The case for centralised derivative pricing
As regulatory change meets technology innovation, Rob Gray (pictured) of Dion Global Solutions looks at the future of pricing structured instruments in a centrally cleared world. He also explains the benefits of standardized and fully automated valuations across all OTC instruments, regardless of the asset class.
For those immersed in trading structured products – the world of regulation, squeezed margins and demanding investors needs no introduction.
The deluge of regulation may have the ultimate goal of reducing systemic risk, but managing the new reality is no picnic, specifically for large brokers and banks attempting to navigate central clearing and exchange trading for instruments previously traded over the counter (OTC).
Previously, change was met by the simple expedient of more software, more modules, more infrastructure and more people. However today, tighter trading margins and squeezed profits mean this is no longer practicable. The challenge boils down to a simple and much-repeated equation: doing more with less while managing growing demands for transparency, responsiveness and auditability.
The lessons of FX options
The pricing and valuation of structured products is a case in point. Currently banks and brokers have different systems and different pricing models populating the back and front office. As a result, many firms find that the value a trader places on a given contract is not the same as the risk manager ascribes. Attempting a mark-to-market reconciliation, calculating credit exposure or explaining the discrepancy to curious regulators exposes the underlying flaws and risks inherent in having disjointed and disparate pricing models.
Europe’s recent experience of standardising and automating FX options demonstrated the inefficiency of many firms’ underlying IT infrastructure. And since the move towards central clearing and electronic trading is unlikely to decelerate, we can expect repeat patterns for other forms of swaps, options and futures. This will become more prominent as OTC contracts are traded across different asset classes.
The FX options experience showed that a single system for pricing and valuing OTC assets has a huge advantage. When the same system is used to price and valuate multiple structured products then the advantages too are multiplied.
These advantages fall into four broad categories:
1: Easy compliance. Regulation in the name of risk reduction comes in two very broad categories: investor transparency and capital adequacy. A single pricing system addresses both. Firms can apply the same models to all pricing calculations at every stage of the workflow. Discrepancies are eliminated and timely reporting is possible. Audits cease to be a time and resource-consuming administrative headache.
Regulators aside, it provides firms with a completely accurate picture of their entire exposure at any given moment. Not only does this make it easier to meet capital adequacy requirements, it also helps to minimize market and credit risk and enables firms to pool resources to make more efficient use of posted collateral.
2: Efficient operations. Even bulge-bracket brokers can no longer afford to maintain bloated IT estates. It is simply not economically viable to avoid rationalisation; nor does it deliver the accurate, straight-through processing that regulators and investors demand. That’s doubly true for the small cap brokers, trying to compete with the big players while scaling their businesses to meet new demands from both customers and legislators. Automating and standardising the pricing of multiple OTC contracts into a single system, reduces costs associated with IT infrastructure, support and licensing – as well as time-consuming manual processing – which helps to create a more flexible and scalable operation.
3: Enabling innovation. There is no denying there has been a degree of rationalisation of asset classes on offer from individual firms. However, on balance, more products are needed to stay competitive. Larger brokers are meeting demands from asset managers with increasingly multi-asset operations, alongside corresponding multi-asset trading desks and support systems.
This leads to an increase in demand for a more flexible and diverse hedging capability. With a standardised pricing system in place, firms can give themselves the room to add new instruments to their service offerings to meet client demands for a variety of structured products both as a speculative investment and as hedging strategy. It is another example of the need to do more without increasing costs.
Crucially, a system that facilitates compliance is also one that can reduce the risks associated with new product development, ensuring these meet the firm’s own risk and profit profiles and helping them demonstrate the rigorous processes required to secure a trading license for new instrument classes.
4: Competitive positioning. The overwhelming majority of structured products will move onto exchange. This is an assumption made by regulators and derivatives traders alike. But the nature of the markets is that there will always be new products that are one step ahead of the regulatory curve. These new customer offerings are the foundation of a firm’s competitive positioning: provided they are suitable for both clients and markets and stay within accepted risk parameters.
With a system already in place that enables standardised pricing across all and any derivative instrument, firms have more leeway to develop these products and bring them to market. It allows attention and skill to be applied to product development rather than administration. It also enables firms to more easily apply a consistent trading philosophy or set of principles across their business, helping to build an easily recognisable brand in a crowded and competitive market.
The technology revolution
But what makes pricing and valuation one to watch in 2015 are the new delivery methods.
The legacy of previous system implementations casts a shadow over the trading community. It is consequently tempting to view arguments in favour of new types of system through the distorting prism of budget, cost, upheaval and disruption. But if 2008 was the year of financial crisis, it was also the year when agile, smart, and distributed technologies started to take off. And while the financial industry has largely been focusing on the implications of the subsequent regulatory regime, it has not as yet fully absorbed the implications of this quieter – and almost exactly contemporaneous – technology revolution.
That is set to change. Cloud installations of even the most sensitive data are reducing infrastructure costs, big data analytics are providing unprecedented levels of insight into business operations, and agile development is ensuring that deployments meet the requirements of today rather than requirements at the time the system was commissioned. Pricing and valuation is no exception.
A standardized, cloud-delivered and automated pricing model built to handle any number of instruments is more representative of a fast, connected and fully electronic market than most pre-2008 systems. Not only does such as system make the calculation of end-of-day P&L more accurate, it offers new insights into which instruments, traders, markets and assets are the most successful. Future gazers could do a lot worse than place it on their list of growth areas for 2015.