We recently conducted a capital markets study that surveyed more than 230 global buy and sell side institutions. The results showed that 92% of firms’ derivatives usage will either increase or stay the same in 2017.
In their search for better returns in a low rate environment, firms are engaging in more sophisticated investment strategies, and expanding into new asset classes, currencies and instrument types, including exotic derivatives. This upward trend in the use of derivatives was confirmed by the recent Bank for International Settlements (BIS) Central Bank Triennial Survey. The report found that the daily average turnover of foreign exchange and interest rate derivatives traded worldwide – on exchanges and OTC - rose from 10.5 trillion USD in April 2013 to 11.3 trillion USD in April 2016..
However, oftentimes firms are held back by legacy systems that prevent them from implementing more complex strategies involving derivatives. Evidence of this trend was seen in FINCAD’s survey results. For those firms considering more sophisticated investment strategies, 57% were either unsure or certain that their systems were unable to handle such changes. As a result, many would need to invest heavily in overhauling their valuation and risk systems. This may be at least part of the reason why 67% of firms we polled indicated that they will need to increase their investment in technology over the next year.
Thought leader, John Hull, PhD, of the Joseph L. Rotman School of Management offered his thoughts on the struggle firms face in their quest to improve returns. “The low (and sometimes negative) level of interest rates creates serious challenges for firms looking to generate improved returns. As such, some market participants are finding success in improving yield through the use of derivatives and sophisticated trading strategies,” John stated.
Hull’s colleague, Alan White, PhD, agreed that low interest rates have had a major impact on returns, as has slow economic growth. “The low rates permeate through to the returns on all assets so fund managers have become desperate for return. The stock market has been the one bright spot in this situation. As discount rates decline, stock prices (the PV of future cash flows) rise,” White stated. “Further, even modest rates of growth look substantial compared to the low discount rates that also drive up stock prices. However, I don’t see how this trend can continue much longer without some sort of stronger economic growth,” he added.
Alongside low interest rates and increased market volatility, FINCAD’s survey also showed that greater regulatory scrutiny surrounding derivatives is a large concern for today’s firms. According to the study, greater derivatives regulation means that more capital, additional reporting and greater cost are all required to maintain the same business.
Interestingly enough, additional regulation has not prompted firms to back off of their use of derivatives. In fact, 87% of organizations reported they are currently using derivatives, including futures, options, swaps, swaptions and hybrids/structured products in their investment strategies. In response to this analysis, White weighed in, “Increasing regulatory and capital requirements are squeezing derivatives businesses everywhere. However, a promising area is equity trades where futures forward and swaps are used as leverage tools to amplify returns.”
An overriding theme of our research is that firms need flexible and future-proof technology that can enable them to take challenges such as low interest rates, regulatory change and other similarly perplexing issues in stride. The current reality is that small-scale tools are too basic, and in-house developed legacy systems are too rigid to support the complexity, nuances and demands of derivatives trading today.
White agreed that the trend we’re seeing in market participants moving towards more advanced and capable technology systems is noteworthy. “Our current risk management problems are solvable through appropriate application of FinTech,” he said. Hull echoed this sentiment and added, “Technology skills are becoming as important as math skills for a quant. Nowadays, there is a great interest in machine learning and "big data" applications on the buy side.”
In essence, what financial institutions need is a comprehensive valuation and risk solution that enables them to move quickly on market opportunities. They also need an advanced modeling framework that affords utmost freedom and control for developing complex trading strategies that boost their return-generating potential. This is the only way firms can gain an edge in a fiercely competitive market.
For a visual breakdown of our findings, check out our Capital Markets Survey Infographic, and for additional information view our press release.