The Dodd-Frank law will succeed in bringing clarity to the murky $600 trillion over-the-counter derivatives market in the long run, but experts say it will generate some short-term pain at banks, as many will be forced to make costly software upgrades.
As a means to prevent a repeat of September 2008, when the collapse of the OTC derivatives market helped drive the global economy into a ditch, U.S. lawmakers moved to require that derivatives trades be cleared through central clearinghouses. The idea was to stop a sequel to the AIG and Lehman Brothers fiascos, in which neither firm was able to settle its derivatives trades when the credit markets froze more than two years ago. Both episodes subsequently left hordes of counterparties out in the cold.
The role of a central clearinghouse is to identify the risk on both sides of a trade and then settle the deal once the transfer of cash and securities is completed. If one of the counterparties in a trade were to default on a transaction, as did Lehman Brothers and AIG, the deal would be guaranteed by the clearinghouse, which raises money by collecting margin from member firms.
But analysts say these new guidelines will carry deep technological implications for buy-side trading desks, since their existing infrastructures will need to be revamped. And those updates are likely to carry a steep price tag.
"In the long run, central clearing will make it easier and cheaper to process trades, but it's going to take some time and a good amount of money to get there," says Tabb Group analyst Kevin McPartland. "This is really going to involve everything from changing the front end to accept input from the trader for where the trade must be cleared, all the way down through physical connectivity to clearinghouses and platforms, and to managing variation margin payments."
In addition to the requirement that derivatives transactions be guaranteed by central clearinghouses, the Dodd-Frank law also stipulates that trades be conducted on exchanges or Swap Execution Facilities. In the past, OTC derivatives transactions were largely negotiated over the phone.
But after regulators finalize later this year the rules governing how the swaps market will function, there will be a need for an infrastructure that can funnel trades that are executed on a Swap Execution Facility (SEF) to the clearinghouses, according to Roger Freeman, a buy-side analyst with Barclays Capital. He notes that central clearing of credit default swaps already is under way in the U.S on a small scale. "Some of the initial trades that are being done in the clearinghouses have taken a long time to do," says Freeman. "These are not 10-second transactions. You have the dealer on one side, the clearinghouse on the other, and then you have middleware providers like Bloomberg that offer software to connect to the clearinghouse.
"There are hiccups in there that need to be resolved, and this is to be expected with any sort of new process," Freeman continues. "This infrastructure doesn't exist."
Hurry Up and Wait
Observers note that until regulators finish sorting out how swaps trading will work under the finance reform law, firms are mostly sitting on the sidelines, taking a wait-and-see approach before investing in new software and hardware. In fact, many are in the midst of conducting studies to help them get a grip on what they'll need in the new landscape.
"The majority of fund managers are waiting for the regulations to become clear about what they have to do," says Jeff Gooch, the chief executive of OTC derivatives processing firm MarkitSERV. "We're literally holding hundreds of meetings with buy-side firms to explain what they have to do and what the technology and implementation will look like."
But when they do pull the trigger, the amounts of money spent on technology will be staggering. According to Zohar Hod, a high-ranking executive at the OTC derivatives pricing and valuation firm SuperDerivatives, the investment in infrastructure will be massive. "How much money will be spent over the next 10 years because of this? Billions," he says. "Everything needs to be built in."
Swaps traders are going to need platforms that can sweep the market for the best prices at which to execute a trade, and dealers will need to create SEFs, which in turn will have to build connectivity to the clearinghouses. In addition, every trade will have to be reported electronically.
On the trading side, many banks will look to simplify this process by building off of existing platforms. But with volumes and data traffic set to explode down the road, the swaps market is about to get a lot messier for the buy side, says George Michaels, the founder of G2 Systems, a boutique consultancy and software firm.
"It increases the complexity of your cash management systems. You're dealing with dozens of new transactions for every one you had in the past," Michaels explains. "The amount of work that your operations crew has to do in order to reconcile those cash transactions increases. So not only do you have a software headache, you have an operations staff headache, since their workload increases. It's a big honking nightmare." As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio