Regulators around the world are pursuing a relentless agenda aimed at reducing risk and increasing transparency. The derivatives industry, with its 24-hour global and highly interconnected business model, is therefore providing an interesting challenge for them. The macro-economic position, as abnormally low interest rates have become the new normal, is not helping either. This suggests that a futures commission merchant (FCM) model dependent solely on intermediating between clients and liquidity may not be viable going forward.
The changes can be summed up in two words: convergence and aggregation. Distinct over-the-counter (OTC) and exchange-traded workflows that used to run along separate but parallel streams have now become permanently intertwined. The FCM of the future will need to refine its strategy and streamline its operations accordingly.
The dust is yet to settle, but the signs are that the traditional on- or off-exchange paradigm will evolve towards a broader spectrum of standard and custom contracts. The standard contracts will take many forms and be traded across both designated contract markets (DCMs) and swaps execution facilities (SEFs). Flexibility will be critical, and may include the potential evolution of an agency model that aggregates liquidity on behalf of the buy-side and combines relevant liquidity onto one screen regardless of where it is traded. One of the key tools for FCMs in all this will be benchmarking algos, such as daily volume-weighted average price (VWAP). As algos working across multiple pools of liquidity proliferate, transaction cost analysis will also play an increasingly vital role. Buy-sides will apply it to decide which brokers to use, and so it will become critical in demonstrating an FCM’s worth.
Aggregation will also extend to risk and margin, which will enable FCMs to provide the greatest possible clearing efficiencies to their clients. The middle office and its interoperation with clearing houses, credit hubs and clients will be where this particular battle is fought.
In this light, maintaining multiple desks that run different trading applications looks increasingly old-fashioned. It hinders efforts to manage compliance and risk but, above all, it is simply too expensive. The same is true of deploying multiple third party screens to clients just to meet specific trading quirks or habits. Anachronism and sentimentality have no place in today’s FCM playbook.
What is needed is a more centralised approach to business workflow so that information can persist more fluidly through the entire firm. This needs to be done in such a way that different desks and clients feel empowered rather than constrained by centralised bureaucracy.
Rising to these challenges poses a tough set of questions, especially with regards to technology. The goal is simple: a resilient, high-performance backbone that centralises as many functions as possible but is flexible enough to accommodate different desk and client needs. But how can that best be achieved?
The first question is whether to build or buy. When so much remains unclear, buy becomes the strategic option; not only is it cheaper, but it's more effective too. This is especially true when the entire platform is outsourced as the provider can generate economies of scale unavailable to individual firms. It also allows FCMs to replace fixed cost with variable cost, and so scale how they address the market and new opportunities.
Then there is the question of how to balance a 'one size fits all' approach with the advantages of customisation. The answer lies in encouraging modifications where appropriate, but allowing them to be deployed and monitored centrally.
But perhaps the most pressing question is how to support the newly consolidated workflow. Intelligent workflow needs to extend seamlessly across all contract types and flow easily from front through to back office. Many technology vendors that claim to offer this capability struggle to deliver because their workflow has been assembled from smaller technology firms that they have acquired. Such systems can be hard to implement and a nightmare to support.
A more sensible approach to workflow technology enables FCMs to route orders seamlessly between desks and geographic locations. By using one consolidated workflow, compliance and risk can be turned from potential weakness into a powerful competitive differentiator. FCMs will need to be able to break down an order and smart route it over multiple markets whilst still maintaining its integrity. Because of the lack of fungibility involved, this link needs to be maintained at a system level and yet remain easily accessible to the end user.
Algos and TCA also require careful consideration. Most cash equity instruments are fairly static and therefore relatively easy to monitor and map over time. This is in contrast to a typical derivatives trade, which often needs to be rolled over a number of sequential contracts. Another challenge lies in the variety of asset classes supported by derivatives, and so an algo that works for one may not work for another.
For all these reasons, successful technology implementation is now a matter of partnership with the vendor. It’s not just about the roll-out; it’s the ongoing maintenance too. This requires an ongoing relationship with a supplier that has the global support, operating precision and experience to bring the necessary resources and structure together.
In other words, technology in and of itself is only part of the solution. It is the way it is used, the relationship with the supplier, and the end goal that makes the difference. A point solution - however good - can only solve a point problem. For FCMs facing a whole new way of managing workflow, costs and clients, that’s simply not enough. Instead, a workflow approach to connect the different parts of the firm together provides the only tenable solution and the necessary backbone to face the future with confidence.
The is based on a white paper published by Fidessa in December