“Utility is success,” Thomas Edison once claimed, arguing he wasn’t motivated to invent things that didn’t sell well: if no-one used them, what was the point?

Firms with competing visions of a more robust post-trade architecture for futures and options might bear this in mind. Market participants think standardizing trade allocations could prevent a repeat of the chaos that resulted from the thousands of trade breaks witnessed during last year’s Covid volatility, with many calling for a new post-trade utility—but each has their own perspective of what a better workflow would look like.

If the futures industry fails to come up with a home-grown solution, the decision could be taken out of its hands, some fear. The head of clearing at one futures commission merchant (FCM) says: “Given what the data shows—and given the many conversations regulators have had—they have observed they may at some point want to put a regulation in place. If the industry doesn’t solve the problem, it’s probably quite likely regulators would do that.”

A senior manager at a market infrastructure firm says regulators could go as far as forcing clients to execute and clear trades with the same broker—effectively ruling out so-called give-ups, in which a client sends an order to their chosen executing broker, which it then gives to another broker to clear.

Give-up trades became a trouble spot during Covid-induced volatility last year, when FCMs’ back-office platforms buckled under the sheer weight of trading volumes, resulting in missed margin payments and give-up trades erroneously left on the books of executing brokers.

You’re going to get a lot of pushback from people like us that have strong, robust execution businesses. We’re not going to just concede that to anybody else  

Operations executive at a futures broker

So, what might a better workflow look like, without the draconian step of banning give-ups? Many point out the over-the-counter market didn’t witness the same kind of operational issues seen in the listed space last year. From this perspective, the standardization of allocation and confirmation methods around a smaller set of middleware providers is something futures markets could borrow from the OTC, which built much of its infrastructure from scratch to support new workflows that emerged from the post-crisis push towards central clearing.

Under this vision, rather than a client separately communicating instructions to an executing broker and a separate communication to a clearing broker, a single venue could exist where both executing and clearing broker get the instruction at the same time—more or less mirroring what happens in the bilateral and cleared OTC rates workflow.

This school of thought would seek to achieve a wholesale replacement of existing touchpoints, possibly through a hub underpinned by emerging distributed ledger technology (DLT)—a technology that promises huge benefits, but which has yet to be deployed at scale in such a format.

An alternative idea, floated by vendor Traiana, would take out the middleman in the form of executing and clearing brokers, and have clients communicate their allocation instructions directly to clearing houses based on a common set of transaction data standards. This would not depend on participants adopting a future-looking technology.

The operations executive at a futures broker is not in favor of being cut out of the loop, however. Vendor-inspired solutions tend to benefit vendors more than the end-client, he adds. “You’re going to get a lot of pushback from people like us that have strong, robust execution businesses. We’re not going to just concede that to anybody else. Vendors come up with tools that maybe only work for five or six clients, and, all of a sudden, we’re paying for a technology that may not work for all clients because the vendor has decided that they’ve brought those clients in.”

A third school of thought that some hope could nix both issues—forcing change on clients, and creating a costly new vendor solution—would see FIA Tech, a wholly owned subsidiary of the Futures Industry Association, as an ideal candidate to progress the utility, which already has connectivity to central counterparties (CCPs), brokers, and many clients.

“There’s plenty of vendors that could build a hub. But you’ve got to get a consensus to do that,” says the clearing industry veteran. “The reality is, the people that should be doing it is FIA Tech, or else you’re starting from scratch. I don’t think that the industry is going to agree to have any other new vendor be their one source unless it’s one they control—which would be FIA Tech.”

Buy-side hurdles

For brokers, the operational pain point they would like to see resolved—potentially through a type of utility—is the bespoke nature of each individual client’s workflow with FCMs. Methods of communicating allocations can range from interaction with web applications, sending data files or emails, many of which require significant manual interventions.

Problems also arise when buy-siders don’t meet administrative deadlines. Some FCMs recount horror stories of large asset managers, multiple times a month, turning in futures allocations after the batch run has ended, resulting in the need for overnight manual processing and putting huge strain on operational teams ahead of the next working day.

The clearing head reasons that buy-siders themselves should see operational benefits if allocation processes are improved. They would have their trades in the right accounts at the right time, rather than “chasing around for their own trades and possibly not having their margin calls right”.

And what would buy-siders need to contribute? “Just in terms of the allocation process, improving the timing of sending in their allocations. I think that would be one key one,” he answers.

On the buy side, one aspect of the current workflow that some would like to see improved concerns pre-allocation and credit checks. When a trade comes in from an asset manager, its executing broker holds the positions in a so-called suspense account until the average price is known, at which point, orders can be allocated equally across funds the client manages.

The head of trading at a US buy-side firm compares the process unfavorably to the operational workflow of the OTC cleared market, which he says is smoother through the use of pre-allocation and pre-trade credit checks.

“What shocks me the most isn’t so much the processing of allocations, but from an FCM perspective, the FCM is approving the credit without actually knowing which fund it goes to,” he says.

Others agree. “The problems were around give-up, give-in style flow. You don’t really have that in OTC, which has pre-credit checks and straight-through-processing [STP] at point of trade,” says a European clearing house executive of March 2020’s margin congestion.

Under the utility model that would seek to streamline communication between CCPs and buy-siders, the client would be more readily identified at the clearing house. It is said, therefore, that credit controls could then be implemented. FCMs could accept trades that are matched and defined, as opposed to the carte blanche process of today, which allows a trade to come from any executing broker under their three-way agreement with that FCM and flow into that FCM’s account.

The head of clearing is skeptical, however. He says the solution would work well if a client only ever traded on one clearing house. But where clients trade on more than one clearing house, “then, clearly, you’re going have to split those limits across the clearing houses—because CCPs don’t talk to each other”.

Eurex—which saw several of its largest clearing members suffer outages and backlogs amid a huge increase in volumes and messages flow last March, with late allocations at the center of it—says it has yet to have serious conversations with any stakeholders about its involvement in any such utility.

A spokesperson for the bourse says the topic of a new futures market utility to standardize allocation flow from the buy side to FCMs “has not yet been raised by our participants. … However, we can say that we are currently analyzing the post-trade period, and looking at whether we can extend it and thus increase the time window for clearing participants to allocate give-ups.”

Another stumbling block to finding a single way to standardize futures and options allocation processing is that some buy-side clients have a preference for how they trade and how they get charged. How they’ve been filled on their orders is said to be a “sensitive point”.

The operations executive at a futures broker explains that clients have different rationales for what’s most important to them.

“For some, it is how clean the orders get out. For others, it’s the entire process and who’s doing it. I can tell you, there are certain clients that literally monitor it and have analytics behind exactly who has had problems, who has delayed problems, who has sent trades T+1…—then they adjust their execution allocations based on the analytics they have.”

There are certain clients that literally monitor it and have analytics behind exactly who has had problems, who has delayed problems, who has sent trades T+1 – then they adjust their execution allocations based on the analytics they have

Operations executive at a futures broker

That means FCMs can see processing efficiency as a competitive differentiator, in terms of how cleanly they deliver allocations in a timely fashion, and those FCMs generally see more flow from buy-side clients.

Further, even if it is agreed that trade processing might be mutualized, there remains the knotty question of how to share the bill for doing so. Buy-siders are unlikely candidates to step forward with their wallets open. For most firms, trading futures is a small part of their business, and they expect service providers to adapt to their technology.

The operations executive at a futures broker says that, if funding a utility fell only to FCMs, they would at least want to know the return on their investment. And if buy-side clients were expected to spend and change their technology, they may resist that, viewing it as a service the sell side generally provides.

The head of clearing at a second FCM agrees that getting asset managers to upgrade their technology will be an uphill task because that community does not drive innovative change in the post-trade STP space. “A lot of what we do is try to cater to those folks. If they want to send in spreadsheets, if they want to email and call, we try to work with them.”

For some, lack of engagement from the buy side is an injustice. The clearing industry veteran contends that the buy side must share some of the cost for designing a new system because it is “jamming in” more and more volumes, and not paying FCMs enough, despite remunerating their own staff at levels paid on the sell side. “Yet then the buy side are saying they don’t have money to pay for anything.”

Visions of the future

Alongside FIS, legacy providers in the space include Broadridge—signed by RJ O’Brien & Associates in November, as the vendor seeks to break into the market for exchange-traded derivatives (ETD) processing—as well as kit from Ion.

But, in addition, a panoply of vendors claim their own visions for how to improve futures processing using emerging technology.

Arjun Jayaram, CEO of Baton Systems, a DLT provider, says the need for a futures utility “absolutely makes sense—but it’s not going to be cheap”.

Concurring with the need for data standardization, as advanced by Traiana, Jayaram also stresses, however, that the model for a utility should account for the fact that the lifecycle of futures trades is longer than the daily lifecycle of foreign exchange trades, for example.

“A futures trade lifecycle can last 30 days or longer,” he says. “The lifecycle is much longer than in the FX space. There’s potentially margining happening every day, positions being open, closed, rolled over, netting, and reconciliations. I see the need for standardizing data to better match trades, but this is more complex than that. There are more intermediaries—buy sides, FCMs, and exchanges. A more collaborative workflow is required. The entire lifecycle needs to be managed on a ledger that all parties can see.”

Developing a DLT alongside existing systems would cost FCMs “$4 million to $5 million every year for the next few years. … And then you migrate it over to the new technology stack,” he says.

Independent consultant Jerome Kemp, former global head of futures, clearing, and foreign exchange prime brokerage at Citi, is now working as an adviser to Baton Systems. He thinks the 24-hour, batch-based settlement cycle is a “ball and chain on every FCM”, and reliance on existing market infrastructure and platforms—“still chugging away with 20th century server-based batch logic”—is not the way forward.

Kemp believes a trusted distributed ledger, which allows participants to receive synchronous data as it becomes available, would remove the need for multiple validation steps using third-party applications, not to mention “the armies of middle-office staff whose work it is to untangle the Gordian knot of fails on a daily basis”.

He adds: “I do think that DLT could be leveraged in this space, and I’d humbly suggest that this is not optional. The next ‘big one’ could see FCMs calling down lines aggressively, given the white-knuckle experience that the Covid meltdown was for the majors.”

Others developing emerging technologies also have ideas on how to proceed. Zohar Hod, former head of post-trade processing platform truePTS, would use smart contracts on a centralized database.

In Hod’s new venture, as founder and chief executive of One Creation, he is developing tools for exchanges to control digital data rights. Applied to futures, his model would see participants owning and controlling their data, which they could then share with a utility on their own terms.

That concept could, in theory, go some way to resolving concerns FCMs may have about who gets to see their trades.

A CCP risk management expert says: “Would the utility somehow know absolutely everything about the market? Would you have a sort of ghost sitting in a central limit order book, knowing who is getting executed against who, basically running the market?”

Hod’s solution would use multiple levels of end-to-end encryption to restrict rights to see data: “It would allow an institution to share data with a utility, and still keep some control over it.”

A third DLT vendor, Axoni, has already built products for the post-trade derivatives space, particularly in equity swaps and credit derivatives. Ishan Singh, its head of solutions, says the firm has been working with a cross section of leading FCMs and buy-side firms to design a solution that addresses the “long-standing friction that exists in the ETD space”.

He adds that a distributed ledger provides all relevant parties with a reliable, real-time view into the state of a trade and related workflows, such as allocations. “We believe the notion of needing to remove hops to and from a middleman is an antiquated objective in a world of automated, peer-to-peer data replication,” he says.

Could FIA Tech be the answer? Futures data flows through FIA Tech’s Atlantis settlement platform, which consumes give-up data from futures exchange clearing systems, although Atlantis doesn’t connect in real time to the internal systems of FCMs.

The operations executive at a futures broker would also like to see FIA Tech build upon its offering to produce a standardized allocations tool. “Then, if you’ve invested in the technology buildout for FIA Tech, you might get a reduced price on that?”

The head of clearing at the first FCM agrees FIA Tech could well be one provider of a solution. “It would be relatively simple to upgrade their systems to real-time,” they say. “But I don’t think it’s obvious to me that there will be one solution. There will be some competition.”

The clearing head also cautions that the industry should not attempt to travel too fast, too quickly. In favor of first adopting middleware that could eventually migrate to DLT, he says: “What we’re looking to do here is effectively change all four wheels on a car whilst it’s still moving. If you go straight to DLT, and if not everyone can communicate to you via that technology, then you’ve got a really fancy car that no-one can drive.”

“Going that full leap in one go probably isn’t going to be viable,” he continues. “Especially given you’ve got so many players in the ecosystem—CCPs, clearing members and clients. If you wait for DLT, it could be a couple of years down the line.”

Could regulators intervene?

The industry may not have that much time to find a solution. 

In 2012, the Commodity Futures Trading Commission (CFTC) regulated for better risk management of give-ups through rule 1.73, which requires clearing members to establish risk limits for clients and use automated means to screen orders for compliance with those limits. 

The events of March 2020 raised questions about the industry’s compliance with those standards. At the height of the Covid-19 induced volatility, the use of average price allocation methodologies by buy-side firms resulted in a huge flood of orders reaching the biggest FCMs late on successive trading days. As trades passed between executing and clearing brokers, wonky IT and outmoded workflows led to dangerous operational bottlenecks that one bank likened to a systemic incident.

Some now believe the CFTC could look to enforce rule 1.73 more rigidly. “Regulatory authorities are taking a look at accuracy and standards within the futures business, and comparing them to over-the-counter markets. They’re saying: ‘We’ve seen the problems that come with a spike in volatility, and the algos that mean you’re trading throughout the trading day, and only allocating very late in the day,’” says a senior manager at a market infrastructure firm.

The CFTC did not respond to a request for comment in time for publication.

What might tighter regulation look like? The head of clearing at one FCM says of rule 1.73: “One of the views back then was the only way that could get resolved was to make the industry go full-service only, which is not a good thing for clients. A client only able to execute with their clearing member is not an optimal outcome. Executing brokers have different offerings in terms of algos, which can improve the performance of trades. And a decent portion of the market is still executed off-screen and blocked on.”

An operations executive at a futures broker agrees. He thinks “the buy side would resist being dictated to: ie, to say ‘you can only execute with who you’re clearing with’,” and adds that the industry is focused on coming up with “a more technology-driven solution”.

Others are skeptical, however, that regulators would really pull the trigger on imposing a solution—not least because the pool of sizeable FCMs that are able to sustain clearing as a profitable business has been in long-term decline.

A clearing industry veteran says: “If the regulators say FCMs have to do more, it’s going to be a problem, because a lot of FCMs will say: ‘We’re out. We can’t afford it.’ The regulators can’t come down on the existing FCMs because there’s only eight to 10 of them.”