Increased uncertainty across global financial markets has tested the capacity of financial institutions to optimise their use of capital. The growing risk also creates a need for larger capital buffers, potentially paralysing capital that could be used to support revenue generation.

At the same time, over the longer-term, regulatory and cost pressures are accumulating which ties up resources, and in turn, limits business growth. Not only does this created a combined pressure on firms but also reduces the internal liquidity of their capital.

In this environment, more effective capital management becomes a competitive advantage for broker-dealers. The capacity to reduce costs in post-trade could be the gamechanger for companies to navigate the current market complexity. At a roundtable recently held by Markets Media and BNP Paribas’ Securities Services business, colleagues from a range of market operators, broker dealers and market participants discussed how they are being affected by market volatility, its effect on capital management, and their models for working around these constraints.

Market perspectives from NZX and HKEX

The discussion opened with representatives from New Zealand Exchange (NZX) and Hong Kong Exchanges & Clearing (HKEX) groups outlining their respective markets and the pressures their members were facing. Larger global brokers in these markets are often well-capitalised based upon their multi-jurisdictional capital rules. However, there are also plenty of local and regional members whose capital requirements are lighter and potentially face a more challenging capital environment if risks increase. As a consequence, these firms appreciate their partners in market infrastructure who can better support them through efficient capital management, notably through post-trade services.

Capital and risk controls in trading and clearing

In both market-maker and clearing businesses, it was noted that firms were increasingly consolidating as a result of commercial pressures and heightened sensitivity to use of capital.

Sell-side firms reported that cost has been a major concern across the board, and analysis within operations teams has led to a revision of the type and number of systems that were being used, as well as capital arrangements.

The role of post-trade costs in strategic decision-making

Kathy Ong, director of product management Asia Pacific, Securities Services at BNP Paribas, said, “If you look at different types of costs, firms historically focussed on trading cost. But when you build in post-trade costs such as clearing, market fees, and regulatory capital (which is significant in Hong Kong), net costs per trade will rise dramatically.”. Companies are taking more notice of those when assessing strategy and feasibility. In Hong Kong SAR, we have the added challenge of T+0 in Stock Connect. When you map out regulatory and operational risks on smaller scale operations, how do they grow their margins? Unless they can achieve a particular size, it becomes a challenge.”

The asset class in question carries specific risks. It was noted that fixed income markets, being over-the-counter (OTC) face greater risks. Failed trades are more common in the fixed income space, with some clients being very sensitive to this, such as foreign clients or central banks.

“They don’t want their trades to fail, but if they are buying and an intermediary is selling to them, while buying from another counterparty simultaneously, and that counterparty doesn’t deliver, how can the intermediary deliver it to the other?” one attendee said. “Exchange fails are less common as trading is centrally managed.”

Regional trading holidays pose another issue for gaps appearing between trading and post-trade activity, creating challenges where investors would trade instruments in another market, but regional trading holidays force intermediaries to process extended period from trade to settlement, which have accounting implications, and the risk of extending credit for an elongated period of time to a client.

“They may not necessarily like that either, so there’s an internal review process around that and cost is very important because for that extended period, you may have to do a repo to fund the inventory, because the other side of the trade may have a normal settlement period. There are implications.”

If the intermediary did not anticipate this when initiating the trade, the question arises as to how they build this cost/risk dynamic back into the trade. Consequently, there is a convergence of awareness of front, middle and back office mindfulness to incorporate these costs as part of the trading world.

Overlap with operational resiliency and mitigating volatility

For the major banks in attendance, managing growth locally and internationally was a key consideration for C-suite decision makers. That made awareness of operational constraints a priority, due to the impact under both calm and testing market conditions.

One firm also noted that when scaling up, its reliance on manual processing was a massive barrier to rapid growth. For example, the recent volatile market conditions have created operational pressure and capital constraints for the firm.

In addition to OTC markets, equity markets are also seeing increased automation following their electronification. This boost to automated e-trading has resulted in very low margin and high-volume business units that must operate with maximum efficiency, focusing on streamlining operations and reducing costs.

While regulation creates the framework for capital rules, some participants suggested that the current framework created challenges for market participants, as well as potentially increasing systemic stability.

“The Global Financial Crisis really drove two big market initiatives from a regulatory standpoint” noted one participant. “Firstly, capital and operational risk or counterparty credit risk measures were applied. Then bankruptcy procedures were set up. While the former evolved through mutually recognised global regulators, the latter regimes did not. From Hong Kong we see a lot of market participants trying to deal with that asymmetric model. Defaulting on one central counterparty (CCP) has an established procedure, but then how do you deal with the liquidation of those, and porting? In addition to that, how do they deal with different bankruptcy procedures in different jurisdictions?”

This is also a challenge in European and US markets. However, this issue is in a much greater magnitude in Asia due to jurisdictional fragmentation.

“Trading and clearing can go global, but settlement is a whole different conversation, and there’s a lot of repeated exercise in terms of processes and operation,” said another participant. “Capital has to be double-funded in many cases. So, this raises capital cost.”

Consolidation is taking place in the clearing space as there are fewer firms who are capable of clearing trades and standing behind a guarantee from an intermediary perspective.

“We do have to take into consideration what that means if a default situation happens in another jurisdiction as it relates to the Hong Kong entities,” noted one attendee.  “Regulation in Asia is becoming a lot more conservative. Regulators are taking a more rigorous approach, including anti-money laundering and sanction practices. These add costs and this is aggregating in the region.”

Supporting the sell side

HKEX has seen 800 cash market members ten years ago reduce to just above 600 today, while its derivatives business has fallen from nearly 200 clearing members to 153.

“Hong Kong’s cash market ADT exceeded HK$240bn (US$31bn) in the first half of the year, up over 118% year-on-year, and investor interest is still growing,” said Tae Yoo, managing director of global client development for HKEX. “However, the market needs to deal with the risks associated with a more concentrated broker community operating in different jurisdictions in Asia that also have different risk profiles, bankruptcy procedures and counterparty clearing risk management procedures. That’s why we are seeing brokers trying to enhance their settlement and post-trade operation to manage these risks.”

For a smaller market like New Zealand, it is crucial to right size the size and scale of its market, while not overlaying excessive additional regulatory and cost given its size.

“We must make it easy to trade and clear, we can’t have barriers to access,” says NZX’s head of secondary markets development, Brandon Tai. “Then looking at post trade in New Zealand, the market has two CSDs which creates operational inefficiencies, but there was no discussion at an industry level at the time about that development.

“Now, 15 years later, we’re operating in an environment where on-market execution trading is happening through the exchange and the CCP, with institutional flow also going across the other CSD,” he continued. “BNP Paribas’ Securities Services business is bridging the gap, though membership of both CSDs but we think there needs to be a conversation because all of those transactions just layer on cost inefficiencies. We are agnostic as to what change looks like.”

Some larger brokers have been able to build platforms themselves to tackle risk management and efficient capital optimisation internally, which has supported their business in periods of raised volatility. However, brokers who have not invested in this way can find these periods more difficult.

Partnering for success

“In terms of capital efficiency, I would say our business is very efficient in running our balance sheet in a very inefficient manner,” said one participant. “We obviously want to be efficient and squeeze the most out of it. In times of volatility that becomes hard because the way that we do it is still very manual. Our team’s challenge is trying to make that process more efficient. You’ve got so many systems and processes and people that you need to get involved when you’re trying to be capital efficient, so that’s our biggest challenge.”

Another noted that from a volume perspective, volatility was great, but it creates its own challenges operationally.

“Specifically, to do with capital, we’ve been engaged in coming up with ways of how we can reduce costs,” said another participant. “Looking at our target operating model and then removing some of those cost pressures related to the services that we avail externally, BNP Paribas’ Securities Services business has been helping us with one of those big projects. We are looking at the target operating model and seeing what we can move to a bigger balance sheet within the wider group, so that we reduce some of those regulatory capital impact we have here.”

Third-party clearing was cited as a clear winner for better efficiency, for all of the dealers in discussion.

A major broker dealer observed, “The easiest way to be more capital efficient, and at least the reduce the capital once, is to utilise a bank entity to become a clearer. That’s where the Securities Services at BNP Paribas service came into play and not just in Hong Kong, that can be applied to any markets. TPC is quite an easy choice for me.”