Electronification of the OTC derivatives market

Guest Contributor: Gerard Rafie, SVP of Product Management, Calypso Technology

For more than a decade, the OTC swaps market has shown flashes of becoming more electronic, yet with little progress to report especially in the dealer-client business. Now, Title VII of the Dodd-Frank Act (DFA) ushers in an overhaul of the derivatives market structure with tremendous impact on trading and clearing technology.

At the heart of the DFA’s Title VII is mandated central clearing and execution with a registered venue. To this end, several clearing houses have already launched fully functional clearing facilities for OTC interest rate and credit derivatives, while interdealer brokers and market data platforms are vying to be the first of many execution facilities. The SEC expects more than 20 participants in this space but delays in the rules definition have made it economically challenging for new entrants to join. As of July 1, less than 10% of the expected new rules have been delivered.

Whatever the final rules, implementation of Title VII will accelerate electronification of the OTC swaps business. We’ll see a revolution similar to what the market experienced in the early 2000s in the fixed income business, which moved from a telephone-based business to an electronic marketplace. During the initial period, the industry saw up to a hundred digital execution and liquidity platform providers emerge in an effort to gain first to market advantage. Today the business is handled largely through a handful of providers through basic market mechanics and evolution.  It is reasonable that the OTC business will experience similar growing pains. Another fallout from electronification will be a significant uptick in the amount of data processed on a daily basis. This will drive a need to develop more low-latency technical infrastructure.

Market participants, market makers and their buy-side clients need to develop an IT strategy that can evolve with rapidly shifting market requirements. Connectivity to all participants of the reformed OTC market structure will be critical, linking clearing firms and clients through a switchboard of SEFs, affirmation platforms, exchanges, market data providers and swap repositories.

Trading and risk management systems will need to efficiently interface with these external service providers as well as other internal processes. A direct effect of the latest financial crisis is greater scrutiny of counterparty risk and more diligent management of collateral. Whether firms decide to use standardized vanilla swaps that centrally clear or more esoteric bilateral instruments, the technology challenge will be considerable. The valuation of counterparty risk in swap pricing and the efficient use of collateral represent new technological and workflow challenges. In the centrally cleared scenario, firms will have to calculate and post daily margins. This is where a majority of clearing-related IT spend is focused. All participants will focus on capital efficiency and optimized use of collateral. Technological integration of all these functions will be critical to gain real-time insight on transactional efficiency and ultimately, profitability. Implementation of DFA will finally lead to decisive electronification of the market and a new paradigm for OTC swap transactions.

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