CamiloAlarcón, Fixed Income Trading Senior Associate of Credicorp Capital Colombia

Fintech evangelists claim that in the next 10 years, financial industry will be nowhere close to what we know today in terms of speed, efficiency and process optimization. What does that say about a country that is lagging the last 20 years of financial developments?

Technology is essential for traders and portfolio managers, if they want to be able to incorporate the cutting edge in financial instruments into their repertoire without compromising their ability to respond and execute said instruments in changing market conditions.  In a world where multiple asset classes and products interplay in real time, analytical tools are paramount for efficient and agile decision making. Nevertheless, if having the required technological infrastructure seems necessary, a regulatory framework that accommodates such changes and the basic knowledge among market participants to enact them is essential.

For Colombia, the case is not one of incorporating the latest financial innovations in to the market, conversely, is that of it being incipient despite currently passing the 10-year-old mark.Particularly, the futures market is in stagnation, with low trading volumes and few active participants. Most market agents agree that the explanation for this is twofold: technology (both in the back and front offices) and education.

Colombia’s most liquid market is the local sovereign bonds (COLTES), with 1.5 billion dollars of average daily traded volume, multiple investors (local and off shore) anda competitive market making scheme that provides sufficient liquidity to investors at a competitive cost.  However, the bond futures market remains illiquid with one twentieth of the cash’s market daily traded volume (73 million dollars) and few participants willing to intervene. Why?

For market making institutions and dealers, the reason appears to be that the operational capacity of their front office is unable to fulfill its duties in both cash (which is fiercely competitive) and futures markets. The prevailing argument is that given their current capital (both human and technological),these institutions don’t have the capacity to actively participate in both markets and quote prices in changing market conditions. Moreover, most instruments for risk management and trade analytics must be developed and funded in house, rising costs for trading desks and ultimately delaying the implementation of the necessary technological infrastructure many traders need to be active participants.

This problem has been solved to some degree by some banks and brokers, with intensive investment in developing proprietary tools and human talent. However, not all market participants have the know-how and budget to develop such instruments, and those institutions that have the capabilities to participate are too few to generate liquidity amongst themselves.

In a futures market with low volatility, where capturing the bid-ask spread is scarce, incurring in such costs is not an attractive investment for most participants and futures market making remains overly manual task prone to operational risk. The effect on the market is clear: the capacity of many agents to participate in the futures exchange is very limited, decreasing the competitiveness of quotes (in both bid ask spread and size), operated volume and volatility, making the market making business unprofitable. Clearly there’s a vicious circle in this dynamic.

Considering this situation, the local exchange has taken steps towards improving their technological infrastructure with the development of a new and consolidated platform. Whereas before traders had to place orders for bonds and futures in two separate systems, this platform will enable them to place orders in both cash and derivatives markets using only one system, improving their capabilities to hedge their positions with ease. Additionally, it will provide basic risk analytics such as bond sensitivities and derivates greeks; it will have improved connectivity with MS Excel for trading algorithms; and the matching engine will permit high frequency trading.

The main objectives are that market participants can have all the information they need to manage and execute their trades efficiently through a single platform and that the system engine will be able to handle new developments in proprietary algorithms and trading bots. Although these improvements will certainly enhance the capabilities of all participants, they are only part of the solution. Education is crucial to develop the necessary user base for new products. Colombia remains a market where most investors have developed an expertise mainly in the cash market and derivatives instruments are seldom incorporated into trading and portfolio strategies.

On the other hand, some buy side institutions remain inactive because their back-office software doesn’t have the capacity to liquidate the daily P&L of their futures positions and manage the required margins.  This task in some cases is done manually at the end of trading hours by their back office and is obviously prone to human error, discouraging portfolio managers to actively trade in the futures exchange. Some agents have proposed that this process is outsourced to a liquidating agent or a custodian that has the necessary infrastructure to handle such tasks, but the current regulatory framework doesn’t allow them to do so. Currently, only FIC’s (mutual funds) are required to outsource all their back-office activities to custodians, but it’s not unreasonable to expect that pension funds and other institutions will follow suit, given the operational limitations they currently face.

Regulation should promote and enforce the necessary changes to allow for more operational efficiency and increase investor’s capacity to incorporate futures into their portfolios. Urgency, however, doesn’t appear to be on the table, as most investors haven’t found a real need to hedge their portfolios in a decade of complacent local rates that have only moved downwards. The rates market may not be so complacent in the future.

There is a lot to be done if Colombia is to bridge the fintech gap. Although recent developments may hint that technology is pushing forward in some respects, both regulation and education need to catch up before any traction is gained. There is no need to argue how necessary the derivatives market is for both traders and investors.