The Evolution of Clearing

Ali: Markets ConversatION is a new ION podcast where we discuss topics of importance to capital markets participants with product owners, subject matter experts and industry leaders.

Hi everyone, and welcome to markets conversation podcast. I’m Ali Curi. By now, most of us know that financial markets are affected by domestic and global events, inflation, war, food shortages, supply chain disruptions. The list goes on. What sort of impact do these events have on banks, brokers, and firms that are at the forefront of supporting trade at a global scale.

So on today’s episode, we’ll take a closer look at how banks, firms, and brokers are managing risk through these challenging economic times by leveraging technology. Joining us in our conversation today is our special guest, from ION’s cleared derivatives management, is Bruce Roberts, who’s headquartered in London.

Let’s get started.

Bruce Roberts. Welcome to the podcast.

Bruce: It’s great to be here, Ali.

Ali: Thank you for joining us. So Bruce, before we get to our conversation, let’s learn a little bit more about you. Have you been in finance your whole career?

Bruce: No, I’ve not always been in finance. I worked in American higher education for several years before I decided to complete an MBA in international management.

So I’ve always been energized with working in a global and diverse environment. So I had close interest in economics and finance subjects impact individuals and companies. So that led me to working for UBS in Zurich for three years and before moving to London and working with them for 17 years.

And then I went on to do consulting and global business development before I joined ION as part of the global cleared derivatives management team, and it’s been a great experience.

Ali: So let’s touch on a couple of challenges in the financial market. I’m sure there are many but for now, let’s talk about a couple of ’em. One managing risk, and two cost deficiency.

Can you break down for us some of the cost pressures and margin requirements that firms are dealing with right now, especially when you factor in things such as the war in Ukraine, inflation, supply chain disruptions, et cetera. Again, what are some of these cost pressure and margin requirements that firms are dealing with right now?

Bruce: Cost has been a significant challenge for all members of the financial community since the financial crisis and the amount of regulation that firms have to comply with, whether that relates to clearing more products from over the counter to an exchange has increased significantly. In the regulatory regime, such as Dodd-Frank and Amir in Europe with the basal three changes on risk, weight assets have impacted firms in a way they operate their businesses and the cost to run their firms through segregation of assets, regulatory reporting has had a large impact. So the impact has been firms also having to run projects after projects for these regulatory programs over the past decade to implement and comply with these new regulations and the cost of which has had to be funded through increased efficiency. It’s also been higher cost, uh, in some instances to clients, and it’s also meant that the decision’s been made by a number of firms to actually exit from the market. As the cost of business was too prohibitive to compete effectively. So in the end, this concentrates risk into fewer participants in the market and as an unintended consequences, in some ways, to how the market has evolved.

If you also look at the present period with the war in Ukraine that you mention, you see that with volatility and energy, oil, and gas and agricultural products, there has been significant volatility to suppliers and consumers of these products. We witness this today as consumers at the pumps, when we fill up our cars and most participants in these markets, as we do at home, want to lock in some certainty to the prices that they will pay for budgeting and running their operations or businesses, so you will have some speculators as always, but with the amount of collateral that has increased up to 10 times to buy hedges, which are futures contracts on energy or commodities, what you’re finding is that some participants are going unhedged, and are being exposed to the volatility in the market. So this is a concern for all participants as it increases risk, and that risk will have specific counterparts that are not being able to pay, which could result in default and losses being occurred by a number of participants.

Ali: You brought a risk in regulators and the perfect storm is, um, crypto assets right now, regulators are under a lot of pressure to protect consumers, it’s been a hellish couple of weeks for crypto companies. Value has dropped. Withdrawals are frozen. They’re laying off staff. It’s a really challenging time right now, Bloomberg referred to Bitcoin right now as entering its darkest phase.

What are your thoughts on where all this is headed? I mean, will it get worse before it gets better?

Bruce: So I do, um, not to be a pessimist because I’m generally an optimist, but I do think that we will see, you know, a more downward trend, um, before things get better. And that’s largely driven by a number of headwinds from, the war in Ukraine to the increase in interest rates to bring down inflation that’s, occurring across the world with higher agricultural and commodity prices. So, you know, as those, take effect, it’s hard for central banks and governments to land the economy in a gentle approach. So I do think we’ll see more volatility and we’ll see a readjustment in pricing. And crypto is one example of that. And other assets will also such as housing and others will also be impacted.

Ali: You brought up clearing earlier. I wanna change gears a little bit and discuss derivatives clearing and in particular, the future of cell side clearing, what are some notable impacts that we’ve seen in the clearing industry since the pandemic hit.

Bruce: So it became more evident when COVID abruptly shut down the world economy in March 2020. So the global futures and options markets experienced record trading activity and extreme volatility. Our markets function as expected, um, and handled this enormous stress. However it exposed several longstanding bottlenecks and the trading and clearing infrastructure that must be addressed. So the largest of these were the averaging of trades, the allocation of trades and decline accounts and unclear trades at the end of the day, leaving the executing brokers and clearing members with uncollateralized exposures. So the futures industry has faced the ongoing challenge of fragmentation with the number of participants engaged in the industry, and by this I mean clients executing brokers, clearing brokers, exchanges, and clearing houses with how efficiently all of these parties come together to pass information between one another, to clear a trade and pay collateral to reduce the risk of exposure.

Ali: Now, I read a recent report that cited the two thirds of clearing providers are predicting growth for their business, which seems a little bit of at, at odds with the volatility in the markets right now. So how do you reconcile these two seemingly contrasting situations that they’re predicting some growth for clearing providers, and yet the volatility in the markets is causing a downturn. It just, they don’t seem to reconcile. What are your thoughts?

Bruce: First question I always ask is, to analyze, you know, what is the benchmark for growth and the futures industry has reduced in the number of futures clearing merchants by more than half since the financial crisis due to the cost of doing business.

So capacity has been more concentrated in the fewer clearing firms as I mentioned earlier. The continued move of products to on exchange trading increases the flow of business through these FCMs. Plus the advent of new products such as crypto futures. So the size of the market will increase in terms of the breadth of products and the volume of trading, but not all firms will necessarily be as profitable. So there are a number of measures of growth. And for firms to be successful, the management of their balance sheets is going to be more and more important, especially with changes such as the standardized approach for counterparty credit risk and to have successful growth and risk management, they’re gonna be keys to, you know, how you look towards the future.

Ali: Let’s talk data management for a minute. The FIA, the Futures Industry Association, released a report proposing that the industry modernize the processes, their data standards, so there’s clearly a support from modernizing, but from your perspective, Where could modernization or the future of sell side clearing be headed?

Bruce: So it’s an exciting, uh, topic. So the FIA has initiated a review on post-trade settlement processes and the objective was to study the lessons learned, create industry task force and gather the views of global exchanges, clearing houses, vendors, and customers. So this led to the FIA issuing a blueprint with several recommendations aimed at making the industry more effective and efficient.

So some of the blueprint recommendations were, for example, you know, forming an independent market standards board to oversee the development of certain, uh, market standards and best practices, uh, in the trade and clearing life cycle. The other was to then have a standards board overseeing governance that broadly represents the whole industry and its stakeholders with its deliberations that were open and transparent to the marketplace as a whole.

So the FIA discussions align on industry standards are starting, but I would expect over the next six months for the FIA to publish the agenda and roadmap for what they want to tackle. I would not expect a significant, uh, breakthrough in a short period, but the keys to success are bringing all of the constituents together. So buy side, sell side firms, such as banks and brokers, the clearing houses, the vendors, and FIA technology to align on data, and industry standards. So it’s an exciting period, as I said, and the industry continues to evolve and technology’s gonna be a significant catalyst as it has been to managing risk and changing the ways of work, but also using more predictive analytics.

Well, along the same lines of data management and standardization, let’s discuss data breaks because that appears to be an ongoing challenge in the industry as well. When you break down. For us, how the industry is tackling the issues of data exceptions between buy side and sell side as how it relates to front office, middle and back office.

So this is a question that goes to the heart of managing risk and the call space for participants. So the first question is to ask again, what do you mean by data exceptions, between buy side, sell side firms. An example is an asset manager or a corporate client who’s executing a future’s trade on an exchange through their broker to hedge their risk.

And the broker does the trade with the client, but then has to give that trade up to their client’s clearing broker, who’s responsible for the management of the accounting controls and reporting, uh, for the client. So the clearing broker may be completely different organization to the executing broker who actually did the trade for the client. So the clearing broker receives that trade from the clearing house, but has to wait until they receive the allocations, which are the split of the trade into their individual sub fund accounts. This will also involve averaging out the price from the different fields that were completed. And this is not one, you know, average and pricing methodology that’s used. So then you start to overlay this with the client, dealing with different executing and clearing brokers who all have different trade allocation and averaging processes with different timings by markets and that whole lack of standardization of data, processes, and protocols, all leads to trades, not clearing correctly on trade date, or being reconciled correctly.

And in summary, you end up with a number of data exceptions in your workflows and in your control layers that are risk and costs to the firms. So the industry’s debate at issue of defining and adopting common data standards, processes, and protocols, but most participants, I would suggest do not see a commercial advantage to organizations developing and maintaining these separately.

So that lands itself to collaboration and the current processes are a considerable cost to firms due to the processes not being scalable and a potentially increasing risks and costs. So a lot of this is driven by under investment in technology, by participants. And it became, again, very evident during COVID who had invested in technology and those firms that had not, and were trying to do things manually.

So looking now two years back, On most firms they’ve started to review their current clearing technology, as many will have been on the same platform for more than a decade. So the next evolution in the future’s market, I would surmise, will also open the opportunity for vendors to partner closer with executing and clearing brokers, to help them resolve the front to back adoption of common data standards, processes, and protocols, so that each firm does not have to go out and build it individually. The other opportunity to adopt automated processes that these new vendor platforms offer such as standardized workflows, automated averaging methodologies and data symbology mapping services will drive real time and scalable processes, which holds the keys to how we simplify our processes and reduce risks in the industry.

Ali: So standardization and ultimately modernization of their technology and processes. Is probably key in, in moving this forward or addressing some of these challenges.

Bruce: Absolutely.

Ali: Bruce let’s change gears for a minute. What is some advice you wish you had heard earlier in your career?

Bruce: That’s a great question.

I guess I would offer a few observations for those working today. I’d encourage managing your career and your ongoing learning and development. You should be investing in yourself at the development of your technical and softer skills. For some of those who join large organizations, those courses are readily available online or in classroom based format.

But, um, many others have to work, you know, more independently to develop those. So the key message is stay relevant and keep up to date. The other observation is to develop and maintain your network. Colleagues, industry, peers, consultants, et cetera, are all part of a larger ecosystem that represent the industry, and it’s an area that many individuals find that they’ve under invested in during their career. So nurturing your network to assist you in the future is worth your time and effort. As you may need to call up on it periodically throughout your career.

Ali: Bruce Roberts. Thank you for joining us today. It’s been a pleasure having you on the podcast. I hope you visit us again.

Bruce: Thank you. It’s been my pleasure.

Advert: This episode is brought to you by ION. At ION our cleared derivative solutions automate your complete trade life cycle and deliver actionable insights whenever and wherever you need them.

We offer execution and order management, post trade processing and a complete front to back business solution. To learn more, visit us at iongroup.com/markets or email us [email protected].

Ali: And that’s our episode for today, you can follow ION Markets on Twitter and LinkedIn.

Thank you for joining us. Until next time.