Derivatives boom ramps up operational pressure

Trading volumes in global exchange-traded derivatives hit 61 billion contracts in the first nine months of 2022, putting the market on track to hit a record for the fourth year in a row, according to the Futures Industry Association (FIA). Recent months have been characterised by booming markets in Asia (in particular at the NSE), an equity derivative trading boom, and waves of retail investors taking positions on commodities. While this is great news for exchanges and market makers, it also raises questions around whether market participants are equipped to handle a much heavier burden on operations and workflows.

Across more than 80 global exchanges, options volume soared in 2022, amid growth of 64 percent compared with the previous year, the FIA said. Futures volumes, by contrast, were flat. Across futures and options, Asia-Pacific saw 66 percent growth, while North America grew a more modest 9 percent. Europe, meanwhile, saw volumes fall by about 12 percent, as trading in Moscow tanked. There was robust growth of 48 percent in equity volumes, while currencies grew 39 percent, and interest rate volumes rose 12 percent. Commodity volumes fell, despite massively increased participation among retail investors, amid a shift from futures to options.

Within the fixed income space, short-term interest rates contracts, both in the US and Europe, saw the highest levels of volume growth, after a triple-whammy of extraordinary rate hikes in major economies, the Libor transition, and a reported lack of liquidity.

Higher derivatives volumes fed through into exchange performance. CME Group in January said that it achieved a record international average daily volume (ADV) of 6.3 million contracts in 2022, up 15 percent from 2021. The unprecedented levels of activity, reflecting all trading outside the United States, were driven largely by growth in equity index and foreign exchange products.

Another key trend of the past year has been the ramping up of retail investor interest in commodities. Daily average trading volumes in the CME’s micro contracts for gold, crude oil, silver, and copper were up 93 per cent year-on-year as of the end of November, the FT reported, leading to concerns over retail investor exposure to the highly volatile asset class.

For banks and brokers, as well as buy-side traders and asset managers, the growth of the derivatives market is a double-edged sword. While it can be seen as a positive for risk management, portfolio shielding, and investment strategies, it also leads to significant capacity and operational burdens. There are common challenges around pricing, execution, and margining as well as in matching, workflows, and case management. These risks often play out as manual errors, inefficiencies, delays, data failures, and a continuing lack of transparency.

In one small example of the challenges of scaling, a common market practice when it comes to allocations is to communicate high numbers of trades just a few minutes after the market’s close. With numerous orders coming across over a short period, there is a huge challenge for executing broker desks in identifying the exchange executions associated with the order and working out an average price.

In a paper published in early 2022, IOSCO pointed to the need for operational resilience across regulated entities. This requires more than simple technology fixes, it said. Resilience must be extended to processes and personnel. A key principle of resilience, IOSCO said, is to get ahead of potential disruption. That means focusing on preventative measures, and taking in the full range of critical business processes.

Applied to the derivatives market, an obvious place to focus resilience efforts is in trade processing. Indeed, in a recent FIA flash poll, the requirement for more efficient processing was cited as a top priority by operational staff on both the buy side and the sell side. Indeed, increased efficiency was seen as a vital tool in boosting liquidity in exchange-traded markets.

As policymakers and market participants are discovering, the fast expansion of the derivative market requires adaptation efforts right across the business; not just in the front office. Moreover, firms are required to raise the bar through the trade lifecycle, from order management to post-trade confirmation, netting, settlement, and reconciliation.

In the face of these challenges, the reality is that many firms are still unable to capitalize on straight-through processing efficiencies. With manual workflows still dominating at many institutions, the market in aggregate has a way to travel to reach the levels of efficiency that would keep error rates and unnecessary costs to a minimum. The task, therefore, must be for operations team to continue to tackle issues around data, processing, and manual ways of working. As leading firms are showing, the solution should not be to throw FTEs at the problem. Rather, firms should adopt a strategic approach based on a new normal of increased trading volumes, urgently putting in place protections that will ensure lower risks for the long term.