Six things we learned from Boca-V

FIA's annual spring conference provides a unique opportunity to hear industry leaders talk about the main trends affecting the derivatives industry. This year's conference brought together more than 40 speakers including exchange leaders, government officials and industry executives for three days of discussions on a wide range of topics.

Here are six takeaways from the conference:

1)  Brexit poised to disrupt the clearing landscape in Europe

The derivatives industry has known for a while that the European authorities are keen to see derivatives clearing move out of London. But if there was any doubt about their determination, Mairead McGuiness put that to rest. McGuinness, an Irish politician who served in the European Parliament for 16 years, was appointed European commissioner for financial services in October. In her keynote speech on the first day of Boca-V, she described the EU's reliance on UK clearinghouses as "unsustainable" and said that "rebalancing the exposure is a matter of financial stability for the EU."

She framed the issue of derivatives clearing as an inevitable outcome from Brexit. "The EU needs to reinforce its capacity to deal with new risks and responsibilities that follow from the UK’s exit from the EU," she explained. "Our objective is not to move or steal business away from London but rather to build our own infrastructures."

For the near term, derivatives clearing can continue in London under the terms of a temporary equivalence determination. That will expire in June 2022, however, and McGuinness emphasized that this time period should be used by the industry to begin migrating clearing to the EU. Ideally that will happen voluntarily, she said, but she also noted that European regulators are "re-assessing" the systemic importance of UK CCPs and could recommend that they should relocate to the EU.

"This time-limited decision is not a free pass or a waiting area for EU market participants," she warned. "Rather, it should be used by market participants to reduce their excessive derivative exposures to UK-based CCPs, and by EU CCPs to build up their clearing capability."

The comments from McGuinness highlight the profound changes in the European financial services sector triggered by the UK's departure from the EU. In January, after Brexit formally took effect, many European market participants stopped using trading venues in the UK for euro-denominated swaps and switched instead to swap execution facilities in the US, which benefitted by having recognition from both EU and UK authorities. Likewise, a large volume of share trading migrated out of London to Amsterdam, the new home for many trading venues previously based in the UK.

The focus now shifts to clearing. Initially it was thought that OTC swaps were the primary concern for the EU authorities, but McGuinness cast a broader net. She spoke of "two clearinghouses" in the UK, an apparent reference not only to LCH Ltd, which has the lion's share of the interest rate swap clearing business, but also ICE Clear Europe, which clears interest rate derivatives, equity derivatives, credit default swaps and commodity futures and options.

The implication is that over the next 12 to 15 months, some portion of the clearing business now located in London should migrate to clearinghouses such as Eurex in Frankfurt and LCH SA in Paris. That is likely to lead to a more complex and more fragmented clearing landscape, with some customers continuing to rely on UK clearinghouses and others on EU clearinghouses. But it also will lead to more competition among clearinghouses, not only within the region but possibly also from the US, where CME Group is poised to pick up a share of the business.

Even Amsterdam may have a role in this battle. Last year, Cboe Global Markets, the US exchange group, bought EuroCCP, a Dutch clearinghouse with a large footprint in the cash equities markets, and said it plans to use the clearinghouse as the springboard for entering the European equity derivatives markets later this year. "We are committed to Amsterdam," Ed Tilly, Cboe's chairman and chief executive officer, said during Boca-V.

2)  Exchange leaders worry about political risk in relations with China

Europe is not the only region where political risk is creating uncertainties for exchange leaders. The rapid growth of futures markets in China has sparked tremendous interest from the global derivatives industry, but tensions between the governments of the US and China are casting a shadow over the prospects for new business opportunities.

The escalation of tensions between the US and China has been particularly harmful to the Intercontinental Exchange, which has struggled to comply with recently imposed sanctions on certain Chinese companies listed on its subsidiary the New York Stock Exchange. Those sanctions were aimed at curtailing investment in companies associated with the Chinese military, but crucial details on the scope and the timing were missing when the sanctions were rolled out late last year.

Jeff Sprecher, ICE's chairman and chief executive officer, lamented the lack of clarity in US policy toward China, and said the uncertainty is creating obstacles for cross-border capital flows.

"Our relationship with China is so fluid," he said during Boca-V. "Are we going to work together and be frenemies, or are we going to ignore each other and have a bit of a cold war?"

Terry Duffy, the chairman and chief executive officer of CME Group, also raised concerns about political risk in this area, although he focused on the other side of the relationship. He acknowledged that China has opened its financial services sector to the outside world, but he expressed doubt about the permanence of this policy. "We've been hearing about China opening for a long time," Duffy said. But what if they open, and then close, he warned. "You've got to be very cautious about going into China."

3) The rise of retail is spilling over into derivatives

When the first wave of the pandemic hit last spring, institutional investors pulled back on their use of futures and options, but retail investors filled the gap -- and more. The biggest beneficiaries have been exchanges such as ICE, Nasdaq and Cboe that have a piece of the US equity options markets, with trading volume breaking records multiple times during the second half of the year. There has been some spillover into futures markets as well, with retail traders flooding into smaller-sized versions of equity index futures such as the micro contracts listed on CME Group.

During Boca-V, exchange leaders welcomed this trend as positive for markets, and several said they plan to roll out more smaller-sized products for this segment of their customer base. But the exchange leaders acknowledged that there are some less positive aspects of this trend. Several expressed concern about the use of social media to coordinate trading strategies, as seen with the so-called "meme" stocks such as Gamestop. Several called for more education so that retail traders making the jump from equities understand the complexities of futures and options, and for more transparency into the rules around short-selling and payment for order flow.

"We welcome investors to interact with our markets," said Adena Friedman, president and chief executive officer of Nasdaq. "We just need to make sure we create the right environment for them to do it safely."

4) ESG is the next "mega trend" for the institutional side of the business

Day three of Boca-V was dedicated to sustainability, and the discussions confirmed that the growing popularity of the ESG investment theme is one of the biggest long-term trends on the institutional side of the derivatives industry. Meaghan Muldoon, global head of ESG integration at Blackrock, commented that almost 70% of the inflows into the firm's actively managed investments came from sustainable products. Audrey Choi, the chief sustainability officer at Morgan Stanley, added that interest in ESG among the firm's clients has risen to the point where more than a third of client investments have a sustainable mandate. 

The discussions also provided an update on efforts to create voluntary markets for carbon emissions. Chris Leeds, executive director for commodity origination at Standard Chartered, spoke about the work of a high-profile task force led by Mark Carney, former chief executive of the Bank of England, that aims to increase the size of voluntary carbon markets by several orders of magnitude. The task force is now in the process of developing benchmarks for this market, with the expectation that this will pave the way for standardized contracts traded on exchanges.

Exchange leaders welcomed the ESG trend and gave numerous examples to show how it is affecting their business strategies. Michael Peters, chief executive officer of Eurex, focused on his exchange's success in listing futures on ESG versions of equity index futures and suggested that Eurex is aiming to introduce similar contracts for fixed income investors. ICE's Sprecher highlighted his firm's leadership in the trading of emission allowances and added that ICE recently began offering data to help municipal bond investors assess the climate risk in their investments. David Schwimmer, the chief executive officer of the London Stock Exchange Group, talked about his exchange's role in developing disclosure standards for listed companies as well as supporting ESG investment with data from its recent acquisition Refinitiv.

5) The tide is turning on digital assets

It is no secret that the derivatives industry is split on how to deal with the rise of bitcoin and other digital assets. Proprietary trading firms, exchanges and technology vendors are rushing into this new asset class, while the response from banks and asset managers ranged from skepticism to outright opposition.

The tide is turning, however. During day two of Boca-V, Chris Giancarlo, the former chairman of the Commodity Futures Trading Commission, led a discussion on the institutionalization of cryptocurrencies that highlighted efforts to provide custodial and prime brokerage services for institutional investors. As Tom Jessop, a former Goldman Sachs managing director who now heads Fidelity's digital assets division, commented during the discussion, these services are essential building blocks for the ecosystem needed as this asset class matures.

"We're still early in broadscale institutional adoption," Jessop said. "We're moving out of the realm of early adopters and moving into traditional institutions that are trying to bring these asset classes into an established investment framework."

Colleen Sullivan, co-founder and chief executive officer of CMT Digital, a Chicago-based trading firm that got into bitcoin more than seven years ago, explained that firms like hers have more freedom to explore new areas because they are not managing client money and are not bound by the same regulatory restrictions as a fund manager. But she urged regulators to provide more clarity in this area so that regulated entities can participate more easily. Sullivan also offered several insights on the rapid growth of decentralized finance, also known as "defi", and commented that decentralized trading venues such as Uniswap are growing much more rapidly than more conventional cryptocurrency exchanges such as Coinbase.

Even more telling was the one-on-one interview conducted by Don Wilson, the founder and chief executive of DRW Holdings, one of the largest trading firms in the industry, and Michael Saylor, the chief executive of MicroStrategy, a publicly traded software company. MicroStrategy began moving its treasury reserves into bitcoin last year, and its bitcoin holdings are currently valued at $5 billion.

In his conversation with Wilson, Saylor explained why he believes that bitcoin makes sense for corporate treasurers. On the one hand, the monetary response to the pandemic and the prospects for inflation have weakened the value of traditional assets such as cash and short-dated Treasury debt. On the other hand, he sees bitcoin as a monetary and inflation hedge because of its characteristics as a stake in a "trillion-dollar digital monetary network" that will grow rapidly over time.  

When asked if he would consider selling some of MicroStrategy's holdings of bitcoin if the price doubled, he made it clear that he has no intention of selling any time soon. "No, I'm not going to flip back," Saylor said, adding that he expects capital to flow into bitcoin for decades to come. "I think bitcoin is going to remain the stronger asset because of its deflationary nature and technical characteristics," he said.

6) Fintech is entering a golden age

In the derivatives industry, as in other areas of the economy, the impact of the pandemic on the work environment has dramatically accelerated the adoption of new technologies. During Boca-V, several speakers pointed to specific examples of this trend.

Nasdaq's Friedman commented that cloud computing is "going mainstream" and spoke about emerging applications of artificial intelligence in market surveillance and financial crime detection. Brenda Hoffman, who runs the technology infrastructure supporting Nasdaq's markets, spoke about greater willingness to experiment with new technologies. Donna Rudnicki, head of data strategy for the capital markets business of the Royal Bank of Canada, talked about harnessing the data flowing through the bank and using artificial intelligence to create customized services for customers.

Tracy Jordal, head of EMEA operations and trade support at Pimco, talked about the benefits of using Slack, the business communication platform, to collaborate in the work-from-home environment. Mark Beeston, managing partner at Illuminate Financial, a venture capital firm specializing in capital market fintech, talked about how the pandemic has added fresh impetus to digitization trends in the banking industry and said the search for new solutions for the remote work environment is creating "an incredibly rich area" for entrepreneurial startups.

In some areas of financial services, advances in technology are pitting traditional financial institutions against "big tech" companies such as Amazon, Google, Facebook and Apple. In the capital markets space, however, the model seems to be more about collaboration than disruption.

Derek White, a former banking executive who recently joined Google Cloud, gave some insights into that model during a keynote conversation on day two of Boca-V. White described cloud computing as a "platform for innovation" and outlined several use cases relevant to the derivatives industry including trade surveillance, regulatory reporting, liquidity reporting, and the reduction of settlement failures. He also spoke about how cloud is driving a change in culture; by creating more "connectivity" within firms and across the capital markets ecosystems, he said cloud is breaking down barriers to collaboration and paving the way for more innovation.

"Cloud is bringing together business and technology teams more than anything I've ever seen in my career," White said. "Executives are sitting together and co-developing and co-innovating, both within an organization as well as bringing in partners."

FIA itself is set to play a role in this trend. During his opening remarks on day one of Boca-V, FIA President and CEO Walt Lukken announced an initiative to improve the industry's operational efficiency. The initiative was sparked by the massive increase in trading volume triggered by the pandemic, which highlighted several long-standing problems in how trades are processed.

"Modernizing our post-trade settlement process will be a prime focus of FIA in 2021 and beyond," Lukken said. "We must, as a community, bring our industry stakeholders together to find ways to simplify and standardize the lifecycle of a cleared trade."