When new rules create a new market, competitive differentiators take time to emerge. First one must clarify whether the product and/or provider can even do the job, before relative performance, price and service levels can be taken into consideration.
Take derivatives clearing. When new rules proposed mandatory central clearing for liquid OTC derivatives, many users of these instruments assumed that the brokers they employed to clear listed futures and options would be able to take on cleared swaps business too.
If your clearing broker can clear German bond futures as a member of Eurex Clearing, the German clearing house, you might expect it to clear OTC derivatives instruments via the Frankfurt-based central counterparty too, following approval under the European market infrastructure regulation, granted earlier this month. You might also expect them to offer cross-margining opportunities where available.
But a number of first movers into the combined listed and OTC clearing space are now struggling to deliver. Some asset managers that signed up with a couple of their futures clearing brokers as soon as they realised they were going to need to centrally clear OTC instruments too have realised that perhaps they jumped the gun. The problem with being a first-mover on the buy-side is that you can make a commitment to a new way of operating before the factors that determine your requirements and obligations are set in stone. The problem with being a first-mover on the sell-side is that you can under-estimate the investment required to deliver a service and may find – especially if you under-price it – yourself overtaken in the long run. For the COO of the fund manager, as the realisation dawns that the service you bought does not fit your purpose, you face the uncomfortable prospect of withdrawing from the arrangements and undergoing the RFP process all over again.
This is of course understandable. The migration of OTC derivatives clearing demands that asset managers and their sell-side providers get to grips with a whole host of new processes that entail many short-term workarounds and long-term investment decisions. The extreme variations in data quality received by trade repositories since European trade reporting requirements came into force, provides ample evidence of this. Evolving rules, guidelines and processes all add to the confusion, putting today’s wise decision at risk of becoming tomorrow’s embarrassing admission.
Over time, as client requirements become clearer, so product capabilities will become more robust. What seems to be required right now is a lot of handholding and advice during the various onboarding procedures for reporting, clearing, valuation, delivering collateral etc. This puts the emphasis on high levels of service over an extended period of time, which perhaps does not play to the traditional strengths of the broker, characterised by the sales trader, who can always make his commission by offering a client a better price tomorrow if today’s does not appeal. It is unsurprising then that many banks are bringing their transaction-focused brokerage arms closer together with their custody teams, which have often taken a long-term, relationship-based approach to revenue generation. Custody mandates, for example, turnover every seven years on average, which should instil a serious commitment to service levels.
Integrated broking-clearing-custody services may encourage a service-focused rather than volume-based approach to relationships between asset managers and their sell-side counterparts. It may also result in steadier, more predictable revenue streams from institutional clients, based on monthly fees rather than transaction volumes.
But I still wonder whether the pace of change could be faster. While new clearing and collateral management services are being defined and implemented, fund managers should also be aware of the opportunities to reduce their trading costs through innovation in instrument design at the exchange level – or at least cognisant of the price differentials between similar instruments on competing exchanges as venue rivalry heats up. Brokers should be differentiating themselves by pointing out these opportunities too.
After all, every axiom has its opposite. Instead of ‘Act in haste, repent at leisure’, I could have called this blog ‘He who hesitates is lost’.