In the world of fashion, trends from years ago tend to come back in some form. Well, the same is true in the not-quite-so-glamorous market of over-the-counter derivatives. Seven years after the 2008–’09 financial crisis, the same contracts that at one time were more vilified than runway knockoffs are once again the talk of the street — Wall Street, that is, not the high street.
A study by the Bank for International Settlements shows that market values for OTC derivatives increased to their highest levels in three years in 2014, jumping from $17 trillion in June to $21 trillion in December. What’s driving this renewed interest, and who will reap the rewards?
You can’t answer these questions without first considering the deluge of regulations that has rained down on the industry. From the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 to the Markets in Financial Instruments Directives I and II, the main concern for fund managers, regardless of their size, has been finding ways to stay within the rules. This has led to a boom in compliance officers and widespread adoption of corresponding technology and infrastructure tools. All because every aspect of a fund’s performance is now under the microscope.
As a consequence of having to conform to the same rules, firms across the spectrum have been adopting similar risk-averse trading strategies. Therefore, it has become far harder for firms to differentiate themselves. But with regulatory houses now in order and confidence rising, many are turning back toward what they do best — increasing margin and profit. Hence the reemergence of OTC derivatives. And in an attempt to steal a march on the competition, the latest buzz is around contingent convertible bonds, more commonly known as CoCos. Unlike collateralized debt obligations and credit default swaps — which are now so 2008 — CoCos are recognized for preventing systemic risk.
For top-tier managers with large resources, refocusing trading strategies to incorporate these new products is hardly a tall order. And at the other end, while they may not have the same resources, boutique players have the flexibility to adjust their trading models. It’s somewhat of a different situation for funds operating in the middle tier, however. They simply don’t have the human resources or the capital of the top-tier players, and they aren’t as nimble as the smaller ones.
The upshot is that these midsize firms need to review operations with a view to cutting costs. Only then will they be able to deliver the scale needed to support new OTC strategies, or they will risk falling behind. This is no easy task, which is why firms are looking for systems that can remove the headache of managing complexity — whether that’s operating multiple asset classes to consolidate, control and manage risk, or satisfying the reporting demands of regulators. Having infrastructure in place to handle all this frees up fund managers to focus on devising the best possible trading strategies in order to compete.
Despite the recent increase in activity, it’s hard to say whether we are at the start of a longer-term move back to OTC derivatives. Capital adequacy, clearing, collateral and margin pressures mean derivatives are unlikely to deliver pre-2008 levels of profitability. But as long as there’s some profit to be made, one thing is for certain. Successful fund managers will be the ones with the right systems to handle any returning volumes, regardless of the OTC instrument in vogue.
Edward Lopez is vice president, EMEA, at OpenLink , a financial technology provider, in London.