Derivatives Reform Kicks Off Competitive Struggle

By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.

Originally published on TABB Forum 

The real story in the derivatives market – one that is playing out mostly behind the scenes and that still is being written – is the competitive struggle that has been kicked off by regulatory reforms. Here are some of the drivers shaping the competitive landscape. 

As the world’s regulators race to finalize the rules for derivatives reform, and the industry races to adapt to them, there is another drama playing out, mostly behind the scenes: the competitive struggle that has been kicked off by the reforms. This struggle is the real story in the derivatives market, one that is still being written. And it is the most interesting story of all.

In order to understand the competitive struggle, we have to understand the environmental changes, which may not be as obvious as the regulatory ones. Here are a few:

1. As the market moves from entirely bilateral to mostly cleared transactions, the pricing power of the banks and interdealer-brokers will erode. This is already becoming apparent in the narrowing of spreads, but there is a deeper implication. Lots of new pre-trade factors, such as the capital rules for banks and the choice of CCP, will impact pricing, so customers can no longer afford to simply accept a dealer’s price. They must demand the kind of technology that will allow them to shadow-price transactions, so as to ensure that they are getting a fair deal. This will be particularly important as daily pricing and variation margin make the mispricing of a trade immediately and painfully apparent.

2. Allowing clearinghouses, data repositories and exchanges to compete and to be run as profit-making businesses has opened up several new competitive possibilities. The fact, for example, that some data repositories are standalone entities and others are offshoots of another business, such as a clearinghouse, means that the same market function may represent completely different business models to different vendors. The fact that everyone agrees that there are too many CCPs and SEFs in the market leads everyone to expect consolidation. But consolidation can be a messy process, and the fact that this business is, at its core, all about risk makes this consolidation a potential risk nightmare.

3. We are already seeing the beginnings of the move away from a completely principal market to a partially agency market. That trend will certainly accelerate among the vanilla products, although it will be much slower among the bespoke products. In any case, the relationship between brokers and customers is very different than it is between dealers and customers, and both sides will have to learn how to communicate in a brokered market. Up to now, this culture change has been the focus of the dealer community, particularly among traders and salespeople; but customers will have to learn new ways of communicating as well.

4. The fragmented regulatory environment has done more than make it harder for everyone to get into compliance; it has opened up some short-lived marketing possibilities. As customers, in particular, wade through the documentation, reporting, and clearing undergrowth, and the generic solutions offered by the dealer lobbying groups have proven less than palatable, some enterprising dealers have been working on compliance with larger clients to gain a competitive advantage. Whether someone will do that for the larger universe of smaller customers, and thereby build a significant business, will be one of the most interesting questions.

Now let’s look at the new competitive landscape and see what shapes are emerging from the mist.

1. The most important competition will be over order flow. Whether we are talking about a SEF, a dealer, a CCP or even a data repository, the key to the future is capturing and holding onto order flow. Every competitor in every segment of the trade cycle is focused on this struggle. And there are some interesting and perhaps unexpected outcomes. One development is the use of certainty of clearing (CoC) as a competitive weapon. Everyone from SEFs to CCPs to FCMs is trying to be the party that provides CoC, so that they become the preferred access point to the market. There are other ways to compete for order flow, of course, so we should expect to see rebate competition among exchanges, and perhaps even the venerable research-leads-to-orders model that prevailed in equities years ago.

2. We should expect to see a blurring of the lines between the market functions as the competition heats up. We have already seen the combining of trading and clearing units at the big banks, but it is even more obvious to combine the FCM and broker function as markets move from principal to agency. We shouldn’t be surprised to see a SEF/CCP combination in the not-too-distant future, as both markets are overcrowded, and that combination would help capture order flow.

3. Although customers are expected to be the beneficiaries of all this competition, they will have to adapt to the new realities in order for that to be true. In the same way that buy-side research had to mature to replace sell-side research in equities, buy-side expertise in derivatives will have to mature to keep up with dealer expertise in the new world. One possibility, of course, is that the buy side will simply back away from swaps in favor of futures or simply unhedged positions; except for commodities, however, that trend hasn’t really developed yet.

So what can we tell for sure about the outcome?

1. The new derivatives world won’t look much like the old one, so market participants that are trying to hold onto the old ways for as long as possible, or even just comply with the new rules, will find themselves at the back of the pack, or even out of the race.

2. If controlling order flow will be the key, it will require new relationships between customers and just about everyone else in the market. If customers don’t want to have those relationships dictated to them, they will have to be active participants in the evolution of the new world.

3. There will be a significant consolidation among many of the vendors, and it could get messy; there will be business combinations among the vendors, perhaps in unexpected ways. Since many of the relationships in this market involve long-term risk, those combinations could come as an unwelcome surprise.

4. Understanding what is happening in the evolution of the market will require a combination of data analysis and business acumen. Either one by itself may give you a feeling of confidence, but only the two together will make you a winner. In the end, the key traits for success will be intelligence and agility, as they are in any competition.