By Daniel Carpenter, CEO of Meritsoft (a Cognizant company)
Interest rate derivatives (IRD) pose cost challenges for investment banks, driven by a surge in trading activity last year. According to the latest ISDA Swaps Info Quarterly Review, IRD trade count increased by over 20 per cent to 2.3 million in 2022, from 1.9 million in 2021.
As IRD trade activity rises, so do the fees that banks need to pay to their interdealer brokers (IDB). Some banks have been paying millions per year to facilitate IRD transactions across over the counter (OTC) markets. Banks can negotiate rates with an IDB, but the rates can vary drastically depending on the specific nature of the IRD trade, making it hard to calculate.
As a case in point, an investment bank may well be running an IRD trading strategy with two or more different elements to it. For example, one strategy could combine a spread designed to profit from an uptick in the value of an underlying asset, and a spread conversely aiming to profit when the same underlying asset declines. If the banks can’t identify this type of strategy, then there is no way of knowing which IDB rate to apply for the trade.
Over a third of IRD trades are strategy-driven and so by the time the trade gets into the back office, all the IDB sees is one element to match off to on the other side of the trade. If the IDB has not booked this trade correctly, the investment bank could end up paying more. How do investment banks reduce their brokerage costs for their IRD trades? The answer lies in getting their data houses in order. Most investment banks have very old and clunky upstream systems, which makes it incredibly difficult to locate and centralise the relevant data to run their IRD calculations.
Currently, banks are sending their trades to numerous places within their brokerage ecosystem. By the time the key information gets to the back-office billing system, they are inevitably missing some of the data that used to be upstream. Banks need a system that can calculate everything automatically, as opposed to sticking to highly manual processes.
Rising IRD activity offers up greater complexities. All investment banks acknowledge that costs continue to rise, and very few people within institutions have a true grasp of exactly what these costs are across the entire business. While investment in systems to address brokerage costs has been slow, how long can investment banks afford to wait to address this specific problem when costs are increasing across the wider business?
Banks cannot afford not to have a grasp on what they are paying, to whom and why. The longstanding lack of transparency into these costs is costing investment banks. This is because they are potentially paying twice, or worse, not understanding what they are paying for and using outdated rate cards which makes negotiating with IDBs impossible. Ultimately, if banks can’t identify the various types of IRD trade types, and they are being charged per leg when they shouldn’t be, money will continue to be wasted at a time when every penny really does count.
