model is no less fortunately for firms battling to stay in compliance, the ESMAapplicable to trading than to the many other fields where it has risk management requirements are broadly consistent with thebeen successfully deployed. FPL recommendations. ››The biggest current issue in commodities markets is of course position limits. While legal tussles continue over the Dodd- Frank/CFTC rules in the US, implementation may be required by year end 2012, and we await ESMA’s crafting of the MiFID 2 principles into new European regulations. Full compliance with the CFTC rules in their current form implies assessing real-time global positions in a range of commodities: this will be very demanding for US firms trading internationally and across multiple listed and OTC markets.We count 70+ derivatives exchanges globally that attract There must be concerns about potential regulatory arbitragesignificant levels of business, and a global broker needs as long as these rules are not applied worldwide.connectivity to most or all of them. ››Multi-platform risk management is important in cases where aDavid Morgan firm uses several different technical trading architectures, andmarketing director, trading and client needs to consolidate its view of activity across them for risk andconnectivity, SunGard’s capital markets business margin management purposes. Optimizing the allocation of trading limits and margin deposits is normally the core objective here. Recognizing this, an increasing number of exchanges can provide real-time ‘drop copies’ of all completed trade details – and in some cases also open orders – to reflect all of a member firm’s market activity, and software vendors are responding with the necessary tools to receive and analyze these consolidated feeds: SunGard’s Global Execution Server is an example.46 Listed derivatives trading: challenges, opportunities and technologies
cash-market and FX transactions as part of complex hedges. TheDMA, algos and HFT leading software products that support strategy creation and execution today offer all the flexibility and market connectivityIncreasing levels of technological sophistication among that most users require, so we can expect yet more imaginationderivatives market users have fuelled the growth of DMA trading to be employed in exploiting the potential of these tools.in recent years. More and more investors and traders nowdevelop and execute their own strategies (often built into ‘blackbox’ automated trading engines), and simply want the means to Exploiting market fragmentationsend orders to market as rapidly as possible. The main demandson brokers are then for extended capabilities in the trading As noted earlier, derivatives markets have as yet seen almostworkstations and other software tools that they provide to their none of the fragmentation that has revolutionized equity marketsclients: strategy trading is discussed on the following page, and in North America, and more recently in Europe after MiFID. Thethe use of algorithmic trading to improve execution quality is also one major exception is of course the US equity options market,more and more prevalent. where the usual proprietary-contract ‘rules’ have not applied andIncreasingly, brokers differentiate themselves in their marketing we see a structure very much like the underlying cash market,via the breadth and innovation offered in their algo suites, which with the same accompanying technologies of smart routing andoften include traditional equity-market staples – TWAP, VWAP etc. liquidity-seeking algorithms in wide use.– as well as derivatives-specific exotics. Growth in the use of these Elsewhere, there are early signs of change. In Europe we seeimpact-management algos is, however, still hampered by the Turquoise Derivatives and the BATS Chi-X combine makingdifficulty of performing accurate and meaningful transaction cost moves to compete directly against Eurex and NYSE Liffe, but theanalysis in derivatives markets. Leading brokers are working hard creation of a few non-fungible derivatives contracts is still a longto address this gap, as good TCA tools could act as a real way from what these firms have achieved through opendifferentiator for them. competition in equity markets. There are radical proposals in theThere is also demand for wider access to exchanges. Despite EU’s MiFIR that require open access to clearing for trading venuesthe market concentration in certain segments discussed above, and competition between multiple CCPs, but the exchanges arewe count 70+ derivatives exchanges globally that attract arguing forcefully against these moves. They state thatsignificant levels of business, and a global broker needs proprietary contracts cannot be fungible across multiple tradingconnectivity to most or all of them: the technical complexities venues, and that shared clearing is therefore not practicable; theyand costs involved in this are of course a major factor driving also argue that interoperable derivatives clearing is not possible,the rise of managed service usage. which implies separate contracts for each CCP. We can expect much further debate and lobbying on this issue.Alongside the DMA growth, we have seen the large-scaleapplication of high frequency trading techniques in the There is also significant activity in the fast-growing Asian financialderivatives markets: often the HFT firms are themselves market- centers, with new exchanges in mainland China, Hong Kong andmaking exchange members, but in other cases they use Singapore. Apart from the Chinese markets’ naturally strongbrokerage services, and may then demand specific low-latency position in commodity derivatives, it is too early to tell how muchtechnology support. These firms now make much of the running impact the Asians will have in competing for global businessin major markets: in the US, the CFTC has noted that HFT players against the established US and European markets. If the currentparticipate in more than half of the trading volume in liquid Hong Kong Exchanges bid for the London Metal Exchangefutures contracts, and has made proposals to require registration succeeds, this will of course impact on the inter-region dynamic.and to pre-test algorithms. The exchanges recognize the value ofthe HFT business in terms of liquidity provision and of coursedirect revenues, and continue to expand and promote their Where from here?colocation facilities and related services. The continuing trends described above show that much is still in flux, and there is a lot to play for in the fast-changing competitiveStrategy trading environment. There is potential for the central market structures to alter radically under the two major influences of globalization-The continuing growth here is fed by wide availability of the driven mergers and new regulations, and this could in turnnecessary automated tools to support the trading of complex impact significantly on the priorities and strategies of brokeragestrategies. Exchanges have perhaps failed to capitalize fully on firms. As noted above, in attempting to manage the rapid pacethe potential for listed strategies: their offerings in recent years of market and technology changes, FCMs are likely tohave remained relatively static and undifferentiated. But this may concentrate increasingly on their core business competencesreflect a lack of demand for standardized products: there has and to outsource large elements of technology management.been no lack of creativity in the range of multi-legged strategies Given the increasing range of possibilities that will be out there,that individual trading firms have built, and in many cases these everyone involved in the listed derivatives markets will have tocould not have been put together by any individual exchange, make hard choices about direction, but (at least for those withas they span multiple derivatives markets and also involve strong stomachs!) the ride will continue to be an exciting one. www.sungard.com/360trading 7 5