Broker-dealers must become more technologically savvy in the derivatives space if they want to impress buy-side clients. Lynn Strongin Dodds reports.
Multi-asset trading is increasingly common among asset managers looking to enhance efficiency and deliver better execution for their clients (see Christoph Hock: On building efficiency).
The ability to trade both cash and derivatives instruments gives buy-side traders a considerably better range of options when looking for liquidity in the fixed income markets.
Anthony Perrotta, partner, global head of research and consulting at TABB Group says, “The development of multi-asset trading differs, depending on the type of fund manager and whether they invest passively or actively. However, what everyone is trying to achieve first and foremost is the best execution because it drives alpha.”
Dealers, beset by rising costs and lower margins are keen to match their clients’ needs while increasing efficiency. Standing apart from the pack though is and will not be easy particularly in fixed income and derivatives. Stringent capital and leverage rules under Basel banking regulation has made it much more expensive for banks and brokers to use their balance sheets to hold inventory, and trade and finance positions in the more illiquid bonds and over-the-counter (OTC) markets.
Reacting to this development requires that the sell-side firms break down the instrument siloes that limit their ability to service clients efficiently. BNP Paribas moved its listed derivatives business to a single Fidessa platform in July 2016, noting that it centralises risk management and gives a single point of access to client orders from single- and multi-dealer platforms, as well as voice orders.
The existential nature of efficiency in the derivatives business was alluded to by Raphael Masgnaux, global co-head of Prime Solutions & Financing and G10 Rates at BNP Paribas, who said in a statement, “There are fewer global banks around today which can provide the full range of services.”
The prolonged quantitative easing and the ensuing suppression of bond yields and market volatility have not helped the banks’ cause. The result is that there are fewer firms who want to play in the principal pool while their agency colleagues are facing greater competition from the rising number of electronic trading venues. At last count, there were roughly 99 of these platforms to facilitate fixed-income trading from London to New York and Singapore, according to technology consultancy Alignment Systems.
“Although it is not uniformly true, the buy side traditionally has been more multi-asset class and less siloed than the sell side,” says Richard Hooke, buy-side product director at Fidessa. “This is because they needed the breadth of exposure and active investment to achieve their goals whereas brokers tend to be more specialised and had specific desks trading the different asset classes. However, the key thing at the moment is around execution and liquidity efficiency.”
Turn up the volume
Trading volume in FX and interest rate derivatives markets has risen by nearly 10% over the past three years, according to the recent Bank for International Settlements Central Bank Triennial Survey, which polled close to 1,300 global financial institutions. It showed that the daily average turnover of foreign exchange and interest rate derivatives traded worldwide – on exchanges and OTC – rose from US$10.5 trillion in April 2013 to US$11.3 trillion in April 2016.
These higher volumes in standardised and cleared products reflect a move onto electronic trading and more centralised order books. This is benefitting fixed income electronic trading stalwarts including Thomson Reuters-backed Tradeweb, Bloomberg and MarketAxess who are already grabbing a big chunk of the electronic derivatives business. Companies such as Citadel Securities and Virtu Financial are also muscling in on the sell-side territory, particularly in interest rates swaps and US Treasuries respectively.
Turnover is also rising as buy-side firms deploy more sophisticated derivatives strategies to enhance yield. Over the past three to five years, fund managers have widened their use of the instruments from the traditional hedging tools to one that can, for example, express directional views both short and long.
The trend was borne out by a recent study by FINCAD, a provider of risk analytics and derivatives risk management software, which canvassed 230 global buy and sell-side firms. It confirmed that fund managers are expanding their derivatives horizons with 87% currently using a wider range including futures, options, swaps, swaptions and hybrids/structured products in their investment strategies.
It predicts that the upward trajectory will also continue as 92% of firms in the study are looking to either increase their usage or stay the same. For many though this would require a major overhaul or replace their valuaton and risk systems. The problem is that the “small-scale tools are too basic, and in-house developed legacy systems are too rigid to support the complexity, nuances and demands of derivatives trading today,” according to the report.
“The buy side will not be looking for technological solutions from the sell side,” says Rob Garfield, head of product marketing at FINCAD. “They will be turning towards financial technology vendors for that. However, the sell side will not go away, and differentiating itself will be a challenge because of stricter regulation. It will have to start to view itself less as a direct counterparty, and more of a conduit of liquidity and market intelligence. Those that do this well will be the most successful.”
Broker game changer
Accepting the changing market and adapting to it will require best use of balance sheet, technological efficiency and an evolutionary pace that matches other players in the space.
Carl James, global head of fixed income trading at Pictet Asset Management says, “You have greater regulation and automation and less people. For the sell side the question is how best they can leverage the technology across asset classes in order to get to the top of the tree.”
Brokers can also distinguish themselves in their abilities to structure trades to generate higher returns. For example, structured products such as bond repacks, which typically combine a sovereign bond with an embedded interest rate swap, have become popular in recent years especially for insurance companies.
Perrotta also believes both buy- and sell-side firms can sharpen their edge by creating ‘operational alpha’ when dealing in the OTC derivatives market. In the past this was tied to the middle and back office, but today the participants who can implement integrated front-to-back-office infrastructure will generate greater cost efficiencies and controls, which in turn will lead to a better performance for a client’s trade.
In many cases, this is easier said than done. According to a study conducted with Broadridge last year, this not only entails creating an enterprise view of the data but also integrating technology systems and creating a scaleable and robust risk engine. The advantages may be worth the investment in that operational risks inherent in operations are lowered while the costs of maintaining multiple technologies are also reduced.
James adds, “It is not a blank sheet of paper because people have gone through the process on the equity side. This is not to say you can substitute fixed income for equities but there is a road map. We are already seeing some of the technology moving across to the FX space and I think in time we will see fixed income, particularly in the rates space, follow suit.”
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