Gill Wadsworth takes a deep dive into the impact the UK’s “mini budget” had on the derivatives market.
The so-called mini budget from the then Prime Minister, Liz Truss in late September wreaked havoc on markets but particularly fixed income and derivatives. In fact, “poorly managed leverage” in liability driven investment (LDI) strategies run by UK defined benefit pension schemes required a £20 billion bailout by the Bank of England.
The promise of £45 billion unfunded tax cuts triggered a rise in gilt yields which led to a fall in the net asset value of these leveraged LDI funds. This was significant since there has been a sharp increase in the use of derivatives for asset liability management.
Research from Coalition Greenwich published last March reveals the buyside increased the use of derivatives for hedging in LDI from 23% in 2021 to 50% this year. Only 25% used derivatives primarily for alpha generation.
“This year the pressures have been felt in certain areas of the market such as the LDI pension fund strategies, which came under significant pressure as sharp downward moves in gilt prices resulted in unprecedented margin calls for these firms against their derivatives positions,” says Will Mitting, founder and managing director at Acuiti.
In a statement published this November, Sarah Breeden, executive director at the BoE, noted, “What happened to LDI funds is just the latest example of poorly managed, non-bank leverage throwing a large rock into the pool of financial stability.”
Luis de Guindos, vice-president of the European Central Bank, also released a statement in November reflecting on the chaos felt across the markets in the second half of the year.
“Not for the first time, we have been reminded that, when positions are leveraged or when exposures are created through derivatives, the impacts of market shocks are often felt well beyond those investors that are directly affected,” de Guindos said.
Improve risk management
The LDI crisis – and that of Archegos and LTCM before it – Breeden says “highlight how financial strains on leveraged non-bank investors can transmit directly to the large banks at the core of the financial system. And it highlights again that if leveraged investors use several counterparties, overall leverage is hidden from each of them”.
She says that banks and counterparties may need to have “access to more information on the risk positions and balance sheets of their leveraged counterparties if they are to understand fully concentrated and hidden exposures”.
Breeden also called on dealer banks and prime brokers to equip themselves with “better data on clients’ overall leverage and positions” to strengthen their risk management.
Lee Bartholomew, global head of derivatives product R&D fixed income & currencies at Eurex, agrees firms need to determine and make better use of the data that is available to improve risk management.
“There has been a trend towards greater electronification which means that executable risk gets sliced into smaller chunks, allowing traders to scale into positioning. There are certain segments of the buyside that are sophisticated in how they put on risk, but who don’t necessarily take the same consideration when exiting risk, which can have a knock-on effect in the short term on liquidity and adjacent markets.”
He continues: “It’s not necessarily about the amount of data you can get, it’s how you use that data and apply it specifically to your business and, within your product, trading mandate. This is an important factor that separates those businesses that are navigating the markets well (outperforming) versus those that are probably finding it more challenging.”
This is a view shared by the International Settlements and Derivatives Association (ISDA) which in a white paper published this May, said firms have been overwhelmed by the deluge of data they are obliged to maintain as a result of market reforms brought in to avoid a repeat of the 2008 global financial crisis.
Not only do these regulations increase the volume of reported data, they also directly scrutinise the quality of the data and require firms to adopt new standards and classifications and provide a data audit trail.
ISDA says, “The net effect of these new requirements has been profound and has impacted virtually every market segment and activity within the derivatives market. Firms have implemented new regulations at pace, layering complex new technologies on top of an antiquated infrastructure that is struggling to meet the new demands placed upon it. The creation of vast amounts of data to support compliance with many disparate and duplicative reporting requirements has resulted in data quality and consistency issues.”
Thorn in the side
Arnaud de Chavagnac, head of cloud, technology and services marketing at capital markets technology firm Murex, says that as technology has evolved in derivatives trading, including associated middle- and back-office functions, the limitations of hardware have been “a thorn in the side” for the sellside.
“This is especially important from a risk perspective as banks need to perform huge numbers of calculations, restructure trades and rebalance hedges much faster. With the recent volatility in markets, the need for computer power has never been greater,” he says.
Fortunately for those in the derivatives business, there have been significant advances in technology that help meet data challenges and the demand for full automation.
In particular, de Chavagnac says the cloud “is key to providing the flexibility for enabling derivatives trading in the market conditions of our modern world”.
“Not only can banks harness huge computing power, but this power is also elastic and instantaneous. The systems automatically increase and decrease their hardware footprint depending on their workload requirements without human intervention required to dial up or down the capacity.”
He adds: “You rent the service you are using, as and when you are using it. This is significant as it removes a constraint allowing banks to restore their agility and focus on their core activities, namely better serving their customers and managing risks more accurately and swiftly.”
While de Chavagnac espouses the benefits of the cloud, ISDA is in favour of greater use of distributed ledger technology (DLT) to help derivatives markets participants overcome data management challenges.
As part of its roadmap to innovation, ISDA says “a golden source of trade data for regulatory reporting is critical for efficient and accurate reporting” but notes that there is “no one key source from which trade data is available to market participants. Further, smaller corporates that do not have the expertise or the budget may still be reliant on manual processes to extract data to comply with their trade reporting obligations”.
The Association argues that DLT could improve data quality by establishing “golden sources” of data that are shared between relevant parties and allow a regulator to access its trade repository providing a “cryptographic guarantee” for reporting.
Mitting says: “DLT will have a major impact on derivatives markets. It will bring significant efficiencies to post-trade settlement and reduce or eliminate the need for reconciliations. In addition, the near real time settlement enabled by DLT will have a major impact on intra-day liquidity.”
Despite the push to electronification, Bartholomew warns market players against adopting technology for technology sake.
Bartholomew believes, “It is important to understand which technology is vital to your business for it to be successful. Does it help generate alpha or more effectively manage your beta? Sometimes you need to take a step back and ask what is most applicable for your business model and what’s going to push the needle.”
Third-party support
As part of a strategic look at how derivatives trading operates, some organisations are considering a move to outsourcing.
A 2021 research report from Quinlan Associates found that despite benefiting from numerous technological developments over the years, especially the growing use of electronic trading, “the buyside trading desk has had to contend with several challenges, including a dearth of competitive pressure and unresolved inefficiencies” alongside cost burdens.
As such, firms are using outsourced trading to reduce the typically high costs of trading, such as IT, personnel, as well as moving to a variable or on-demand cost model.
However, Bartholomew says this is not a trend that is immediately apparent in the derivatives space.
“People want to keep [trading] as part of their core competence, but there is a need for greater understanding of how the plumbing and pipes work (the subtle nuances that can stretch out extra performance). If they haven’t written the [algorithms] themselves, how do they know what they are using is optimised for their business? This needs greater focus and attention.
In response, Sylvain Thieullent, CEO at Horizon says he expects to see financial services companies increasingly outsource their tech to third-parties.
“There is regulatory pressure on financial companies to make sure that they are in control of their technology and the master from A to Z the systems they are using. A financial services firm cannot be a leader in technology and software because that is not their core competence so we will see them outsourcing to experts.”
©Markets Media Europe 2023
