Rob Daly: Smarter, Not Faster, Wins the OTC Race

Rob Daly, Sell-Side Technology

As US regulators finally define the parameters of the Dodd-Frank Wall Street Reform and Consumer Protection Act, dealers and other market participants are racing to have their systems ready to trade on the first day of the new regulatory regime. Rob takes a quick look at what still needs to be done.

For the next 18 months, I do not envy a single financial technologist attached to any swaps desk in the US, or the world for that matter.

I have heard on numerous occasions that most IT projects in the investment banking community equate to changing all four tires on a Formula One racecar while it is in motion. If that is the case, preparing for the necessary changes under the Dodd–Frank Act equates to doing a wheels-up restoration on the same moving racecar.

Thanks to the vague language in the Act needed in order to pass it originally, US regulators and the industry have been going back and forth hammering out the specific roles that everyone will play in the new market structure as well as how it will operate.

The original deadline for Dodd–Frank compliance passed like a summer breeze in mid-July and the US Commodity Futures Trading Commission (CFTC) gave everyone in the industry an extension until December 31 to meet the new requirements.

Now that we are officially in the fourth quarter of the year and the negotiations between the interested parties continue, there is no way that the dealers, swap execution facilities (SEFs), central clearing parties (CCPs) and trade reporting organizations will have their systems tested and in production by the end of the year.

Painless and Familiar
Speaking to a few electronic trading platform operators, their goals are to keep swaps trading as painless and as familiar as possible on their venues. Dealers, on the other hand, have a much more difficult set of challenges. According to research done by industry consultancy Rule Financial, Dodd–Frank will affect roughly 85 percent of legacy over-the-counter (OTC) front-, middle- and back-office systems.

Given that magnitude of change, it might be tempting for firms to “rip and replace” their current end-of-day batch-based systems with ones that will be able to meet the real-time or intra-day reporting requirements. But it doesn’t matter whether firms roll out new systems or try to bolt on the necessary technology to existing ones; they need the final details as soon as possible since an overhaul like this may take 18 months or longer to complete.

I’m not sure which is going to be more painful for technologist: preparing their internal systems to handle the new reporting, pricing and trade data storage requirements, or linking, testing and trading on the more than 60 announced venues seeking SEF status as well as the multiple reporting and clearing facilities that plan to serve the new market.

The market will never tolerate such fragmented liquidity for very long. Nevertheless, as firms come out of the starting gates to trade in this new market, they are going to have to spread out their bets to see which venues have enough liquidity to remain viable.

Trading Smartly
Like it or not, dealers are going to have to deploy some sort of smart order-routing capabilities that will need to take into account the various announced SEF models. The majority of SEFs plan to use the familiar request-for-quote (RFQ) model used in the rest of the credit market. However, there are a few upstarts looking to introduce a displayed order book instead.

Also, given the non-fungible nature of these electronically traded instruments, these smart order-routers might need to work similarly with the trading algorithms that operate on the equities options market. Instead of looking for apples-to-apples trades in various pools of liquidity, they would look for trades that will behave similarly to the original instrument. In any case, these routers need to be head and shoulders above the smart order-routers that firms have today.

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