The new regulations in the US and Europe require banks to make several new connections to Swap Execution Facilities and Organised Trading Facilities, central counterparty clearing houses  and Swaps Data Repositories. The complicated logistics behind connectivity is likely to have an impact on the business, operations and technology, so banks will need to figure out the optimal way to restructure their groups for the new environment.

Under the US Dodd-Frank rules, standardised derivatives will have to be traded on an exchange or SEF and centrally cleared. Europe is introducing a trading venue similar to SEFs that will be known as the Organised Trading Facility. Trade data must be reported to a Swaps Data Repository, regardless of whether the transaction is bilaterally or centrally cleared.

To this end, a web of new connections has to be established. The SEFs will have to connect to the CCPs, and the CCPs will have to connect to the SDRs. In addition to connecting to the SEFs, OTFs, SDRs and CCPs, banks will need to connect to their counterparties. Simple, isn't it?

"You would assume - especially in Europe with this new definition of OTF - that there would be a large number of new venues for everybody to at least consider to connecting to," says Bob Fuller, director at connectivity provider Fixnetix. "So it's just the sheer complexity of the web that gets created that becomes a problem."

Traditionally OTC derivatives have been traded over the phone, but most communications will be done electronically in the future - at least that is what the regulators are advocating. The cost of establishing electronic connectivity has to be built into the business case for participating in a given market segment. This is not trivial given that each connection could cost over $1 million, and the total industry spend may run into the billions.

"If you're in the OTC market, you probably operate under a phone and/or hybrid system where you have some sort of electronic communications plus voice," says John Jay, a senior analyst at Aite Group. "It's going to come down to ‘how much can we make in a given marketplace, and how much is it going to cost us'."

The Volcker Rule in the US and the corresponding rule proposals in Europe could potentially stop brokers from creating products, limit the number of new trading venues and significantly curtail liquidity. Assuming that does not happen, several SEFs, OTFs and SDRs could emerge on both sides of the Atlantic. In Europe, the best execution rules require brokers to scour the market for the best price for the customer, so they are likely to have to connect to all the OTFs. Best execution does not apply to OTC derivatives in the US, but competitive pressures may still force firms to connect to all the SEFs.

Firms run the risk of establishing many connections to new entities only to find they are not doing enough transactions through some of them to justify the investment. Moreover, a significant number of them may not survive over the long haul.

Some observers believe the new regulations will present new opportunities for growth, but Aite Group is sceptical. Unlike equities, the OTC market is customised and speed is not the priority. A factor input, such as a curve, may change so the dealer cannot pull the trigger immediately. In addition, it is not a many-to-many market. There are perhaps a couple  of dozen dealers in the world who are willing to make a market and take on the risk in these products. As a result, the market does not necessarily lend itself to a central order limit book model.

"In my mind it's very analogous to the fallacy of build it, they will come," says Jay. "At the end of the day, it really begins and ends with the actual market need. What I believe will happen is ultimately there's going to be a lot of money that will be spent to comply with this stuff, but the actual flows will not differ."

The shift from predominantly voice to electronic trading will have a fundamental impact on front-office workflow and back office operations, and staff will need time to adjust to the new environment.

Theoretically, once a trade is completed electronically on the SEF, the confirmation and collateral requirements will be sent automatically to the counterparties and reported to the CCP and SDR. When a voice trade is done, an electronic version will have to be created. But firms need to agree who is responsible for reporting the transaction to the SDR. Under Dodd-Frank, if a dealer is trading with a non-dealer customer, and both are US domiciled, the dealer has the reporting obligation. If the transaction is between two US-based dealers, at least one of them has to report. If the transaction is between two non-dealers, the obligation is decided according to a hierarchy.

Cross-border transactions are more complicated. When a trade is transacted between a foreign dealer and a US domiciled non-dealer customer, the US customer has an obligation to report either directly or through an agent. The customer may appoint the foreign dealer, SEF, clearing house or another party as its agent. But when a US bank enters into a transaction with a foreign bank, the US bank must report to US authorities while the foreign bank must meet its regulator's requirements.

Firms are still unclear exactly what data they have to provide and when they need to provide it. Does it have to be sent in near real time? Dodd-Frank specifies that counterparties are required to report trades for the purpose of real-time price dissemination as soon as technologically practicable, but that has not been fully defined yet. On average it takes eight minutes for an interest rate swaps trade to be fully confirmed on MarkitServ. Electronic confirmation in other asset classes may take more than 15 minutes. Another question that needs to be answered is whether reporting must be done strictly by way of digital feeds, or can be communicated by voice.

The technology exists to make all the necessary connections to comply with the regulations. But the lack of clarity from the regulators, and uncertainty about what the market will look like, is taking a toll on market participants. When senior managers ask their IT staff what resources are needed to comply, the best they can do is offer a price range. They have a conceptual understanding of what must be done, but they do not know the full scope of the project.

More to the point, it takes time to build out a connectivity solution, so firms need to think of ways to streamline the process and hire the right staff.

"Banks often hire people who don't understand the product or the process," warns Sonia Goklani, chief executive of Cleartrack, which offers OTC clearing tools and advisory services. "Ultimately, they end up running into problems with compliance."

In most firms the clearing, bilateral trading and prime brokerage businesses each have their own technology silo, and they are very different in the way they manage the process flow, reporting, market data, pricing and risk. Without synergies, they cannot achieve economies of scale and service clients properly. The large players in the OTC derivatives markets are struggling with this while HSBC, BNP Paribas and Commerzbank, which do not have a legacy technology problem, are gearing up to capture market share.

Once the new regulations take effect, the SEFs will need to send pricing and market data to the banks. Then the banks have to figure out how to leverage their infrastructure to allow these pipes to communicate.

"Either you build separate connections and get the market data connections to talk to the SEF connections, or you build totally new connections for the market data and SEF prices," Goklani explains. "Banks need to decide whether to build a whole new pipe so they get both together for derivatives, or leverage the existing pipe they have."

Legacy technology is not scalable enough to extend the pipe, and building a new one is expensive. Cloud computing may be a solution, but then banks must figure out how to retain, manage and mine the data in real time. They need skilled technologists to support that effort, which adds to the cost.

Goklani believes banks initially should implement a short-term technology strategy to cope with the demands of the immature market structure. They can use Excel macros, Access and SharePoint to semi-automate transaction processing and on-board clients. Meanwhile, they should dedicate resources to figuring out how to build a framework for all the functions pertaining to connectivity, margins, limits, collateral and data repository reporting. As the market matures and new CCPs, SEFs, OTFs and SDRs emerge and fall by the wayside, banks can implement a formalised technology platform to support the business in the long term.

"With a flexible, adaptable framework, if I build the connectivity to Tradeweb for CDS today, it should be easy for me build the connectivity for interest rate swaps or variance swaps tomorrow," says Goklani. "But banks are not thinking that way at this point in time. They're thinking only in terms of building individual connections. It's a mindset problem."

Ultimately, some banks may decide to outsource. Outsourcers such as Fixnetix already connect multiple brokers to exchanges, and they can use their network to allow brokers to talk to each other.

"Even for the likes of a Goldman Sachs, a very large trading house, it's going to become very difficult to create that broker network and make it pay for itself," says Fixnetix's Fuller. "So you've got to start looking at an outsourcing model ... plugging into networks where other people are already connected."

According to Aite's Jay, the top tier banks are further advanced in their preparations than the smaller firms that have to start building their infrastructure from the ground up. They also have the greatest voice when it comes to influencing the regulators. But that is not to say the larger banks have a smooth ride ahead.

Banks will need to figure out how to align their clearing and executing brokerage businesses, which are separated by a Chinese wall, and the individual desks within them. The products that will be affected are foreign exchange, listed derivatives including futures and options, credit and rates. Some clients may want to hedge their trades across multiple desks: they may want to do a single name credit default swap and hedge it with futures and options, for example. Firms will need to manage their exposure to clients across multiple desks from a margining and credit perspective as well as report their position to multiple regulators.

Restructuring groups is a political issue. The traders on different desks do not always see eye to eye and the traders, operations and technology staff may not have a strong relationship. Yet a coordinated approach is critical to client retention. According to Goklani, JPMorgan has achieved some success in this area, but it remains a challenge for Citi and Deutsche Bank.

"Banks need to come up with an incentive-based mechanism so the business, technology and operations people work together just like they do in consulting firms," she suggests. "Deloitte has a point system to encourage its partners to work together. If they do well, they get a higher compensation at the end of year."

At this stage, the industry is beyond questioning whether the new rules make sense. Market participants are simply awaiting more guidance from the regulators so they can make strategic plans and allocate resources. They want to get on with it and start making money again. Some may decide that participating in the OTC derivatives market is no longer worth the cost and hassle. Clearly, as they move forward in their journey, connectivity will play a key role in their decision making.