Technology Implications and Costs of Dodd-Frank on Financial Markets. Larry Tabb Founder & CEO TABB Group

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1 Technology Implications and Costs of Dodd-Frank on Financial Markets Larry Tabb Founder & CEO TABB Group CFTC TAC Washington DC March 1, 2011

2 Contents Workflows High Level Existing High Level Proposed SEF s Prime Brokers spending estimates Progress Conclusions 2

3 The existing market is bilateral with dealers in the middle Hard Inventory Corporation (end user) Existing Market Structure Futures Exchange Corporate End User Minerals Accept 1 Inventory Bid Hedge Fund Asset Valuation/ Agriculture Balance Sheet Risk Energy Treasurer Bid Bid 2 3 Asset Manager Inter-dealer broker Currency Corporate End User Asset Manager Corporate end users accumulate risk through their day to day business. This could be inventory, commodities, currencies, credit or interest rate risk. They work with dealers to model the risk and solicit bids from one to multiple dealers to hedge that risk. The corporate treasurer picks a dealer who wins the deal. The dealer typically will try to find and end user or a financial institution that wants the opposite risk and will try to sell it to another counterparty. Sometimes the dealer with use and Interdealer broker to lay off the risk with another dealer

4 Under DF, standardized swaps are matched by SEF, centrally cleared, & centrally reported Corporation (end user) Proposed Market Asset Manager Hedge Fund Hard Inventory SEF Members SEF Members Trades & Margin Insurance Co Minerals Bid Large 1 1 Asset Manager Inventory Asset Valuation/ Agriculture Balance Sheet Risk Energy Treasurer Bid Bid Accept Large 2 Large 3 SEF Trade Info & Market Data Firm 1 Prime Broker 1 Small 1 Hedge Fund Hedge Fund Insurance Co Currency Corporate End User Fund Margin Prop Shop Trade Repository House Trade Info The corporate end-user business is unlikely to change much of the clearing requirements for end-users has been exempt and under FASB133 only exact hedges can get balance sheet relief and it is not expected that a significant amount of customized products will be centrally cleared and SEF-traded. However, it is mandated that all standardized swaps be both centrally cleared and traded on an SEF. We anticipate that much of this business will be done with financial non-dealer financial institutions such as hedge funds, asset managers, insurance cos, and proprietary trading houses

5 SEFs, while not fully defined, will need some very specific technology SEF Members Co location Management External Valuation / Evaluation Providers External Market Data Providers SEF Technology SEF Members s s Firms Prime Brokers Credit Management Market Data Ticker Plant SEF Surveillance Firm Firm Firms Connectivity Messaging & Networking Support Pre-trade risk Matching Engine Prime Prime Broker Prime Broker Brokers Post trade Notice of Execution house Communications House SEF infrastructure is fairly straightforward. The four major technology aspects of a SEF will be managing connectivity and messaging, risk management (however, not as substantial as the clearing house), matching, and market data. SEFs typically do not pay for connectivity, however the larger and more successful, the more challenging is the communications and infrastructure requirements. Increasingly there may also become demand for co-location.

6 house s primary job is to manage default risk but that encompasses a lot Trade Feed External Asset Manager External Valuation / Evaluation Providers External Market Data Providers House Members SEF Bank Liquidation Cash Risk Management Firm Liquidation house Default Fund Management s Firm Firm Firms Connectivity Messaging & Networking Support Cash Positions Cash Management Cash Margin Valuation New Trade Entry Comparisons Netting / Novation Position Management Prime Prime Broker Prime Broker Brokers Trades Reconciliation Margin Cash Settlement Default Fund Mgt. Trade Reconciliation Identifier Management Multiple Trade Repositories While house technology is not as real-time as an SEF, the Central House manages risk. houses typically receive two copies of each trade one from the SEF and the other from the members. They are reconciled, netted/novated, cash is settled and then placed in a position repository where they are valued each day, and the excess/deficit values are exchanged with dealers on a daily basis.

7 Unfortunately for dealers, much of their infrastructure needs to be added as business is expected to shift s will have significant technology investments to make. SEF s don t exist, SEF eligible products don t exist, all trade repositories don t exist, many clearinghouses are just getting started. Also Prime brokerage facilities are not set up, credit lines, as well as ways of modeling the products are not standardized. Firm Technology Credit Risk External Valuation / Evaluation Providers External Market Data Providers Risk Management Clients Asset Manager Hedge Fund Prop Desk Credit Lines Cash Connectivity Messaging & Networking Support Cash Management Position Limits Positions Cash Market Data Outgoing Market Liquidity Risk Valuation Credit Risk Insurance Co Pre-trade Risk Management Identifier Management Comparisons/ Reconciliation Netting / Novation Prop Shop Small SEF Communications Position Management Regulatory Compliance Reporting P & L house Recon Cash Margin Multiple SEFs Multiple Trade Repositories Multiple Regulators Multiple houses Bank

8 Primes will provide leverage and access for hedge funds and prop traders this business is new too Prime Brokers Clients Prime Brokerage Technology Front End Portal Margin Credit Lines Cash Management External Market Data Providers Risk Management Credit Risk External Valuation / Evaluation Providers Market & Liquidity Risk Valuation Prop Shop Connectivity Messaging & Networking Support Position Management Hedge Fund Reporting Pre-trade Risk Management Margin Hedge Fund Administrators Executing SEFs Bank Multiple houses Multiple Trade Repositories Multiple Regulators Prime brokers provide credit and credit intermediation services (transact using the banks credit and not the fund s credit. This allows the fund to buy at better prices. Primes also provide financing (for securities not necessary for derivatives) and manage margin. Because of the lending relationship the Prime needs to keep a close eye on the financial condition and the leverage of the fund.

9 Largest dealers will spend over $1.8b to restructure OTCD business for Dodd-Frank IT Spending Estimates for large dealers (top 15) ( Top Tier (3-4 firms) Mid Tier (4-5 firms) Third Tier (5-6 firms) TOTAL ecommerce $ 158 $ 87 $ 35 $ 281 Low-touch Distribution $ 162 $ 90 $ 36 $ 288 CCP $ 217 $ 120 $ 48 $ 385 Risk $ 347 $ 193 $ 77 $ 617 Collateral $ 129 $ 72 $ 28 $ 230 TOTAL $ 1,015 $ 563 $ 225 $1,804

10 IT spending by US Broker/s took a in credit crisis but back on the positive trend $30 $25 $20 US Broker / s Financial Markets IT Spending (in US$ billions) CAGR -7.9% CAGR 8.2% CAGR -13.5% CAGR 6.4% $15 $10 $5 $

11 Client needs, which are focused on new regulations, drive prioritization of IT initiatives Regulations drive client demand, and responding to client demand provides competitive differentiation; hence the top three drivers behind IT prioritization Client demand is the clear primary driver for major dealers as that is what will bring more order flow. Inter-dealer brokers are more focused on competitive differentiation and regulatory compliance as client demands have changed little postlegislation. Drivers behind prioritization of OTC derivative reform IT initiatives Reducing costs/roi is not the primary driver for any participants in our study. 1 Least Important Most Important- 5

12 and execution have been the primary focus for dealers, inter-dealer brokers and service providers Both top and mid-tier brokers feel confident in their current readiness for central clearing. Readiness with major OTC derivatives reform related initiatives Top tier dealers are generally more prepared for changes in the execution landscape than are mid-tier brokers. Inter-dealer brokers are prepared for changes to the execution landscape and are less focused on clearing. Overall compliance, reporting and reference data changes are further from completion for all as many of the detailed rules are still to be written. 1 - Not Yet Started Completed - 5

13 Credit and Rates are the primary focus of dealers, inter-dealer brokers and service providers The early focus on central clearing of CDS forced it to the to top of the priority list for most market participants. Product priorities for OTC derivatives reform IT initiatives The last few months have seen a shift of focus to interest rate swaps as the asset class will likely see the high percentage of positions move to central clearing. Commodities (including energy swaps), OTC equity derivatives and OTC FX derivatives are taking a back seat for dealers, inter-dealer brokers and (for the most part) with regulators. 1 Lowest Priority Highest Priority - 5

14 Conclusions The dealers are currently scrambling to build out their capabilities TABB estimates that the largest 15 dealers will spend approximately $1.8B to implement the Dodd-Frank rules for derivatives While dealers have invested heavily over the decades, products, clearing, trading, business and distribution models are all changing While regulation is significant, client demand driving development From a business perspective clearing and execution are the key investment areas Firms are focused on heavily on credit and rates than Commodities, Equity, or FX Swaps

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