Prior to the 2008-2009 financial crisis, trading levels and return on equity (RoE) for trading were at an all-time high. After the financial crisis there were strict rules imposed by regulators which have significantly impacted all areas of trading including post-trade processing and fixed income trading.
Trading activities such as reporting and clearing have been affected, as has the profitability of banks. The strict regulatory environment has also meant that organisations need to develop compliance strategies in response to new regulations and are turning to technology to comply with regulatory requirements, and enter new markets in a quick and cost-effective way.
Organisations currently have a number of regulations to report to, such as the Basel Acts, the European Market Infrastructure Regulation (EMIR) and Dodd-Frank, which have pushed for greater transparency, more efficient reporting and expect firms to find better ways to manage and deter risk. Basel’s review of market risk rules, which has a deadline of the end of 2015, looks at the effect of changing market prices in capital requirements for banks’ trading operations. This is an area of reform that still requires explanation and because banks still need extra work carried out on this review it may delay their completion. In the US, the Volcker Rule (part of Dodd-Frank) has made it harder for banks to take part in proprietary trading (trading on their own account) which has resulted in a number of banks withdrawing from the market.
Since the financial crisis politicians and regulators have criticised financial institutions for trading for their own benefit rather than for the benefit of individual investors. According to a Mckinsey review last year, FX, post-regulation RoE is down from 30 per cent to 16 per cent. FX is a capital-lite business characterised by quick turnaround and little overnight risk taking, however, since the Forex allegations, banks such as Barclays have been forced to pay fines and take steps to change their culture and strengthen compliance practices.
McKinsey says there are four categories of tactical response leading banks have taken since the financial crisis:
- Optimising portfolios, including improved hedging, sale of capital-intensive portfolios, and restructuring positions.
- Improving capital, risk models and data quality. This includes making amendments to the VAR model to calculate stressed VAR and new modules to calculate the IRC, CRM, CVA and expected positive exposure (EPE), a counterparty risk measurement required by Basel III.
- Improving financial efficiency, including optimising the balance sheet and enhancing current liquidity, capital, and funding stocks.
- Boosting operational efficiency by driving greater use of electronic trading and reducing head count and IT costs.
How has trading been affected?
Post-trade processing is an important part of the trade process which allows the buyer and seller of securities to verify trade details and amend any mistakes. Until the financial crisis much of the EU’s trading regulation was directed towards achieving a single market in securities, however, post-financial crisis the regulation now includes the reduction of systemic risk. In Europe, regulators are focusing on improving the management of derivatives, imposing strict liability on custodian banks for loss of clients’ assets and extending the regulation of the Financial Market Infrastructures.
According to Tom Carey, President, Global Technology and Operations Solutions, International, Broadridge, post-trade processing is focused on “a move towards best-practice, the adoption of global standards, and providing transformational levels of processing efficiency for both domestic and cross-border flows.”
Regulation affects post-trading infrastructures such as central clearing houses, central securities depositories, and trade repositories (TRs) and firms are expected to support financial stability and encourage market transparency.
Regulations such as Dodd-Frank, Emir and Mifid have also affected fixed income trading. The fixed income market is heavily dominated by financial institutions and the average trade size is often millions of pounds worth of bonds. When it comes to the fixed income market, Mark Watters, Director, AxeTrading said that regulation has had a significant impact. “Dealers have continued to scale back bond inventories and capital they risk in making markets in fixed income. Regulation has been a key factor.”
What part does technology play?
Organisations are implementing new post-trade technology which enables them to comply with regulation and make more capital. “Increasingly, firms are looking to transform their operational model in order to return to the higher levels of RoE achieved prior to the financial crisis,” Carey said.
Electronic trading has become a popular method of trading because it allows transactions to be made quickly and effectively and some industry experts believe that regulation has accelerated this trend. Activities such as electronic trade confirmation, increased collaterisation and trade reporting are also all practices which increase transparency and control within the trade process. Some firms are also increasingly building infrastructures to support e-trading and automated risk management.
According to Watters, “An ICMA report published at the end of November 2014, estimated that currently around 40% of all European investment grade credit transactions are now electronic, although this still remains predominantly for smaller tickets. For European credit indices (iTraxx) approximately 90% of the trades are now electronic. The same trend is clearly evident in fixed income markets around the globe, from the Americas to Asia-Pacific. In a recent blog article, John Greenan found over 80 venues where fixed income deals could (at least in theory) now be transacted electronically; a sharp increase since 2009 and the number continues to grow.”
Trading is an extremely competitive industry and sell-side firms are often trying to expand internationally in order to stay ahead of competition. “International trading is of growing importance to sell-side firms as a means of expanding their service offerings in order to remain competitive and drive profitable growth for both the firm and its clients,” Carey said.
The only way to enter new international markets is to implement technology which enables this to happen and according to Carey, “firms utilising a best-in-class post-trade service will be able to enter new markets quickly, efficiently, and cost-effectively, by leveraging the experience of the service provider and the provider’s ability to mutualise capabilities. This can help circumvent many of the market-level challenges relating to the processing nuances and procedures, reporting and service connectivity. One area of recent innovation is the focus of firms to process local market clearing and settlement for their international affiliates using post-trade technology and services.”
Since the finanical crisis technology has provided a way for traders to keep up with the fast-paced trading environment and has enabled them comply to a number of strict regulations. Watters’s describes today's fixed income environment as a perfect storm which is encouraging technological innovation and says that technology will continue to provide solutions for the trading environment.“The current fixed income trading environment is creating a ‘perfect storm’ for fixed income trading technology. The combined impact of regulation, record low interest rates, continued strong issuance, and fragmented liquidity is posing new challenges for fixed income traders. Technology is now being sought to provide many of the answers.”