DerivAlert Commentary

The Road to Blockchain – Why a Silver Bullet Is No Good Without a Way to Fire It

Posted on Wed, May 25, 2016 @ 11:30 AM

By Trevor Belstead
Originally published on Tabb Forum

Blockchain and distributed ledger solutions seek to transform established business models, from trading to settlement. This transformation is so disruptive to some existing businesses that it will challenge many banks’ ability to survive. As a first step, banks need to re-evaluate their business models and architectures in the context of reduced complexity and fewer opportunities of differentiation in basic services.

There is great hype around the blockchain, with organizations seemingly falling over themselves to make sure they are at the forefront of the new technology. Indeed, Deloitte recently announced five new blockchain partnerships and 20 prototypes. However, it might not be the catch-all, silver bullet solution it seems. In fact, before financial services firms can benefit from the great potential of a distributed ledger, the industry first needs to undergo a complex transformation—one that, as yet, has no clear endpoint. Companies need to effectively address today’s challenges in order to reap the rewards in the future.

Any technology that promises large improvements in market-wide efficiency, such as significantly reduced settlement times and faster collateral movements, will always gain broad interest. There are always hurdles to overcome before big ideas become reality, especially for something as radical as a distributed ledger, which seeks to transform various established business models, from trading to settlement. This transformation is so disruptive to some existing businesses that their business models will be almost completely redrawn. It will challenge many banks’ ability to survive, create value in their long-standing businesses and deliver profits to shareholders. As a first step, banks need to re-evaluate their business models and architectures in the context of reduced complexity and fewer opportunities of differentiation in basic services. 

This change will not happen overnight, and financial institutions cannot afford to simply wait for it as followers. They need to consider existing problems and issues and find common ground with other market participants in terms of their business operating models. Banks have opportunities to collaborate now and address a number of the issues found on the road to the blockchain model of the future. If they work to create shared platforms, the transition to a distributed ledger will be simpler. Blockchain will not magically reduce requirements for cost reductions, increased transparency and higher efficiency in the short term. This is why addressing these problems today will better position the markets for the move.

It is easy to identify the challenges—actually addressing them is the hard part. Financial institutions have a range of questions to answer as they take the next steps toward blockchain solutions. First of these is the existing legal and contractual framework. Where does the trust really reside in these platforms? Who owns a platform and the data? Regulators need to play an as-yet undefined role in deciding what changes to the legal framework and laws will be needed. Firms will also have to look carefully at the operational landscape as well as how early adopters will integrate with legacy systems—a company will not simply wake up one day and be fully migrated!

All that is even before considering aspects of security, identity or cost, revenue and ROI models. Equally, how would institutions address operational risks and failures? It is clear that there is a lot of complicated groundwork, planning and adjustment to be done before this particular silver bullet can be fired. One potential approach is increasing the use of outsourcing services from third parties or market utilities – in effect creating shared platforms that are simpler to migrate into from current operating models. Outsourced services can span a bank’s key business lines, from the cash equities brokerage arm to securities finance, money management and Foreign Exchange (FX), to name a few.  

Of course, there are many points to be examined before taking advantage of outsourced services and the efficiencies they offer. Banks need to place their trust in the outsourcing service providers and therefore may not develop or operate their own versions of these services. Outsourced solutions need to work across business lines and service levels must be carefully monitored, with a clear understanding of who is responsible for meeting them, or accountable for missing them.

Importantly, outsourcing services pave the way for the collaborative model of the distributed ledger, as well as building new contractual frameworks and trust models. Banks are also free to concentrate on strategic investments that drive revenue and profitability rather than spend time on commodity activities. Outsourcing should also improve ROI ratios and reduce operational costs—key benefits in an age of ever-mounting cost pressures. Common platforms and shared services may also reduce the cost of compliance, mutualizing many areas of the work currently repeated at every institution.

Many market areas are making promising strides on the road to blockchain, which may be the ultimate goal for a common platform. To prepare for it, financial services companies should carry out an honest assessment of their future business models in the context of blockchain. With that backdrop, they should further review the current challenges and their progress toward collaboration using outsourced services. Until then, there is still no clear picture of exactly how many miles there are left to travel, or on how long it will take to load that silver bullet.

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Tags: Collateral, Blockchain, Fintech, DLT

The 5 Pillars and 3 Layers to Enterprise Blockchain Solution Design

Posted on Wed, May 25, 2016 @ 10:30 AM

By Fran Strajnar, BNC
Originally published on Tabb Forum

The quest to find functional blockchain solution designs that can scale to enterprise requirements is at fever pitch. But neither public nor purely private blockchains meet the requirements of the financial services sector. Rather, a systemic approach that effectively provides two blockchains is required.


Unless you've been living under a FinTech rock, you would have noticed that blockchains are the hottest topic in the space today. The quest to find functional blockchain solution designs that can scale to enterprise requirements is at fever pitch.

After having reviewed countless “private blockchain” designs for the financial services sector, I have come to understand that most solutions are striving for a single cryptographic or mathematical solution to all key requirements (outlined below).

I believe a systemic approach is required. Instead of the everything-on-the-blockchain approach, we recognize the key considerations and layers involved, and build a solution design that addresses the correct requirements on the correct layers.


Banks, FinTech entrepreneurs and legacy infrastructure providers such as IBM have requirements that far exceed public blockchains’ (e.g., Bitcoin) current capabilities.

For instance, with Bitcoin’s capacity today sitting at 220 million transactions per year, any substantial bank will single-handedly exceed this limitation.

When you start using blockchain transactions as a record and data-integrity management service, the number of transactions can quickly explode

The problem with this unfolding thought-process of “Bitcoin can’t do it; we’ll build our own,” is the resulting “purely private blockchain” designs, which sacrifice security and immutability for scale and privacy.

(Some of) what is being explored today:

  • Clearing & Settlement (ASX NASDAQ & various)
  • Syndicated-Loans (R3 & many others in stealth mode)
  • Smart-Contracts & Smart-Assets (, Tradle)
  • Federated Bank Feeds & Federated Invoicing (
  • Payments (Swift, Ripple, Western Union & various)
  • Digital Identity (Skucard, OneName & various)

Solutions vary in application, but they all share the same infrastructure design considerations, whether they know it or not.

Let’s take a look at key solution requirements.

The 5 Pillars of Enterprise Blockchain Solution Design:

  1. Permissioned/Private. Writing records is exclusive to members; third parties can be granted read access, with the general public excluded. The permissions architecture goes beyond “access = everything” and allows third-party access to specific raw data, as deemed appropriate, for interoperability and application requirements.
  2. Decentralized/P2P. Allowing for equal control over the shared database among all permissioned participants and of equal importance; distributing the number of full copies of the ledger to maximize the probability that there will always be a complete record in existence and available for those with permissions to access.
  3. Immutability & Data Integrity. Records are guaranteed to be cryptographically secure, with no possibility for bad actors to threaten data integrity.
  4. Scalability. The ability to secure trillions of transactions or records without compromising the networks synchronization, security, accessibility or data integrity.
  5. Security. Support for data encryption and the management and enforcement of complex permission settings for participants and third parties.

How do we achieve all 5 pillars in a solution design?

Blockchain technology for enterprise applications, particularly for the financial service sector, needs to ensure it not only can scale, but comply with regulation, offer consumer protection through privacy and security, and meet a growing list of feature requirements.

Most private blockchain solutions build their own blockchain and end up offering vast scalability at the expense of solid immutability and security.

We propose, instead of a single mathematical or cryptographic solution, to take a systemic approach by offering effectively two blockchains: One acts as a private data-store, security and integrity engine; the other being public and incentivized, addresses the finality, security and immutability requirements.

Separating immutability from scalability considerations, solves several current blockchain design bottlenecks.

The outcome is a foundation that can service the demands of enterprise applications without compromising on one of the five key enterprise solution design pillars.

Let’s take a look at the three integral layers required and where each of the above 5 pillars is serviced.

The 3 Layers: #1 The Blockchain


Solution considerations of the Blockchain Layer:

  • Used for: “Pointers”
  • Pillars: #2 - Decentralized/P2P & #3 - Immutability & Data Integrity

The Blockchain Layer doesn’t need: Storage, Business Logic (complex permission structures), Data Storage, etc.

Instead of trying to achieve all five key pillars (solution design requirements) on one public network, we accept the fact that public blockchains are a terrible storage solution and will struggle to scale.

A public Blockchain is not Dropbox …

... nor is it a conventional database capable of running a billion-plus transactions per week. Therefore we will not see Bitcoin or Ethereum (as they are designed today) power global trade or the Internet-of-Things on their own.

“Pointers” or “hashes” (see: Merkle-Trees) are transactions that do not disclose any valuable information to the public, who can also access the open blockchains. However, for people or machines who know which addresses to track for a new hash, these pointers offer two uses:

  1. Notification to a status change or new entry made on the secondary, private blockchain, in the next layer - The Data-Store Layer (see below); and
  2. Validate the integrity of the data placed in said private chain.

Using only a purely private blockchain will result in a struggle to provide immutability. If Lehman Brothers built a blockchain and everybody used it, the company’s collapse would also mean a systemic network collapse and bring down all applications reliant on this private blockchain.

The epiphany: Use the strength and utility of open, distributed and incentivized blockchains for a part solution and complete the solution “off-chain” on a private distributed database designed for scale and business logic.

The 3 Layers: #2 The Data-Store


Solution considerations of the Data-Store Layer:

  • Used for: Encryption, Business Logic (permission structures), Data Storage, etc.
  • Pillars: #1 - Permissioned/Private, #4 - Scalability & #5 - Security

The Data-Store Layer doesn’t need: Open-Access or limited transaction payloads due to block sizes or other public blockchain constraints.

In our Enterprise Blockchain Design, very limited raw data is recorded on the public blockchain; the majority of data is recorded in a private data store that behaves like a distributed relational database. The data-store is then configured to auto-hash, in bulk, transactions sets onto a public chain, at any required interval, creating a merkle-tree-“receipt,” which notarizes and validates the full dataset hosted on the private data-store. We recently ran a proof using our Bitcoin Liquid Index, to create the world’s first Blockchain-Secured-Index, allowing us to power decentralized derivatives in a trustless manner.

The data-store is also capable of creating child-accounts (sub-data-stores), therefore offering deep business logic and complex permission settings.

This compartmentalization of data ensures the absolute security and privacy of participants’ full transactional data.

The 3 Layers: #3 The Application


Solution considerations of the Application Layer:

  • Used for: Processing the first two layers into a useful business application.
  • Pillars: None

The Data-Store Layer doesn’t need: Any of the Blockchain or Data-Store Layer functions or considerations.

The Application Layer is the “connector” into and out of the Data-Store (and from there, the public blockchain of choice, for the underwriting of data integrity).

The Application Layer can be anything – a bank’s front-end customer portal or a back-end lender’s portal for managing applications or repayments.


The key to viable Enterprise Blockchain Solution Designs is a systemic approach in which the five key pillars are separated into the correct design layers.

This approach not only will allow for rapid deployment of blockchain technology in enterprise solutions, it also will create a symbiotic feedback loop between public and private blockchains, which only diversifies design risk and increases interoperability, paving the way for second- and third-generation applications and entrepreneurs.

Of course, some serious development went into building the integral middle layer, “The Data-Store,” that we used in our proof of concept, but it is available for commercial use today.

Remember: Networks always end up demanding interoperability. Build well and build for the future.

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Tags: Blockchain, Fintech, DLT

Blockchain Makes for a Risky Business Case

Posted on Wed, May 25, 2016 @ 10:00 AM

By Larry Tabb, Tabb Group
Originally published on Tabb Forum

The first-mover advantage offered by traditional solutions doesn’t apply to blockchain and distributed ledger technology. In fact, blockchain has a first-mover disadvantage. So how do we drive blockchain adoption and realize its full potential?

Blockchain/distributed ledgers have the power to radically shift the economics on Wall Street. But the power of the blockchain comes from ubiquity and scale. So what does that mean for blockchain adoption?

Traditional solutions are implemented when a firm sees an opportunity. That opportunity either needs to generate a return, or limit the firm’s downside. The first mover accepts greater investment and execution risk for the opportunity of competitive differentiation and the profits projected therein. Next come the fast followers, who leave the first-mover profits on the table for the opportunity to reduce implementation risk. Finally, the laggards invest so they don’t become competitively disadvantaged.

Blockchain/distributed ledger technology, however, doesn’t fit into this paradigm. Investments such as blockchain do not come with first-mover advantage; it is the opposite – they have first-mover disadvantage. The first mover makes the investment; however, if no one follows, that investment can be a total write-off. In fact, by not investing, the first mover’s competitors can actually precipitate the first mover’s failure.

This makes for a very risky business case.

For blockchain technologies to be successfully adopted, one or more of three scenarios must occur: First, investment must be made mutually by some sort of consortium, utility, or external third party with connected and very deep pockets. Second, an outside vendor must bankroll the investment. Or third, solutions must be co-opted from something that already exists.

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Tags: Blockchain, Fintech, DLT

MiFID II & MiFIR: Reporting Requirements and Associated Operational Challenges

Posted on Tue, May 24, 2016 @ 09:45 AM

By Mahima Gupta and Shashin Mishra, Sapient Global Markets
Originally published on Tabb Forum 

While the key objectives of the Markets in Financial Instruments Directive I were to bring greater standardization and improvements in collateralization and risk management, MiFID II seeks to enhance transparency and supervision to ensure methodical markets and harmonize reporting requirements across member states. What obligations does MiFID II impose on investment firms, and what will be the associated impact and operational challenges?

MiFID I came into effect in 2007 to facilitate cross-border financial services within Europe, ensuring a competitive landscape between trading venues while safeguarding the interests of consumers and investors. This was followed by the global financial crisis of 2008 that necessitated subsequent regulations to ensure tighter control and supervision of over-the-counter (OTC) derivatives market activity. Until that point, MiFID I was only a directive. However, these developments, along with the technological and financial innovations across the industry, mandated an update in the legislation. Member states must now enforce both the directive and the regulation by January 2018.

Though the regulators released the final proposal for MiFID II in October 2011, it is garnering the requisite attention only as the deadline approaches. The industry has been busy meeting compliance obligations for European Market Infrastructure Regulation (EMIR), which had an earlier deadline of 2013 and a lesser scope forming a stairway to prepare for the larger directive—MiFID II. The European Securities and Markets Authority (ESMA) was also delayed in drafting its requirements and technical standards for the industry to follow.

When it became evident that the industry was struggling to make the necessary preparations to be compliant with MiFID II, the European Commission delayed the compliance timeline to January 2018. However, even with an extra year, reporting participants cannot delay preparations to meet the obligations due to the numerous challenges they must address, requiring focused attention and substantial effort.

Reporting Obligations

MiFID II reporting requirements are generally divided into two categories: transparency reporting and transaction reporting.

Transparency Reporting

Transparency reporting consists of obligations to report both pre-trade and post-trade information on potential and final transactions, respectively. MiFID II extends the reporting requirements to a wider universe of instruments that includes:

  • “Non-equity” instruments, such as structured finance products, bonds, emission allowances and securitized derivatives. These are to be traded on newly introduced organized trading facilities (OTFs), which are multilateral trading systems that are not regulated markets (RMs) or multi-lateral trading facilities (MTFs). They can execute orders on a discretionary basis, but not against their proprietary capital.
  • “Equity-like” instruments, in which the underlying is an instrument traded on a trading venue or submitted for trading on a trading venue, or an index or basket composed of instruments traded on a trading venue.

Pre-Trade Transparency Reporting

Reporting MiFID I had pre-trade transparency reporting applicable for equities traded on platforms such as MTFs. MiFID II extends these requirements to non-equity instruments and applies to OTFs as well.

This entails the reporting of a range of bid and offer prices or quotes as well as the depth of trading interests at those prices, or indicative pre-trade bid and offer prices that are close to the price of the trading interest. These have to be reported to consolidated tape providers (CTPs), which combine and publish trading prices and volumes from exchanges. By virtue of this reporting requirement, CTPs will have access to a continuous electronic data stream of pre-trade market quotes which, when available to market participants, will enhance transparency and aid market stability and trustworthiness. The only exemptions include large-scale orders and illiquid financial instruments.

Post-Trade Transparency Reporting

For all equity-like instruments, RMs, MTFs and OTFs must publish the price, volume and time of transactions executed in their platforms as close to real-time as technologically possible, preferably within seconds. This information must be published via Approved Publication Arrangements (APAs). Deferred publication is available for certain conditions, such as large-scale orders and illiquid financial instruments, as with pre-trade transparency reporting.

Transaction Reporting

Firms will need to report more data fields under MiFID II than they did under MiFID I. Some of the new information includes the traders’ and decision makers’ details, such as personally identifiable information and more granular time stamps. The objectives of these changes are to enable regulators to trace back the transaction footsteps when investigating potential market manipulation and to track down accountable personnel. This detailed post-trade information must be reported by Approved Reporting Mechanisms (ARMs).

While market participants, such as central counterparties (CCPs), are not liable to report pre-trade and post-trade transparency information, they would be required to report transaction details for the trades that are cleared through their platforms. However, investment firms have an obligation to adhere to all three reporting requirements. This is especially true if the firm functions as a systematic internalizer (an investment firm which, on an organized, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or an MTF).


Operational Challenges with Reporting

Although the industry has addressed multiple issues when dealing with Dodd-Frank, EMIR and other regulatory reporting across jurisdictions, MiFID II presents new challenges. Some of these are data management-related and some require infrastructure upgrades. Reporting participants will be faced with the following operational challenges:

Periodic Changing of Liquidity Categories

Instruments under the “non-equity” category will be periodically assessed for their liquidity. If deemed sufficiently liquid, the instruments will receive a waiver from reporting pre-trade transparency information and granted permission to defer publication of post-trade transparency reporting.

As a result, reporting firms will have to keep tabs on the liquidity status of their traded non-equity instruments and switch between reporting pre-trade transparency and real-time post-trade transparency. While many non-equity instruments will fall under the illiquid criteria for some time to come, a few may cause operational nightmares with their frequently changing status.

Similarly, even when sufficiently liquid, these instruments can get above waiver and time allowance based on other trade-specific parameters, such as an order exceeding a size specific to an instrument. These thresholds will also be defined by ESMA and will be revisited regularly. This will incentivize firms to trade above a certain size and may result in an increase in block trades for these instruments.

Multiple Channels of Connectivity

 A new regime of data consolidation and reporting to entities, including consolidated tape, APAs and ARMs, pose operational complexity and put pressure on resources. While the purpose of each of these entities is different, as is their directive to receive and collate respective data (as noted in Figure 1, below), the industry would benefit if a single entity could provide all three services.

However, that doesn’t seem to be the case at present. More than one existing ARM under MiFID I plans to register as both an APA and an ARM, but have different specifications to follow and possibly will need to create separate systems as well as legal entities to do the job. This will lead to less harmonization across the board and will add to the reporting complexity for market participants, unless they decide to register as direct submitters.

Time Sequencing and Clock Synchronization

Regulators are asking for the ability to rebuild trades by accurately time sequencing both preceding and subsequent events. Accuracy is expected in microseconds for algorithmic and high-frequency trading, and one second for manual trades.

To avoid scenarios in which data can appear to travel backwards in time because it was sent from one location to another that had stamping clocks slightly behind the first one, firms need to revisit how they implement time and stamp data packets. They will have to synchronize their clocks to an authorized location of Coordinated Universal Time (UTC) as clock drifts would no longer be acceptable. Releasing data for public dissemination on a consolidated tape—even a few microseconds earlier—may result in market impact, placing other firms at a disadvantage and risk of regulatory breach.

Managing Personally Identifiable Information (PII)

PII, as used in US privacy law and information security, is information that can be used on its own or with other information to identify, contact or locate a single person, or to identify an individual in context.

MiFID II reporting includes information on the buying trader, selling trader and even the advisor on behalf of any party. This information is not limited to name, country of residence or even date of birth. It is personal information such as “national identifier” and passport numbers. Figure 2, below, summarizes PII options as outlined by MiFID II. Each piece of information, if it reaches the wrong hands, can jeopardize a person’s identity. This information can also be misused to execute wrongful trades on the person’s behalf, thus compromising his or her integrity and career.

Every entity in the MiFID II reporting chain—including banks, venues, third-party reporting service providers, APAs, ARMs and regulators—must have the requisite security measures in place to protect the identities of the industry personnel involved.


Non-Reporting Operational Challenges

Apart from the operational challenges, firms must also consider a variety of business impacts that will require changes in either process or infrastructure, or both.

Pre-Trade Transparency Reporting

As firms make their quotes on OTC and non-equity orders public in real-time, competitors will have a chance to fill those orders. Thus, firms will need to adjust their sales, pricing and risk management systems to account for such lost opportunities, as well as to quickly react to competitive opportunities.

New Category of Trading Venues

Under MiFID II, OTFs are being established to bring OTC derivatives onto exchange-like venues. While the creation of OTFs is expected to increase market transparency and competition, it will also reduce bilateral risk in the system. Plus, it will change the market dynamics where existing platforms may choose to become OTFs or MTFs. The presence of so many platforms in the market will result in fragmentation that may in turn make price discovery more difficult, although pre-trade and post-trade transparency reporting will try to address that issue.

Commodity Trading Operations

Under MiFID I, non-financial market participants trading on their own account in commodities and derivatives to hedge their core business risk are exempt from reporting obligations. With MiFID II, non-financial market participants must not only prove that their trading activity demonstrably reduces the risks attached to their core commercial activity, but they must also prove that the capital employed for carrying out this activity is their own.


MiFID II is one in a long line of regulations that are forcing market participants to fundamentally change operational systems and processes—and consider broader business impacts. At the same time, these organizations are also facing the ongoing pressure to reduce operational costs.

Continuing to add functionality to internal systems and tack on new modules to address requirements from multiple regimes is an approach that is simply no longer sustainable from a cost perspective. What’s more, in-house systems take away critical and costly resources from projects designed to support revenue growth or business expansion.

Leveraging a system designed from the ground up to manage reporting requirements can help firms address compliance needs in a cost-effective and scalable manner. It can be modified to comply with existing regulations, giving firms a strategic structure for similar needs while achieving further economies of scale. Finally, it can help firms collaborate if they are using the same systems as their peers, driving a common view of reporting best practices. With the extended deadline for MiFID II, market participants have the time to change course and capitalize on an approach that can not only minimize the cost of reporting, but also help drive business value by establishing a long-term extendable platform.

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SBSDR Part 2: What Will SBSDR Cost?

Posted on Mon, May 16, 2016 @ 09:15 AM

By Tod Skarecky, Clarus Financial Technology
Originally published on Tabb Forum

The SEC version of a Swap Data Repository promises to provide transparency into the single-name CDS market. But just when – and at what cost – is still up in the air. ICE Trade Vault appears to be the first to throw its hat in the ring to process single-name credit derivatives, but how lucrative is the opportunity?

A couple months ago, I published an article detailing the generalities of SBSDR – the new trade repositories intended to capture securities-based swaps such as single-name CDS and equity swaps (“SBSDR: The SEC Version of a Swap Data Repository”). At the time, there had been no applications by potential candidates. Fast forward to today, and it appears as though ICE Trade Vault has thrown its hat into the ring to process single-name credit derivatives. You can see its completed FORM SDR and all of the related exhibits on the SEC page here.

Brief Timeline

Before you get too excited, let’s try to understand what this means for when we might see our first single name CDS come out of an SBSDR. Trying to piece together a timeline is not as easy as it might seem, but here is my attempt:

  • It would seem ICE first filed its form SBSDR on March 29, 2016, amended it April 18, 2016, and the SEC published the notice on April 22, 2016. I believe it’s that April 22 date that has meaning when it comes to when they could be approved.
  • For good measure, it was published in the federal register on April 28, but the appropriate certification clock seems to be on the notice date, not the register date.
  • By law, the SEC has 90 days to grant registration or start proceedings to determine if registration should be granted. These proceedings need to be completed within 180 days, but can extend another 90 days if the SEC deems necessary. By putting out the request for comment on April 22, I take that to be the “proceedings.”
  • If you add this up, 180 days from April 22 is October 22 (perhaps slipping to Jan. 22, 2017?). And if you add the 6-month compliance lag time for participants to comply with a certified SBSDR, that takes you to April 22, 2017, for the first INBOUND trade reports to happen.
  • Then – we’re not done yet – another 3 months before the first public dissemination; so July 2017 to see the first PUBLIC securities-based swap report.

I am aware others have quoted a faster timeline, but I am sticking with this one.

Interesting Tidbits

I’ve now read all of SBSDR legislation §240.13-n and §242.900 – §242.908, as well as ICE’s submission and appendices. I have to say, ICE seems to have its head on straight, and I trust it to get this right. I am particularly excited about the flags that it has included in its 901(c) Primary Trade information; however, I will leave my thoughts on that to another blog on another day (SBSDR Part 3!), as I intend to formally respond to the SEC request for comment, and do not want to front-run the government here.

If you read through the entire ICE application and exhibits, I would broadly classify the filing documents as follows:'

If you read through the entire ICE application and exhibits, I would broadly classify the filing documents as follows:

  • Organizational disclosures, internal governance, financial references
  • Policies for the SBSDR and sample forms they would use to request participant information
  • Exhibit GG.2 which I interpret as their draft rulebook
  • Exhibit N.5 which details every field they propose be reported to the SBSDR by the reporting counterparty
  • Exhibit M.2 which discusses ICE Trade Vault fees


I’d often wondered what sort of revenue an SDR can garner, and frankly whether Clarus should start our own SDR. I was also curious to know what kind of “tax” this whole SBSDR would mean to the market. So I was drawn to the fee schedule. Here is the ICE Trade Vault SBSDR fees:

  • Flat $1.13 per $1 million notional
  • Fees charged to the clearing agency (for cleared) or both participants (uncleared)
  • Minimum monthly fee of $375 (if you have any position)
  • No rebates
  • No further fees for lifecycle events, helpdesk, etc
  • No double-counting / double-charging for swaps previously reported elsewhere.

This fee structure is nice and clean, and mimics the ICE Trade Vault fee schedule for its CFTC CDS Index offering, which is $1.13 per million for single name and $0.45 per million for Index trades. (Remind me – why were there ever single-name CDS in CFTC SDR?)

As a comparison, the DTCC SDR fee structure for all 5 CFTC asset classes is a monthly position-based maintenance fee. You get 1,000 positions free every month, but that 30-year IR swap will count as a position for the next 360 months, so if it is above your 1,000 free cap, it will cost you anywhere from 40 cents to $3.50 every month, or $144 to $1,260 over the life of the trade.

Bloomberg’s CFTC SDR charges $10 per trade. Very Bernie Sanders-like – “10 bucks a trade.” And the maximum monthly charge is $50,000.

CME’s CFTC SDR fee schedule is also trade-based. Participants get 25 free IR, Credit and Commodities reports every month and 1,000 free FX reports per month. Each IR, Credit and Commodity trade above that is $5 and each FX trade is $1.50 (Bernie Sanders might say “Buck Fiddy”). There is a $200 minimum fee per month, and a $250,000 cap per year.

Ongoing Cost to the Industry (Is Being an SDR Lucrative?)

So I thought it worthwhile to see what sort of revenues ICE could expect from an SBSDR venture.

To start with, you need to know the size of the single-name CDS market. Without having access to private data, that’s difficult to quantify. In fact, that is one of the arguments for having a swap data repository! It just means that we’re forced to do some back-of-the napkin math to see how many CDS trades we can expect to see in an SDR:

  • The ISDA surveys here seem to only tell us about notional outstanding, so I will skip that.
  • The recent 4 May 2016 BIS statistics here seem to also only focus on notional outstanding. But you are able to glean two things from the global data:
    • 27% of notional outstanding in total Credit is in the U.S. Europe is almost double that.
    • Single-name CDS accounts for 58% of the total Credit notional outstanding of 12 trillion USD.


BIS June 2015 Survey

  • The older BIS statistics here seem to roughly mimic those numbers, and are still in notional outstanding. The important thing is this tells us what percent is cleared: 30% as of June 2015 (probably again in notional outstanding terms, but I will take it).
  • Last year I did a separate back-of-the-envelope estimate that concluded that 15% of the single-name CDS market in the U.S. was cleared.
  • Clarus’s CCPView tells us there were on average 7,000 single-name CDS trades cleared every week last month (split roughly 61/35/4 across ICE U.S, ICE Europe, LCH).
  • CCPView tells us there was on average $31 bn notional of single-name CDS cleared every week, which equates to a seemingly small average trade size of $4.5 m.
  • TIW data tends to require a decoder ring to decipher, but I believe it’s telling me that there were roughly 17,000 new single-name trades last week, totaling 181 trillion in notional. This in fact nicely corroborates the story from CCPView and BIS that ~7,000 trades are cleared each week and 30% of the market is cleared – though it does imply the size of your average cleared trade is smaller than a bilateral trade.


TIW Weekly Data Table 17, Week Ending 6 May 2016

So, if you followed my back-of the napkin math – and I admit it’s a pretty filthy napkin by now – I feel somewhat comfortable to say:

  • Weekly single-name CDS Trade activity is ~20,000 trades.
  • Average trade size is ~10mm USD (with cleared trades being much smaller than bilateral).
  • 30% of the market is cleared.

Wouldn’t it be so much simpler if we just had actual trades we could look at!? SBSDR couldn’t come too soon.

Now, before we multiply ICE’s $1.13 per million fee x 20,000 trades x 10 to get its projected weekly revenue, we need to adjust that 20,000 trades for how much of it will come under the remit of the U.S. SBSDR rules. Remember that BIS said 27% of the outstanding notional was “U.S.” I think that is too aggressive to use in our math. I recall the SBSDR rules generally say:

  • If a U.S. Person on either side – you need to report the trade.
  • If cleared by a U.S. Clearing agent – you (the DCO) needs to report the trade – and of course ICE clearing house will report to ICE Trade Vault.
  • Some confusing language about registered swap dealers/swap participants but that are not U.S. persons (they need to report, too, but the data will not be publicly disseminated).

Frankly, I have to guess here. How much of the CDS market is touched by a U.S. Person? Is ICE Clear Europe a U.S. Person? Is Asia really insignificant in CDS? Will non-U.S. dealers register with the SEC?

So let’s assume everyone is a U.S. Person:

$1.13 fee per million X 20,0000 trades per week  X Average trade size of 10 million = $226,000 per week

Or just under $12 million per year. However, we also must consider the fact that both sides of an uncleared trade need to pay the fee, so let’s add 50% to that, which gives us $340,000 per week. So $17 million per year.

That is, if they dominate a market where everyone is considered a U.S. Person. So not likely. Probably more like a quarter of the market touching a U.S. person, so perhaps $4 million per year. Frankly, because ICE is the dominant clearing house for CDS and hence will have to report all cleared trades executed on venue, it probably think it’s better to have $4 million in revenue per year than to have to pay SBSDR fees to another SBSDR!

If anyone sees flaws in my math, please let me know. Otherwise, I am sticking with it.


Securities-based swap trade reporting is coming. Just when is up in the air, but the action starts anytime from later 2016 to mid-2017.

ICE has submitted its application, and it is very thorough. Its fee structure would seem to not inhibit the market; the implied “tax” to reporting counterparties is on the order of $4 million per year to the market as a whole. Of course this $4 million does not include the presumable billions in costs to conform with the regulations. But I am optimistic that outside of the major banks, and particularly for cleared trades, it’s less of an impact than the first (CFTC) SDR implementation.

And just think of the benefits: We will finally be able to play with real trades and get rid of our filthy napkins.

Lastly, I again ponder whether Clarus should start our own SDR. We’re a mean and lean fintech firm – we could do it. But of course we’d have to hire lawyers and lobbyists to chase down that $4 million per year revenue. Let us know what you think, I bet we could arrange a discount to $1.12 per million for you!

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Tags: SDR, CDS

Exchanges Should Disrupt Swap Portfolio Compression Using Single-Sided Swap Futures

Posted on Fri, May 13, 2016 @ 09:45 AM

By Michael Hyland, Stonewyck Investments LLC
Originally published on Tabb Forum

With the mandated clearing of OTC swaps, even clearing houses are getting into portfolio compression of OTC interest rate swaps. But futures exchanges are missing out on a big opportunity.

Portfolio compression of OTC interest rate swaps has been a hot topic for the past few years. Now, with the mandated clearing of OTC swaps, even clearing houses are getting into the game. Given all of the excitement, it is surprising that futures exchanges are missing out on a big opportunity to disrupt the portfolio compression process. All that these exchanges need to do is promote the use of the old-fashioned EFP (Exchange for Physical) process via a new-fangled interest rate swap futures product.

What is portfolio compression?

Interest rate swap portfolio compression is a risk-reduction service that results in smaller derivatives portfolios for participants. Compression is achieved by simultaneously terminating a large number of OTC swap trades between a host of different counterparties. These counterparties are compensated for the mark-to-market value of their terminated swaps via cash-out sums. The trades chosen for elimination have substantially offsetting market risk. New regulatory rules stemming from Dodd-Frank and EMIR have made the compression process increasingly important.

While the algorithms involved in portfolio compression can sound quite exotic, the process can be boiled down to a series of bilateral swap terminations. The open market risk created by each successive termination is offset by terminations later on in the same compression process. The process continues until all eligible swaps are terminated as desired or the market risk of future swap terminations cannot be offset.

But the success of any swap compression effort depends on a variety of factors. First, a large number of counterparties are needed in order to achieve worthwhile results. Second, all of the counterparties need to be available to cooperate in the process at the same exact time. Third, the process involves a variety of paperwork, including legal agreements. And finally, counterparties can only hope to terminate swaps if it is mutually agreeable.

How can the portfolio compression process be disrupted?

Futures exchanges have a natural opportunity to disrupt this complicated process. All that these exchanges need to do is introduce an interest rate swap futures contract that makes the “Exchange for Physical” process easy.

In an “EFP,” customers agree on simultaneous buy/sell transactions. One of the trades involves a physical commodity (i.e., the OTC interest rate swap) while the second trade involves a listed futures contract (i.e., the new swap futures contract). The normal goal of an EFP trade is to transfer market risk from an OTC instrument to an exchange-traded one (or vice versa).

EFP trades should be a logical choice for frequent swap market participants looking to continually reduce the size of their OTC swap portfolios. After all, the EFP would convert unique, non-fungible OTC contracts into standardized futures contracts that benefit from netting.

For example, assume that two banks executed an OTC interest rate swap via a Swap Execution Facility and then delivered that swap to a clearing house. If both banks further decided on an “EFP,” the cleared OTC swap would be terminated by the clearing house. The market risk and market value of the terminated OTC swap would be replicated with a market equivalent position in interest rate swap futures contracts cleared by the same clearing house.

As additional OTC transactions were converted to futures contracts via the EFP process, netting would naturally eliminate offsetting positions and massive amounts of portfolio compression would be achieved on a daily basis.

How do single-sided swap futures fit in?

The only obstacle preventing futures exchanges from offering this “compression via EFP” service now is the poorly designed swap futures contracts that are available at the moment.

Current swap futures contracts are defined to include both the floating and fixed legs inside of one tradable instrument. This instrument has the same fixed coupon over the life of the contract, and its fixed coupon will almost never be the same as the fixed coupons of the OTC swaps that dealers are hoping to compress. As a result, it is usually impossible to replicate both the market risk and market value of existing OTC swap trades using the current swap futures contract construction.

Fortunately, the unparalleled flexibility of Single-Sided Swap Futures (patent pending) can make the EFP process trivial. Single-Sided Swap Futures (SSSF) are unique because they separate the floating leg and the fixed leg of a swap into two separate contracts. For example, being long one float leg contract could represent receiving LIBOR on a quarterly basis for 10 years on a $1MM notional. Meanwhile, being short one fixed leg contract could represent paying a 1% fixed annual coupon on a $1MM notional every six months for 10 years. When traded as a spread package on a futures exchange, counterparties would be able to recreate fixed/float swaps of any size and notional amount.

From an EFP perspective, SSSF make it easy to recreate the approximate market risk and market value of any previously existing or newly created OTC swap. Therefore, exchanges and clearing houses that offer SSSF should also be able to offer automated EFP services that allow for nightly conversions (provided both counterparties to the OTC trade approve).

For example, imagine a spot starting fixed/float swap with a $10MM notional, a 10-year tenor and a 2.17% coupon. As a cleared OTC swap, the transaction is valued by the clearing house on a nightly basis. In an EFP, the risk of the float leg of the OTC swap would be easily transferred to SSSF float leg contracts via a ratio of one SSSF float leg contract per each $1MM of OTC swap notional (so that 10 SSSF floating leg contracts would be created).

Meanwhile, the number of SSSF fixed leg contracts generated by the automated EFP would be roughly 21.7 (i.e., one contract for each 1% coupon on $1MM notional). The exact number of SSSF fixed leg contracts would be determined (perhaps to as many as five decimal points) by the clearing house such that the resulting net futures value of all SSSF fixed and float contracts would equal the mark-to-market of the terminated OTC swap.



Using Single-Sided Swap Futures for portfolio compression via EFP highlights the flexibility and ease of use that make SSSF superior to any other interest rate swap futures instrument currently available. Futures exchanges and clearing houses that move quickly to offer SSSF to their customer base will benefit in numerous ways

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Tags: CCPs, Compression, Swaps, Clearinghouse, OTC IRS, efp

Margin Compression in Interest Rate Derivatives: The Big Squeeze

Posted on Thu, May 12, 2016 @ 09:40 AM

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

The long-anticipated introduction of central clearing for over-the-counter interest rate swaps in parallel with the rollout of new capital, liquidity and leverage constraints for banks is bumping up the cost of hedging interest rate risk in Europe for brokers as well as their buy-side customers. What steps are required of buy-side firms to assess their hedging options?

Forewarned is forearmed; but sometimes it’s hard to use prior knowledge to your best advantage. 

Take, for example, the impact of post-crisis regulatory reforms on the cost of hedging interest rate risk in Europe. The long-anticipated introduction of central clearing for over-the-counter interest rate swaps in parallel with the rollout of new capital, liquidity and leverage constraints for banks is bumping up costs for brokers as well as their buy-side customers. In the U.S., which has already implemented G20-mandated central clearing and electronic trading of interest rate and credit default swaps, the new rules have given rise to a wave of innovation, in part due to the increased costs they impose. New instruments have been launched in Europe, too, including exchange-traded swap futures, which offer market participants the opportunity to offset their risks in ways that may prove cheaper or better suited to their needs than centrally cleared interest rate swaps. 

But while swap futures slowly gain momentum in the U.S., Europe stands nervously at the starting gate, ahead of a year of deadlines as the European Market Infrastructure Regulation’s (EMIR) clearing mandate finally comes into force. Some costs are already rising, but the overall cost/benefit analysis for continuing use of existing instruments, versus migration to swap futures et. al., is far from certain.

Will exchange-traded instruments provide a viable alternative as the prospect of cost hikes dampens the appeal of swaps? The buy side may need to keep its options for the foreseeable future, but it is worth examining some of those cost drivers for both the sell side and the buy side in order to further understand the motivation for using new approaches for hedging interest rate risks. 

Regulatory backdrop

Two of the biggest policy conclusions drawn from the collapse of major financial institutions in 2008 were that the opacity of the OTC derivatives markets and the size of bank balance sheets posed unsustainable systemic risks. Thus, the G20’s 2009 summit in Pittsburgh mandated central reporting, central clearing and electronic trading for standardized OTC derivatives – enacted under national and regional legislation, such as EMIR and the U.S. Dodd-Frank Act – and imposed higher capital charges and margin requirements for non-standardizable OTC instruments, based on guidelines drawn up by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). The BCBS was also tasked with tightening up the capital rules for banks, ostensibly to hike the cost of products and services in line with their inherent risks. Known as Basel III, and subject to “gold-plating” by local regulators, the new capital framework introduces a number of measures that increase the cost of clearing, structuring and execution services in the OTC derivatives market, as well as the cost of accessing collateral. Both Basel III and EMIR involve multi-year implementations, but they must also be placed in context of other legislation, notably MiFID II, with its implications for pre-trade transparency and best execution.

Explicitly, the aim of the G20 political leaders and the Financial Stability Board – the coordinating body for implementing post-crisis reforms – is to encourage banks to find cheaper and safer ways of providing the more high-risk services to clients, not least in the derivatives markets. This takes time and causes pain, as service providers and market participants alight on new innovations. But unintended consequences are also a fact of large-scale regulatory reforms, as recognized by regular revisions by the BCBS, and the European Union’s consultation on the collective impact of post-crisis legislation. Among several pertinent examples are capital charges on client collateral held by clearing members and the negative impact of Basel III’s leverage ratio on banks’ appetite for repo market business, which in turn hampers buy-side firms looking to transform assets into eligible collateral to post as margin at central counterparties (CCPs) in support of centrally cleared interest rate swaps.

Feeling the pressure

How does regulatory change translate into industry cost? Historically, buy-side clients posted collateral for interest rate swaps according to terms agreed bilaterally with a broker in a credit support annex (CSA). With the switch to central clearing of swaps, the buy-side firm needs one or more of its brokers to serve as a clearing member at multiple CCPs in order to post initial and variation margin on its behalf, according to collateral eligibility terms and schedules dictated by the CCP. Some broker-dealers in the European swaps market were already clearing members at some, but not all, European CCPs, for the purposes of clearing futures and other exchange-traded derivatives. But few, if any, had all the necessary connections to the growing range of CCPs needed to offer clients swaps clearing choice, and none already had the necessary risk and collateral management models and processes in place. 

Investing in the infrastructure needed to support a new, if complementary, service was already a challenge for banks under the shadow of Basel III. But the uncertainty of a return was multiplied by delays to EMIR’s timetable for launching central clearing, with a number of major banks deciding the risks and costs were no longer acceptable, quitting the market before it went live. As such, there is still a scramble for even large buy-side firms to sign up with clearing brokers ahead of the December deadline for mandatory clearing by non-clearing members. Moreover, the same mix of regulatory uncertainty and capital constraints means no major sell-side firm is currently supporting indirect clearing, designed by regulators for mid-tier and smaller users of interest rate swaps. This relative absence of competition has inevitable implications for pricing.

Laurent Louvrier, EMEA Head of Sell-Side and Hedge Funds, Risk Management Analytics, at MSCI, says Basel III may have an impact beyond the capital requirements imposed on execution and clearing services. “Generally, banks have to set aside more capital for certain activities, but the impact of this is combined with some very specific rules which exacerbate the impact, such as the capital treatment of collateral posted by clients for margin purposes, which is somewhat counter-intuitive and increases costs significantly,” he says. “Further, as a direct consequence of the new capital regime, some banks are retreating from specific areas of trading. Fewer offers in the market mean less competition, less liquidity and higher costs.”

New structures and processes must also be put in place for non-standardized derivatives that cannot be cleared centrally. From September, bilaterally cleared swaps will be subject to the BCBS-IOSCO risk mitigation framework, including consistent calculation methodologies for initial and variation margin and new controls for the exchange and secure holding of initial margin. As well as putting new models and processes in place, banks are factoring new costs into their pricing. “For bilateral trades, we’re starting to see pricing being impacted by XVAs, the valuation adjustment factors, due to regulatory capital requirements on the banks. Firms are no longer putting their heads in the sand and are taking a pragmatic approach, adjusting to the new environment ahead of the new rules,” says Liam Huxley, CEO of Cassini Systems, a provider of OTC cost and margin analytics.

Conflicting interests?

Nick Green, Global Head of eRates Product Management at Crédit Agricole CIB, sees a number of costs stemming from the regulation-driven shift in brokers’ counterparty risk distribution. Rather than many relatively small exposures spread across multiple buy-side clients in the bilaterally cleared world, brokers now face fewer, larger risks concentrated at a handful of CCPs in the centrally cleared environment.

“Clearing and collateral costs vary across CCPs and according to the size and nature of a clearing member’s aggregate position. If underlying client positions are highly skewed in a particular direction, the dealer can quickly find itself posting a lot more margin as it triggers bigger thresholds, which result in ever steeper collateral requirements. These increased collateral costs inevitably feed back into the price to the client,” he explains. 

Moreover, the proliferation of swap-clearing CCPs can also increase costs beyond mere connectivity. One variable arises if the client wishes to clear a swap at a different CCP than its dealer would choose, which is likely to be a common scenario as spreads offered by CCPs will reflect different risk implications for the buyer and the seller of the contract, informed in part by their existing positions. In the U.S. cleared swaps market, a market has developed in the spread between LCH.Clearnet’s SwapClear and CME Group for clearing the same swap tenors as participants seek to balance their exposures across the two and so minimize their clearing costs. 

“Clients can often get a better price by choosing to clear at the CCP that is favorable to the side of the trade they’re on. But they must also consider the overall collateral requirements: posting collateral in two CCPs is less cost-efficient than concentrating all your positions into one,” says Green. “These differences in price will become more of a factor as a wider range of CCPs become active in the swaps-clearing market.”

Cassini’s Huxley says buy-side firms need to assess these costs independently, including the embedded costs of the broker posting collateral to the CCP, which, as Green points out, will vary based on its overall position. “Buy-side firms must understand that the price offered by the broker will vary across clearing channels. And when you build in your own operational holding costs and collateral requirements bearing in mind the nature of your portfolio, the cheapest option offered by the broker might end up costing you more over the lifetime of the trade. But whichever choice you make, you’ll need to be able to demonstrate why you’ve done that, from a MiFID II best execution perspective,” says Huxley. 

Hunting elephants

Even after all these costs are factored in, we still haven’t mentioned the elephant in the room, according to Robert de Roeck, Head of Multi-asset Structuring at Standard Life Investments. For him, the critical challenge of the centrally cleared environment for interest rate swaps is mitigating the drag on performance caused by the need to post eligible collateral at CCPs. “The more of the fund one is required to hold in low-yielding eligible collateral, the greater the impact on fund performance,” says de Roeck, whose team oversees the firm’s liability-driven investment (LDI) funds.

According to de Roeck, delays and amendments to the European framework have already had “a material impact” on the ongoing development requirements for buy-side trading platforms. Access to interest rate swap markets is still considered fundamental to most LDI strategies, as the bespoke nature of OTC instruments enable managers to precisely hedge client’s long-term liabilities. (Pension funds have a temporary exemption from EMIR, but it is not clear how this will be replaced.)

“With bilaterally collateralized derivatives, the counterparty-negotiated CSA has historically allowed for the posting of assets already held within the fund, with the obvious benefits,” he explains. “Under central clearing, the assets that qualify as eligible collateral are very limited: cash or sovereign debt as initial margin, and only cash for variation margin.”

A typical pension fund liability hedging portfolio implemented on a bilaterally collateralized basis might easily require an additional 4% to 8% of the fund to be held in eligible collateral in order to meet the initial margin requirements under exchange clearing. This is before taking into account the eligible collateral requirements for variation margin. As a consequence of the more restrictive collateral posting constraints, asset managers also increasingly require access to a deep and liquid repo market in order to transform ineligible assets into eligible collateral. However, the impact of Basel III on the ability of banks to offer liquidity in repo markets is very much in question. “The ability to fully retain the fund’s exposure in funded return seeking assets and repo them out as required has, in my opinion, long since gone. Firms might end up holding 5% to 15% of the value of their funds in low-yielding eligible assets,” says de Roeck.

Exchange-traded instruments may well provide an alternative for certain funds but, he asserts, innovation will be required in order for such contacts to suit the idiosyncratic characteristics of LDI funds: “Historically, futures haven’t really cut it for LDI funds because they haven't offered the duration to meaningfully hedge pension and insurance liabilities. We are talking about durations of 20 years-plus, while the most liquid future in the sterling rates market is the 10-year gilt future.”

The swap spread effects being observed at the long end of the term structure are causing a rethink among providers and users of swaps, but de Roeck is also looking for other types of innovation, including new mechanisms for exchanging collateral assets in a repo market now hamstrung by capital regulations. “While Basel III makes repo too balance-sheet intensive for banks to participate at historic levels, there are still large pools of eligible collateral out there the owners of which are willing to lend out at a price. As such, peer-to-peer collateral transformation platforms might be the way forward, subject to agreement on the regulatory context,” he says.

Innovative alternatives 

Although anecdotal evidence suggests that cost pressures are beginning to make themselves felt, only the very largest buy-side firms are centrally clearing swaps in Europe, while even fewer have dipped their toes into the exchange-traded environment, despite the launch of numerous innovative contracts. This makes it hard to get a handle on future preferences. The slow growth of swap futures in the U.S. underlines the challenges of shifting liquidity in the derivatives market, but Cassini’s Huxley offers exchanges evidence for optimism, based on his platform’s analysis of the overall costs of new instruments versus cleared swaps. 

“It’s a multi-dimensional picture: the cost-benefit of swap future alternatives depends on how directional or balanced your portfolio is, as well as the exact nature of the trade. But if you’re running a directional portfolio, and hedging shorter duration, then you can find that putting on swap futures instead of swaps can give cost savings of up to 55+% over the lifetime of the trade,” he says.

Despite such potential savings, asset managers face a number of challenges in assessing and migrating to new instruments, says independent consultant David Bullen. “The investment consultants who are advising their pension fund clients on how to manage interest rate risk are not yet fully aware of these complexities. Pension fund trustees do not make major decisions without their investment consultants, but these advisors, not to mention actuaries, have not got the requisite tools to understand these new interest rate products at this stage,” he says. “The world simply hasn’t caught up with today’s market reality.”

The need to educate stakeholders and the difficulties of picking a winner from the current crop of swap future offerings add to the inertia resulting from ingrained processes and the weight of open interest. “There is clearly a market need for these new instruments, but the immediate challenge is the lack of liquidity, which is providing a disincentive for major firms to go into the market and test out these alternatives,” observes MSCI’s Louvrier. 

But the clock is ticking down on the EMIR deadline and the new costs of using OTC swaps will become more evident to asset managers of their clients. As such, many buy-side market participants will intensify their scrutiny of the new innovations, weighing up their fit with long-term requirements and operational realities. 

“For some firms, it will make sense to leverage existing collateral pools generated by their use of exchange-traded fixed-income, but that only makes sense if the available futures instruments meet their needs and can offer liquidity over the long term. Even the perfect product needs time to build momentum,” says Hirander Misra, CEO of GMEX. 

Bullen suggests that many on the buy side will have to cover all their bases, at least in the short term, securing access to OTC and exchange-traded interest rate derivatives. “To date, swap futures have mainly found favor at the shorter end of the market, with the reluctance of some exchanges to offer longer maturities, suggesting there will always be a place for OTC trades,” he observes. “The very precise hedging needs of a pension fund mandate typically favor OTC, but on the other hand we’ve seen over the last decade growing buy-side demand for instruments that can help them manage the roll risk.” Moreover, the widening cost differential between longer-dated OTC swaps and futures is now encouraging exchanges to offer 30-year contracts. 

Two years ago, Deloitte estimated the cost to the industry of reforms to OTC derivatives in Europe at €15.5 billion per annum, with the burden weighted toward the bilaterally cleared sector. Those figures are likely in need of upward revision, but reflect the scale of change faced by users of interest rate swaps, by far the biggest OTC market. This offers opportunity to investors, but new business will not simply fall into their laps. 

“The existing futures construct doesn’t automatically work as a replacement for OTC interest rate swaps, which is why we have come up with a futures paradigm that is more closely aligned to OTC instruments,” says Misra. “New products have to be aligned with existing processes and analytics. You need to be able to demonstrate the cost savings and hedging effectiveness over the life time of the instrument, but the more you can intertwine yourself into existing workflows, the better chance you have of succeeding.”

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Tags: Basel III, U.S., Buy-Side, IOSCO, G20, MiFID II, leverage ratio, EMIR, Derivatives, BCBS

Blockchain Is Part of the Solution, but It’s Not the Whole Solution

Posted on Mon, May 09, 2016 @ 09:45 AM

By Leda Glyptis, Sapient
Originally published on Tabb Forum

Even the coolest technology is not a story unto itself, and blockchain is no exception. The blockchain is part of how we can re-imagine the entire value chain. But simply rebuilding familiar processes on the blockchain is not useful.

It turns out there is such a thing as a dumb question. Literally “dumb,” as in moot and unanswerable. And a large number of smart, busy people are spending precious time trying to answer it.

“What are you doing with the blockchain?” is the technology equivalent of: “Hammers are cool – what are you doing with hammers?” The concomitant of which is an inordinate amount of time spent looking for nail-shaped objects to hit with said hammer. But in DIY, only the simplest and least life-changing of projects can be tackled with a single tool, no matter how cool. And that truth holds in financial services as well: Even the coolest technology is not a story unto itself.

Why does that matter?

Because the set of capabilities we bundle under the umbrella term “blockchain” is powerful, exciting and potentially radically transformative, and going around trying to find “something to do with it” is the equivalent of using a magnificent fire breathing dragon to light cigarettes.

Every journey starts with a single step, and every prototype, every pilot and every POC has been essential on the road to building the confidence that this technology is real. Each successful laboratory experiment has built the base of the pyramid a little stronger, a little wider. It is essential and I don’t mean to dismiss it. But how many times do we need to confirm that it works before we start putting it to real-life uses?

But that is only half the reason why I can’t get excited about experiments in the post-trade and settlement world. The other is even more fundamental: what we call “the markets,” in all the complexity of a mature and layered eco-system, evolved over a couple hundred years to serve a series of needs and requirements with the best technology available at each juncture.

With every passing year, advances in communications and mathematics permitted for the creation of derivative functions. Regulation, secondary markets and leaps in information technology accelerated the evolution of what is now an extremely complex animal that employs millions of people, generates trillions of dollars and – in all its convoluted abstraction – has a real day-to-day impact on real lives at a micro and macro level: from the milk in your fridge to your mortgage and credit card, to financing national infrastructure and global initiatives, money is locked into a cycle of value and inter-connected activity.

The need for value exchanges, credit, liquidity and risk hedging has not diminished during the course of this journey; on the contrary. The way those needs have been interpreted and serviced, however, has been evolutionary, reactive to circumstances and constrained by the technology available which, for most of this journey, has been minimal.

That is no longer the case.

We have entered a period of immense technical and technological creativity, a golden age of civilizational acceleration. The advent of the digital era allowed technology to power human experience in a way that feels unmediated.

Simply put, a lot of what we used to do to get from A to B is no longer needed. The blockchain is part of how we can re-imagine the entire value chain. It is also why rebuilding familiar processes on the blockchain is comforting but not useful.

We have gone through a learning phase as an industry, starting from a place of fear: Could this technology totally disintermediate us? Experiments were carried out to prove whether it could, and the debate now is on the tipping point and scale needed for “blockchain to take over” as if it were an active agent of change in itself. Endless committees, panels, industry consortia and internal working groups. An uneconomical number of talented people are tinkering around the edges, doing interesting things and learning a lot.

A whole library of white papers has been produced, visualizing various versions of a future whereby blockchain rules all and whoever commissioned the paper has a position of continued relevance. Not all of those visions can be true.

So what do we do next?

We drop the dumb question and ask the hard ones.

We need to separate the value chain conversation from the service conversation. How we used to make money will change. The way the financial markets work will change. This technology will be part of the change. Let’s focus on purpose and re-assert our relevance to an emerging value chain. As I said, I am a huge fan of the capabilities. This is why I would like to see a focus on business outcomes and the right tool to solve business challenges and power business opportunities.

We live in complex economies. That means specialization and composite systems where each part (human and non-human) contributes something different. Treat what we summarize under the blockchain banner as a set of technical capabilities. Focus on the business problems, then design the best solution to suit your needs. And if you can’t do that, you may need to solve for a talent challenge rather than a technical one.

Banking provides a series of services that remain essential for individual and commercial activities. The way those services are currently provided is tied to the specific conditions – regulatory and technological – that prevailed when each department, pricing structure and service line was set up. Those realities have changed and although the functions of banking, writ large, are still needed the way they are carried out is not.

That is a hard question to tackle. No matter how creative we get in the lab, executives remain responsible to shareholders, who want to see a dramatic shift in operating costs to go along with the new lower revenue post-crisis paradigm. This framework doesn’t make for pleasant conversations or for wholesale institutional alignment behind the unsung hero that is the banking innovator, swimming upstream day after day, asking the hard question: How do we remain relevant in a world that renders the way we do things – but not the things themselves – irrelevant.

If you sit in a part of a bank that provides agency services (no longer needed in a world that allows for trust-less transactions on the blockchain) or reporting services (rapidly replaced by API connectivity), that’s grim news; but if you are a customer, retail or institutional, the news is great. If you are the banking executive, you have time for neither because you have a responsibility to your customer, employees and shareholders to focus on the big question: In a world that may no longer need every aspect of my activity but still needs my services, how can I use the amazing wealth of new technical capabilities to reassert my value proposition, serve my customers’ needs and equip my people to deliver?

The blockchain is part of the answer, but not the whole answer. As ever, answering the real question is hard, but unless there is a clear line to business relevance, then the best experiments will not move the needle. In redefining business relevance, we will figure out what to do with blockchain. And it will be valuable. It will also be new.

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Tags: Blockchain, Fintech, DLT

The ‘Missing Link’ in Today’s Interest Rate Derivatives Markets

Posted on Thu, May 05, 2016 @ 09:00 AM

By David Bullen, Bullen Management Ltd; David Dixon, Independent
Originally published on Tabb Forum

Reduced market liquidity and structural market changes are driving up the cost of accessing traditional interest rate products for end users, pushing them to find alternatives. The evolving sub-asset class of IR swap futures sits neatly between the precision and flexibility of over-the-counter products and the liquidity and transparency of exchange-traded derivatives.

Interest rate (IR) markets have changed substantially since the financial crisis, both visibly and in their market structure. These differences challenge asset management firms attempting to operate on behalf of their clients, especially in liability-driven investing (LDI), where the rules and market are continuing to change around them. The risk management requirements of liability-driven investments challenge asset managers that turn to banks for solutions and liquidity in their desire to transfer risk on behalf of their clients.

New factors that have yet to impact fully, such as the greater flexibility surrounding pensions, prompting elevated transfer-out requests, increase the appetite for LDI fund flexibility. However, this desire for flexibility is at odds with reduced market liquidity and the structural changes that will make flexibility more costly. The reduced market liquidity is largely a result of a reduction in bank balance sheet levels deployed behind IR market-making functions in the bond, repo and swap sectors and the general profitability of investment bank franchises.

Many of the factors at work in European IR markets also affect the U.S., although the differing structures of the respective pension industries (401K vs. defined benefit/defined contribution) are generating different consequences. That said, the core need in the global market for IR liability hedging remains and will be viewed with much more focus on liquidity and flexibility considerations.

While the changes, current and planned, to the capital rules for banks have fundamentally changed the provision of IR market services, their full impact will only be felt in the future. Hence, there has been no massive shift away from over-the-counter (OTC) IR products yet, which some commentators mistakenly take to mean nothing has changed.

Regulations such as Basel III, especially the capital requirements within the leverage ratio rules, have significantly increased the amount of capital that banks are required to hold. This, coupled with the funding/liquidity requirements of the liquidity coverage ratio and net stable funding ratio rules, has severely restricted or indeed in some cases closed some banks’ business lines – for example, repo. Consequently, the cost of accessing these products for the end user is much higher. In addition, price competition for end users has been affected, as fewer prime brokerage and clearing services for OTC products are now available.

As a result of the leverage ratio, or the supplementary leverage ratio as it is known in the U.S., banks have withdrawn from, or re-priced, their balance-sheet intensive businesses. For firm evidence of this, one need look no further than the existence of the London Clearing House (LCH) to Chicago Mercantile Exchange (CME) “basis” in cleared IR swap pricing, whereby equivalent swaps are priced differently at the two institutions. This re-pricing phenomenon has prompted a range of new entrants to join the market: witness the arrival of non-traditional bank market-makers, hedge funds and other new market intermediaries, such as Citadel. These groups have demonstrated they are only too happy to step into new areas to provide market services and liquidity. Given some asset managers’ view that they expect and want to pay for leverage, it seems clear that market forces will encourage and reward these new entrants.

It remains to be seen whether these attractions will be strong enough to encourage asset managers themselves to act as market-makers to any meaningful or consistent extent. But the advent of a broader range of exchange-traded derivative (ETD) products, with their more “all-to-all” friendly trading protocol, will likely help bring about this outcome. The start of clearing of OTC products, with the ensuing removal of the credit risk element post-novation to the clearing house, also directly facilitates asset managers’ access to new sources of liquidity. They can become those sources themselves or indeed trade with other asset managers in the so called “all-to-all” model, the general clearing member’s involvement notwithstanding.

The repo market is a key area of change where there are already new entrants seeking to maintain liquidity, evidenced by the creation of collateral exchange efforts like DBV-X. The group’s CEO and founder, John Wilson, notes that Basel III has prompted dealers to withdraw capacity and widen spreads at a time when clients have growing collateral transformation needs. “Counterparty diversification will be essential for firms wanting continued access to deep liquidity and tight spreads,” he said. “However that will need to also encompass non-traditional counterparties like other buy-side firms and corporates.”

One prediction by an asset manager recently was of the “death of the reverse repo market,” given that it swells dealer balance sheets for little benefit whilst what capacity does exist is allocated according to the profitability of a client’s general derivative business rather than any fair market pricing logic. Collateral optimisation services on a principal basis are just too expensive due to the balance sheet costs of undertaking repo business, unless carried out as agent by custodians or via the new “agency” style services on collateral exchanges.

What of the drive to clear OTC derivatives mandated by the G20? As one asset manager commented, “Clearing is a red herring,” because it is the least significant consideration for funds, or should be. The more significant market development is Basel III and its additional capital requirements for dealers in line with the leverage of the position.

Red herring or not, the advent of mandatory clearing has not helped. It has started to create an uneven playing field that favors trading interest-rate risk in exchange-traded format – 1-day value at risk (VAR) margining (for exchange products), versus 5-day VAR (for OTC products). There are, in fact, slight variations of this with Europe being a 2-day net position for VAR and the U.S. being 1-day gross for ETD. Also, LCH charges 7-day VAR for client positions in OTC IR swaps. However, this still means margining for effectively the same risk profile is far cheaper for ETD versus OTC and should, over time, drive more business toward ETD formats, given best execution responsibilities under MiFID II.

OTC offers greater precision of asset-liability matching, while ETD offers better liquidity and transparency, suggesting both ETD and OTC interest rate risk formats will continue to co-exist. Current thinking suggests short-term IR markets and “imprecise” hedging products will be ETD format “owned,” whereas long-term IR markets, which provide a more precise hedging product, will remain OTC “owned.” However, this does leave the increased cost squarely in the end user’s corner.

The challenge for future liability driven investment (LDI) users of IR markets will be to decide how and where to link effectively both ETD and OTC IR markets in practical terms.

An ETD v OTC “link” is therefore needed. The evolving and new sub-asset class of IR swap futures is one tangible part of providing this link. Their form and attraction sit neatly between the precision and flexibility of OTC and the liquidity and transparency of ETD. The enthusiasm of providers to win in this race is apparent in the crowd that has gathered: there are currently five offerings from CME, ERIS, EUREX, GMEX and ICE. It generally takes one to two years to develop new sub-asset classes, such as swap futures, to the point at which they are widely available and liquid. Given the legendary difficulty of establishing exchange-traded contracts, there is some urgency here for one or two of these new products to be successful: 2018 is, after all, only seven future quarterly “rolls” away.

Mandated pension fund clearing in 2018 will drive pension funds and, in turn, asset managers to consider using this new and evolving asset class. Their fiduciary responsibilities for best execution and optimum collateral create a drag on their clients’ and pensioners’ monies, likely forcing them to trade this new asset class. Generating a credible market in these new products will also drive them to lobby liquidity providers, high-frequency trading firms, brokers, investment banks and innovative exchanges to provide products that address these needs.

Where does all this leave the traditional investment manager providing LDI services to, for example, pension funds? The incumbent providers might not be incentivized to make the investment necessary when they have such an established market position.

As one asset manager recently commented: “Successful LDI managers will need to excel at accurate hedging, liquidity provision and alpha; all whilst providing stable leverage at low cost, high levels of flexibility and clear best execution ability.” No mean feat in today’s IR market. The LDI toolkit, in order of importance, is effectively made up of four skill areas:

  1. Getting the hedge right
  2. Being liquid and flexible
  3. Generating alpha
  4. Minimizing drag costs (e.g. clearing costs)

The traditional means of interest rate de-risking a pension portfolio from moves in the interest-rate environment has been through the use of interest rate swaps. These OTC derivative instruments, rightly or wrongly, became one of the bogeymen of the last financial crisis and have attracted the attentions of regulators. This has in turn increased the cost base of OTC businesses across the board.

Investment consultants who advise pension schemes and other mandates on de-risking trades are yet to hear about or understand the full economics of new IR asset classes like swap futures. Currently, they are discounting these products as too innovative, insufficiently liquid or both. This situation is likely to change rapidly, largely due to the impact of capital requirements on the one hand and the push to clear derivative business on the other.

Asset management firms’ technology tends to change at a glacial pace versus that of market infrastructure and banks, so those asset managers that can position themselves correctly will have an opportunity to disrupt and enter the LDI market with a cheaper, more transparent and flexible product offering based on both ETD and OTC interest rate derivative products.

Current IR risk-transfer markets, following changes in capital rules and regulations, are unbalanced and provide insufficient liquidity to asset managers. Diligent best execution by asset managers will probably magnify this imbalance over time and be resolved only with the arrival of new entrants and new products.

To misquote Bill Clinton: “It’s the balance sheet, stupid.” It is the regulatory and mainly capital rule changes that have altered the provision of interest-rate risk transfer mechanisms available today. The current construct remains likely incomplete and certainly untested in terms of scale by the market’s users.

As such, ETD and OTC will need to co-exist. New instrument types, such as swap futures, while unproven, underdeveloped and new, are nonetheless an essential missing link in the IR markets of today.

Advanced new asset management operators offering LDI services that provide flexible and transparent products and services that see the world as one linked continuum of IR risk, both ETD and OTC, are likely to thrive. They will probably win pension fund de-risking mandates, which tend to be the most discerning selector of appropriate IR risk management products and, through necessity, pioneering users in interest-rate risk transfer mechanisms.

There is a pressing need for active, old and new market participants of all types to be willing to step in and provide the traditional risk-transfer function of markets, with a steady eye on their business models. Also, a new generation of LDI products, including some form of alpha generation, needs to be urgently designed and adopted, given real yields’ flirtation with negative territory.

In addition, for those asset managers that call the market structure moves correctly, there is a significant business opportunity to win new market share and an ability to avoid significant unnecessary costs.

‘The best way to call the market structure correctly is to take a view and influence outcomes by being proactive,” says Ricky Maloney, of the rates and LDI team at Old Mutual Global Investors. This is something relatively unknown in the asset management sector, because it has historically been the banks that have driven such market innovations and change.

Given what lies ahead, what should an asset manager do?

  • Spend time on market structure;
  • explore and understand new products like swap futures;
  • talk directly to product providers and innovators;
  • start to plan and budget for market infrastructure change;
  • seek information from bank and non-bank sources and
  • compare the pictures and data provided.

Crucially, asset managers need to hold views on market structure topics and express them vocally, as well as get into the business of sponsoring and founding new markets. Welcome to the world of “picking winners,” perhaps the other “missing” ingredient on the journey to the brave new world of interest rate risk-transfer markets.

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Tags: OTC, Derivatives, End-Users

Lingering Problems with the Volcker Rule

Posted on Wed, May 04, 2016 @ 09:00 AM

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

When the Volcker Rule went into effect in July 2015, it was a significant revolution in the trading practices of U.S. banks. Millions were spent preparing for compliance, and lots more on the new business as usual. Despite all of the effort, however, there are still some aspects that aren’t running smoothly. George Bollenbacher looks at some of those lingering problems and asks whether the VR will help or hurt the safety of the banking business.

When the Volcker Rule (VR), one of the major parts of the Dodd-Frank Act, went into effect in July 2015, it was a significant revolution in the trading practices of U.S. banks. Millions were spent on preparing for compliance, and lots more on the new business as usual; but it shouldn’t surprise us that, despite all that effort, there are still some aspects that aren’t running smoothly. Let’s take a look at some of those lingering problems, sorted by exemption.


This was always regarded as the most troubling aspect of the VR, so it was where banks spent most of their time and effort in preparation. Perhaps the most resources were applied to the tracking of trade volumes in comparison to reasonably expected near-term demand (RENTD). As it turns out, the tracking was much easier than determining RENTD in the first place.

It hasn’t helped that most markets have been more volatile than everyone had expected, or that one major market, fixed income, has been decidedly less volatile than expected. And the future is full of possible sea-change events, such as a Brexit, the long-awaited Fed tightening, or the possibility of a hard landing in China. To top it off, lower trading margins and profits have prompted banks to reduce staff and positions, and to rely more and more on algorithmic trading.

All those factors, taken together, lead to a very murky view of RENTD, to the point of calling into question the very idea of a “reasonable expectation.” Those market makers that expected the Fed to tighten by now, with the resulting paroxysm in the fixed income markets, have prepared for customer demand which, however reasonable to expect, never materialized. After one or two repetitions of that exercise, they probably backed off. Inevitably, somewhere down the line we will see those events come to pass, but by then most people’s RENTD won’t be anything close to reality.

However, even if the VR had never happened, those market events would be most likely to occur. Long periods of low volatility and low spreads, with the resulting drop in liquidity, followed by sea changes in monetary policy, will invariably lead to market dislocations. If market makers feel constrained by RENTDs that are unrealistically low, based on past experience, they will be hanging back just when they are needed on the front lines. When that happens, critics may blame the VR, but it’s hard to see how it could play out any other way, even without the rule.

Liquidity Management

This exemption got much less press than market-making, but its lingering problems may be significantly worse. The culprit here is a combination of the hold-to-maturity basis of the exemption and the extraordinarily low short-term rates. With historically low loan demand, and suppressed earnings throughout the banking industry, this has led to banks’ reaching for yield in their liquidity portfolios.

The same impending market changes that bode ill for RENTD will have significant impacts on the liquidity exemption. If banks have been moving out on the yield curve and down the quality spectrum for yield, their liquidity portfolios are exposed to high degrees of volatility whenever rates start rising. Any attempts to liquidate those portfolios in the face of rising rates faces a double whammy – losses on the portfolio and questions about compliance with the held-to-maturity exemption rules.

There doesn’t appear to be much a bank can do about this conundrum, short of giving up on the idea of getting yield from the portfolio. Even repositioning the portfolio in advance of a rate rise gives the appearance of excessive trading as defined by the VR, and waiting for the inevitable will only make matters worse. Here, again, we can ask whether the projected financial consequences of reaching for yield and then having to liquidate have anything to do with the VR, or are simply the result of market forces. Either way, we would be explaining a bad situation.


This exemption was probably the most far-reaching of the VR reforms, and undoubtedly the least discussed – in the press, anyway. The hallmark of this exemption is metrics and math; the quantification of both the risk and the hedge, the tracking of the correlation, and making mid-course corrections to any hedge positions.

All of these requirements look like good business processes, bringing discipline to what was often a seat-of-the-pants practice. But we must remember that the exemption applies to all hedging, not just the hedging of market risk. In other words, risks associated with such basic banking practices as loan origination, asset-liability management, or even cross-border expansion must follow the same rigorous requirements.

In many of these cases, banks may not have good foundations for either the risk assessment or the hedge construction. Even where they have history to rely on, it may not be a good yardstick for an uncertain future. It may not only mispredict the risk, it may mispredict the hedge performance as well.

Of course, risk is inherently about the unknown, but there are two kinds of unknowns to be confronted here. The first is the path of what we can think of as the independent variables, the things that could cause the losses. The second is the relationship between the independent and dependent variables, particularly in the more arcane risks.

One possibility of these complications and higher rigor may be a decision to bypass the hedge entirely as too difficult to construct. If banks feel they may face criticism for attempting a hedge that didn’t work, taking on the risk itself may look like the easier path.

Is the Rule to Blame?

Given the ample opportunities for things to go wrong in banking, we should anticipate a certain amount of finger-pointing in the future. One discussion I fully expect to hear is about whether the VR helped or hurt the safety of the banking business in general. That discussion will likely focus on results, without taking into account the alternatives, but we need to understand both sides, and preferably before the big changes happen. Some questions that need to be asked:

  • To what extent does the rule encourage good processes while discouraging bad ones, and vice versa?The intentions of rules are always good, but the results aren’t always what we expected. Where rules complicate a good process to the point of making it unattractive, they can have exactly the opposite of their intended effect.

  • How much can any results be traced to the rule itself and how much are a function of market forces?Many of the changes in bank trading over the last five years have been due to those market forces, and not to rule changes. In the future, as we assess additional impacts on the structure of the banking industry, we need to separate out those things caused by rule changes from those things that would have happened anyway.

  • What is the difference between rules and good management? The VR drafters, and its enforcers, sincerely believe that they are fostering good risk management across the banking industry. But, if risk is about the unknown, then no rule, no matter how specific, will cover the waterfront. So to the extent that rules lock banks into specific behaviors, they may actually inhibit risk management.

The future of the banking sector in the U.S. is a function of many things, among them the Fed’s actions as a central bank and management’s skill and flexibility in dealing with uncertainty. Since almost all the money in the country is made up of banks’ promises to pay, we all have a major stake in how well they do their jobs. To the extent that the VR prompts better risk management, it will have been worth it. To the extent that it is a burden, we may all live to regret it.

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Tags: Dodd-Frank, Volcker Rule, banks