Raymond A. Kahn, FinTech Advisor, tell us why collaboration among participants will be the most effective way to identify and implement advancements in the exchange ecosystem.
I was privileged to be asked to discuss FinTech opportunities at the 56th WFE General Assembly & Annual Meeting in Cartagena, Colombia earlier this month.
The conference consisted of an impressive group of exchange/CCP executives plus other senior bankers, market makers, and buy-side participants. Individuals were eager to explore ways to improve the exchange markets, to increase market stability and liquidity, and to grow economic returns and market opportunities. The conference was informative and thought provoking, leading me to contemplate the best way for the industry to pursue advancements and efficiency gains.
When considering improvements, one must do so in the context of a relatively consistent and globally regulated exchange ecosystem. Thomas Hammond, a well-respected leader in the exchange industry, eloquently defines the market as a "distribution system managing payments and risk." Each participant has defined roles for trading and executing, managing risk, funding, daily life-cycle requirements, margin payments, and default management.
For listed and cleared derivatives, transactions can be executed with many market makers. Once cleared, exchanges are responsible for managing the risks of its members and the subsequent margin payments required at the member level. Clearers must manage counter-party risk at the end-user fund level, manage daily regulatory margin payments at the fund level, maintain adequate funding liquidity to pre-fund exchanges’ margin calls related to the end-users’ portfolios, and hold conditional capital to enhance the safety of exchanges. This requires extensive headcount, global infrastructures, and substantial capital resources. For this reason, there are only about a dozen banks that provide global client clearing services, with more banks paring back their offerings than those that are expanding. The clearing banks are key components of the exchange ecosystem. They are also the most challenged presently due to low returns related to tighter capital rules on cleared and listed products, and to large fixed expenses related to maintaining their payment, risk, compliance, and regulatory infrastructures.
Articles abound about opportunities to create economic value by moving more trading to exchanges and electronic markets or by utilising blockchain based solutions in clearing that bypass exchanges and/or clearers. I strongly support advancements that produce efficiencies in trading, payment processing, and clearing. However, I believe that each type of participant in the existing ecosystem plays a key role and will remain necessary going forward. It is imperative that each new proposal considered maintains at least the equivalent regulatory standards and protections of the existing exchange ecosystem without diminishing overall safety and risk standards. For instance, greater electronic trading will likely continue to create economic savings and tighter spreads. If trading volumes move further away from clearing banks, a portion of the trading savings will need to find a way to the clearing providers. Without respectable returns for each type of ecosystem participant, the cleared markets will become even more concentrated in a handful of clearers, thus increasing market concentration, reducing risk mutualisation, and potentially limiting global clearing capacity. These factors could subsequently produce reduced trading liquidity.
Regarding FinTech alternatives, technology innovations will play a key role in generating incremental efficiency improvements to the existing infrastructure. Key opportunities exist to drive improved economic performance, greater transparency, and more cost efficient post-trade and payment processing. Until some transformative technological advancements have been approved by global regulators to replace portions of the existing exchange ecosystem, market participants need to work more closely to implement new efficiencies within the existing exchange ecosystem.
The exchange ecosystem at the moment is an elaborate distribution system of payments and risk management. In the current period of tremendous transition and technological advancements, it is critical that new improvements be implemented in ways that benefit the businesses creating the benefits without simultaneously weakening existing risk, payment, and/or safety features. The global exchange markets are not a zero-sum game in which only gains are derived from others’ losses.
The exchange industry continues to expand rapidly. Participants should not be cavalier or ignore challenges that exist within the ecosystem. Participants should not expect revolutionary technological advancements to transform the industry quickly. Collaboration among participants will be the most effective way to identify and implement key and much needed advancements in the exchange ecosystem. The WFE will continue to play a key role.
Raymond A. Kahn presently advises exchange participants and FinTech companies on ways to create efficiencies in the cleared and bi-lateral capital markets. Mr. Kahn previously managed a major FCM, managed a large global loan portfolio, and traded OTC products. He is a frequent speaker and advocate at global regulatory meetings and industry conferences.