ION’s Bruce Roberts says new derivatives platforms must be tech-savvy, seamless, and scalable to succeed

Key Takeaways

• Incumbents face competition from new platforms as demand soars
• Participants must streamline ops, manage risk and optimize costs
• Partnering with product companies provides a competitive edge

ION executive Bruce Roberts and Stephen Bruel from Coalition Greenwich appeared on the Markets ConversatION podcast last month to discuss the changing landscape of derivatives.

Established exchanges and clearinghouses play a pivotal role in transforming this critical corner of the financial world. The market is evolving fast, with current exchanges moving into new products while facing competition from new competitors entering the market.

The derivatives market primarily facilitates risk transfer among participants by providing mechanisms for liquidity and price discovery. Exchanges and clearinghouses function as trusted intermediaries for institutions. During the 2008 global financial crisis, listed and cleared instruments proved resilient in the face of extreme volatility and market dislocation, while uncleared bilateral instruments did not. This led to a regulatory push to route more derivatives transactions through the exchange and clearing model.

For Roberts, head of business development for cleared derivatives, the last real seismic shift occurred with the movement of over-the-counter (OTC) rates and credit products after the financial markets crisis. The Dodd-Frank Act in 2010 and the Commodity Futures Trading Commission (the CFTC) implemented a new set of clearing requirements for the standardization of OTC interest rates and credit default swaps (CDS) instruments to be traded on exchanges.

New platforms, new realities

In the last five years or so, there has been a significant increase in the number of new products traded in the sustainable energy transition, such as cobalt and lithium, which are crucial components for battery manufacturing, and cryptocurrencies such as Bitcoin futures.

The number of exchanges and clearinghouses has been static over the years, but we are also starting to observe changes with new exchanges entering the market over the last few years.

There are different drivers for those different exchanges and clearinghouses, but if you look at the energy transition as one that is happening globally, you start to observe the need to increase liquidity and access to capital and risk management to fund this transition.

‘Operational efficiency and capital efficiency are keys to enabling that, along with a regulatory framework that supports the growth of derivatives markets for participants,’ Roberts said.

Market participants are interested in price discovery and managing liquidity risk, as well as in leveraging the operational efficiency of exchanges and clearinghouses to manage high volumes and periods of volatility.

‘Collateral requirements are another, and the ability to use collateral offsets to net margin requirements are a key consideration for firms trying to hedge their risks in uncertain or volatile periods,’ Roberts said. ‘And finally, the cost charged by exchanges and clearinghouses will always be a concern to market participants.’

Innovation and opportunities

Technology provided by exchanges and clearinghouses that offers front-to-back solutions, helps manage risk and compliance and optimizes costs is critical. According to Roberts, ‘innovation is such an important part of what the derivatives markets have achieved and continues to play a role in, and that benefits the wider economy and society.’

When asked how he thought new exchanges could be successful, Coalition Greenwich’s Bruel said it can be difficult to take market share from incumbents and create liquidity in a new product. ‘I think for new exchanges, it’s identifying the unmet market need, and then thinking about what your differentiation is.’

But other elementary things need to happen, including ensuring regulatory approvals and attracting clearing members. New platforms also need to ensure that they build the necessary liquidity pools to allow clients to trade and process all these transactions effectively.

‘So, it’s really a multifaceted story where the product that you’re listing, trading, and clearing has to meet a market need,’ Bruel said, ‘but then you also have to make sure you have the infrastructure, meet regulatory approval and that market participants can access the technology in order to allow people to effectively transact.’

Democratization and price discovery

For Roberts, financial markets are more versatile, interconnected, and complex than ever, none more so than derivatives, ‘where profound technological developments and automation democratize access to a market that was once the preserve of professional investors.’

To highlight this, he referred to recent work ION carried out with a Canada-based platform that introduced a centrally cleared, physically delivered futures contract and derivatives for energy, metals, and carbon markets — new instruments whose aim is to provide better price discovery and improve risk management. ‘The exchange is building an advanced risk management tool tailored to the needs of retail investors.’

The boom in demand from retail investors for financial products has fueled exponential growth for new products and brokers, clearinghouses, and exchanges, and incumbents now face competition from new participants.

How do new platforms succeed?

Roberts said three elements are critical for new entrants to be successful: being tech-savvy, being able to provide a seamless operation to minimize risk and having scalability.

New platforms should limit their scope at the start and launch a select set of products that allow them to create liquidity and depth in the market.

Operators unencumbered with legacy systems or fragmented data have a distinct advantage. The ability to move to real-time and be positioned in the advent of markets moving 24/7 gives such entrants optionality. Resiliency and recoverability are also critical because meeting regulatory and government requirements will be an ongoing demand.

The fundamental strategic decision, however, is whether to build systems in-house or outsource, Roberts said, recommending partnerships with product companies ‘who have built easy-to-use trading and order management platforms with the connectivity backbone to route orders and low latency and high volume easily to your venue.’