What is your background in the securities finance sector?
I have been involved on the technology side of securities lending, delta one and prime brokerage for almost 20 years, having worked for various global investment banks building platforms for trading, operations and finance. For example, at a Japanese bank, I put together the team to build its Greenfield synthetic prime platform.
After many years of doing this, we thought it was a good time to get together with like-minded people to set up a consultancy that is mainly involved in change management to bring together trading, operations and technology consulting. We work on various verticals, including equity, fixed income, FX, risk, and so on, and assist clients from target operating model design and infrastructure review, to core system implementations.
We cover all areas of equity finance and linear derivatives, from securities lending and prime brokerage (synthetic and physical), to delta one trading. Our people have had experience in all these areas, having built up their expertise working on Greenfield, or changing projects across the banking industry.
What are some of the advantages of delta one?
Ultimately, delta one refers to a trade in any derivative product that has a delta (or rate of change ratio with its underlying asset) at or very close to one, ie, for a movement in the price of the underlying asset there will be a near identical move on the price of the derivative. The products that are traded are often referred to as linear derivatives. Examples are equity swaps, dividend swaps, index arbitrage, forwards, futures, exchange-traded funds, CFDs (contracts for difference), portfolio swaps, and so on.
The main advantage of these products is that they closely track an underlying asset and can be less risky than buying the asset itself. Instead of buying an equity index, a hedge fund may buy an exchange-traded equity index fund. These derivatives are attractive because they typically require a low level of upfront capital.
The delta one business differs structurally from bank to bank. It is very dependent on the bank’s equity derivatives capability and their position in prime brokerage as it could sit in either business area.
In 2010, J.P. Morgan predicted that it would be a prime future source of revenue for global investment banks—have you seen this growth?
The last few years have been particularly challenging for the investment banking industry with businesses downsizing due to all the well documented global issues: uncertainty in Europe due to the debt crisis, the slow-down in the Chinese economy, and the US fiscal cliff. This has led to a fall in trading volumes and an increase in volatility, thereby eroding investor confidence. All of these factors have played a big part in how the markets have performed since 2010.
Several prominent fraud cases have also played a part in denting confidence in the delta one business. However, even in this environment, the delta one business has not been performing too badly as businesses have been efficiently managing their balance sheets and optimally managing their inventory.
One reason for the success is the surge in growth of ETFs. On average, they are expected to grow about 20 percent a year, as hedge funds and institutions increasingly rely on these products for both exposure to the markets and as protection against volatility. Also helping the growth of these desks is increased demand from investors for computer program trading, which uses mathematical models to execute transactions.
Delta one desks are a profitable business, and on the surface at least, not a particularly risky one. But like many things in this industry, the practice can become perilous if not properly managed.
What regulations are significant concerns for delta one?
The post-credit crisis has seen increased central bank intervention in global markets and the overall climate of increased legislation has affected the industry and put pressure on revenues and operating margins—the cost of doing business is increasing.
With the Volcker Rule of the US Dodd-Frank Act restricting prop trading, the core issue is how to distinguish between pure market making and proprietary trading. For example, with market making, trying to determine the intention behind trades is difficult because when making a market you are effectively at risk. Whether you define this as prop trading or client facilitation can be a grey area. The bulge bracket banks have all spun off or reduced their prop desks.
In Europe, with Basel III, the latest set of capital constraints to be imposed following the financial crisis, we have global capital rules that make it far more costly to hold risky assets on trading books. It raises capital requirements across the board.
However, delta one desks are expected to weather the regulatory overhaul more easily than many other trading businesses. It should remain one of the most profitable areas on trading floors, together with high-volume computer-driven program and electronic trading.
How does Delta Capita fit into the delta one space?
At Delta Capita, we are very aligned with how investment banking businesses are structured from a front-to-back perspective. All of the partners have worked at investment banks at a senior level for at least 10 years.
The vertical that I am responsible for covers all elements of equity finance, prime brokerage and linear derivatives. If I need to call on any expertise from another vertical, say equity, the partners are easily accessible and we complement each other. We keep abreast of what’s going on in the market through the experience gained while working with clients. We also write whitepapers and constantly undergo training to keep up with the new and latest thinking. We can therefore assist clients with all manner of consulting, from tactical project turn around to front-to-back strategic reviews from business, operational and technical perspectives.
What are your thoughts on regulatory initiatives to create a trade repository for all securities lending transactions?
‘Shadow banking’ regulation and the idea of providing transparency to limit systemic risk is an interesting topic. Given that there is a need for balanced regulation, we need to ensure that we understand the Financial Stability Board (FSB) requirements as they currently apply to both securities lending and repo transactions. There are certain recommendations that need to be looked at again, as some of the regulatory standards would interfere in areas left to national regulators, for example, setting fixed or minimum floors for haircuts and limiting the types of collateral repo that buyers might accept.
Given that there needs to be a distinction between the securities lending and repo markets as they are quite different, the FSB will need to tailor its recommendations accordingly. This applies to differences around the world for which the FSB would need to participate with national regulators in order to consider its recommendations in light of the particular circumstances in each individual market, rather than directing these regulators to adopt a specific type of requirement.
What is on the horizon for Delta Capita?
In the last couple of years, Delta Capita has been involved in a number of change projects as investment for new product implementation has decreased and client drivers have been on improving efficiencies and decreasing costs.
In 2013, we are seeing a cautious return to investment on new products and systems as confidence begins to grow. We have bolstered up our practices over the past year in anticipation for the uptick in activity and have a number of projects either on the go or in the pipeline. Of particular interest to me is a front-to-back review we are conducting for a banking client of its equity and equity finance infrastructure.
We are also actively working with software vendors to review the best-fit-for-purpose applications that are openly available in the market to support the securities lending, prime brokerage and delta one business. These areas were traditionally dominated by in-house solutions or collections of point solutions from vendors, with little cross-asset support. This is a very costly and operationally risky approach. Our clients recognise this and look for opportunities to improve how the necessary functionality is delivered.
Historically, there have only really been a small handful of technology providers that were limited in terms of products that they supported, ie, one of either securities lending, repo or equity swaps. However, now there are commercial solutions that cover all three products and on a front-to-back basis. We look forward to working with our clients on how they would fit in and be adapted, either on a standalone basis or integrated with their in-house systems.
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