Today’s markets are focused on regulatory change and adapting to the new over-the-counter market and futures framework. Sanela Hodzic, managing director at Calypso Technology, spoke with JLN editor-in-chief Jim Kharouf about how Calypso has transformed itself, how clearinghouses are changing and why FCMs need to look ahead if they are to compete in the new derivatives arena.
Q: We’ve seen a lot of regulation coming down the pike. How is Calypso fitting into the new market structure?
A: We come from an OTC heritage and rode the credit wave in providing technology to firms looking for credit trading and risk management. Then clearing and Dodd-Frank became a reality. We were very fortunate. In the early days around late 2009 and 2010, we had two partners that approached us. That was the CME Group and Eurex. They said “Look, OTC products traded today in your system will become cleared products. We want you to provide technology to us, as a clearing house so we can offer those services to the market.” So over the past two years, we worked with the CME and Eurex to build out and transform our platform from traditional bi-lateral risk trading and processing of derivatives into a clearing platform for OTC swaps. We then expanded that into FX NDFs (non-deliverable forwards) and so on.
Today, we have 17 clearing customers. Of those, seven are CCPs which also include SGX, TSE (Tokyo Stock Exchange) which just went live on interest rate clearing and credit clearing with us, Hong Kong Exchange and BM&F BOVESPA. So we’ve had tremendous penetration into new CCP services. All seven use us in about the same capacity, to provide clearing, processing, valuation and risk management of OTC products.
As we went through that cycle we suddenly got FCMs and banks who asked “Can you help be the system or book of records on the FCM side. So in essence, we created a mirror clearing product for the FCMs and banks in the U.S., that processes these new OTC products. That really comes in three parts. That’s the connectivity, processing of end-of-day files and the third and most important, is being the risk management system for the FCM, and being able to provide the initial margin and variation margin for customers, but also the collateral they use to mitigate that.
If you think about Calypso’s heritage, we’re a cross asset class system. So if you talk about clearing, you have functions there with risk management, collateral and processing. Very few people can wrap that all around into one solution.
What I constantly find, with futures people with FCMs, they work at the higher level where everything is aggregated, everything is omnibus and it’s low complexity and high volume. We come from the derivatives angle where everything is detailed by customer, or below the customer, knowing where every piece of the trade and collateral is, and high complexity with lower volume. The two worlds are colliding in some sense and I think our platform can do a good job catering to that segment of the clearing market.
Q: As you see this convergence, what will it look like operationally for FCMs?
A: You’ve heard it a lot lately about the futurization of swaps. Some say swaps are coming along but they are really just a string of futures. So I’m going leverage that and jam those through. From day one, with vanilla products, that will probably work. But look what’s happening with the rule making, and Rule 1.73, (which will force FCMs and swaps participants to create new risk-based limits on options positions, as well as monitor liquidation costs, options stress tests and other compliance elements) and LSOC (Legally Separated Operationally Comingled). When those regulations came out, you had to be much more stringent and break them down to a detailed customer level, or you had to do a credit check in under 20 seconds, all of sudden FCMs are saying they can’t do it and need more time. That’s a byproduct of this approach, that I’ll do what I’ve always done on the futures side. That’s the real issue. So for day 2 and beyond, you’re really going to have to solve these problems, change the operational model, deploy better systems and ultimately drive a different business model for the FCMs.
Q: So how are FCMs going to make it? They face a low interest rate environment, more regulation and lower volumes with thin commissions.
A: It’s not a question of more capital investment. It’s a question of optimizing the use of your balance sheet. Today, people sacrifice balance sheet to sponsor customers on an intra-day basis without any regard. Why do they do that? It’s an optimization problem. On one hand you have a certain amount of customers who pledge collateral. On the other, you have CCP venues and you’re stuck in between, and charging some fee for that which is a razor thin model. But I believe they really haven’t optimized their own funds.
The first part is understanding how you can do more with what you’ve got. That’s often times is a matter of not having access to information. Secondly, with all these regulations, you’ll be able to do much less, such as with LSOC. Your ability to do stuff with collateral will be significantly reduced. So what do you do? Perhaps fees do go up if this model is to survive. So if you want this, customers will have to pay. But they will just have to pay in a different way. Maybe it’s in more transparent, up-front fees but then behind the scenes where FCMs made money on netting, use of collateral go down. So the up-front fees have to go up.
Q: When you work with FCMs, what do you find? Are they not seeing all the opportunities available with the assets they have in place?
A: In regard to OTC clearing, which requires a lot of balance sheet and margin compared to futures, they are focused on the operational stuff. FCMs want to know, “How do I jam this into my futures system? How do I train my staff? How do I get the legal documents in place and get my first three customers stress tested?” But they are forgetting the big issue. A year from now, if they are successful, they are going to have a liquidity squeeze. They are going to run out of balance sheet. Someone at the very top of the bank is going to shut them down because they are not a very profitable business.
So when I ask them questions such as “What are you going to do about liquidity management?” “What are you going to do about your cash management?” They simply haven’t thought about these topics. That’s really where I think technology can help, further that analysis and do more with what you’ve got. They’re so busy with regulatory stuff right now, they can’t lift their head up to talk about these bigger issues which will define their business as successful or not.
Q: So how do FCMs start addressing that liquidity issue that’s down the road?
A: I hope Calypso can be a pioneer in that area. But the vendor community is equally behind. There isn’t something where you just search the web and go buy yourself software for FCM liquidity management. As an industry, we’re really going to have to think about this and take lessons and solutions out of the banks and treasury settings and apply that to an FCM. We have some ideas and there are lessons we’ve learned from some of the CCPs. Again, it’s a transformation from bi-lateral OTC to cleared processing.
I believe a large percentage of those tools are available at Calypso. It’s a matter of putting them into practice.
Q: So do you think this strategy of switching OTC swaps into futures will work?
A: It remains to be seen. There is a very practical business reason for that. If you do that, futurization of swaps, you lose a lot of natural offsets. People trade futures and swaps in one portfolio for one reason, they are naturally correlated and you get some benefit from that. That’s just the nature of our business. It’s the same with swaps and futures. If you try to make everything look the same, where is your diversification? What’s a hedge? So I really don’t think everything is going to be a futures. It kind of defeats the purpose of the complex instruments in the first place.
That aside. If you talk about simple vanilla swap processing as a futures or swap, the issues surrounding LSOC make that cumbersome and significantly more important in the way you manage collateral. So you still have that squeeze, independent of the product strategy.
Q: What’s on your checklist for 2013?
A: First is what is going to happen in Europe. We have an FCM solution for the U.S., but as EMIR becomes reality and people are looking to buy systems to comply. So we see opportunity internationally. And as we move ahead with the phase one stuff on clearing, more investment in collateral and liquidity. So we’ll provide more analytics to help FCMs there.
Q: In the technology space, it seems the value proposition is best offered by firms that will help customers save money today, not offer the latest bell and whistle. Do you see that?
A: Absolutely. That’s the difference of what you’ve seen in the mid-2000s and today. Then it was, who has the latest and greatest technology to help my business grow? Credit derivatives. If so great. Today, its about cost savings, total cost of producing that, but also about the license to operate. If you do not have the technology to clear, you become a fossil. That’s the issue – a regulatory tailwind and a license to operate. In clearing, those drivers are more important. We hope our platform, being 100 percent Java, will allow our customers to achieve more functionality.