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Swap Alternatives Fall Short as U.S. Swap Market Transitions

By Colby Jenkins, TABB Group
Originally published on TABB Forum

While fragmentation of global swaps liquidity appears to be abating somewhat, trading on SEFs in the U.S. has been slow to evolve. Meanwhile, though swap future growth has been steady, there still is no comparison between interest rate swap and interest rate swap futures liquidity. Ultimately, however, the higher costs of margin for non-standardized OTC swaps will be strong incentives for both European and U.S. firms to look to listed derivatives to hedge risk.

It was assumed that a growing divide between European and U.S. swaps liquidity pools would continue to expand, based on initial cleared interdealer interest rate swaps (IRS) data from ISDA. A hesitation on the part of global participants to do business with U.S. persons that are, as CFTC Commissioner Giancarlo recently put it, “branded with the scarlet letters of ‘U.S. person’” after implementation of mandatory swap execution facility (SEF) trading has been the driving force behind the trend.

Recent data published in ISDA’s report, “Cross-Border Fragmentation of Global Derivatives: End-Year 2014 Update,” however, suggests that while fragmentation certainly still exists, it has begun to abate slightly for Euro-denominated swaps – for now. Since August 2014, shared volume in Euro-denominated IRS between U.S. and European dealer counterparties has more than tripled after hitting an all-time low in July 2014, at which point 94% of global volume in Euro-denominated cleared IRS was exclusively traded between European dealers (see Exhibit 1, below).

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Source: LCH.Clearnet SwapClear, Cross-Border Fragmentation of Global Derivatives: End-Year 2014 Update (ISDA, April 2015), TABB Group

Prior to October 2014, when SEF trading first went live, the USD-denominated swaps market was a relatively even mix between shared volume (U.S. Dealer/European Dealer), U.S. Dealer/U.S. Dealer volume, and European Dealer/European Dealer volume, with all three buckets having normalized to contribute roughly one-third of total cleared swaps traded globally. During Q4 2014, however, shared volume between U.S. and European dealers grew dramatically. As of the latest available month of data, shared volume in USD-denominated swaps for the U.S. market is nearly double that of regionally biased volumes, peaking at 42% of global volume in December 2014 (accounting for 61% of the USD-denominated market specifically within the U.S.), while USD IRS volume traded exclusively between U.S. dealers or European dealers both fell during the same period (Exhibit 2, below).

Exhibit 2: Global Market for Cleared USD IRS, Notional Volume Market Share]

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Source: LCH.Clearnet SwapClear, Cross-Border Fragmentation of Global Derivatives: End-Year 2014 Update (ISDA, April 2015), TABB Group

Taking a step back, in terms of notional activity, the U.S. swaps market is still in a state of flux, pushed and pulled by regulatory influences and macroeconomic conditions (Exhibit 3, below). And any dynamic system subject to ever-changing variables will experience periods of ebb and flow. This certainly has been the prevalent trend over the past few years in the U.S. markets, especially in the case of interest rate derivatives.

Exhibit 3: U.S. Interest Rate Derivatives Market Monthly Notional Volumes (ex-FRA)

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Source: TABB Group, ISDA

Concurrent with an overall stagnant interest rate derivatives (IRD) market is a SEF universe that has been slow to evolve. After a lull in trading in the last two months of 2014, SEF volumes have grown in 2015, albeit only slightly. During Q1 2015, average daily notional SEF volume traded for IRD achieved consecutive monthly records in February and March. March set the all-time record monthly average daily notional traded (ex-FRA) at just under $164 billion.

[For details on recent developments in the U.S. Interest Rate Swap market, market share and volume trends within the SEF trading landscape, and emerging liquidity dynamics between European and U.S. regulatory regimes, please contact TABB Group for information on our recent report, “U.S. Swaps 2015: Paradise Lost?”]

Now that the once-threatened overhaul in OTC swap workflow has become a reality, market participants either will have finalized or begun the process of embracing the new paradigm, or taken steps to find alternatives. Looking to the collective Interest Rate Swaps Futures universe, a product that headlines have heralded as the principal contender for the traditional IRD market, growth has been steady but limited (Exhibit 4, below).

Exhibit 4: Interest Rate Swap Futures Volumes and Open Interest, CME DSF & ERIS SF (Jan ’13 – March ’15)

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Source: CME Group, ERIS, TABB Group

In notional terms, there is still no comparison between interest rate swap and interest rate swap futures liquidity. Looking at average daily notional trading volume, interest rate swap futures volume typically still accounts for only a fraction of a percent of IRD notional volume – meaning the market, while expanding, is not a viable alternative. Nonetheless, volumes and open interest in CME Group’s deliverable Interest Rate Swap Futures and Eris Exchange’s Interest Rate Swap Futures have grown significantly since 2013 – indicating that market participants are increasingly interested in testing out these waters until reliable and homogenous liquidity across contracts emerges.

An eventual rise in interest rates may serve as a catalyst for the next wave of conversion, as a rate hike and return of volatility will have new implications on capital resources for firms facing much higher Value at Risk (VaR) calculations. This ultimately will result in higher costs for end users of traditional swap products, and with that, the appeal of listed alternatives will likely grow. The lower VaR multipliers and margin treatment for futures contracts will become more persuasive compared to OTC alternatives.

Within Europe, where central clearing will be mandated across the board next year, margin considerations are also front of mind. For European buy-side firms relying on interest rate swaps as a risk management tool, the range of margin treatments based on their hedging preference (choice of swap) is a heavy burden to consider. Margin treatments for non-standardized OTC swaps are based on a 10-day VaR treatment, while standard vanilla OTC swaps are accessed on a five-day VaR basis and listed derivatives only a two-day VaR treatment. These treatments within the European regime are similar to those within the U.S. in which swap futures are calculated on a two-day VaR as opposed to a five-day treatment for swaps. Ultimately, the more specific the hedge, the higher the cost. These rules will be strong incentives for both European and U.S. firms to look to listed derivatives for more economic risk management exposure as the global OTC market overhaul carries on.

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Cleared for Launch: A New Era for OTC Derivatives

By Mike O'Hara, The Realization Group
Originally published on TABB Forum

Buy-side users of OTC derivatives face many uncertainties as they prepare for mandatory central clearing in Europe, and they are turning to their dealers and clearing houses for help. But the widening range of instruments available offered by trading venues in response to the central clearing mandate is drawing in new market participants. Meanwhile, for CCPs, central clearing is an opportunity to generate new relationships and revenues, but it requires adjustments to existing services and operations as well as the development of new ones.

Buy-side users of OTC derivatives face many uncertainties as they prepare for mandatory central clearing in Europe, a requirement that finally comes into force next year, but which stems from the G20’s 2009 pledge to reduce systemic risk in the market. Initially, the European Market Infrastructure Regulation (EMIR) demands that major clearing brokers must centrally clear a select group of highly liquid interest rate derivatives. But eventually all counterparties must make arrangements to adopt central clearing if they want to carry on using any standardized OTC derivative. 

For asset managers – many of which fall into EMIR’s ‘Category 2’ basket of market participants that must start central clearing derivatives six months after clearing brokers migrate – interest rate swaps (IRSs) are a core risk management tool for bond portfolios, also used for hedging very specific client liabilities as part of liability-driven investment solutions. Ahead of EMIR’s deadlines, asset managers have been assessing the capabilities of clearing brokers, getting to grips with the collateral implications of margin calls by central counterparties (CCPs), selecting account structures to protect clients’ assets and liaising with end-clients such as pension funds to inform them of the cost and risk aspects of the new clearing requirements. 

On top of these complex and challenging tasks, asset managers – along with other users of OTC derivatives – must also come to terms with “frontloading,” a requirement unique to Europe’s approach to migrating from bilateral to central clearing. Because derivatives contracts expire over a variety of maturities, the migration process could lead to some instruments being centrally cleared and others bilaterally, thereby creating an uneven playing field for market participants. 

To ensure that the European market moves swiftly to a centrally cleared environment, EMIR includes the frontloading obligation, which requires bilateral trades entered into before central clearing is introduced to be centrally cleared once the new rules are in force. The rule has proved controversial and has been subject to a series of changes and clarifications over the past 12 months or so. In short, the frontloading period has shrunk, the range of exempt counterparties has increased, and a threshold has been introduced whereby only non-clearing member financial institutions with more than a certain level of derivatives notional outstanding must comply with the requirement. 

Nevertheless, there will be a seven-month period during which ‘Category 2’ asset managers know that any bilateral agreement to enter into an IRS is very likely to result in a central clearing obligation, if the contract has not expired by the time the EMIR clearing mandate comes into force.

Buy-side clearing challenges

For the vast majority of asset managers that have not previously centrally cleared OTC derivatives transactions, the initial response to the incoming EMIR clearing mandate has been to select a clearing broker and a CCP through which to clear. Some firms that already used exchange-traded derivatives turned initially to their futures clearing brokers, but the central clearing of OTC instruments is such new, unchartered territory that many asset managers have found themselves looking for brokers that could demonstrate capabilities and expertise across the OTC and exchange-traded space and across asset classes. 

The advice of clearing brokers is critical to another of the important decisions facing asset managers – that of selecting appropriate account structures. EMIR specifies that as well as existing omnibus account structures that hold the assets of multiple clients of a clearing member, CCPs must offer individually segregated accounts. These are designed to offer maximum protection to asset managers’ clients, such as pension funds whose assets are posted as collateral, thereby funding initial and variation margin payments in support of centrally cleared OTC derivatives transactions.  

From a frontloading perspective, one of the first tasks asset managers need to do is establish whether they trade sufficient volumes of OTC derivatives to be categorized as Category 2 or Category 3 market participants, the latter benefitting from a longer phase-in period. Although Category 2 and 3 firms have different clearing obligation timelines, the frontloading obligation only applies to Category 2 firms.

“To define yourself as Category 2 or 3, you need to calculate your OTC derivative positions – at an individual fund level and not at a group level – over a rolling three-month period to determine if you are over the EUR8 billion notional activity that would determine the fund being regarded as Category 2,” explains Lee McCormack, Clearing Business Development Manager at Nomura. “You also need to work out who you’re trading with, whether they’re going to be classified as 2 or 3, and whether the frontloading obligation applies.” 

Moreover, buy-side firms need to consider the operational and valuation implications of having OTC derivative transactions on their books that fall under the frontloading obligation. Trading a swap on the understanding that it will eventually go for central clearing may have an impact on credit support annexes (CSAs) and discount valuations, with implications for pricing too. 

For Luke Hickmore, Senior Investment Manager at Aberdeen Asset Management, uncertainty about clearing costs is the primary but not the only concern over frontloading. “There will be a period during which we’re holding the contract but we won’t know what the clearing costs are going to be at the end of that period. How that affects the value of your contract is going to be really important and needs addressing as soon as possible. Buy-side firms and their end-clients will have to look closely at the existing CSAs they have in place with their counterparties as well as the documentation provided by clearing houses. For us, it’s about taking a project management approach to getting over these complications,” he says.

The number of parties potentially involved and the complexity of the issues raised by frontloading means prompt action is required by asset managers, regardless of the scope for further slippage of regulators’ timelines. “Buy-side firms should be working with their clearing members now to get their trading limits and initial margin limits in place so that they have a lot more certainty that when they trade that product, they will be able to put it into clearing simply,” recommends McCormack.  

The earlier the issue is addressed, the better chance asset managers give themselves of working through all of the implications, from the front to the back office. “Buy-side firms need to be in a position to track, monitor and report transactions that will need to be frontloaded and ensure that those positions are then factored in as far as central clearing is concerned. It is not necessarily that difficult, but there is a great deal of operational work to adapt systems for adequate tracking and reporting, as well as the work required in terms of interfacing with CCPs in preparation for central clearing of IRS and other OTC derivatives,” says Hirander Misra, CEO of GMEX Group. 

From an operational perspective, Aberdeen’s Hickmore cites regulatory uncertainty as causing problems for the buy side at a time when resources are stretched by a need to deal with a wide range of reforms and rule changes in parallel. Europe’s central clearing rules have been consulted on, re-drafted and delayed on several occasions, and it is highly likely that asset managers will not now have to start clearing interest rate swaps until Q3 2016. That might give extra time to prepare, but the stop-start nature of implementation projects is far from ideal. 

“A lot of it has been done, but has now been put on ice. We saw our project stop at the end of last year when the time to clearing was getting longer. Since then, we’ve revisited the project to ensure our cost assumptions and concerns over operational complications are still valid. That’s not easy and it requires resources,” says Hickmore.  

Alternative approaches

As noted earlier, a key objective of the emerging post-crisis regulatory environment is to reduce systemic risk in the OTC derivatives market. In part, this means incentivizing market participants to choose the most highly regulated and operationally robust instruments. For example, the margin requirements for non-standardized OTC derivatives are based on a 10-day value at risk (VaR) treatment, while margins for plain vanilla, centrally cleared OTC derivatives are calculated on a five-day VaR basis, and listed derivatives attract a two-day VaR treatment, making the latter potentially the cheapest to fund over time, provided it offers the same level of protection. 

Aberdeen’s Hickmore views higher margin requirements for centrally cleared OTC derivatives compared with the historical cost of bilateral trades as a potential performance drag on his portfolio. “It’s not about transaction or usage charges; it’s about the long-term performance brake that placing collateral with a CCP for initial and variation margin can put on the portfolio. It’s hard to quantify, but asset managers are going to have to get on top of it,” he observes. 

The rising cost of swaps and other OTC derivatives instruments, not to mention the multiple uncertainties over future clearing costs, as exemplified by frontloading obligations, has sparked a number of innovations from venue operators that have caught the eye of buy-side firms. 

“The overall weight of the regulations and the costs of clearing trades centrally versus bilateral transactions mean that our clients are looking at exchange-traded alternatives with keen interest,” says McCormack.

In the US, swap futures listed by the CME Group and Eris Exchange have gained a foothold, while in Europe new exchange-based products are also being introduced ahead of EMIR’s central clearing mandate. One of these is GMEX’s Constant Maturity Future, the value of which is based on an underlying proprietary index to replicate the economic effect of traditional IRS, in an exchange-traded environment. 

“Buy-side users of OTC IRS are facing a capital shortfall as these instruments are forced into central clearing, and are looking for cheaper alternatives. With a Constant Maturity Future, you get the effect of an IRS, but a lower cost of margin and the cost of funding due to the two-day rather than five-day VaR treatment,” explains GMEX’s Misra. 

“The GMEX Constant Maturity Future closely mimics the underlying IRS market, the difference being it’s a two-day VAR product as opposed to a five-day VAR product, so it’s substantially cheaper on the cost of margin and the cost of funding,” continues Misra. “With an IRS-type framework but exchange-traded, that is good for the buy side because they can look at moving some of their positions to contracts like this. Equally, it also ensures that they can use their capital in a much more efficient manner.” 

Aberdeen is actively looking at use of exchange-traded alternatives to centrally cleared OTC derivatives and sees tools such as the GMEX Constant Maturity Future as having operational benefits. “For us, certainly in a credit world, it’s a good instrument, because it doesn’t have to be rolled all the time,” says Hickmore. “This means you can have a portfolio fully hedged off against your risks all the way across the yield curve on an ongoing basis. The on-exchange nature of such products also makes them operationally simpler.” 

But further innovation is required if asset managers are to find exchange-traded alternatives to all their hedging needs. “We’ll certainly be looking to do more exchange-traded derivatives, but many of our clients need more custom-built interest rate swaps, which will have to be centrally cleared,” says Hickmore.  

Developments in the exchange-traded market may not be sufficient just yet to replace the precision that tailored OTC derivatives can deliver to individual counterparts, but the widening range of instruments available offered by trading venues in response to the central clearing mandate is drawing in new market participants. Niche money managers that might have balked at the complexity of the OTC market are exploring the new competitive landscape with vigor says Nomura’s McCormack. 

“Smaller clients that have never had access to the OTC markets are seeing this as a great opportunity to get into trading different types of products,” he observes.  

Supporting roles

Despite new innovations such as swap futures, some buy-side market participants will continue to want to use familiar hedging instruments, at least until the new regulatory and competitive landscape takes a firmer shape. As such, they are looking to their clearing brokers to provide execution services, access to clearing and expertise, with the latter perhaps being the most important factor for buy-side firms that have never previously dealt directly with a CCP. 

“Both clearing brokers and clearing houses need to continue their efforts to raise awareness among buy-side firms of the implications of central clearing and the opportunities to maximize capital efficiencies – for example, by identifying and pursuing margin offsets across similar product sets,” says Misra. 

Clearing houses have had to embrace an entirely new role in interfacing directly with investment management firms, having previously dealt only with clearing members. According to Byron Baldwin, Senior Vice President, Eurex Clearing, they are already working closely with the buy side, notably by simulating currently unfamiliar processes in preparation for central clearing, such as posting margin, on a daily basis.  

“In our simulation program, we take trades from execution through to clearing and then generate the reports they would receive. It’s a matter of testing the pipes between the various platforms, testing the information flow, seeing the confirmation of trades, and understanding the margin calculation process. A lot of buy-side firms are sending us their portfolios to help them assess the margin implications of the positions within those,” he says.

For CCPs, central clearing is an opportunity to generate new relationships and revenues, but it requires a number of tweaks and adjustments to existing services and operations as well as the development of new ones. Eurex Clearing, for example, already accepts a wide range of asset types as collateral for margin payments and offers cross-margining across listed and OTC products. 

In 2014, Eurex introduced new services – Direct Collateral Transfer and Collateral Tagging – to help buy-side firms to tackle new challenges thrown up by central clearing of OTC derivatives, such as transit risk (i.e., the risk that collateral directed by an asset manager to an individual segregated account resides with a clearing member at the point of default and thus does not reach the CCP). “By introducing Direct Collateral Transfer, we eradicated transit risk. With Collateral Tagging, a big fund manager with 100-plus segregated accounts can achieve operational benefits by having just one fully segregated account with collateral tags on a per-fund basis,” explains Baldwin. 

Although the services required to handle the shift to central clearing are gradually falling into place, many challenges remain. Larger buy-side firms typically have a greater capacity to absorb the implications of regulatory change than their smaller counterparts. Their obligations under reforms such as EMIR are greater too, of course, but smaller firms must also comply, often needing more input from their sell-side counterparts to do so. 

“There is a level of clients which will have had lots of attention from their dealers and from their CCPs; but also there are a lot of smaller clients who have not had the time and attention,” notes McCormack. “It’s also important to get the message out to them, helping the clients understand their obligations and how they can prepare for them.”

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CFTC’s Massad Testifies on New Reg Framework for Swaps Before Senate Agriculture Committee

As the U.S. Congress debates changes to the Dodd-Frank financial reform legislation, CFTC Chairman Timothy Massad testified before the Senate Agriculture committee earlier today. In wide-ranging remarks, he discussed the past, present, and future state of regulatory reform.

He first spoke to the need for the clearinghouse model:

Of course, central clearing is not a panacea. Clearing does not eliminate the risk that a counterparty to a trade will default – instead it provides us with powerful tools to monitor that risk, manage it, and mitigate adverse effects should a default occur. For central clearing to work well, active, ongoing oversight of clearinghouses is critical. And given the increasingly important role of clearinghouses in the global financial system, this is a top priority.

Over the last few years, the agency has strengthened its clearinghouse regulatory framework, incorporating international standards and taking other steps to bolster risk management practices and customer protection. Today, we are engaged in extensive oversight activities that include, among other things, daily risk surveillance, stress testing, and in-depth compliance examinations. Our oversight efforts also focus on risk at the clearing member and large trader levels. And while our goal is to never get to a situation where recovery or resolution of a clearinghouse must be contemplated, we are currently working with fellow regulators, domestically and internationally, on the planning for such contingencies, in the event there is ever a problem that makes such actions necessary.

Massad went on to discuss the need for high quality data in order for clearinghouses to function effectively:

We are focused on three general areas regarding data. First, we must have reporting rules and standards that are specific and clear, and that are harmonized as much as possible across jurisdictions, and we are leading an international effort in this regard. Only in this way will it be possible to track the market and be in a position to address emerging issues. We must also make sure the SDRs collect, maintain, and publicly disseminate data in a manner that supports effective market oversight and transparency. This means a common set of guidelines and coordination among registered SDRs. Standardizing the collection and analysis of swaps market data requires intensely collaborative and technical work by industry and the agency’s staff. We have been actively meeting with the SDRs on these issues, getting input from other industry participants, and looking at areas where we may clarify our own rules.

As one example of rule clarifications, I expect that very soon we will initiate a rulemaking to clarify reporting of cleared swaps as well as the role played by clearinghouses in this workflow. This rulemaking will propose to eliminate the requirement to report Confirmation Data for intended to be cleared swaps that are accepted for clearing and thereby terminated. This will simplify reporting burdens and improve the data that we receive.

Finally, market participants must live up to their reporting obligations. Ultimately, they bear the responsibility to make sure that the data is accurate and reported promptly. We have already brought cases to enforce these rules and will continue to do so as needed.

He followed by highlighting some of the issues the agency is currently dealing with when it comes to cross-border recognition and harmonization:

Following that agreement, the European Commission advised us that it was still not able to find our supervisory regime equivalent and grant recognition to our clearinghouses because it is concerned that the margin methodologies used by U.S. clearinghouses are inferior to theirs and create an unacceptable level of risk to Europe. We disagree, and our discussions have been focused on these issues, in particular our respective rules on margin methodology for futures. We follow a policy of gross collection and posting of customer margin for a minimum one-day liquidation period. That is, the clearing members must pass on to the clearinghouse the full amount of initial margin for each customer. The Europeans methodology is based on a two-day liquidation period, but it permits netting: if one customer’s exposures offset another’s, then the clearing member can post initial margin netted across customers. To see how these different approaches compare, we provided them an analysis using actual data for seven days.

We reconstructed what the required margin would be under each regime for the nine largest clearing members of one U.S. clearinghouse. These clearing members represent about 80% of the total customer margin. And what we found was that one-day gross was substantially higher than two-day net for each clearing member, and for each day. That is, the total amount of customer margin under one-day gross was as high as 421% of the amount under two-day net, and was never less than 160% of that amount. We have since looked at two other clearinghouses, and found even larger percentage differences.

In addition, it is also important to remember that margin requirements are only one part of an overall supervisory framework we have to mitigate risk. There are many other aspects of our supervisory framework that enhance financial stability and customer protection.

To read Chairman Massad’s full remarks, including those on oversight, agency funding, and various security challenges, please click here

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Swaps Reporting Update: ESMA Gets Semi-Serious. The CFTC? Not So Much

By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum

Global swaps reporting has been something of a disaster. And while ESMA’s recent efforts to clarify reporting requirements offer some guidance in the EU, the CFTC’s attempts to improve reporting go nowhere.

Since every swaps market participant and every swaps market regulator recognizes that transaction reporting has been something of a disaster, we are all waiting to see what the regulators will do about it. Recently, two swaps regulators went in somewhat different directions on this subject.

First, the CFTC issued two no-action letters (“NALs”) and a proposed ruleon trade reporting in the US. The first NAL (Letter 15-24):

“… provid[es] relief from certain Commission regulations to permit SEFs and DCMs to correct clerical or operational errors that cause a swap to be rejected for clearing and thus become void ab initio; and the relief allows counterparties to resubmit the trade with the correct terms. The Error Trade No-Action Letter also permits SEFs and DCMs to correct clerical or operational errors discovered after a swap has been cleared. It allows counterparties to execute a trade to offset the cleared trade and also submit a new trade with the correct terms.”

The second NAL (Letter 15-25) extends:

“… the time period for relief previously provided in No-Action Letter 14-108, from September 30, 2015 to March 31, 2016, with certain modifications. This [NAL] provides relief to SEFs from the requirement to obtain documents that are incorporated by reference in a trade confirmation issued by a SEF, as required under Commission Regulation 37.6(b), prior to issuing the confirmation and from the requirement that a SEF maintain such documents as records, as required in Commission Regulations 37.1000, 37.1001 and 45.2(a). This letter also provides new relief from the requirement in Commission Regulation 45.3(a) that a SEF report confirmation data contained in the documents that the SEF incorporates by reference in a confirmation.”

The proposed rule:

“… eliminate[s] the Form TO annual notice reporting requirement for otherwise unreported trade options in Commission regulation 32.3(b). Instead, a Non-SD/MSP would only need to provide notice to the Commission’s Division of Market Oversight (DMO) within 30 days after entering into trade options (whether reported or unreported) that have an aggregate notional value in excess of $1 billion in any calendar year or, in the alternative, a Non-SD/MSP would provide notice by email to DMO that it reasonably expects to enter into trade options, whether reported or unreported, having an aggregate notional value in excess of $1 billion during any calendar year. Additionally, the Commission proposes that Non-SD/MSPs would under no circumstances be subject to part 45 reporting requirements in connection with their trade options.”

That’s about it. So the CFTC has really stepped up to the plate this time! And US swaps trade reporting remains pretty much a disaster.


ESMA’s process for clarifying requirements is to address them in regular updates to its Q&A document, found on its website. The primary reporting changes are contained in questions 20a and 20b.

Question 20a is actually two questions: “Are all fields specified in the Annex of the Commission Delegated Regulation (EU) No 148/2013 mandatory? Can some fields be left blank?”

The answer:

“In general, all fields specified in the RTS are mandatory. Nevertheless, two different instances need to be acknowledged, namely:

“1. The field is not relevant for a specific type of contract/trade, [okay to be left blank] and

“2. The field is relevant for a given type of contract/trade, however:

“a. there is a legitimate reason why the actual value of this field is not being provided at the time the report is being submitted, or

“b. none of the possible values provided for in the Annex of the Commission Implementing Regulation … apply to the specific trade [okay to be populated with NA].”

We’ll see some of the fields that fall into these categories when we look at the ESMA spreadsheet referenced on the next page.

Question 20b, while shorter, is much more inclusive: “How are TRs [Trade Repositories] expected to verify completeness and accuracy of the reports submitted by the reporting entities?” This is the first question ESMA has addressed on report validation, so every aspect of its answer is important.

To begin with, the phrasing of the question implies that the TRs are responsible for both the completeness and accuracy of the reports. Completeness is relatively verifiable, based on the data requirements for each field, contained in a spreadsheet published by ESMA. Even the accuracy of some fields could be verified. For example, the “clearing threshold” field pertains to whether the reporting counterparty is above the clearing threshold, and presumably can be checked against records held elsewhere.

However, most of the data elements are not all that verifiable by the TR. Even simple things, like the LEIs of the parties to the trade, are not really verifiable if that is the only identifier used, unless the TR checks the LEI against the issuer database to see if it exists. But that still doesn’t say it’s the right LEI. If any of the data elements in a report are inaccurate, either inadvertently or on purpose, and the TR has no way of finding out, is it still responsible for verifying the accuracy? A crucial question.

Now let’s look at some of the answers in the ESMA document.

“The table [the spreadsheet linked to above] includes two levels of validations which should be performed by TRs:

  • “The first level validation refer to determining which fields are mandatory in all circumstances and under what conditions fields can be left blank or include the Not Available (NA) value, as clarified in TR Q&A 20a above.
  • “The second level validation refer to the verification that the values reported in the fields comply in terms of content and format with the rules set out in the technical standards. Where applicable, the logical dependencies between the fields are taken into account to determine the correct population of the fields. The second level validations are complemented with instructions on the fields which should be populated depending on the action type.”

Thus ESMA’s definition of verification is the kind of validation we have already seen by many repositories. They look to see if the data in the fields conforms to the rules, but not necessarily if it is accurate. No real improvement there. Now we have to look at the spreadsheet to see what’s required.

Looking at the Spreadsheet

The first question is: What data elements are allowed to be blank? Some are expected, but are there any that are unexpected? In Table 1 (Parties) we find item 5 – Domicile of the Counterparty – which can be blank if the party ID contains the domicile. Thus validation here requires a two-part check: Does the ID contain the domicile? If not, is it populated here?

Item 6 – Corporate sector – has the same condition, so another two-part check. There are several other IDs that are optional, such as broker, clearer, and reporter, and the hedging flag for financial parties, all expected and probably not checkable.

Under Table 2 – Details of the transaction – we look at field 12 – price/rate. Here the field cannot be blank, but the rules allow a value of 999999999999999,99999 – obviously in lieu of blank or “NA.” This will lead to the same instances we have seen in the US, where there is no actual price reported for some trades that should have one. There is no indication in the spreadsheet or the Q&A as to whether the TR is responsible for determining if a price is required. By the same token, the spreadsheet allows NA in field 13 – Price notation.

Where does that leave us?

So are we in a better place on trade reporting with these regulatory releases? In the US, not at all; in the EU, a bit. And it is not a good place to be if you are a regulator, a customer, or even a market observer. We still know very little about what’s going on in the market from the trade reports.

ESMA has started threatening to punish inaccurate swaps reporters, but it will have to find them first. Given that the TR business is a competitive one, and dealers do most of the reporting, don’t expect TRs to start trumpeting how tough they will be in verifying reports. So I guess it’s a pretty good place to be if you’re a swap dealer.

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CFTC Chairman Timothy Massad Testifies on the Resources Required by the Agency to Help Meet Its Responsibilities

In testimony regarding the President’s request for the Commodity Futures Trading Commission’s budget for the 2016 fiscal year, Chairman Timothy Massad spoke before the U.S. Senate Committee on Appropriations, the Subcommittee on Financial Services and General Government in Washington DC. He discussed the steps the CFTC has taken to enhance transparency and market integrity, working collaboratively with other agencies like the SEC and international regulators to harmonize swap trading rules and requirements, while continuing to remain engaged in compliance, surveillance and enforcement.

Chairman Massad noted that the agency needed an increase in funding from the previous year to help meet its growing responsibilities as trading continues to move to electronic platforms:

“…the CFTC’s budget is not at a level that is commensurate with its responsibilities. Our responsibilities in the last few    years have increased significantly, and now include overseeing the swaps market, an over $400 trillion market in the U.S., measured by notional amount. In addition, the markets the Commission has traditionally overseen have grown in scale, technological sophistication, and complexity. The number of actively traded futures and options contracts has doubled since 2010 and increased six times over the last 10 years. Trading is increasingly conducted in an automated, electronic fashion, and cybersecurity has become a major new threat to the integrity and smooth functioning of the critical market infrastructure that the Commission regulates. While these developments, among others, have brought new responsibilities and challenges to the Commission, its capabilities have not kept pace. Our resources continue to be stretched far too thinly over many important responsibilities.”

His testimony touched on a number of different areas. He first discussed the importance of derivatives and oversight efforts:

“The derivatives markets are profoundly important to a wide variety of businesses in our country. They enable businesses of all kinds to hedge commercial risk, whether it is a farmer locking in a price for his crops, a utility hedging the cost of fuel or an exporter managing foreign currency risk. Those businesses depend on the Commission to do its job efficiently and sensibly. The Commission’s budget is a small, but vital, investment to make in order to make sure these markets operate with integrity and transparency.

It is also helpful to remember how excessive risk related to swaps contributed to the 2008 financial crisis, and the cost of that crisis to American families and our economy, to recognize the value of this investment. That crisis resulted in eight million jobs lost, millions of foreclosed homes, countless retirements and college educations deferred, and businesses shuttered. Indeed, the amount of taxpayer dollars that were spent just to prevent the collapse of AIG as a result of its excessive swap risk was over 700 times the size of the CFTC’s current budget. Another perspective on the size of our budget is the fact that from 2009 through 2014, the Commission collected fines and penalties of approximately twice its cumulative budgets. This year the fines and penalties collected are already about 10 times our budget.”

To read his full testimony, please click here

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CFTC Commissioner J. Christopher Giancarlo Comments on Regulatory Framework for Swaps Trading

A veteran of Wall Street, Commissioner Chris Giancarlo of the Commodity Futures Trading Commission recently issued a statement regarding the ongoing debate over the future of reform following comments made by CFTC Chairman Timothy Massad on the future of swaps market regulation. Commissioner Giancarlo stated:

“I commend the CFTC for its recent announcement of first steps in improving its regulatory framework for swaps trade execution and SEF operability. I support these commonsense measures that address concerns raised in my January 2015 White Paper: namely, streamlining the process of correcting error trades, flexibly interpreting SEFs’ financial resources requirement and simplifying swap trade confirmations by SEFs.

He also highlighted his focus on working with fellow members of the CFTC towards realizing the regulatory objectives set forth in the Dodd-Frank Act.

Commissioner Giancarlo’s comments follow similar sentiments described in a speech by Chairman Massad last week and a recent profile in trade publication Institutional Investor. See his full remarks here

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CFTC Chairman Massad Extends No-Action Relief on SEF Data Reporting

In a speech to the DerivOps North America 2015 conference, Commodity Futures Trading Commission Chairman Timothy Massad spoke about the future of swaps market regulation. Comparing it to the regulation of futures on the 40th anniversary of his organization, he spoke about the need to balance transparency and reliability while not stifling future growth of the industry. He believes that progress has been made so far but that more work is needed.

He also extended the agency’s no-action relief for SEF confirmations and confirmation data reporting, which will alleviate the need to maintain copies of ISDA Master Agreements for all trades and to report confirmation data on uncleared swaps to swap data repositories until March 31, 2016.

The wide-ranging speech discussed a number of different areas. First among them was the need to revise the current set of regulations so they work for – not against -- industry players:

“Over the last ten months, one of our priorities has been to work on fine-tuning the new rules so that the new framework works effectively and efficiently for market participants. In particular, we have made a number of changes to address concerns of commercial end-users who depend on these markets to hedge commercial risk day in and day out, because it is vital that these markets continue to serve that essential purpose. This has included adjustments to reporting requirements and measures to facilitate access to these markets by end-users. We will continue to do this where appropriate. With reforms as significant as these, such a process is to be expected. We are also working on finishing the few remaining rules mandated by Dodd-Frank, such as margin for uncleared swaps and position limits.”

Massad spoke about the need to make sure clearinghouses themselves were run effectively in the event of a catastrophe:

“Oversight of clearinghouses has been another key priority. Under the new framework, clearinghouses play an even more critical role than before. So we have also been focused on making sure clearinghouses operate safely and have resiliency. We did a major overhaul of our clearinghouse supervisory framework over the last few years. Today we are focused on having strong examination, compliance and risk surveillance programs. And while our goal is to never get to a situation where recovery or resolution of a clearinghouse must be contemplated, we are working with fellow regulators, domestically and internationally, on the planning for such contingencies, in the event there is ever a problem that makes such actions necessary.”

In the context of extending no-action relief for SEF data reporting, Massad also highlighted past use of no-action letters for temporary relief as firms attempt to achieve compliance and regulatory objectives and areas of future use:

“This no-action letter also provides relief for SEFs regarding their obligation to report Confirmation Data on uncleared swaps to SDRs. SEFs have expressed concern that to comply with their reporting obligations for uncleared swaps, they might be required to obtain trade terms from the same ISDA Master Agreements or other underlying documentation that, as I have just discussed, are not otherwise available to them. In light of these concerns, this relief clarifies that SEFs need only report such Confirmation Data for uncleared swaps as they already have access to without undergoing this additional burden. I would note that SEFs must to continue to report all “Primary Economic Terms” data for uncleared swaps – as well as the Confirmation Data they do in fact have – as soon as technologically practicable. I would also note that the counterparties to the trade have ongoing reporting obligations for uncleared swaps.”

To see his full remarks, including greater description for the use of no-action letters for error trades and data, please click here.

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4 Big Questions Dogging Financial Market Reform

By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum

The prognosis for financial regulation in the US appears very poor at the moment. Here are four important questions about structural reform that need to be answered to get regulation back on track. Otherwise, we may just have to wait for the next financial disaster to prompt lasting change.

The recent series of papers on reforming the financial regulatory structure published by the Volcker Alliance makes interesting reading. You may or may not agree with the conclusions; but I, for one, can’t help but think that there are some important questions about structural reform lurking just under the surface that either were not asked or were subsumed in these papers. So let’s get them out on the table and see where they lead us.

No. 1: Should a central bank be the primary banking regulator?

The Volcker Alliance documents recommend that the primary banking regulator should be the Fed. But we need to look closely at the functions of a central bank, and a banking regulator, to see if that combination really works.

To begin with, a central bank must be, by definition, a bank. That sounds obvious, but it has one or two subtle implications. The first is that, in the modern world, 99.99% of money is actually a bank’s promise to pay. And every commercial bank’s promises to pay are offset by the central bank’s promise to pay. So all of these institutions are tied together in a web. Whether the entanglements of that web make it harder for a central bank to act as a truly independent banking regulator is open to debate, but we probably need a healthy public discussion of that topic, for a start.

Then we have to recognize that most central banks are also lenders of last resort – generally to the banks in their system. Here, it is important to understand that the last resort function only happens in a crisis, but the potential is there all the time. If the regulator is doing its job well, the last resort function usually remains just a concept; but events that aren’t within the purview of the regulator, such as the actions of another country’s regulator, can bring on a crisis in a hurry. If that happens, is it better to have the banking regulator separate from the lender of last resort? Another topic for discussion.

Finally, central banks have a set of functions that require them to be active in the markets, such as controlling interest rates and currency values. These functions especially require them to deal as principal (and sometimes as agent) in these markets, often trading with the banks in their system. Thus, we could easily see instances where the central bank as monetary authority is dealing with a bank in one way, and the banking regulator is dealing with the same bank in another way. Whether the needs of the central bank as market operator might trump the needs of the central bank as regulator is another subject for discussion.

There are countries, of course, where the only regulator of the banking system is the central bank, but those countries may not have the same political or economic framework the US has. In any event, if we are going to restructure financial regulation in the US, we need to answer this question first.

No. 2: How should we define market regulation and depository regulation?

A variation of this question has often been discussed, in the form of combining the two market regulators in the US. Since we’re the only country with separate regulators for securities and commodities, the Volcker Alliance recommendations are to combine the SEC and CFTC, to nobody’s surprise. Have one banking regulator, and one market regulator, so the logic goes.

But there is another, perhaps more relevant question: Should we instead place the depository functions of both banks and brokers under depository regulation, and the market functions of those same institutions under a market regulator? Should we have one regulator charged with protecting, in effect, both checking and trading deposits, and another regulator requiring all market participants, large and small, including clearinghouses, to act professionally and prudently?

The idea that one depository regulator would oversee both a bank and a brokerage firm may sound strange, but it is more palatable if we define regulation along functional as opposed to organizational lines. The recent experience with such requirements as Volcker Rule examinations has shown us that the expertise necessary for depository regulation doesn’t usually translate well into regulation of principal trading functions, and vice versa. To the extent that deposits are insured, as they are in both banking and brokerage, the regulation of deposit takers is essentially the same across both industries. And the surveillance of market participants, whether they are trading for their own account or for others, is homogeneous enough to be handled by one regulator across all market participants.

There are, of course, lots of discussion points here. This would require two regulators for all entities that both take deposits and trade in markets, but most financial institutions have more than one regulator anyway. This structure would preclude what we currently see in Volcker Rule exams, the folly of having five sets of examiners, the Fed, the OCC, the FDIC, the SEC, and the CFTC, all trying to come up to speed on what is essentially the same subject. If asked, most financial institutions would probably prefer to have one regulator knowledgeable in their depository functions and one knowledgeable in their market functions, as opposed to several regulators trying to handle both functions.

No. 3: How important is international symmetry in regulation?

There has been discussion about international asymmetry in financial regulation for as long as I can remember, perhaps as far back as Walter Bagehot (you can look him up). Even then, the crux of the matter was regulatory arbitrage. Long ago, it was about moving physical money and assets into venues where regulation was more lax or out of date. Today it’s about moving transactions or funds electronically between venues for the same purpose.

As it turns out, there are other reasons to move transactions between venues, such as tax and counterparty location, so every intra-company, cross-border trade isn’t a regulatory arbitrage. On the other hand, cases like AIGFP, where trades done in London by a French-chartered company resulted in a $150+ billion Fed bailout of a US insurance company, show that regulatory arbitrage can have some very significant impacts, in particular the kind of “blow-back” danger we saw in AIGFP. In the ongoing regulatory conversations about the implementation of the Pittsburgh G-20 agreement, there have been some sharp words exchanged about regulatory practices that led to blow-backs.

Thus, it is a good idea to prioritize the regulatory asymmetries that would promote the kind of arbitrage that could result in blow-back, while placing less importance on asymmetries that would keep the problems contained in the venue where they began. The area of most interest today is the recognition and regulation of derivative clearinghouses. Since the implementation of the G-20 agreement is generally recognized to have greatly concentrated the risk in the derivatives market, perhaps the most important international symmetry concerns CCPs. The main Volcker report only mentions clearinghouses once, in passing, and the national case studies not at all. Given the amount of attention being paid to the international regulation of CCPs, that’s an important omission that makes the report look a bit out of date.

No. 4: Finally, is this all just a waste of time?

The Volcker Alliance report laments – and everyone is probably aware of – the many unsuccessful attempts to streamline financial regulation in the US. If most impartial observers recognize that US financial regulation is decidedly sub-optimal, and that the structure is at least partly to blame, we need a clear understanding of why that structure persists.

Perhaps we can start the explanation with this quote from the report, which is itself a quote from the Financial Times: “Former Senator Chris Dodd echoed that sentiment in a speech last year. ‘I would’ve established a single prudential regulator and gotten rid of the rest,’ he said. But, he added, ‘I got about three votes at the time.’” That leads to the immediate question of why such an obvious improvement would be so unpopular in the halls of Congress.

That may sound like a naïve question, but it’s really not. If the members of Congress have enough intelligence to understand the benefits of such a change, then the only explanation I can see is that the financial industry has so much influence over Congress that it can stop this kind of reform in its tracks. Assuming that this isn’t a case of blackmail, then it can only be a case of money, perhaps suitcases of money.

If that logic is correct, and I’m anxious for it to be proven wrong, then the prognosis for financial regulation in the US is very poor. If financial institutions can – pardon the expression – bank on a fragmented regulatory structure to give them the freedom they want, then we just have to wait patiently for the next financial disaster. In that case, the Volcker Alliance documents might make interesting history someday, but not public policy today. 

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An Oasis in the Desert: Collateral Management in a Funding Constrained World

By Radi Khasawneh, TABB Group
Originally published on TABB Forum

Market conditions and regulatory complexity have combined to make efficient management of collateral a critical component in a wider process of controlling trading and funding costs across the industry.

Market participants are caught in a pincer movement of regulatory-led market change that will make collateral management an increasingly crucial component of decision-making for trading desks and risk managers. This change has been driven by US and European regulations aimed at moving bilateral, over-the-counter (OTC) swaps onto exchange-like venues and through central clearing and a separate push by national regulators to impose renewed and more stringent capital calculations on the banks that act as the intermediaries for the buy side.

The net effect of all of this cannot be overstated. TABB Group estimates that shifting non-cleared OTC swaps to central counterparties will eventually require approximately $2 trillion in additional collateral deposits. And that is just one piece of the overall puzzle that means a more systematic attitude to the collateral workflow has to emerge. Alternative figures published last year by the DTCC put that OTC collateral figure at $4 trillion, showing how widely these estimates can vary. In any case, it is clear that the efficient use and management of collateral has become a key part of strategic thinking as the consequences of regulation are weighed.

To give an idea of the sheer scope of these figures, total collateral held against non-cleared OTC contracts at the end of 2013 was $3.2 trillion, according to figures published by ISDA. That figure includes the decline in non-cleared swaps as US and European mandatory clearing began to take hold; but 90% of those non-cleared swaps are subject to collateral agreements in any case.

Global clearinghouses have reacted to this by dramatically expanding the scope of their cleared products and enhancing the ability to net exposures across products and portfolios (as part of incorporating this new volume into existing flow). Nevertheless, the fragmented regulatory environment also has led to a proliferation of clearing entities across jurisdictions. Exhibit 1, below, shows the divergence in margin haircuts applied by global CCPs for the same securities. There is an obvious bias to home country securities (government bonds and equities) that can be posted, and the vast majority of collateral posted is in the form of either cash or sovereign bonds; but the extent of the differences shows that there is definitely scope for a change in approach to how collateral requirements are managed at global trading firms.

Exhibit 1: Margin Haircuts Applied to Securities by Global CCPs

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Source: TABB Group

Futures Commission Merchants (FCMs) have reacted to this by updating and enhancing their own technology platforms to allow clients to manage their own exposure through their platforms. In a survey of more than 50 US buy-side swap traders conducted last year, 33% of respondents said they selected their FCMs based on their technology platforms. Interviews with 16 FCMs conducted in the second quarter of 2014 showed that collateral management ranked highly as a strategic differentiator for firms (Exhibit 2, below); it also was the top area cited when asked to identify an area that would lead to the greatest increase in revenues for the business.

These positive trends are counteracted by a much more challenging funding environment overall. Sustained low interest rates have hit the performance of collateral reinvestment at firms (whether that is pure net interest income or passing through negative interest rates on cash balances), and the finalization and phased introduction of an Enhanced Supplementary Leverage Ratio (eSLR) in the US has had a seismic effect on bank attitudes toward balance sheet usage. The new calculation imposes a stricter, additional 2% capital buffer on bank holding companies and requires them to calculate notional, rather than netted, derivatives exposures in some cases. The leverage ratio denominator also takes into account off-balance sheet exposures that were previously not included. All of this adds up to a headache for firms designated as globally systemically important financial institutions (so-called G-SIFIs). In this year’s FCM interviews, nearly 90% of FCMs cited regulations – and specifically the SLR – as the key concern over the past 12 months.

Exhibit 2: Key Differentiators for FCMs, April 2014

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Source: TABB Group

What all of this means for the buy side is that higher collateral requirements will inevitably be accompanied by higher baseline costs, as fees are revamped to reflect the changing funding environment for banks. The Dodd-Frank Act in the US, the European Market Infrastructure Regulation and the Markets in Financial Instruments Directive (MIFID II) already have had a large effect on buy-side workflows (Exhibit 3, below). Rather than simply focusing on sourcing and tracking the correct form of collateral securities, firms are increasingly being offered the tools to optimize and analyze decision-making and valuation.

Exhibit 3: New Collateral Workflows

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Source: TABB Group

All of that being said, change has been slow in coming. There is a dependence on CCP models across the board, and 40% of US buy-side swap traders do not validate these valuations at all. FCMs have indicated that adoption of collateral analytics, although valued, has been slow.

TABB Group expects – and has argued for – the emergence of an expanded role for collateral-use decision makers at buy-side firms. There is a need for an ability to rapidly allocate collateral and optimize its use through efficiency in tracking, monitoring and managing collateral inventories across business lines. As these figures emerge, wholescale adoption of more sophisticated, global approaches at buy-side firms will have their champion. 

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Could Liquidity Itself Shape Fair and Efficient Market Structure?

By Doug Sanzone, Bayes Capital Markets
Originally published on TABB Forum

There has long been a question of whether regulatory relief should set market structure to ameliorate market deficiencies or whether competitive forces are sufficient to lead to efficient and productive markets. One of the competitive forces that can help today’s equity markets is liquidity itself. Can liquidity serve as the basis for effectively centralizing the fragmented market, and what is needed for fair and orderly interaction of all flow, regardless of source?

Much has been made of the deficiencies in market structure in the equities markets: fragmentation owing to too many venues; predation by HFTs; regulatory arbitrage and incrementalism; the decline in the number of equities listings with attendant volatility; the cost of trading; the inability to access the trade itself.

There has long been a question of whether regulatory relief should set market structure to ameliorate market deficiencies or whether competitive forces, conditioned by technology, are sufficient to lead to the efficiency and productivity markets have experienced in the past. The fact of the matter is that there has always been an appropriate balance between regulation and competition.

That said, one of the competitive forces that can help today’s equity markets, and which has not been sufficiently exploited, is liquidity itself. It is an economic fact that centralized markets, where all buyers and sellers can interact, are de facto efficient: supply meets demand and sets an efficient price.

That is not the case since the demise of centralized exchanges for equity trading – be they either dealer or auction driven. But suppose markets could be constructed in such a way that even though the structures don’t have the ideal efficiency of a centralized market, the underlying driver of markets, supply and demand – in other words, liquidity – was intermediated in as near efficient manner as possible. Here liquidity itself becomes the driver of market structure.

The question is: Can liquidity itself serve as the basis for effectively centralizing the market, if there are mechanisms to intermediate all the flow, rather than discriminating on the basis of selective types of flow?

This will require a bit of a rethink by market players if a truly effective level of supply and demand is to be achieved. And the rethink required is specific to liquidity: to suspend judgment on “types” of liquidity and see all liquidity as equal – quant, HFT, traditional, day trader, hedge fund. Flow is flow. More is better.

That said, there are legitimate historical reasons why certain types of flow developed in certain ways, and why players did not deem it appropriate to interact with other types of flow given the strategies they were seeking to execute. So what is to be done? What is needed for fair and orderly interaction of all flow, regardless of source, and which will allow all participants to interact on an equal footing are the following:

First, a neutral meeting point, an environment where diverse types of liquidity can interact in an anonymous, fair and orderly manner. This will require a compliance gateway to filter out any possible manipulative activity associated with orders with a very short-term trading horizon along with connectivity to the various important market centers using the latest technology available in order to access any liquidity outside the environment in a low-latency manner.

Second, algorithmic tools to interact with market. That genie is out of the bottle; algorithms will always be necessary to access liquidity in a low-impact fashion with minimal information leakage.

Third, a specialist/market maker to provide liquidity when needed whose motivation is to service order flow by providing liquidity when needed to maintain an orderly market to attract the next order, not to extract maximum trading P&L from each order by using the advantages of better market access and technologies to arbitrage the inefficiencies caused by Reg NMS, and the proliferation of multiple lit and dark trading venues. The execution of flow in this context is not simply agency (though that is the “first pass”) but actually replicates the traditional ability of order-driven market making when naturals do not meet. Here routing is simply not sufficient; but genuine market making providing liquidity as a service to the customer order completes an efficient marketplace.

Fourth, a neutral execution point that simultaneously satisfies all of the conditions above – once the aforementioned conditions are created, liquidity will naturally gravitate toward an environment that will allow orders to interact with each other in a fair and orderly price-time manner, leading to both superior price discovery and liquidity at those prices. This would create an environment that does not merely have access but aggregates the maximum possible liquidity available.

The effect, then, is as near a template as possible for an effective centralization in a fragmented market. A tall order? Not when judged against the criteria of continued market clunkiness and inefficiency.


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