FUTURE OF DERIVATIVES CLEARING

FUTURE OF DERIVATIVES CLEARING

Future of Derivatives Clearing2

EXECUTIVE SUMMARY

The futures industry has to overcome its past to have a positive future, whilst dealing with the challenging present. Demands are greater across the board – from clients wanting better, more timely and more transparent services; regulators requiring more transparency and demonstrations of business control; futures clearing businesses being transformed into full-fledged derivatives clearing businesses that include complex OTC derivatives; and bank management critically reviewing all business lines for capital stewardship, profitability and viable long-term cost structures. No one can survive, or thrive, by applying the same methods and solutions in trading, operations or clearing to a future where revenue growth is not enough and strategies continue to move in a cross-asset direction. The days of independent silos have ended.

Derivatives clearing businesses have to be on a new path. Post-trade is the area where change can have the greatest positive impact for an FCM. The greatest gains in performance, transparency, control (operational and cost) and customer service all come from addressing the current state of post-trade – moving to operational models supported by technologies commensurate with the front office.

Number of FCMs as reported by the CFTC1FIGURE 1

The futures world has changed. This is no surprise to anyone in the business dealing with the ongoing rollout of global regulations, low to negative interest rates and the need for all banking businesses to wisely use capital. The effects

of these changes can be seen in the reduction in the number of FCMs (see Figure 1) and the retrenchment of remaining businesses along asset and geographic lines. The competition to attract and retain profitable business has never been higher.

Figure 1: Number of FCMs as reported by the CFTC1

FCM COUNT

200

180

160

140

120

100

80

60

40

20

0

FCM Count FCM Count >0 Client Required Funds

200

2-0

6

20

02

-11

200

3-0

4

200

3-0

9

200

4-0

2

200

4-0

7

20

04

-12

200

5-0

5

20

05

-10

200

6-0

3

200

6-0

8

20

07-

01

200

7-0

6

20

07-1

1

200

8-0

4

200

8-0

9

200

9-0

2

200

9-0

7

20

09

-12

2010

-05

20

10-1

0

20

11-0

3

20

11-0

8

20

12-0

1

20

12-0

6

20

12-1

1

20

13-0

4

20

13-0

9

20

14-0

2

20

14-0

7

20

14-1

2

20

15-0

5

20

15-1

0

20

16-0

3

Future of Derivatives Clearing 3

INDUSTRY BACKGROUND

ETD has been its own unique business silo within banks. As such, it has been driven by its own modes of delivery (technology

and operations) to customers. Clients have come to expect a high performance, scalable, real-time (microsecond and millisecond) response to needs and deployment of the latest technologies and algorithmic complexity to execute refined investment strategies from trading desks.

The front office is an exemplar of adoption of, and adaptation to, the latest innovations in computing technologies across all industries, not just financial services.

Then post-trade experiences and expectations arrive. Batch processing, manual interventions (even for trades without exceptions), lack of immediate transparency on trade statuses with FCMs and CCPs – all increase the costs of service for FCMs and reduce the ability to make the best possible decisions based on current positions and lifecycle statuses by the FCM and their clients.

Customer expectations have been driven by this long-term state of service. It is an environment built with the expectations of ever-increasing revenue streams, versus a focus on profitability. In a more benign environment, these characteristics can, and have, survived. But the environment has changed. Customers are implementing ever more in the way of complex multi-asset strategies – exposing them to different service models within each FCM organisation they deal with and expecting the highest levels of service across the relationship. This is especially true as OTC markets move to a cleared model.

Customers expect better service across all aspects of their lives, professional and personal, and are not going to continue to accept the ‘way it has worked’. Neither do regulators nor bank management. Customer service must increase, whilst meeting the expectations of regulators for controls and transparency within post-trade operations. Management expects the best use of capital and profitability.

Since the 2008 financial crisis, how has new regulation affected the stability of the global financial system?

68%Increased stability23%

No change

10% Decreased stability

Regulation has brought stability to financial markets…

FIGURE 2

Over the next five years, how will regulatory pressure on global securities firms change?

61%Increase

31%Remain

the same

9%Decrease

... but regulatory pressure on global securities firms will intensify over the next five years.

IncreaseIncreased stability

78%

67%

U.S.

Europe

Asia 51%

U.S.

Europe

Asia

39%

67%

75%

FIGURE 3

Figure 2/3: Regulation has brought stability to financial markets, but regulatory pressure will intensify2

Future of Derivatives Clearing4

No business line is immune to deep scrutiny. As we have seen with business exits across derivatives and other banking business lines, if the customer logic, profitability and efficient use of balance sheet are not there, even long-standing revenue generating businesses will be scaled back or shut

down. Derivatives post-trade management cannot escape this logic – evolution and change are non-negotiable. The question is what type of change will best enable the shift from today’s cost structures and service models to a sustainable path for derivatives businesses.

DERIVATIVES CLEARING: THE NEW PATH

The customer must be put at the heart of post-trade operations. Clients and the traders serving them need to know not just the pricing

risk of a trade, but also the clearing risk at the time of trade. Receiving post-trade data – positions, clearing status, open trades, margin (including currency) exposures – in real-time – becomes critical to making the next trading decision. If the clearing or any of the post-trade status updates gets delayed by minutes, then that risk is not dealt with and strategies may unravel. This becomes far more significant in the derivatives world where the notional value of the trades is very high compared to cash instruments.

The client, whether a buy-side investor or proprietary trading desk, must have visibility across all derivatives classes – ETD and OTC – of clearing statuses with CCPs. For this visibility to be real-time it cannot depend on the phone or email – mechanisms such as real-time portals and APIs must be available for the customer to see current statuses and use that information to make the best trading decisions. But the flow of information cannot be one way if FCMs are going to offer the best services and be able to give the most accurate information to their clients. Where a portal or API is given to a client to receive status, they must use it to provide key information such as allocations or preferred close out approaches to the FCMs in real time. Providing these self-service mechanisms, and ability to ingest data into FCM systems real-time, is a critical part of deploying real-time information delivery to customers.

1. The cost mutualization imperative in trade processingBanks have taken aggressive steps to rebuild ROE in the face of post-crisis regulation. However, as a new wave of regulation is introduced and market structures continue to change, business rationalization and headcount reduction will not be enough to earn their cost of capital.

Cost reduction remains one of the most critical levers for reversing ROE declines (see chart above). But with front-offi ce headcount reduced by 20 percent since 20103 and back-offi ce investments rising due to regulation, many banks have exhausted the major cost-reduction opportunities within their existing operating models, and have little choice but to pursue more aggressive measures.

One of the most signifi cant opportunities lies in trade processing, where the industry spends $17 billion to $24 billion per year on core post-trade

CHARTING A PATH TO A POST-TRADE UTILITY

4-8%

15%

9%

Source: Broadridge analysis; BCG, McKinsey

Pre-regulation

Time

average ROERegulation

(Incl. Basel 2.5 & 3)Corrective

actions2014

average ROEUpcomingregulations

Future ROE before

mitigation

Future ROE after

mitigation

Cost, risk, optimization,

revenue growth & segment focus

Total (Average)

RE-REGULATION TO

Regulations Corrective Actions

COST OF EQUITY

3%

9%

1-5%6-7%

10-15%

Pre-Regulation Current Years

processing, reference data, reconciliations, trade expense management, client life-cycle management, corporate actions, tax and regulatory reporting.4

For many institutions, ineffi ciencies and redundancies run deep in these areas. A drought in technology investment that started in the mid-2000s, and worsened after the fi nancial crisis, has left many banks with aging technology infrastructure. Meanwhile, banks continue to bear high costs from system redundancies due to the history of industry consolidation.

Cost reduction remains one of the most critical levers for reversing ROE declines.

4

2. Higher productivity and innovation By structuring a trade processing utility as a managed service with integrated operations and technology, banks could realize higher operational productivity. With pooled talent, a utility would bring greater labor specialization and platform expertise. Productivity tools would enable better capacity planning, so workforces could “load balance” processing volumes across participating banks. By linking technology and operational performance, a utility would enable an outcomes-based model that better aligns costs to volumes for participants.

With accountability to process for multiple institutions, a trade processing utility could become a center for industry best practices by centralizing investments in leading technologies, improving process automation and applying data analytics to increase processing effi ciencies. This would not only reduce the total cost of ownership for individual fi rms, but provide a stable platform for the industry’s top talent to drive innovation and create new effi ciencies.

3. Streamlined complianceA trade processing utility could also streamline compliance by dramatically lowering the cost of regulatory and market structure changes through mutualization. This is increasingly important as new rules and regulations that impact trade processing come into effect.

For example, market structure changes, such as TARGET2-Securities and the U.S.’s upcoming T+2 initiative to shorten the settlement cycle, will require investment in platform modifi cations. New transaction and risk reporting requirements,

such as the Consolidated Audit Trail (CAT) and Basel’s BCBS 239 regulation, are setting challenging standards for timely and accurate data aggregation and reporting. And the pending Comprehensive Automated Risk Data System (CARDS) rule, if implemented, would add to the complexity of data reporting requirements. Taken together, these regulations are projected to cost the industry over $5 billion to implement.8

Other regulations, like the Foreign Account Tax Compliance Act (FATCA) — which require fi rms to capture more granular data for customer on-boarding to comply with tax withholding — will add signifi cantly to these costs. On a shared platform, compliance with these rules would be faster and less costly for each individual fi rm because any changes would apply universally. A utility could also help streamline reporting and enable the creation of an industry standard that can be leveraged by banks and regulators.

4. Network benefi tsThe “network effects” of an industry post-trade utility would bring considerable value to all participants, as more and more banks join. Perhaps the most important benefi t would be in mitigating risk.

For example, as more and more trading counterparties join the platform, a feedback loop could be created, enabling more sophisticated pattern analysis on costly trade failures based on data from both sides of the trade. This would help reduce operational risk and improve the client experience. It would also increase operating effi ciencies and help reduce capital charges and penalties.

Crucially, it would make recovery and resolution in the event of a fi nancial crisis easier for all participants as each new institution joined

CHARTING A PATH TO A POST-TRADE UTILITY

A utility could streamline compliance with regulations that are projected to cost the industry over $5 billion to implement.

Recovery and resolution would become easier for all participants in a utility as each new institution joined.

17

Effect of Regulation on Return on Equity (Pre-registration to 2020)FIGURE 4

Figure 4: Effect of post-crisis regulation on ROE (pre-regulation to 2020)3

Future of Derivatives Clearing 5

FIGURE 5

Over the last five years, banks have invested in new technology to improve efficiency and margins…

Over the last five years, banks have re-engineered their business processes to improve efficiency and margins...

55%Not

aggressively enough42%

An appropriate

amount

3% Too aggressively

54%Not

aggressively enough43%

An appropriate

amount

3% Too aggressively

61%

Not aggressively enough

66%

U.S.

Europe

Asia 45%

58%

Not aggressively enough

71%

U.S.

Europe

Asia 43%

Operations models across all asset classes have been moving to exception based processing and the use of proactive workflow management. If operational staff is inundated in a sea of normal-course trades to review, they cannot be responsive to client requests, nor can they focus on the highest priority items, as these become hard to find. To provide real-time responsiveness and controls, derivatives operations must be focused on exceptions.

This processing has to be centered on the customer – SLA-based and focused on strategy enablement. Achieving this requires a rules-driven approach to issue identification, prioritisation, escalation and resolution. Common exceptions need to be clearly identified, and where the risks are low, resolved with minimal intervention by FCM staff. Rules configuration needs to drive the delivery of exceptions back to clients for resolution, where today it would take a phone call or email – a cycle that delays the time to resolution for everyone. Real-time, rules-driven exception handling reduces the risks for clients and FCMs as issues are brought to the fore immediately and pushed to the appropriate people to make the necessary decisions to resolve them.

A real-time, exception-driven client post-trade model opens new opportunities for FCMs to better service their customers. Real-time data flows are a base from which an FCM can look to provide analytics services and new data services. Having

this kind of visibility across positions, margin and clearing states provides an opportunity for more advanced monitoring of liquidity and capital – giving the FCM the ability to better optimise capital usage for the firm and clients. Finally, the cost reduction and staff time freed by enhancing the post-trade operating model increase the resources available to support clients in adopting new trading strategies and models – maximising service and revenue opportunities.

HOW TO GET ON THE PATH

Technology is the lynchpin for getting onto the path to a customer centric, real-time, exception-driven post-trade operational

capability. Technology change is the only way to increase customer transparency to a real-time, self-service driven model. And to move to a rules-driven, exception processing model, only the proper technology enablement can make this possible. This requires investment.

Typically in the front office trading areas, banks have deployed modern technology architecture to handle millions of transactions in a high-performance

Analysts believe banks have underinvested in technology and process improvement to control costs.

Figure 5: Bank technology and reengineering analysis2

Future of Derivatives Clearing6

environment. Equivalent investment has not been made in post-trade technologies. Investment and change are required, but there are obstacles to some alternatives. Global financial reforms (Basel-III and others) require banks to raise their equity capital and keep a very high cushion for any anticipated failures. To satisfy the stress tests required by the regulators, banks have to closely monitor their capital structure and evaluate their assets that occupy their capital. Unfortunately in-house technology assets do take up capital.

Solutions must be capital smart and cost effective. Cost effectiveness comes from using technologies that can perform the tasks required in the new world of derivatives clearing. The infrastructure must support both ETD and OTC through the full post-trade cycle – trade capture, allocations, margin, positions, settlement and clearing. And this technology must be capable of responding in ‘front office’ real-time, delivering a capability where the challenges of today and tomorrow can be met.

■ Medium ■ High

Outsource front-o�ice activities

Outsource middle-o�ice activities (e.g., FA&O)

Outsource technology

Participate in industry utilities

Adopt new technology for front-o�ice activities

Build global shared services centers

Outsource back-o�ice activities (e.g., trade-processing)

Reengineer business processes

Eliminate technology and operational redundancies

Adopt new technology for middle-o�ice activities

Adopt new technology for back-o�ice activities

26%

Rate the cost saving potential for banks that take the following actions over next five years.

Technology and process reengineering hold the greatest promise for cost reduction, particularly in the back office.

5%26%

41%

35%

34%

29%

44%

35%

31%

34%

43%

30% 55%

38%

45%

43%

38%

43%

28%

26%

31%

17%

31%

58%

61%

65%

72%

72%

73%

74%

79%

81%

85%

FIGURE 6

Figure 6: Cost-savings potential for banks2

Future of Derivatives Clearing 7

CONCLUSION

Derivatives clearing businesses face the same pressures – even more so – as other banking business lines. Profitability must be increased,

capital must be utilised effectively, risks must be better managed, and client service must be improved – all in the face of continuing regulatory pressure.

Post-trade technology is the key area for FCMs to focus to successfully face these challenges. As the responses of industry analysts indicate (Figure 6), investment in new post-trade technologies (across all banking business lines) is the key for banks to increase profitability and return on equity. How and where to make these investments, though, is the critical choice facing the FCM community. This is exacerbated by the variety of constraints and requirements that need to be met: the continuing roll-out of regulation; focus on profitability; and the capital constraints already in place.

The best decisions on investment in post-trade technology – to truly address cost, profitability, and regulatory transparency – will be based around the customer. How will the investment improve customer service? How will risk for the client be reduced? How will the FCM be able to offer better services (and capital usage) to their customers?

These questions are best answered by transforming post-trade technology into a set of capabilities commensurate with the front office – an area synonymous with technology innovation globally. Real-time responses and visibility, advanced self-service options, rules-driven exception capabilities, and constant access to up-to-the-millisecond data are imperatives for post-trade technology infrastructure to deliver if FCMs are to embark on a new path of business sustainability and returns to growth.

1 Chart supplied by Clarus Financial Technology.

2 “Restructuring for Profitability – Analysts Predict Opportunities and Challenges for Global Capital Markets Institutions Through 2020,” Broadridge, December 2015.

3 “Charting a Path to a Post-Trade Utility: How mutualized trade processing can reduce costs and help rebuild global bank ROE,” Broadridge, September 2015.

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ABOUT BROADRIDGEBroadridge Financial Solutions, Inc. (NYSE: BR) is the leading provider of investor communications and technology-driven solutions for broker-dealers, banks, mutual funds and corporate issuers globally. Broadridge’s investor communications, securities processing and managed services solutions help clients reduce their capital investments in operations infrastructure, allowing them to increase their focus on core business activities. With over 50 years of experience, Broadridge’s infrastructure underpins proxy voting services for over 90% of public companies and mutual funds in North America, and processes on average $5 trillion in equity and fixed income trades per day. Broadridge employs approximately 7,400 full-time associates in 14 countries.

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Nachi MuthuHead of Derivatives Trading and Clearing Solutionsnachi.muthu@broadridge.com

Paul ClarkHead of Institutional Strategy and Product ManagementGlobal Technology & Operations, Internationalpaul.clark@broadridge.com