Laurent Jacquemin

global head of post-trade services, SunGard's capital markets business

THE FUTURE OF POST-TRADE DERIVATIVES PROCESSING

Posted by Laurent Jacquemin

This blog post originally appeared on FTF News.

In the derivatives industry, significant, year-over-year transaction volume growth has become the norm. With high-frequency trading driving up the volumes of trades to hundreds of thousands or even millions per day, derivatives market participants must be able to manage these higher volumes. Moreover, due to market volatility, the peaks in volume must be managed within shorter time intervals, and this is driving the need for scalability.

A key factor to meeting the challenge is the ability to reduce the length of end-of-day processing and complete tasks more quickly. However, increased volumes can present difficulties for the monolithic back-office systems that firms have invested in and tailored to their business over many years. These systems must be enhanced to scale and perform optimally in an unpredictable and high volume trading environment. But enhancing the scalability of an entire back-office system in order to manage one specific task ramps up the cost of hardware, software and staffing.

So what is the recommended approach?

Component-based processing can help to address these challenges by focusing on improving scalability only for targeted functions or specific tasks. This technology approach means that firms are enabled to manage high volumes while continuing to leverage their current back-office systems without increasing their total cost of ownership (TCO).

This approach helps to increase flexibility by extracting system functionalities to optimize back-office processes. It also helps firms to improve the scheduling of these tasks. This is especially useful for time zone processing and scaling to new business requirements.

For example, let’s imagine that a large global clearing firm wants to ensure its processing in Asia, Europe and the U.S. is successful according to the requirements of each regional timeframe. A component-based approach gives the firm the ability to launch global end-of-day processing that covers all regions with the flexibility to run each one individually according to time zone.

Components also help to increase scalability while controlling TCO. Based on a firm’s specific requirements, they can make technology choices regarding which processes to externalize to improve processing. This eliminates the cost and pain of a switch-over to new platforms or the need for additional hardware.

With the right system strategies, the back office can provide better returns in the long run, especially given the explosion of information and trade volumes. Firms must take steps to strategically leverage technology to be more agile and efficient while still properly managing operational risk. The future of post-trade derivatives processing is here.

 

While you’re here…

David Lewis

senior vice president, Astec Analytics, SunGard’s capital markets business

ADDED PRESSURE: ECJ ON FRENCH WITHHOLDING TAX

Posted by David Lewis

This blog post also appears on Finextra.

The European Court of Justice (ECJ) has now ruled as of May 10, 2012, on the tax discrimination alleged by nine institutions over withholding tax levied on foreign investors in French equities compared with domestic funds which are exempt. Withholding tax is levied at up to 25% on dividends paid out to investors by equity issuers, but where investors from different countries are not taxed at the same level, it is considered to be contrary to the Free Movement of Capital across the European Union.

As if the incoming French president did not have enough issues to contend with, the French Government could be facing actions for up to EUR20Bn in tax reclaims by foreign investors – and EUR5Bn of that may be crossing the channel to the UK.

The battle is not yet over of course, as foreign funds will likely have to prove that they are sufficiently similar to the tax-exempt French domestic funds in order to be treated the same way. Another option available to the French Government may be to solve the discrimination by taxing the domestic funds the same way as the foreign investors – this is not without precedent and may even be a vote winner in France if it can be sold as a tax on banks and bankers rather than the end investor.

On the positive side for claimants, the ECJ have refused to apply a temporal limit to the claims, so past discriminated investors can also take action going forward.

As far as securities lending is concerned, this could have a dramatic effect on one of the most lucrative markets in Europe. Dividend arbitrage, or yield enhancement as it is often known, involves the lending of equities over dividend periods from a fund that suffers withholding tax to one that does not. The enhancement to the dividend is then shared between the funds rather than paid as tax to the relevant tax authority. Without funds being discriminated on the basis of tax, there is no trade.

If this ruling is upheld and indeed enforced, as similar rulings have previously been in Sweden and Spain, then this is yet another downward pressure on earnings in an already embattled market and potentially sets a further precedent for other countries to follow.

While you’re here…

Magnus Almqvist

senior product specialist, SunGard's capital markets business

REGULATION AND COMPLIANCE: HERE TO STAY

Posted by Magnus Almqvist

The overarching objective of increasing market resilience and stability during periods of turmoil is shared by most, if not all, market actors. But that is where the agreements seem to end. How to achieve this, and how successful the regulators can hope to be is something that could be debated and discussed endlessly. We certainly had a good go at it during a recent panel discussion at SunGard’s London Industry Seminar, and I made the following observations from the event.

Regulation is here to stay, and its reach and coverage will continue to change rapidly. It is a challenge to even grasp the breadth of change happening in the various regulatory streams, such as EMIR, MAD, MiFID, and ESMA. What is the full regulatory picture created when these different rulebooks are overlaid? No one seems to be able to concisely formulate this yet.

That leads on to the question: are we creating something efficient? It is, in insulation for individual behaviors such as stemming layering or quote stuffing, but where do the various rules and guidelines get us when looking at the big picture? There is great uncertainty here, which is cause for concern.

Compliance desks are now scrambling to implement new guidelines, directives and regulations as they are published. At this point, information is often confusing, incomplete or still in draft form. When final versions are available, the publishing date is often only months from the go-live date, which is not enough time for firms to properly implement organizational and role changes and IT system improvements to fully comply. This waters down the effect and impact of changes, as regulators are essentially forced into a position where they have to show initial leniency towards implementation.

For any actor in financial markets, strong and well-functioning compliance is now becoming a marketing tool. Customers are increasingly asking how their orders are managed and how they can be assured they are being fairly treated. This is true for trading venues, banks and brokers alike. Regulation is here to stay, and its rate of change, reach and impact will continue to increase. So watch this space, and join us in our next panel debate, as I’m sure it will be another interesting discussion.

While you’re here…

Tim Smith

executive vice president, Astec Analytics, SunGard's capital markets business

THEN AND NOW: 10 KEY THEMES FOR 30 YEARS OF SECURITIES FINANCE

Posted by Tim Smith

Securities financing has evolved over the last 30 years from a quasi-back office activity to a high-profile business in its own right. The main causes and results of this evolution can be grouped into 10 major themes.

Industry Bodies

Thirty years ago only RMA existed, and they were Robert Morris Associates, not the Risk Management Association. During the past few decades, there has been an extraordinary growth in the number of industry bodies that have all battled against initial skepticism to become influential and respected associations in the securities finance space. Groups like ISLA, PASLA, ASLA, SASLA, CASLA, and of course RMA are at the forefront of industry change and response to external friends and foes.

Regulatory Scrutiny

Many believe that regulatory scrutiny of securities financing is a new phenomenon since the 2008 crisis. This is untrue. Regulatory frameworks have kept market practitioners and their compliance officers and lawyers quite busy during the last 30 years. German, U.K. and Hong Kong tax regulations, U.S. uptick and purpose test rulings, and on-off decisions in many emerging markets such as Malaysia have made for exciting times in securities lending. Sometimes, in fact usually, the activity is caught up by accident in some rule change, e.g. the Japanese rule changes of 1998 that made the return of a loan a short sale. In cases like this, the industry has had to respond and scramble for a way round or through.

Systems

Years ago, there were very few systems, and most of them were in-house and stand-alone. Starting with early Excel spreadsheets, the number of service providers has grown. Early single currency-capable systems have been augmented and replaced to cope with the growing cross-border nature of the securities finance business. Local regulatory reporting requirements in many cases have necessitated the abandonment of in-house systems. Ultimately, systems integration is required for efficiency, risk monitoring, and the faster and faster settlement cycles being introduced around the world.

Regional Changes

Decades ago there were only really two regions of securities lending and borrowing – North America and Europe. Indeed, even securities lending for other countries was undertaken by entities based in these two areas. This has clearly changed. Asia-Pacific has seen its footprint expand while the mature regions have plateaued. The newer markets of Hong Kong, Singapore, Korea and Taiwan have augmented the locally mature markets of Japan and Australia. India and China are poised to further change this dynamic. Latin America is fast coming up in terms of scope and ease of doing business, with Africa and the Middle East not far behind.

New Structures

The way that the business has been structured internally to an organization has changed radically over the last 30 years for every stakeholder. Thirty years ago, fixed income repo groups and securities lending operations did not even acknowledge each other’s existence. Now, both groups are intertwined in many firms. The biggest change, though, has been the move from the back office to the front office in many broking firms. Even the lenders and hedge funds have changed their rather laissez-faire approach to one of more active engagement by dedicated personnel.

Fads

Pay-to-hold, equity repo, and portfolio bidding, while still in existence, all went through phases as being the perceived rocket launchers of growth and land grab. In addition, 30 years ago, third-party lending agents were not really a serious contender for business and their jobs were made harder by custodian agents. Now most if not all custodian lenders have their own third-party operations. Even letters of credit, although still used, are not as ubiquitous as they once were due to capital usage and cost.

Transparency

Over the years, attitudes toward transparency have shifted from the desire for one-way mirrors through frosted glass to single-pane, ultra-clear windows cleaned each and every day. This change has sometimes been mandated, but at other times grasped and embraced as a way to keep clients close. This is set to continue as business attitudes to transparency become more aligned with regulatory mandates and system abilities.

Market Turmoil

The cases of Barings and LTCM had major impacts upon business, legal and operational structures. These were further tested in 2008 – perhaps it was lucky that the previous events had occurred because the results may have been even worse without the learning experience. At least now, for example, there are known ways of cashing in collateral, which was not the case thirty years ago when the methodology was arcane and obscure because it had not been tested.

Rates and Levels

Thirty years ago, rates for borrowing Japanese callable securities were in the 300-400 basis point range. Not so today. These sort of rates can sometimes be seen in new markets as they emerge but the rates tend to ease off much more quickly to normal levels based on experience of bringing on new markets and supply to wider access.

The whole GC versus Special dynamic has ebbed back and forth over the years as well. Participants sought to obtain allocations of specials based upon GC balances. During times of market stress, this dynamic has been broken and then re-established when more stable times have resumed. It is probably the case that it will continue to ebb and flow.

Attitude

Finally, the attitude of all participants has changed over the past 30 years. There used to be a certain innocence as everyone was learning as they went along. This produced a very strong esprit de corps among both counterparties and competitors, as all realized that it was to no one’s benefit if securities financing suffered a setback or mistake of its own making. This attitude, while still present, has evolved in a natural growth of confidence and professionalism. There seems to be a general feeling of existing as a valid business as opposed to being an ancillary service built only to support other mainstream activities.

A lot has happened over the past few decades in the securities finance industry. From the rise and fall of emerging markets activity to the development of securities financing systems, from an era of learning to an increasing sense of confidence, there is no question the last 30 years in this business have been both challenging and exciting. Are there other trends you would add to the list? How would you expand on any of the trends mentioned here? We all have many memories, of course.  I look forward to seeing your thoughts.

Jane Milner

solution specialist, SunGard’s capital markets business

THE GLOBAL EVOLUTION OF SECURITIES FINANCE

Posted by Jane Milner

Over the past few decades, we’ve seen the global securities finance industry grow and evolve in many ways. When I started out in this business it was relatively small, and at the time we were seeing a dramatic expansion of the securities lending market. It always was, and still is, very much a people business, and the interesting thing is that many of the folks who were around 20+ years ago are still around somewhere in the industry today.

From the beginning we always saw very different approaches to securities finance from the U.S. markets and international (non-North American) markets; the U.S. was a more highly regulated and standardized environment, resulting in more vanilla, but high-volume, trades. The international players were jumping in from the perspective of seeking high-value “specials” and leveraging cross-border arbitrage opportunities, such as the famous “dividend trade.” At that time, the international securities finance markets were growing rapidly.

In my experience helping customers to solve various problems over the years, I’ve been fortunate enough to see the industry mature firsthand. I have had a front row seat to watch the securities finance markets tackle new challenges, develop new approaches and adapt to changes in the global finance industry. From my own experience, and through asking a few of my esteemed colleagues, a few examples of how things have changed come to mind:

  • “The ‘Big Bang’ in 1986 opened up the UK market to banks and brokers from the U.S., Europe and Asia-Pacific, which ultimately led to an increased globalization of the whole securities financing market. The stock market crash in the following year resulted in many more consolidations within the established market and helped to facilitate the emergence of new markets, making this a very exciting time to be providing software for securities finance.”

  • “When many new players were jumping into the securities finance business, they needed to get up and running very quickly, with as much out-of-the box functionality as possible… I think our record for getting a new player live was two weeks. The server often used to literally sit under the desk; you would never find that now!”

  • “In the early days, decades ago, the desks were small, manned by dedicated specialists who needed to be multi-functional. These specialists also had to have a system to support the broad spectrum of needs around securities lending in different markets. Now there is a tendency to have specialist areas for each function in the securities finance lifecycle.”
  • “Over the years, the number of transaction types supported has increased, and stock lending desks (predominantly in the equities side of the business) expanded into doing some repo and buy/sell back business. In more recent years this also extended into more synthetic transactions, particularly in emerging markets.”

  • “It has been exciting to be involved as emerging markets have come (and gone) in the securities finance space. Countries such as Malaysia, Thailand, Taiwan, and India gained traction in the 1990s, but lost it again following currency exchange challenges and the introduction of tougher regulations. Today we are seeing increased activity in some of these countries as well as within new regions such as Brazil, Russia, China and the Middle East.”
  • “In time, operational standards have emerged, through the auspices of ISLA and its hard-working sub-committee members who have led the world in developing best practices for a number of the trade lifecycle activities. As a result, there is now more automation of some processes, but there is still a long way to go.”
  • “After the global financial crisis of 2008, there is now more focus on risk in the securities finance area than ever before.  Years ago, securities finance transactions were considered ‘risk-free.’ Nowadays you are actually likely to find a dedicated risk professional on the securities finance desk.”

Clearly, the securities finance space has changed and evolved quite a bit, but I believe that innovation is happening faster now than ever before. In the next few years, I expect to see:

  • More automation of trading and lifecycle processes; electronic marketplaces have struggled in our environment, however, cost pressures are likely to result in increased traction in this area.
  • Even greater consolidation of processes; in these times where “cost is king,” all ways of streamlining processes are being considered. For example, collateral management used to sit in silos but this is changing as firms are creating centralized groups to increase efficiency, improve transparencies and enable optimized collateral usage.
  • A move towards CCPs; without being mandated, uptake to date has been slow, however the beneficial capital treatment of trading versus a CCP is likely to mean that central counterparties will prevail over time.
  • Further automation of corporate actions processing; this area has always had the capability to make or break the profitability on a trade – the need for tighter controls in this area are now getting focus.

Across the globe, securities finance has come a long way in the past few decades, but we still see room to grow. It has always been an exciting, people-focused business, and I look forward to seeing what the coming years have in store. What key milestones in the securities finance industry stand out to you? Where do you see securities finance in five years? Leave us a comment to join the conversation.

Note: A special thanks to my colleagues, especially Carol Kemm, for adding your insight to this article.

Nasser Khodri

managing director, Asia-Pacific, SunGard's capital markets business

THE PROMISE OF MALAYSIA

Posted by Nasser Khodri

If any country epitomizes the wilder side of capital markets trading in Asia, it’s Malaysia. But there are signs that Malaysia is ripe for a bit of refinement, which would give this dynamic country the focus it needs to be more competitive in global markets.

On the upside, there are many growth opportunities and a lot of energy to be found in Malaysia. The more relaxed regulatory environment is a striking contrast to the more mature markets of Europe and North America. It’s also a market where major brokers are consolidating to get ready for the next stage of Malaysia’s national evolution. On the other hand, the country’s tendency toward a more free-for-all spirit can sometimes be seen as a challenge.

A case-in-point is the challenge facing the Bursa Malaysia as it attempts to move its members to a new trading platform. The exchange is slated to decommission its incumbent legacy trading platform and 8,000 terminals in use by exchange members by the end of 2012. Not only has the expiration date of the system been changed at the behest of members, but an effort to involve more external suppliers has unraveled as the exchange’s members have not selected a single supplier or set of suppliers that will provide access to the exchange’s new system. This has occurred in an environment that has less regulation and is governed by a great sensitivity to the price tag for any new trading technology, making for a very competitive environment for suppliers.

Despite the growing pains, major brokers in Malaysia are seeing the need to combine forces to become more powerful regional and global players. Even established Malaysian firms are reaching out beyond borders to improve their profile in the region. For instance, the CIMB Group Holdings of Malaysia, a commercial bank that offers investment banking, announced in early April that it will buy the Asian equities business of the Royal Bank of Scotland Group (RBS) for £88.4 million ($142.7 million).

Malaysia is also reaching out on the derivatives front. Bursa Malaysia has had a strategic agreement with the CME Group since 2009, with the partnership making contracts available through the electronic trading platform CME Globex. This synergy is an ambitious attempt to expand the Malaysian derivatives market and the effort has been gaining ground.

Yet it is equities that seem to hold the greatest promise. Malaysia is working to make Bursa Malaysia much more connected to other Asian exchanges to facilitate cross-border trading and thus attract more international investors. Bursa Malaysia and the Singapore Exchange are slated to inaugurate their connection by June. This is the first move in a much larger effort to create electronic trading connections among many Asian exchanges. The Bursa Malaysia-Singapore link will coincide with a summer launch for the highly touted ASEAN Trading Link, an initiative of the Association of South East Asian Nations dedicated to paving the way for an economic pact that parallels the European Union.

With so much happening in Malaysia, trading software and services providers face an ever-growing list of requirements from market participants that want to keep up with the rapid rate of change. All suppliers will have to offer products, features and support that go far beyond meeting local and regional mandates. They must offer the innovative capabilities, partnerships and technical support required for achieving global reach, thus guaranteeing customers a path for growth. This is essential, as Malaysia is one market that is not going to rest on its laurels.

While you’re here…

David Morgan

trading and client connectivity, SunGard’s global trading business

CAPITAL MARKETS REGULATION: TIME FOR A RETHINK?

Posted by David Morgan

This post originally appeared in a longer form on TabbFORUM.

The noise created by the flood of new regulations proposed for the global capital markets, plus the resulting storm of debate, continues to grow louder. I’ve been participating as a technology supplier – but also as a bank depositor, retail investor and pension fund holder. I ask myself how the changes are going to help me:  after all, some of the regulatory initiatives – notably MiFID 2 – have the interests of the retail investor as central principles. But as currently framed, I fear that few of the proposals will hit this target, and I wonder whether it’s time for a radical rethink.

Clearly there were serious issues that caused the crisis of 2008 to unfold as it did. But which issues were most important, and what are the appropriate remedies?

At present, of course, there is no shortage of regulatory remedies; a few are already in place, and a much larger number are at the planning and consultation stage. We are hearing a loud chorus of objection from capital markets participants, on both buy- and sell-sides: the U.S. Dodd-Frank Act and Volcker Rule, along with Europe’s MiFID 2 and EMIR, have all been repeatedly excoriated in formal responses and in the media. But in the current heated climate of anti-banker public opinion, few who can directly influence events seem interested in listening.

I think this non-conversation is very dangerous:  there is fundamental common sense in many of the objections, which focus on the costs and risks of unintended consequences. As such, they should be persuasive to decision makers who want to maintain effective, functional capital markets. The markets may be ‘de-risked’ to some extent by current initiatives, but getting a positive return from them will become much more difficult.

Here’s my take on an alternative way forward. Our picture of the 2008 crisis tends to center on worthless CDOs (evil derivatives!) and bankers lining up for bailouts. But the true root causes were cheap money, bad lending decisions and inadequate regulation over the previous decade, predominantly at the retail level. Our universal banks – common on both sides of the Atlantic since the 1999 repeal of the Glass-Steagall legislation that had separated U.S. banking from capital markets activity – were key players in this chain of events.

I personally believe the Glass-Steagall repeal was a mistake, and that its influence on the large and influential U.S. market effectively unleashed the chain of events which led directly to 2008. There’s insufficient space here to explain why, but it’s done thoroughly in this interview with John Reed. The Volcker Rule is an attempt to replace Glass-Steagall, but the many well-argued objections show that it’s likely to prove a partial, over-complex and ineffective one.

I suggest a much simpler way ahead – one which recognizes that the capital markets framework did not cause the 2008 crisis. This framework certainly needs improvement in some areas – such as the fragmented but opaque European equity market that is the legacy of MiFID 1 – but it does not need the radical rebuild that currently threatens damage through unintended consequences. If we try too hard to protect all the participants from each other, especially during the trading process, end investors will have to pay the heavy insurance premiums that this protection requires.

With these points in mind, I would suggest instead two primary directions:

  • In the U.S., admit that the repeal of Glass-Steagall was a mistake, and reverse it. Also, introduce similar separation of functions elsewhere: we should ensure that retail and corporate bank deposits, and the money transmission system, are insulated from problems in the capital markets. We need these markets to raise and allocate capital over the long term, but if they generate another 2008-style crash, the real world can get by while they rebuild. Investors who have chosen to be ‘on risk’ will of course suffer losses, but no bailouts will be required.
  • In the ‘safe banking’ world, regulators should protect against a return to no-doc and other irresponsible forms of lending. And in the capital markets, they should enforce better behavior via sensible alignment of incentives. It’s clear that, both pre- and post-2008, the shape and size of many personal incentives have encouraged excessive risk-taking with little or no concomitant personal risk. There has been much talk about controlling and changing this environment, but almost no real action. All that’s lacking is the regulatory will, at a coordinated international level.

I’m not the first to suggest either of these initiatives, but maybe the combination is new – and it could be powerful. I acknowledge the obvious difficulties involved in both, and the chorus of objectors may have many members in common with the current one. I’m also conscious that the Glass-Steagall suggestion represents a return to the past – but importantly, not to the past in which the U.S. felt its finance industry was uniquely and unfairly disadvantaged. It implies major change – but simple and clear rather than complex, expensive and ineffective, as I believe we will get with the current regulatory direction.

Of course, such a fundamental rethink has little chance of happening at present: there is too much invested in the current direction, and a global Glass-Steagall would have vast implications. But might it provide a better way forward?

While you’re here…

David Lewis

senior vice president, Astec Analytics, SunGard’s capital markets business

INTRADAY DATA FOR SECURITIES LENDING – CAN IT BENEFIT EVERYONE?

Posted by David Lewis

In financial markets across the world, the trading benefits of up-to-date information are clear; you can trade at the right price and buy or sell as the market is turning towards or away from you, boosting your profits or curbing your losses. Aged data means you are trading behind your competitors and counterparts, weakening your position.

That seems clear enough for the mainstream markets, but what value can it bring to securities lending practitioners, who are under pressure to make better returns, and  regulators, who are seeking to increase transparency and market efficiency while reducing risks for the investor?

One thing is certain: regardless of your market position or industry, the best trades can only be achieved when you have the most accurate, up-to-date data available. Knowing what happened yesterday will not help with liquidity today. But what does that actually mean for all the stakeholders in the securities lending market?

Whether a lender is a custodial agent, third-party specialist or self-lender, the object is to make additional returns for clients within accepted risk and exposure tolerances. The best rates cannot be obtained without the best trading information.

For instance, credit management and risk systems must cater for the counterparts and any limits set them by the beneficial owners, but the requirement to get the best rate for the lent security relies on systems that can provide intraday data and identify new, emerging opportunities for the traders using them. However, this is a tough ask without the necessary data on rates and utilizations and how they are changing throughout the day. In the arms race between supply and demand, it is possible that the lenders are being disadvantaged.

Lending activity around MF Global illustrates this point. As far back as June 2011, the SEC was allegedly looking into the European Government debt exposures that would eventually bring down the derivatives broker. As shown on the graph below, borrowing demand was already on the way up, and it continued well into the third quarter. Borrowing fees remained relatively static at 10bp right up until the news broke more widely. Yet over this same period, balances on loan grew 115%.

By using intraday data to identify increasing demand, lenders could have capitalized on the information available to them by proactively making prices rather than taking them.

But what is the impact of up-to-date data for the rest of the market, especially in light of the latest regulations?  A key aspect of the proposed ESMA SSR rules for locating and reserving securities to borrow is the security’s “liquidity.” Logically, if you wish to avoid naked short selling and increase the certainty of settlement, then you have to restrict trading to liquid securities or reserve your supply before taking a short position. This brings up ESMA’s pre-defined “liquid list” of securities.

Whether a security is on ESMA’s “liquid list” or not, it misses the importance of intraday borrowing liquidity, for inclusion on the list does not mean that it will be easy to borrow at all times. The proposed regulations do go some way towards this by demanding that a recorded confirmation of liquidity is obtained before short sales are made, thereby gauging the availability of a security at the point at which supply is sought. Intraday data will be required to make such processes work in the spirit in which the regulations are expected to be written.

Ultimately, the speed at which we produce, share and consume data will continue to rise exponentially. It affects everyone, and managed correctly can bring benefits to all the stakeholders in our industry and from there, the wider financial markets. Intraday data is here and anything older is so yesterday.

While you’re here…

Russ Chrusciel

head of Valdi Options US, SunGard's capital markets business

3 KEY AREAS TO WATCH IN OPTIONS TRADING IN 2012

Posted by Russ Chrusciel

This blog post originally appeared on TabbFORUM.

The last several months have been crazy for financial exchanges. We had anxiously waited for the Deutsche Bourse–New York Stock Exchange deal to close — a merger that would have fundamentally changed the global exchange landscape for derivatives trading — and watched the deal get blocked by the European Commission. Now, as we eagerly anticipate the implementation of Dodd-Frank legislation and the Volcker rule in the U.S. in the coming months, we should consider how the final implementation will affect trading volumes, trading strategies and compliance needs for those engaged in derivatives trading.

One thing is certain: activity in the financial arena isn’t likely to settle down any time soon.  Within the listed options space in particular, here are three key trends worth tracking as we continue to make our way through 2012:

1. More U.S. options exchanges ARE coming.

Even though there are already nine options exchanges up and running in the U.S. today, I expect one-two more exchanges to be up and running by year-end.  NASDAQ has stated its intent to launch a third exchange (to complement its existing PHLX and NOM options markets). A new entity, the MIAX options exchange based in Miami, plans to launch during 2012. While competition is generally a good thing in the marketplace, is there sufficient U.S. options trading activity to justify 11 exchanges? And if 11 U.S. options exchanges can be supported, what is the additional cost to trading firms, brokers, vendors and others who now have to run lines and build out additional infrastructure to these new exchanges? Each options exchange will have to serve well-defined customer niches within the industry in order to sustain ongoing business.

2. Options exchanges WILL continue to roll out new products.

It shouldn’t come as a surprise that options exchanges need products that participants want to trade. Will the exchanges be able to create products that are reasonably easy to use and understand and that actually serve a useful trading / hedging purpose for the trader? Absolutely! The difficulty will be figuring out which new products will have long-run staying power in the options space. For example, VIX options and some ETF options have been quite successful over the past few years in terms of trading volume – some lesser-known contracts, not as much. Although they are going through approval stages right now, I am quite curious to see if either “Super-LEAP” options (contracts with 4-5 year expiration dates) or “mini-options” (contracts on high priced stocks that deliver 10 shares instead of the typical 100 shares) generate consistent trading interest across the industry. The introduction of new option contracts becomes even more important in a U.S. options market with up to 11 exchanges – as each exchange seeks to differentiate itself from its competitors.

3. Foreign options exchanges WILL draw more interest and activity.

Foreign options exchanges like Brazil’s BM&FBOVESPA and Korea’s KRX already possess significant trading volume, so they are certainly in a position to command attention in the options industry. Since both markets are derivatives hubs in their respective regions of South America and Asia, they can more readily leverage their prior successes into the next two or three years of options trading. In many trading circles, existing volume and liquidity begets MORE volume and liquidity, so both Brazil and Korea are well positioned in that way. Lastly, given that Brazil and Korea serve accelerating regional economies in South America and Asia, these markets are primed to draw increasing options trading interest from the likes of hedgers and speculators across their own regions. Moreover, I predict each of these exchanges will reach out to and work with their neighbors (like Chile or Hong Kong) to promote additional regional strength. Since full exchange mergers are tough to accomplish these days, I also see strong, targeted partnerships taking place between selected U.S. options exchanges and some of their foreign exchange counterparts in the months ahead.

These three trends in the options markets form an interesting foundation for derivatives trading on both a national and international level. Stay tuned to see what develops.

While you’re here…

David Lewis

senior vice president, Astec Analytics, SunGard’s capital markets business

REGULATORY SPOTLIGHT: ESMA GUIDELINES ON ECONOMIC OWNERSHIP

Posted by David Lewis

The common English saying, “possession is 9/10ths of the law” can often be applied when facing small, everyday challenges such as, “Who really booked this meeting room for 3:00 p.m.?” Those sitting in the room tend to win the argument. The European Securities and Markets Authority has been looking hard at the concept of ownership in developing its new regulations on short selling, known as SSR.

The crux of the matter rests on what exactly constitutes a naked short sale; if you own something and then sell it, by simple definition this is not a naked short. However, on first pass, ESMA’s draft SSR indicated that the sale of a lent security would constitute a naked short sale – meaning trouble for the seller. Looking further into the implications of defining ownership brought custodian nominees and the exercising of options and futures into the analysis.

It seems that ESMA has done its homework, and its new Technical Advice on Short Selling has clarified many issues.

  • Economic ownership: looking at the disparity of ownership definitions across the EU, ESMA has had to find a common approach to fit the lending market. For example, in some states, the legal title passes on the trade date and others only once the security has actually settled in the buyer’s account. In order to solve this, ESMA has determined that the beneficial owner can have an “economic ownership” for the purposes of the SSRs. This clears the way for buyers of securities to sell those assets prior to their delivery without constituting a naked short. The impact of such legislation, if unchecked, would have meant no one could sell a security he had bought until it had actually been delivered, creating a massive impact on market liquidity.
  • Sale of a security that is on loan: it is common practice for lenders to have automated mechanisms in place to swap or recall shares on loan when the beneficial owner sells them. When recalled on the trade date, the shares are returned (or swapped with another lender account) in time for the settlement date in all but a small minority of cases. In more complex markets, buffers of unlent stock might be held as additional insurance. However, as a loan (or repo) is actually a sale of the asset, the lender is no longer the registered owner and is technically at risk of selling something that he doesn’t own. Clarification on this point now excludes lent securities from this definition as it has been recognized that the beneficial owner retains “economic ownership” of the security while the asset is on loan.
  • Exercising options and futures: where such instruments can be exercised and the underlying securities are delivered in time to settle the agreed sale, then they will not constitute a naked short sale.
  • Nominees: for economic and administrative reasons, securities are often held in nominee companies and omnibus accounts. Strictly speaking, the ownership of the securities lies with the nominee company, not the actual investor. As such, if the investor sells a security, he is, technically speaking, selling something of which he himself has no legal ownership. Again, the concept of economic ownership has been applied to clarify the situation.

Unintended consequences are a very serious risk when new legislation is being drawn up, and that risk is often greater when regulations must be written in a hurry. The objective of protecting the investor and the marketplace from naked shorting is an admirable one, but sometimes rules meant to make the market more efficient risk doing more damage than good. It is positive to see that ESMA has provided these securities lending clarifications which should hopefully bring the rules back in line with the original aims without harming the markets they seek to protect.

While you’re here…