16 Mar 2023

Eurex Exchange

Clearing Innovation & trends

Ahead of panel at the Derivatives Forum Frankfurt on current innovation and trends in clearing we looked at some of the current events and their impact on the industry.

The full ramifications of the cyber-attack on ION for capital markets are only now emerging. The immediate fallout was significant in terms of comprehending not just the risks involved but how all market participants – asset managers, brokers, market makers and clearers were able to react and adjust in what timeframes and to what level of proficiency. As the dust clears, understanding exactly where the operational bottlenecks remain and how these can be addressed going forward is critical. However, the recent announcement by the SEC to move settlement of all asset classes to T+1 has ratcheted the need for urgent action in the post trade arena. Magnifying the sheer number of assets to be cleared in a minimal timeframe will have obvious implications for settling and clearing securities transactions. However, there are also important wider complications for funding and credit-lines. These will put a strained industry under further pressure just when the need for investment has never been greater.  

Why This Matters Now

Irrespective of the asset traded, the role of the market participant in the trading and settlement process or where they are located - this is a global industry problem that requires a collaborative industry solution. The interconnectedness of global markets means that every market participant is only as robust as the weakest link. One failure or default creates a domino effect affecting many, potentially all.

The move to greater automation and straight through processing from trading to clearing has proved invaluable - when everything works. But automating the booking and allocation process does not guarantee cleared trades, and breaks are possible even in a normal trading environment. Secondly, the reliance on automation and streamlining of the post trade process to lean possibly outsourced means that when there is significant market volatility, there can be insufficient manpower to resolve the problem - precisely when market participants need full knowledge of their positions and risk exposure.   Add in recent geopolitical shocks, quantitative tightening and the rising risk of cyber-attacks and the potential for the gravity of a black swan event to spiral out of control becomes all too evident.

Historic means of assessing risk through known scenarios and random backtesting are rapidly becoming woefully insufficient for today’s market conditions. Recent announcements from Microsoft investing in the London Stock Exchange Group and now Google in CME Group demonstrate just how the technology citadel around financial services is having to readjust to new partnerships offering greater firepower and expertise. But technology providers are also currently beyond the regulator’s remit, an issue that can add complexity to the immediate and mid-term risk considerations. Firms must invest, engage and re-assess regularly with their suppliers and regulators to ensure appropriate integration of greater security into legacy technology infrastructure.

All eyes on the US

Pressures in the post trade arena will be exacerbated further still by the reduction of time to settle transactions being introduced by the SEC, not just for US assets, including those with non-US underlyings creating unique ramifications for Europe to address:

  1. Settling in different regimes will require necessitating the need to post collateral or establish credit lines, a cost rapidly rising in the current quantitative tightening. Asset managers may well need to revert to trading alternative asset classes such as futures to gain necessary performance exposure adding additional cost and complexity through multiple asset trading.
  2. Secondly, US ETFs with Non-US underlings will also be required to settle T+1. Given the current fragmentation in the European ETF market with multiple share classes and listings, this will add to the burden on brokers to fund, given that use of fund overdrafts or holding cash positions can create regulatory breaches.

What Needs Addressing

Operational and technical resilience is already firmly on regulators' and market participants’ radars. The consequences of the global pandemic forced firms to re-assess internal workflows and external collaboration with third-party providers. Whether current technology stacks are fit for purpose going forward for the identification and transfers of orders and partials that may be mid-flight requires stringent applications, robust business continuity drills, clean hand-off protocols and the constant search for gaps by deliberately breaking things to test for errors.

The transition to the cloud exposes legacy infrastructure failures and the urgent need to digitally decouple. There is no shortcut for the industry to modernize quickly and efficiently, but the need to mitigate risk and lower costs in the current economic environment requires a rethink of how to address the challenges. Loss of internal control, domain knowledge, and legal concerns over data ownership are leading firms to address how best to work with third parties who can add valuable additions to clearing workflow processes, what to own, what to outsource, and how to prioritize.

Greater industry standardization globally will ensure consistency of communication so that where outages do occur, business can continue with activity transferred from one participant to another across the full trade lifecycle. This requires open and transparent communication from all parties involved. Lack of timely information to act on can be as damaging as receiving incorrect information. However, there is still more that can be done to reduce complexity and to facilitate allocations efficiently across multiple accounts on T.  Mandatory clearing for European Pension funds, together with the new regulatory policy focus on uncleared assets, means that innovation in clearing will remain firmly in the spotlight to avoid any unnecessary market instability.