Four Years Later, ‘Change’ Still the Key Word in OTC Derivatives Market

As the financial landscape continues to undergo rapid changes due to increased regulatory oversight and ongoing enhancements to real-time market data access, the OTC derivatives market is experiencing a profound level of overhaul. Investment managers are witnessing significant pressure on both their technology infrastructure and operations to adapt to the new reality.

Mas Nakachi, OpenGamma

It all started back in 2009, when Congress passed the OTC derivatives bill, HR 3795, requiring all OTC derivatives swaps transactions to go through a clearinghouse. This was followed by a number of other global regulatory reforms, including the Dodd-Frank Wall Street Reform and Consumer Protection Act, the European Markets Infrastructure Regulation (EMIR), MiFID, MiFID II and MiFR. However, many of the rules and obligations have not taken effect yet, due to implementation dates that have not been reached and extensions are added on to previous dates. For instance, certain reporting deadlines initially outlined in the EMIR will likely not take effect until at least Q3 2013 for credit and interest rate derivatives, and January 1, 2014 for other derivatives.

At the same time, the overall market structure is also experiencing a transformation. Indeed, different types of market structures can be identified, and it is unclear whether the industry will eventually settle on a particular structure. As a result, this evolving framework of Swap Execution Facilities (SEFs), Central Counterparties (CCPs), Futures Commission Merchants (FCMs) and so on is driving a need for faster and more accurate risk management.

Risk management has become central to pre-trade transaction analysis, especially as most trades are now fully margined, often by the CCP. Initial Margin (IM) / Variation Margin (VM) requirements have had an impact on liquidity, and make it more expensive for market participants to use derivatives to hedge risk. As many of the new modern margining algorithms are based on simulation approaches similar to traditional Value-at-Risk measures, market risk and liquidity risk technologies are beginning to overlap in ways they haven’t in the past.

[Financial Industry Is Massively Underprepared for OTC Regulation]

In the midst of all these changes, firms will need to invest in more robust risk management practices. One of the major issues for firms has become the overall cost and measurement of risk of not clearing these derivatives contracts. The European Supervisory Authorities and ESMA are continuing in their efforts to align risk mitigation procedures with those that were presented by the International Organization of Securities Commissions (IOSCO). Even outside of the EU, those trades that are not cleared then drastically increase their risk of higher costs and regulatory scrutiny as opposed to those that are cleared.

Another key driver is the increased need for real-time risk. Everyone in the chain -- end users, FCMs, CCPs -- needs faster, more accurate risk measures. Even the CCPs are moving to more frequent intraday risk, across assets and across listed and OTC products, using new and evolving cross-margining methodologies, which will further push the boundaries of legacy risk infrastructures.

Ultimately, this all calls for more transparency throughout the industry, from financial products and overall market structure to risk management practices and ideally down to the technology infrastructure itself. Risk analytics in particular will need to move from black boxes to crystal boxes -- after all, how does one regulate a black box, if it isn’t clear how the resulting numbers or models were calculated in the first place? Or compare numbers between two firms in the absence of an industry-wide, open standard?

The brave new world of finance requires a new paradigm of openness and transparency. As markets become faster and more electronic, an increasingly important component of the financial services industry is technology. If opaque financial products like CDO^2s, and the resulting inability to correctly risk manage them, caused the last financial crisis, opaque technology at the heart of the financial services infrastructure today could be sowing the seeds of the next one.

Mas Nakachi, Global COO and North American CEO: Mas is OpenGamma’s Global COO and North American CEO. Prior to OpenGamma, Mas spent 9.5 years at Calypso where he was most recently the director of business development for the rates, fixed-income and credit business. In this position, he was responsible for ecosystem development, marketing, client support and new product development initiatives, as well as strategic client acquisition for Calypso’s largest business solution segment. He previously served as Calypso’s director of strategy and corporate development, and began his career developing and growing Calypso’s credit derivatives business, establishing it as a number one ranked solution, as acknowledged by numerous industry publications. Previously, Mas served in key business development and product management roles at other financial technology companies, such as Summit Systems (now Misys) and Integral Development. He also co-founded a financial advisory firm focused on structuring and executing secondary market transactions in illiquid alternative investments and private securities. Mas earned a Bachelor of Science degree in Finance with a minor in Philosophy from the Leonard N. Stern School of Business at New York University.