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Future of Derivatives:

 

Regulatory Changes and Novel Technologies

· Derivatives,Stock Market,Stock Trading

Future of Derivatives:

Regulatory Changes and Novel Technologies

The future of the derivatives market is an issue of significant relevance given the rising long-term trend in the notional amount of OTC derivatives. According to the BIS, notional amounts of OTC derivatives rose to $640 trillion at end-June 2019, marking a continuation of the trend increase evident since end-2016.

While the notional value is not representative of the true credit risk inherent in many contracts, the gross market value of the OTC derivatives market, $12.1 trillion at the end of June 2019, is impressive in its own right (Bank for International Settlements, “OTC Derivatives Statistics at end-June 2019”).

Interest rate derivatives account for the vast majority of the notional value, and the upward trend is driven by increases in euro interest rate derivative contracts.

The decreasing trend in gross market values of OTC derivatives has recently decelerated, with the value falling slightly from $12.1 trillion at end-June 2019 to $11.6 trillion by year-end (Bank for International Settlements, “OTC Derivatives Statistics at end-December 2019”). Gross market values are generally more representative of counterparty credit risk than notional values.

The future of the derivatives market will depend on a confluence of myriad factors, including continual regulatory compliance, the deployment of regulatory initial margin requirements, Brexit, and benchmark reform (ISDA, “Future of Derivatives Survey”).

Issues of relevance regarding the derivatives market differ between brokers, clearers, and clearinghouses (CCPs), and end-users. For CCPs, Basel III rules have a significant impact on the cost of clearing. Firms must consider clearinghouse default funds and may choose to offload unprofitable clients.

For end-users, the SOFR-LIBOR transition and the implementation of Phases 5 and 6 of the Uncleared Margin Rules (UMR) are of the utmost importance . Alternative reference rates will form the basis of an ever increasing proportion of capital allocation and, therefore, risk allocation.

Specifically, a limited proportion of the current users of the Eurodollar futures contract will be able to hedge with SOFR futures, impacting a market with $14 trillion notional outstanding in terms of volume and open-interest and increasing the risk of hedge mismatch (FIA, “Derivatives Market Structure 2020”).

The new forthcoming phases of regulatory initial margin requirements compel several potential adaptations. Market participants generally note that further standardization of the IM CSA terms, an online CSA negotiation tool, the custodian documentation, and onboarding process will be of assistance. Third-party IM calculation services have been developed, but their expansion will reduce friction (ISDA).

However, excessive many changes in the OTC derivatives market will lead to an increase in transaction costs, which must be addressed to maintain profitability.

One area of great potential for cost savings in OTC derivatives transactions is due to emerging technologies such as distributed ledger, cloud, and smart contracts.

These savings will likely appear in areas ranging from tools to support regulatory compliance, as well as the replacement of legacy systems. Furthermore, there can be automation of mid- and back-office operations (ISDA). These ledgers can decrease data inconsistencies and communications errors due to technology issues, reducing transactions costs.

Regulators could also detect systematic and specific risks earlier, directly access trading information of shared platforms, and intervene faster to market or counterparty failures (BearingPoint, “OTC-Derivatives and Distributed Ledger Technology”).

Furthermore, ML technologies show great potential for end-users. For example, BigQueryML is a novel set of machine learning extensions to scalable data warehouse and analytics platforms provided by Google Cloud.

Using BigQueryML, analysts were able to use the volume of Twitter posts for a particular hashtag within a specific timeframe to decide which options contracts will expire in-the-money. ML models were able to demonstrably predict volume, volatility, and value (Google Cloud, “How we built a derivatives exchange with BigQueryML for Google Next ’18).

Naturally, any discussion of the future of OTC derivatives is not complete without consideration of the impact of the COVID-19 pandemic. As of 3 April 2020, the Basel Committee on Banking Supervision and the International Organization of Securities Commissions reported that new standards regarding default pools for bespoke derivatives deals will not come into effect until September 2021 and September 2022.

Therefore, smaller users of swaps contracts such as pension funds and insurers will not be required to set aside margin in the absence of a CCP. Counterintuitively, a relaxation in regulation that is beneficial to market participants will likely decelerate the rate of technological advancement in the market due to a lack of urgency.

In the opinion of this author, market participants should minimize their concern as to the timeframe of regulatory changes and attempt to be the first to implement novel technologies to reduce transaction costs. In this regard, distributed ledger technology as well as AI and ML methods of smart clearing are essential avenues for development.

Written by Cameron R. Shabahang & Edited by Gihyen Eom & Alexander Fleiss

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