The global pandemic has shaken up many industries and has caused market volatility in the financial services space. In particular, this has shone a light on the inefficiencies in clearing and settlement and has amplified the need for an enhanced process in this space.
Clearing is the procedure where financial trades settle, which encompasses the transfer of funds to the seller and securities to the buyer. Clearing is necessary for the matching of all buy and sell orders in the market. The payment and settlement space covers processes including cash flow generation, confirmation of the amounts between participants, netting, payment instruction and settlement management. Industry experts note that this is usually a very onerous set of manual tasks that lacks standardisation and centralisation.
In this regard, industry experts from Eurex Clearing, LCH, FIX, and OCC discuss the challenges in this area and where the opportunities lie, and how technology can help to enable a more streamlined approach.
Picking the SUV or the Sedan?
When it comes to clearing and the challenges of integration and cross-market harmonisation, there is a balance to be struck between what is effective for the trading desk and what is effective for the back office.
When selecting a car, Matt Wolfe, vice president of strategic planning and development, at OCC, says: “There is a reason that crossover SUVs are the most purchased vehicles. They have decent performance while still generally covering our needs for utility. In circumstances such as driving on a twisty mountain road, they are not as invigorating as a sports car. In other circumstances, such as moving a child to college or big weekend projects, they aren’t nearly as helpful as a pick-up truck. For most of us, we don’t often spend a lot of time winding up and down mountain passes, nor do we have a daily need to haul couches or sheets of plywood, so a middle of the road solution is the most practical.”
Unfortunately, Wolfe says, this same context has been applied to trading and clearing systems.
According to Wolfe, the trading desks really deserve sports cars that are designed to be nimble and fast. Meanwhile, back-office teams can be more effective in a pick-up truck where utility is more useful than speed.
Indeed, while the trading desks could benefit from a fast and nimble sports-car-like approach, the back-office favour a more SUV-like approach as the need is for utility, according to Wolfe.
Wolfe cautions that different product types deserve individually designed systems. “Often though a system designed for one purpose is extended to try and support another product. While this can work, it generally leads to certain functions being inefficient and/or manual,” he highlights.
Wolfe illustrates this point by saying: “As firms have grown their trading desks, they’ve often traded in the SUV for a sedan, which has improved the trader’s experience, but it’s made the back-office’s job more difficult and often results in road trips with items sticking out the back of the car and/or items strapped to the roof.”
Echoing the need to look at different products carefully, Matthias Graulich, member of the Eurex Clearing executive board, observes that the market is developing in the direction of looking holistically across products and asset classes to actively manage the banks’ resources, but there is clearly still room for improvement and further integration.
Looking at the current situation in the clearing space, Graulich says balance sheets and capital are scarce resources on the bank side.
“We, as central clearing counterparties (CCPs), can offer multilateral netting benefits for capital and margin requirements, which delivers higher efficiencies than keeping trades bilateral,” says Graulich.
However, he notes that it is one thing for CCPs to offer and implement cross-margining between listed and over the counter derivatives or cross-margining between derivatives and securities finance transactions. What is more challenging, Graulich says, is the capacity for clients to be able to consume that information. This relates to the clients’ systems and also to the clients’ responsibilities, which are often product or asset class specific. “Bringing these responsibilities together and integrating the infrastructure to process these efficiencies is key to success,” he notes.
Ankeet Dedhia, Americas head of product, ForexClear, LCH, says that although FX clearing has seen a significant increase in activity in recent years, due to regulatory incentives as well as margin and capital benefits, there are still some integration and harmonisation challenges which need to be addressed, to enable wider FX clearing adoption. One such challenge, according to Dedhia, is straight-through processing (STP) workflow and platform integration. There are a variety of electronic communication networks, platforms supporting the various voice and electronic workflows in FX.
Dedhia affirms: “The complex environment means that integrating these workflows into clearing and providing STP client experience continues to be a challenge for some participants. To broaden access to clearing, LCH continues to engage with the market to improve and enhance clearing workflow integration.”
Another challenge for some participants is the trade execution costs associated with increased complexity from UMR’s collateralisation, Dedhia notes.
“Some participants may also find that there is a secondary economic impact of needing to pay for optimisation vendors, third-party custodians and other consultants – costs not captured in ‘price’ but linked to execution decisions,” he adds.
Opening the door to enhancements
As some of the main challenges have been identified as inefficient and manual processes, technology is one of the keys to opportunities in this space.
ForexClear’s Dedhia says that clearing provides firms with an opportunity to look at their legacy FX workflows with a fresh set of eyes and identify where and how clearing fits in.
“We expect technology to be a huge enabler of this evolution away from legacy workflows. Clearing also offers multilateral netting for all trading counterparties, hence providing payments and settlement efficiency via netting of payments and collateral obligations,” Dedhia adds.
According to Dedhia, this opens the door for many further enhancements in the payments, netting and settlement space.
“Again, clearing delivers tremendous value to clients with large payment operations, and these technology and workflow providers are all working to turn the key to unlock the necessary solutions for clients,” Dedhia stipulates.
Meanwhile, Wolfe identifies that new modular systems enable both clearinghouses and market participants to operate more effectively, adapt more quickly, and better serve their clients.
He observes that technology is enabling companies to operate systems that are designed to meet the specific requirements of different products and functions, which improves the efficiency and effectiveness over legacy systems where workarounds and manual processes have hampered productivity.
Additionally, Wolfe notes that by having more modular systems, it is easier for companies to adapt their systems to meet their strategic goals. Additionally, lowered operational costs and greater flexibility means that companies can better serve their clients.
Solutions in the making
With all of the challenges in place, solutions to combat some of these issues are coming into play. For example, last year, the Johannesburg Stock Exchange formulated a new trading and clearing solution for equity and currency derivatives to create “better integration and cross-market harmonisation” for its regulatory, trading and clearing markets.
Wolfe notes that in the past infrastructure was very expensive to build and maintain, so it made sense to have the costly servers and databases support as many products using as few systems as possible. However, advancements in cloud technology have made infrastructure cheaper and more flexible.
He says that this enables opportunities to “improve the efficiency and effectiveness of different product teams by breaking legacy monolithic systems into product-focused modules that effectively talk to each other in an independent manner”.
Many firms are decoupling their legacy system functionality into multiple product or function-focused modules that can talk to each other in ways that were not possible before, according to Wolfe.
“The new architecture is designed to have microservice-based systems that handle each product and/or function in their own unique ways. For example, it is easy to configure a cloud environment that has relatively powerful computational resources and relatively lower storage resources to support a trading platform,” he says.
He continues: “It is just as easy to create a separate environment for a back-office position management system with less costly computing resources and greater storage resources. This allows technology to provide much better service to different business units, while often reducing costs.”
The future landscape
Looking at how the clearing and settlement arena take off in the years to come, Dedhia believes that with many market participants experiencing the increased costs of capital and margin on uncleared derivatives, cleared FX has the potential to become one of the largest cleared asset classes, with more participants choosing to clear a wider set of FX products for risk efficiency and operational benefits.
As well as this, Dedhia expects to see further innovation in the clearing and settlement space to support market efficiency.
Dedhia comments: “We have also seen a host of vendors offering compression and optimization solutions to help market participants manage capital costs, margin costs, or counterparty exposure by either participating in bilateral/multilateral compression, or by moving risk across trading counterparties for cleared/uncleared portfolios. Some of these solutions could be extended to make clearing and settlement more efficient and would be something to watch in the future.”
Neena Dholani, global marketing and membership director for FIX Trading Community, suggests that one of the key areas of development is to ensure that post-trade processing, both upstream and downstream of payments are connected and consistent in their messaging language.”
“Within the FIX Trading Community, we allow firms to manage their execution, their allocation and confirmation processing, and now moving down into confirming payment amounts before they are instructed.”
“Allowing for the matching and confirmation of these cash flows brings huge benefits, and whilst they are currently only on a gross level we are looking at rolling this out for net flows as well as looking at settlement management and notifications”, Dholani says.
Meanwhile, at OCC, Wolfe sees the adoption of new technology solutions which are creating opportunities for clearing and settlement. “As the industry implements new and more flexible solutions, it will be easier to expand support for new products as well as new participants. This is certainly a goal of OCC’s ongoing transformation and as more participants can take advantage of clearing, the industry will see a continued decrease in the cost of doing business as well as increased revenues from higher utilisation and/or better pricing,” Wolfe adds.
Graulich predicts there will be changes in terms of the structure of the market. He comments: “Given the fact that today, there is an extremely high level of concentration on a few client clearing service providers, I think topics like direct access or hybrid direct access of the buy-side to CCPs will play a bigger role in the future.”
Additionally, Graulich predicts that this will also address some of the challenges on the banks’ side with regards to balance sheet and capital restrictions.
Graulich concludes: “Technology is again an important enabler to help to put all the necessary pipes in place to make such a new environment work effectively.”
