Dodd-Frank, EMIR To Spur Infrastructure Build-out |
Date: Friday, November 18, 2011
Author: Brian Bollen
The move to electronic trading and central clearing from Dodd-Frank and EMIR will catalyse efforts to build out scalable, utility-like pricing infrastructures, says Boston-based research and consulting firm Celent. Applications spending for front office pricing and middle/back office valuations is expected to reach $634m in 2014, growing at a CAGR of 7.2%, according to a new report, Dodd-Frank and EMIR Derivatives Reforms: Impact on Derivatives Pricing, Valuation, and Technology Expenditures.
Key findings of the report include:
Over the years, derivatives pricing and valuation practices have been shaped by both industry initiatives and regulations around capital adequacy, risk management, and accounting standardization, as well as OTC derivative trade processing and risk control objectives. With the implementation of Dodd-Frank and EMIR on the horizon, these trends are not expected to slow down. Contingent on which regulatory scenarios play out to shape business and competition dynamics, new market structures are likely to change how price discovery or price formation mechanisms are delivered in the coming years.
As derivatives reforms begin to exert themselves, there are multiple scenarios and unknowns for future market structures that have the potential to profoundly change the economics of the OTC derivatives market and its players. Business model convergence and regulatory change are blurring the traditional distinctions between infrastructure players, namely, traditional exchanges, interdealer brokers' electronic trading offerings, and emerging swap execution facilities/organised trading facilities, central counterparties, and trade repositories. Celent believes two scenarios are likely to transpire in the medium term.
1) The most likely scenario is where centrally cleared standardised trades originate from existing execution mechanisms evolving to become SEFs. This could result in a two-tier market with wholesale/dealer-to-dealer facilities, which is distinct from dealer-to-client SEFs. Existing dealer-to-dealer and dealer-to-client execution mechanism scan evolve to become SEFs. This will be the more likely scenario based on present circumstances, regulatory efforts, and existing market participant support.
2) The other scenario is also fairly likely, given present circumstances and regulatory efforts. A strong push by regulators for electronic trading in an exchange-like environment along with broad exemptions will create a bifurcated structure between OTC-cleared and exempted-OTC trades. At present this scenario lacks the industry support of the previous scenario.
In the front office, there are significant regulatory pressures to demonstrate transparent and consistent pricing. Beyond that, a greater degree of scrutiny on pricing practices by other groups outside the front office(e.g., product control, risk, audit) drives requirements for customized user interfaces for each user group but yet still maintain a high degree of standardisation of pricing practices and analytic toolsets. Here, Celent expects front office pricing applications spending for broker dealers, asset managers, hedge funds, and insurance firms will reach $250m in 2014, growing at a CAGR of 7.9%.
For dealers' middle/back office and buy side portfolio revaluation functions, independent pricing and valuation mechanisms are required beyond a sole reliance on front office, broker/counterparty prices, or even CCP valuations. Celent expects that most firms will adopt a multifaceted approach through additional proprietary/internal or third party valuations. Here, for the middle and back office, Celent expects valuation spending will grow at a 6.2% CAGR to $383m in 2014.
As investments are instituted to improve efficacy of pricing and valuation activities "front to back" in order to address regulatory concerns and rebuild investor confidence, the big picture is this: The next generation of pricing and valuation capabilities is becoming a critical investment to form fundamental building blocks in delivering to adjacent risk, capital, liquidity management, and accounting initiatives, as well as essential to the current derivative market structure reforms around Dodd-Frank and EMIR.