Faced with the rising tide of data resulting from increased automation, the derivatives industry is hoping technology can also play a part in helping it handle this increased burden. Jason Mitchell reports.

Derivates v data

The derivatives industry is on the cusp of a technological revolution that should drive down costs and make regulatory reporting easier, but could just as easily result in widespread job losses.

Technology has become a great deal more important to the sector since the global financial crisis. The regulatory burden has soared, leaving firms to try to reduce costs through the increased use of automation and technology. In the US, the Dodd-Frank Act took effect in 2010; in Europe, the European Market Infrastructure Regulation was enacted in 2013 and the Markets in Financial Instruments Directive (MiFID) was implemented in November 2007, followed by MiFID II in January 2018.

Drowning in data

Trading standardised derivative transactions on specified venues and clearing them through a central counterparty has become commonplace. Transparency and risk mitigation are now vital.

Many tasks that were carried out by people have already become automated and the volume of trades has shot up, creating oceans of data that firms must somehow process. One of the key challenges for the industry is to sift through reams of data and to unlock what is useful.

For example, one-quarter of Goldman Sachs employees worldwide are now computer engineers. In 2017, the firm appointed its first chief data officer, who reports directly to the board. Most firms have taken similar measures.

However, this is likely to be only the beginning of the digital transformation, as the industry now faces a plethora of new technologies that will eventually revolutionise it. They could also lead to many more job losses unless staff are reskilled.

Interaction is key

“The derivatives industry receives a tsunami of data every day,” says Alexandra Foster, vice-president for insurance, wealth management and financial services at UK communications company BT. “How that data is analysed is becoming a key differentiator. We are seeing new technologies emerge around big data, analytics and the cloud. The interaction of these new technologies will affect the industry for many years to come.

“Blockchain, in particular, should create significant efficiencies in internal trade execution, the processing of trades, portfolio reconciliation, and in the middle and back offices. However, for distributed ledgers to work properly there must be a great deal of industry collaboration.”

Many tasks at a large number of firms are still completed manually, and the fax machine is still used widely. Integration after a merger or acquisiton is often lacking and many companies are using a mishmash of technological systems, including some that date back 40 years. Furthermore, systems are changing very rapidly: what is state-of-the-art now can become legacy within a few years.

Industry players are struggling with ever more complex workflows, supported by sprawling systems that require constant maintenance to ensure interoperability. This creates a huge challenge for internal operational efficiency and a massive obstacle to economies of scale.

However, in the next five years this is likely to change. Firms are embracing smart contracts and automation; artificial intelligence and machine learning are being adopted throughout the sector. Blockchain has the potential to transform data integrity while slashing reconciliation and reporting costs. What is more, the cloud could be used much more extensively, so that firms do not have to maintain their own vast stores of data.

The CDM standards

The International Swaps and Derivatives Association (Isda) is working on one of the most important technological innovations in the industry at the moment: the common domain model (CDM), an industry standard blueprint for trading and managing derivatives throughout their lifecycle. It provides a common foundation for new technologies such as distributed ledger, the cloud and smart contracts. It should lead to much greater data consistency across the industry and create a technological infrastructure that allows for much wider interoperability between systems.

The CDM has been developed under the guidance of a working group that involves a large number of market participants and technology providers, including blockchain platforms. Access to this model is currently restricted to Isda members – who make up the bulk of the industry – but in the long term, in order for it to work, the infrastructure must be opened up to all firms.

Collaboration is essential for its success, and the industry is already seeing that. On September 21 and 22, 2018, Barclays sponsored a hackathon, called DerivHack, in London and New York to develop the CDM for post-trade derivatives processing. About 80 participants were divided into 20 teams in London and 55 participants split into 15 teams in New York. They had two days to develop ‘use cases’ built on distributed ledger technologies (DLTs) from platforms such as Ethereum and R3 Corda. The latter is an open-source blockchain platform for business and was the most used by participants in the hackathon.

Transforming relationships 

The event’s organisers said the hackathon reinforced the idea that CDM-based interoperable solutions using DLTs could enhance regulatory reporting. If this type of technology becomes widespread in the industry, it could transform the relationship between firms and regulators. Some presentations by DerivHack teams envisaged embedding regulations into their solutions, for example.

“You could get a situation where, once the rules are embedded in the system, contravening those rules becomes quite difficult,” says Jeremy Wilson, vice-chairman of corporate banking at Barclays. “The system would automatically pick up a contravention and either refuse to execute a transaction or send a red flag to some or all parties, thus building automatic, pre-execution regulation into the system and making it safer.”

Ayaz Haji, global head of reference data engineering at Goldman Sachs, says: “During the past decade or so, the industry has become much more regulated and this has made firms change their business models. Previously, their commercial models were much more based around market-making through taking medium- to long-term risk; today the models are much more centred around volumes. Firms are conducting a great many more trades than 10 years ago. Increased electronification has made this possible.

“MiFID II resulted in firms having to collect so much more data pre-trade. That could only be done electronically; it could not be carried out manually. Firms now have a much greater appreciation of data as a primary asset.

“The CDM’s full potential is not yet clear to us. It is a bit like when Steve Jobs designed the first app store. He had no idea how it would fully evolve as an ecosystem and that we would have all the apps that we see today.”

Fragmentation issues

As the derivatives market developed, each firm established its own systems and its own unique set of data representations for events and processes that take place during the life of a typical derivatives trade. This not only means counterparties have to continually reconcile their trades to make sure they have the same information – a big drain on resources – it also limits the potential for greater automation.

Technology across the industry is highly fragmented. For example, the same transaction is nearly always represented differently across firms, and often differently within the same organisation’s multiple systems.

Four main data representation standards for the financial services industry have emerged: Financial Products Markup Language (FpML), a business information exchange standard based on extensible mark-up language; the Financial Information eXchange, an electronic communications protocol initiated in 1992 for international real-time exchange of information in the securities markets; ISO 20022, an ISO standard for electronic data interchange between financial institutions; and Efet, a standard used in the commodity space and developed by the European Federation of Energy Traders.

Regulatory reporting for the derivatives industry around the world is characterised by a lack of consistency. There are 19 regimes globally today but only two – Singapore and Australia – actually share reporting systems.

In the US, the Commodity Futures Trading Commission uses an FpML system, while the European Securities and Markets Authority wants data reported according to ISO 20022.

Standards mismatch

REGnosys, a London-based fintech, has been selected by Isda to develop a digital version of the CDM, based on its digital repository for the derivatives marketplace called Rosetta.

“Having to submit different data presentations to different regulators is a very costly process for the industry,” says REGnosys co-founder and chief operating officer Pierre Lamy. “Firms map multiple data representations to their own proprietary systems and then they have to map it on to different standards for different regulators.

“Furthermore, this mapping is currently buried into myriad systems and is not directly accessible to end-users and auditors, which leads to large operational costs and compliance risks. By positioning the mapping among data standards in a shared digital repository and making it available as machine-executable code to all market participants and regulators, Rosetta proposes a new paradigm for the financial industry.”

Rosetta – which has been open source from the start – provides a data engineering representation of the derivatives world including events, processing and rules. It is an automatic generation of programmatic code that uses natural language-like interfaces.

Industry experts say the current situation resembles a box of Lego but without the instructions. Industry participants know what they are supposed to build, they have all the pieces, but it is unlikely everyone will put them together in exactly the same way. The results may be superficially similar, but they probably will not be identical.

By contrast, if everyone follows the same set of instructions – as they would under the CDM – they would arrive at exactly the same outcome every time. It does not matter whether those instructions are published in English, French or German, the result will be the same provided the blueprint is followed.

“There must be a way of bridging the business world and the technological one,” says Clive Ansell, Isda’s head of market infrastructure and technology. “Many fintech start-ups come up with great products but they struggle with adoption. The Isda CDM will help them understand how the market operates and provide a ‘bedrock of standards’ upon which their products and new technologies can be rolled out.”

Cutting costs

Depository Trust and Clearing Corporation (DTCC), a US post-trade financial services company, has been developing another important initiative, called the Trade Information Warehouse (TIW), based on DLT technology. It is a centralised and secure global infrastructure for processing over-the-counter derivatives over their lifecycle. It is able to automate lifecycle processing for payment calculations, successor events such as reorganisations or renames of corporate entities, and credit events such as bankruptcies, restructurings and insolvencies.

“During the past few years, firms have had to place greater emphasis on reducing costs. Many more trades are being cleared and we are seeing far fewer bespoke transactions. Revenues and margins are down. There has been a lot of emphasis on the back office and reducing costs,” says Val Wotton, DTCC managing director of product development and strategy, derivatives and collateral management.

“But how is it possible to cut costs even further? The main way of doing this is by automating back-office processes and reducing manual intervention. This can be achieved through standardised product representations and processes, and TIW provides that. It will lead to a cleaner, neater infrastructure.”

Industry experts believe there is much more scope for the cloud to be used in the future. UK fintech CloudMargin is developing a cloud-based platform for collateral management in the derivatives industry.

“We provide a solution entirely based on the cloud,” says CloudMargin CEO Steve Husk. “Nowadays, the cloud is seen as a very secure platform. In the collateral management space, many firms still use e-mail and the fax. These are very hackable and far less secure than the cloud. One of the most costly aspects of the industry at the moment is all the multitude of interfaces that exists. The cloud can really reduce costs. 

“Every firm receives huge amounts of data every day. There are just not enough eyeballs to look at it, creating a big opportunity for automation.”

Skills pay the bills 

Innovation has been spurred on by the growing regulatory burden and the industry’s need to bring costs down. However, in many cases, automation is replacing employees. Firms face the prospect of having to decide whether they will function with a lower headcount in the future or whether staff will have to be regularly reskilled or retrained.

“The world is becoming more technical and one of the key questions is: how do we enable reskilling to take place?” asks Goldman Sachs’ Mr Haji. “People need to have the mindset that they will have a certain skill for five years but will then need to be reskilled. It is very important that firms are open-minded and have that mindset, as well. Bankers are now being trained in coding, for example.”

The derivatives industry has the opportunity to become far more efficient through the use of new technologies. This will make regulatory reporting a lot easier and help to keep costs down. However, in the process, the back office is likely to change out of recognition, potentially jeopardising jobs. 


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