Regulations that require financial institutions to clear standardised over-the-counter (OTC) derivatives through central counterparties (CCPs) are beginning to weigh on bank P&Ls. In particular, clearing through CCPs has caused a sharp increase in the operational costs of banks derivatives businesses.
With overall Fixed Income, Currency and Commodities (FICC) revenues down 20 per cent last year and average revenue from interest rate trading within FICC down 40 per cent, banks are not in a position to make incremental changes to their cost structures. Wholesale changes to their business models are needed. One place to make a material impact on these costs is in the calculation of standardised metrics like CCP initial margin (IM).
Bankers see the FICC revenue decline as a secular phenomenon, driven in large part by the cost of complying with Basel III, Dodd-Frank, EMIR and other regulations. These establish tighter regulatory capital requirements, impose leverage and liquidity requirements and force banks to de-leverage and shut RWA-heavy businesses, all of which can reduce FICC revenues. Combined with the negative impact on market trading activity overall caused by regulatory uncertainty and market structure changes, this reduction can be pretty dramatic. To put this in perspective, Goldman generated almost as much core FICC revenue in Q1 of 2009 as it did in all of 2013.
When FICC revenues were on the rise ten years ago, cutting operational costs was not a priority. FICC business heads hired scores of quants to build and maintain proprietary pricing and risk management systems. Those quants and a lot of the systems they built now seem expensive, bloated and unnecessary, especially since standardised solutions with lower initial price points and much lower total cost of ownership are now available. Standardised systems that were not available even a year ago can now calculate CCP IM with much greater precision and speed than most proprietary solutions at a fraction of the cost. And unlike the case with proprietary pricing models for structured products, for which there is real edge in calculating a price more accurately, there is no business reason to calculate IM differently than the CCP.
As it currently stands, banks and CCPs can often end up with very different numbers and banks routinely overfund 15-20 per cent more collateral than their own margin systems say they need intraday, largely in case a CCP makes a bigger-than-expected margin call at the end of the day. Setting aside that buffer ties up capital that cannot be deployed in revenue-generating activities and it ultimately reduces the profitability of these businesses.
And speaking of profitability, only by understanding the true costs of the business down to every trade, in real-time, can a derivatives business today be optimised. Accurate, real-time and granular information about costs is fundamental to decisions about portfolio optimisation, compression and risk management; all functions necessary for balance sheet de-leveraging, RWA reduction and ultimately profitability. Decisions over what positions to novate, tear up or hedge cannot be made with certainty without accounting for their true costs across myriad market structures and regulatory dimensions.
With many new financial regulations progressing towards full implementation, derivatives business managers must find ways to counter all the additional costs these regulations impose on increasingly smaller revenue lines. The first step to doing so is to understand fully what uses of capital produce real proprietary value for the business and what does not. An accurate assessment of this will invariably lead to the conclusion that deploying capital to activities like replicating standardised numbers is a wasteful and inefficient activity that should be replaced with off-the-shelf, modern, industry-standard technology. All the subsequently freed up capital across overfunding buffers, legacy systems maintenance and actual development resources should be redeployed to revenue-generating activities so that FICC businesses can ultimately become growth businesses again.
Only by understanding the true costs of the business down to every trade, in real-time, can a derivatives business today be optimised.