technology implications and costs of dodd-frank on
TRANSCRIPT
CFTC TAC | Washington DC | March 1, 2011
Technology Implications and Costs of Dodd-Frank on Financial Markets
Larry TabbFounder & CEO
TABB Group
2
Contents
Workflows
High Level Existing
High Level Proposed
SEF
Clearing
Dealers
Prime Brokers
Dealer spending estimates
Dealer Progress
Conclusions
Existing MarketStructure
Corporation
(end user)
Hard
Inventory
Asset
Valuation/
Balance
Sheet
Risk
Treasurer
Minerals
Inventory
Agriculture
Energy
Currency
Dealer 1
Dealer 2
Dealer 3
Bid
Bid
Bid
Accept
Corporate End User
Hedge Fund
Asset Manager
Corporate End User
Inter-dealer broker
Corporate end users accumulate risk through their day to day business. This could be inventory, commodities, currencies, credit or interest
rate risk. They work with dealers to model the risk and solicit bids from one to multiple dealers to hedge that risk. The corporate treasurer
picks a dealer who wins the deal. The dealer typically will try to find and end user or a financial institution that wants the opposite risk and will
try to sell it to another counterparty. Sometimes the dealer with use and Interdealer broker to lay off the risk with another dealer
Asset Manager
Futures Exchange
The existing market is bilateral with dealers in the middle
Source: TABB Group
Proposed MarketCorporation
(end user)
Hard
Inventory
Asset
Valuation/
Balance
Sheet
Risk
Treasurer
Minerals
Inventory
Agriculture
Energy
Currency
Bid
Bid
Bid
Accept
The corporate end-user business is unlikely to change much of the clearing requirements for end-users has been exempt – and under FASB133
only exact hedges can get balance sheet relief and it is not expected that a significant amount of customized products will be centrally cleared
and SEF-traded. However, it is mandated that all standardized swaps be both centrally cleared and traded on an SEF. We anticipate that much
of this business will be done with financial non-dealer financial institutions such as hedge funds, asset managers, insurance cos, and
proprietary trading houses
Corporate End User
Asset Manager
Large
Dealer 1
Large
Dealer 2
Large
Dealer 3
Dealer 1
Clearing
Firm 1
Prime
Broker 1
Hedge Fund
Insurance Co
Small Dealer 1
Asset Manager
Hedge Fund
Insurance CoHedge Fund
Prop
Shop
SEF
Trade Info &
Market Data
Trade Info
Clearing
House
Trade
Repository
SEF MembersSEF Members
Clearing Fund
Margin
Trades &
Margin
Under DF, standardized swaps are matched by SEF, centrally cleared, & centrally reported
Source: TABB Group
SEF Technology
SEF infrastructure is fairly straightforward. The four major technology aspects of a SEF will be managing connectivity and messaging, risk
management (however, not as substantial as the clearing house), matching, and market data. SEFs typically do not pay for connectivity,
however the larger and more successful, the more challenging is the communications and infrastructure requirements. Increasingly there
may also become demand for co-location.
Matching
Engine
Market Data
Ticker Plant
Pre-trade
risk
Connectivity
Messaging &
Networking Support
Post trade
Notice of
Execution
Dealer
Clearing
Firm
Prime
Broker
Credit
Management
Surveillance
SEF Members
Dealer
Clearing
Firm
Prime
Broker
External Market
Data Providers
External Valuation /
Evaluation
Providers
Co location Management
Clearing
Firms
Prime
Brokers
Dealers
Dealers
Clearing
Firms
Prime
Brokers
SEF Members
Clearing house
Communications
SEF
Clearing
House
SEFs, while not fully defined, will need some very specific technology
Source: TABB Group
While Clearinghouse technology is not as real-time as an SEF, the Central Clearing House manages risk. Clearing houses typically receive two
copies of each trade – one from the SEF and the other from the members. They are reconciled, netted/novated, cash is settled and then
placed in a position repository where they are valued each day, and the excess/deficit values are exchanged with dealers on a daily basis.
Connectivity
Messaging &
Networking Support
Dealer
Clearing
Firm
Prime
Broker
Clearing House
Members
Dealer
Clearing
Firm
Prime
Broker
External Market
Data Providers
External Valuation /
Evaluation
Providers
Dealers
Clearing
Firms
Prime
Brokers
ClearinghouseSEF
Trade Feed
New Trade
EntryComparisons
Trade
Reconciliation
Netting / Novation
Cash Management Margin
Firm
Liquidation
Default Fund
Management
Valuation
Risk Management
Cash
Position
Management
Identifier
Management
Trades
Reconciliation
Margin
Cash Settlement
Default Fund Mgt.
Cash
External
Asset Manager
Liquidation
CashPositions
Clearing Bank
Multiple Trade
Repositories
Clearinghouse’s primary job is to manage default risk – but that encompasses a lot
Source: TABB Group
Dealer Technology
Dealers will have significant technology investments to make. SEF’s don’t exist, SEF eligible products don’t exist, all trade repositories don’t
exist, many clearinghouses are just getting started. Also Prime brokerage facilities are not set up, credit lines, as well as ways of modeling
the products are not standardized.
Connectivity
Messaging &
Networking Support
Dealer Clients
External Market
Data Providers
External Valuation /
Evaluation
Providers
DealerCredit Risk
Pre-trade
Risk Management
Comparisons/
Reconciliation
SEF
Communications
Netting / Novation
Cash Management
Market
Liquidity RiskCredit Risk
Valuation
Risk Management
Cash
Position
Management
Identifier
Management
Cash
Cash
Clearing Bank
Dealer
Clearing Firm
Hedge Fund
Small
Dealer
Prop
Shop
Insurance Co
Asset Manager
Multiple
SEFsMultiple
Clearinghouses
Multiple Trade
Repositories
Market Data
Outgoing
MarginClearinghouse
ReconP & L
Regulatory
Compliance
Reporting
Multiple
Regulators
Position Limits
Positions
Credit
LinesProp
Desk
Unfortunately for dealers, much of their infrastructure needs to be added as business is expected to shift
Source: TABB Group
Prime Brokerage Technology
Prime brokers’ provide credit and credit intermediation services (transact using the banks’ credit and not the fund’s credit. This allows the
fund to buy at better prices. Primes also provide financing (for securities – not necessary for derivatives) and manage margin. Because of the
lending relationship the Prime needs to keep a close eye on the financial condition and the leverage of the fund.
Connectivity
Messaging &
Networking Support
Clients
External Market
Data Providers
External Valuation /
Evaluation
Providers
Cash ManagementValuation
Position
Management
Clearing Bank
Prime Brokers
Hedge Fund
Multiple
Clearinghouses
Multiple Trade
Repositories
Margin
Multiple
Regulators
Credit
Lines
Market &
Liquidity RiskCredit Risk
Risk Management
Pre-trade
Risk Management
Reporting
Executing
Dealer
Margin
Hedge Fund
Administrators
Prop
Shop
SEFs
Front End
Portal
Primes will provide leverage and access for hedge funds and prop traders – this business is new too
Source: TABB Group
Largest dealers will spend over $1.8b to restructure OTCD business for Dodd-Frank
Top Tier
(3-4 firms)
Mid Tier
(4-5 firms)
Third Tier
(5-6 firms) TOTAL
eCommerce $ 158 $ 87 $ 35 $ 281
Low-touch
Distribution $ 162 $ 90 $ 36 $ 288
CCP $ 217 $ 120 $ 48 $ 385
Risk $ 347 $ 193 $ 77 $ 617
Collateral $ 129 $ 72 $ 28 $ 230
TOTAL $ 1,015 $ 563 $ 225 $1,804
IT Spending Estimates for large dealers (top 15)
(2010 - 2012
Source: TABB Group
IT spending by US Broker/Dealers took a in credit crisis but back on the positive trend
$0
$5
$10
$15
$20
$25
$30
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
CAGR
-7.9%CAGR
8.2%
CAGR
-13.5%CAGR
6.4%
Source: TABB Group
US Broker / Dealers Financial Markets IT Spending
(in US$ billions)
Source: TABB Group
Client needs, which are focused on new regulations, drive prioritization of IT initiatives
Drivers behind prioritization of OTC derivative reform IT initiatives
1 – Least Important Most Important- 5
Regulations drive client
demand, and responding to
client demand provides
competitive differentiation;
hence the top three drivers
behind IT prioritization
Client demand is the clear
primary driver for major dealers
as that is what will bring more
order flow.
Inter-dealer brokers are more
focused on competitive
differentiation and regulatory
compliance as client demands
have changed little post-
legislation.
Reducing costs/ROI is not the
primary driver for any
participants in our study.
Source: TABB Group
Clearing and execution have been the primary focus for dealers, inter-dealer brokers and service providers
Readiness with major OTC derivatives reform related initiatives
1 - Not Yet Started Completed - 5
Both top and mid-tier brokers
feel confident in their current
readiness for central clearing.
Top tier dealers are generally
more prepared for changes in
the execution landscape than
are mid-tier brokers.
Inter-dealer brokers are
prepared for changes to the
execution landscape and are
less focused on clearing.
Overall compliance, reporting
and reference data changes are
further from completion for all as
many of the detailed rules are
still to be written.
Source: TABB Group
Credit and Rates are the primary focus of dealers, inter-dealer brokers and service providers
Product priorities for OTC derivatives reform IT initiatives
1 – Lowest Priority Highest Priority - 5
The early focus on central
clearing of CDS forced it to the
to top of the priority list for most
market participants.
The last few months have seen
a shift of focus to interest rate
swaps as the asset class will
likely see the high percentage of
positions move to central
clearing.
Commodities (including energy
swaps), OTC equity derivatives
and OTC FX derivatives are
taking a back seat for dealers,
inter-dealer brokers and (for the
most part) with regulators.
Source: TABB Group
Conclusions
The dealers are currently scrambling to build out their capabilities
TABB estimates that the largest 15 dealers will spend
approximately $1.8B to implement the Dodd-Frank rules for
derivatives
While dealers have invested heavily over the decades, products,
clearing, trading, business and distribution models are all
changing
While regulation is significant, client demand driving development
From a business perspective clearing and execution are the key
investment areas
Firms are focused on heavily on credit and rates than
Commodities, Equity, or FX Swaps