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Assessing Regulation, Technology & Risk: Three Steps to Ensuring a Happy New Year

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

Despite record US equity prices and an improving economy, the underlying theme of 2014 was one of disappointment – in the levels of liquidity in most markets, in the spreads that market-makers were seeing, in the rising cost of being a market-maker, and in the ability of regulators worldwide to get their acts together. Here’s a preview of the issues that will shape 2015, including the Volcker Rule, mandatory clearing, automated trading and market risk, and three steps to ensure you have a happy New Year.

As we move from Thanksgiving to Christmas, it is traditional to reflect back on the year that is coming to a close, and to begin planning for the New Year. For the capital markets, reflecting on 2014 may result in mixed emotions; so does 2015 look to be any better?

Looking Back

Actually, taking the retrospective view, it would be easy to say that 2014 was a pretty good year, at least in US Equities, where prices spent most of the year rising (although the market has looked decidedly toppy in December). The economic indicators have been gradually improving all year, and the December jobs numbers gave everyone a warm feeling, if only for a moment. The Fed’s long period of aggressive easing finally seems to be paying off, even if everywhere else the world seems to be back on its heels. Corporate profits have been robust, except at the big banks, where mounting legal costs never seem to stop. Not bad, really.

But the functioning of the markets, as opposed to the economy as a whole, has been more of a mixed bag. Michael Lewis highlighted one aspect of the problems, and Carmen Segarra another; but the underlying theme of 2014 was one of disappointment – in the levels of liquidity in most markets, in the spreads that market-makers were seeing, in the rising cost of being a market-maker, and in the ability of regulators worldwide to get their acts, literally, together. As large banks ended the year with another round of impending investigations, more cutbacks in investment banking staff, and more exits from trading and clearing businesses, it would be easy for market participants to say, “Good riddance to 2014; I hope 2015 is better.”

Looking Forward

But the groundwork for 2015 has already been laid, and thus some of the future should be apparent to the careful observer. So let’s look at some of that groundwork close up.


The two major regulatory stories of 2015 will be the implementation of many aspects of the Volcker Rule in the US and the start of mandatory clearing in Europe. Neither of these will be a surprise, of course, but there is a lot of uncertainty about how both events will work out. With Volcker, much of the discussion and trepidation relates to the market-making exemption; but the biggest changes may actually be in hedging. And the technology to support tagging of trades into specific exemptions and the monitoring for violations may be immature, if it exists at all. Without technology, trading under Volcker becomes a manual nightmare.

Clearing of derivatives trades is nothing new either, of course; but making it mandatory for a wide range of participants in Europe is new. The increased cost of margin is well documented, and has prompted some buy-side firms to move from swaps to futures, which has further prompted some FCMs to exit the swaps space; but the concentration of risk in the CCPs is only now coming to front-of-mind. Once that concentration is well understood, and the sources of CCP capital become clear, there will be a scramble to enhance the regulation of that sector, leading perhaps to more exits from the business … leading to even more concentration of risk … leading perhaps to even more regulation.

Trading Technology

As spreads have fallen in every market, trading firms have predictably moved away from manual, expensive trading methods toward automated ones. Every month the percentage of computer-executed trades has been rising, so that by year-end half or less of the trading decisions in just about every market will be made by people. In fact, we even have the science-fiction scenario of buy-side bots trading with sell-side bots.

The biggest risk with automated trading is that most of the algorithms are mean-reversion formulas, meaning that the right price for anything is a function of the price of everything else. Experienced traders know that that kind of pricing works well when markets are essentially stable, but breaks down when large secular shifts occur. Looking at 2015, one such secular shift would be the end of the Fed’s many years of easing, and another would be a resumption of the financial crisis in Europe. Or perhaps both of them at the same time.

The people who run the dealer trading bots are well aware of this possibility, of course, and are prepared to shut them down if they see a secular shift. The problem will be that many of the people who could step into the breach and exercise human judgment were let go over the past few years, so we may run short of expertise just when we need it the most. The resulting trading volatility will be reflected in margin calls, which may exacerbate the same volatility, in a sort of feedback loop.

Market Risk

All this means that the risk in the markets will probably be higher in 2015 than it was this year. One simple measure might be in the potential mark-to-market for the largest category of swaps, fixed-float rate swaps. If we assume $420 trillion outstanding notional, 75% of it back-to-back, with an average tenor of six years, the mark-to-market of just the net exposure for a 100 basis-point rise in rates is $5.5 trillion. Given that such a rate rise would also serve to depress the market value of the very Treasuries used to generate the margin, we can see that there could be a tsunami lurking just under the surface of the markets.

What to Do?

So as this year draws to a close, and the New Year beckons, what’s a market participant to do?

1. Assess your trading and clearing partners – If the risk in the markets is as high as it appears, it behooves everyone to take a hard look at whom you trade with and where you clear. As trading moves more and more from principal to agency, customers will need to know where their liquidity will come from. If your traditional trading partners are feeling constrained by the capital and regulatory requirements, you need to find that out before you need them to stand up and they aren’t there.

The clearing assessment is at least as important. If CCPs are the single point of failure in the market, you need to know how much capital they have, how they can get more if they need it, and – most important – how they screen customers and clearing firms. The CCP space is a competitive business, and competition can lead to lax standards, so you need to be as rigorous with them as they should be with you.

2. Assess your trading technology – Whether you are a bank that will be dealing with Volcker in 2015 or a customer, you need to know how your technology will stack up to the new regulatory requirements. Systems take a notoriously long time to develop and test, so your tech providers should be well along on the upgrades you will need next year. Volunteering to be a beta tester for your vendors can give you early insight into how well they will perform when you need them. If they look iffy, you may need to plan a switch well before the rule changes hit.

3. Talk to your regulators – All the market regulators are feeling their way through these changes, along with everyone else. Some of them, like the OCC, have already begun pre-Volcker examinations, as much to learn what’s being done as to pass judgment. If you are embarked on some preparations that they will have to opine on, it is much better to find out early if they have a problem with your approach, as opposed to getting a bad report later. And you might just find that they are as anxious to learn from what you are doing as you are to learn from them.

The second half of December is always thought of as a slack period in the markets, as well as within market participants; but this December may just be the time to put in some extra work. If you do the things we’ve just described, you might just have a Happy New Year all of 2015, while others are playing catch-up.

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SEF Momentum Fleeting as Trading Experiences Volatility

By Anthony J. Perrotta, Jr. and Colby Jenkins, TABB Group
Originally published on TABB Forum

On-SEF volumes plummeted in November, reminding us that one year in, SEF trading may be out of its infancy, but growing pains are still very much part of the market’s present and future.

Momentum is a fickle friend; at its heart, it’s fleeting. Such was the case on display in the OTC swaps market in November, when notional trading activity failed to sustain the momentum witnessed September and October.

Average daily notional volumes for Off-SEF Cleared IRS increased dramatically in September (+20%) as the market emerged from the summer doldrums. The market held onto those levels through October, before plummeting significantly in November (-25% MoM), as depicted in Exhibit 1, below. As of publication, average daily volumes in December looked to be rebounding, averaging $143 billion per day (+21%).

On-SEF cleared IRS trading in November peaked at just over $1.8 trillion, down 36% from the record high of $2.9 trillion in October (Exhibit 2, below). Some of the decline could be attributed to a shorter trading month (20 days versus 23), but average daily trading volumes fell as well, from $127 billion to $93.4 billion.

Exhibits 1 and 2: Monthly Notion SEF Volumes (IRS)/ Monthly Notional Off-SEF Volumes (IRS)

Source: TABB Group, ISDA

Credit Default Swap Index volumes On-SEF also declined precipitously in November. October’s record-setting volume ($911 billion) quickly became an aberration, as notional transacted fell to $312 billion, a decline of almost 66% compared to the year’s prior average (Exhibit 3, below). Again, the shorter trading month is a factor when looking at aggregate trading volumes, but as with the IRS market, average daily volumes fell, from $40 billion to just under $16 billion.

Exhibit 3: Index CDS Monthly Notional SEF Volumes

Source: TABB Group, ISDA

Underscoring the lack of activity On-SEF in November was the tremendous uptick in Off-SEF trading for uncleared interest rate swaps – $2.88 trillion was traded away from SEF venues in November, a 41% jump from the year’s average to date. Looking specifically to the average daily traded, we see that activity Off-SEF for Cleared IRS rose 54% compared to the 2014 average (Exhibit 4, below). In reality, this total is likely greater than the total reflected in the SDR data, given that block trades (which make up a considerable portion of uncleared Off-SEF trading) are reported at the block threshold minimum.

Exhibit 4: Average Daily Uncleared IRS Off-SEF Notional Volume

Source: TABB Group, ISDA

Despite the recent volatility in terms of overall swap activity, there has been consistency throughout the year for trends relating to how they are trading.

Average trade sizes have consistently tracked downward for On-SEF trades (Exhibit 5, below) and upward for Off-SEF trades for much of 2014. For cleared On-SEF trades, we have seen a more than doubling in actual trade count when looking to 2013 vs. the past few months. This, in tandem with a general increase in overall notional activity for On-SEF trading, even more specifically for USD plain vanilla IRS, suggests an overall increase in turnover.

Conversely, Off-SEF trading had only seen moderate notional growth until November, with no uptick in overall trade counts month to month, which accounts for the increase in average trade size – which is even more pronounced with USD IRS traded Off-SEF (Exhibit 6, below).

Exhibits 5 and 6

Source: TABB Group, ISDA

Looking to 2015, there are many roadblocks remaining for the emerging SEF market. Package trade no-action relief, which was set to expire in November, was pushed back to 2015, and deep technological issues around straight-through processing are still largely unresolved. One year in, SEF trading may be out of its infancy, but growing pains are still very much part of the market’s present and future.

In our recent TABB Group report, “U.S. Fixed Income Market: Industry Trends & Drivers 2014,” we explore some of these trends governing the evolution of swaps trading in the U.S. market, as well as the larger trends within the fixed income ecosystem as a whole. We illustrate the changes underway in terms of the structural components of the market and dive into some of the idiosyncrasies present in the rates, credit, and swaps markets to gain a better understanding of what might await market participants once the winds of change subside and the storm passes.

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The Market of the Future Begins to Emerge

By George Bollenbacher, Capital Markets Advisors
Originally published on Capital Markets Advisors blog

Capital markets participants are nearly unanimous in the belief that almost every aspect of the markets is changing: international regulation, capital requirements, liquidity, and instrument structures , just to name a few. With that much change blowing things around, it can be hard to make out forms in the murk, but gradually the shape of the capital markets of the future is beginning to emerge.

In order to make sense of these emerging markets, we need to understand the interplay of the forces at work. Much has been written about them individually, but we need to look at them in concert, not separately. Only then will we be able to see what is really happening.

The Forces

International regulation – This factor has received perhaps the most press coverage, with everyone bemoaning the lack of coordination and uniformity between regulators. But the most perplexing aspect of international regulation is the very disparate time frames on which the regulators are operating. It is one thing to deal with different rules for different jurisdictions, but quite another to have to deal with rules that are unwritten but sure to come, while other versions are fully in force. Coupled with the fact that some regulators seem to think that their reach extends into other venues, regulation is among the most difficult factors to deal with.

The biggest change most participants are currently dealing with is the Volcker Rule, and its European cousin. Due to come fully on stream in 2015 (in the US) and perhaps a year later in Europe, the main impact of the VR is to insert a layer of monitoring into the trading functions of banks, not just in market-making and underwriting, but also in the hedging of non-trading risks and even in liquidity management. In most cases, banks will not be able to do that monitoring manually, so they will have to rely on software for much of it. Whether their technology vendors (either internal or external) will be ready when the rules become effective is a big open question and one of the biggest risks.

Capital requirements – The second big change is in the ever-rising capital requirements for most kinds of market participants. Basel III is by now old hat, so things might be manageable if that were the lot, but it most assuredly isn’t. First, there is the total loss-absorbing capacity, or TLAC, which was recently introduced by the FSB, expected to be as much as 25% of risk-weighted assets (RWAs). While still a proposed rule, it has raised tremendous consternation throughout the market.

Then, of course, there is the supplementary leverage ratio (SLR) which is the US regulators’ implementation of Basel III. For the big 8 US banks (the G-SIBs) the enhanced SLR requirement is 5%. As with any ratio, it matters greatly what you put in the denominator, and the SLR denominator is quite inclusive, covering OTC derivatives, cleared derivatives, and repos, making the SLR denominator significantly larger than the Basel III denominator.

The latest set of developments in this arena is the discussion of increased capital requirements for derivatives clearing houses, as people start to recognize the CCPs’ role in the concentration of risk. Importantly, almost all of a CCP’s TLAC is currently made up of the default funds supplied by clearing members, so increases in CCP capital will most likely come from the clearing community. This fact highlights the new economics of the FCM business, where increased cost and capital requirements have turned a cash cow into something of a dog, if you remember your BCG four-box.

Dealer bad behavior – After a long period as the undisputed rulers of the roost, dealers in virtually every market have taken their lumps over the last five years. Whether it is for fixing prices in a wide variety of instruments, or playing bait-and-switch in equities, dealers have faced a flood of investigations, fines, bad press and censures. The recent revelations by Carmen Segarra and the Senate Investigation Subcommittee only serve to cement the public’s view of bankers as amoral and opportunistic, if not worse. And the worst may still be to come, as the latest round of FX investigations are expected to lead to the arrest and trial of individual traders. The well-known prosecutorial technique of turning lower-level violators into informants against their bosses means that no one, including the banks themselves, knows how high the cases might go. There’s definitely a chill throughout the trading room.

The Impacts

Costs and Spreads – Every dealer in every market has some story about the phenomenon of higher costs on top of reduced spreads. We can trace the increased costs to many of the forces covered above: new regulations requiring new monitoring, increased capital levels, and a never-ending string of legal events. But the reduced spreads come from a different set of drivers.

One cause is the increased cost of trading for customers, as clearing becomes more and more prevalent, and customers look at hedging strategies more skeptically. As the same number of dealers chase a smaller customer demand, spreads inevitably come down. Additionally, in the largest securities market in the world – US treasuries – the Fed has removed so much of the supply that trading volume has fallen sharply. As a result, dealers have reduced treasury trading staff and come to rely on algorithms to make markets, instead of people.

Another cause has been reduced volatility in most markets, also due to monetary policy. After almost six years of quantitative easing and slow growth worldwide, markets have fallen into something of an induced torpor. Everyone is primed for the moment when the Fed begins to reel in all that cash they created, and there have been several false starts by the markets, but meanwhile the level of liquidity has been far in excess of the demand.

Finally, we have to recognize that some of the dealers’ trading profits came from the darker side – manipulating prices in general and especially during index-setting times or intercepting orders and acting against them, for example. If dealers are truly chastened by the new legal and regulatory environment, we should expect them to pull back in many markets.

Regulatory uncertainty – Every market disaster brings regulatory change, but the 2008-09 bursting of the credit bubble brought something else, a global free-for-all where market regulators attempt unsuccessfully to coordinate their efforts while simultaneously upstaging each other. For dealers and customers alike, the problem isn’t dealing with a set of rules, it’s trying to figure out what the rules will be. The absurdity of having reported CDS index trades in the US for over a year while still waiting for rules on single-name CDS reporting in the same country is perhaps the best example, but the global regulatory landscape looks like the Somme after WW I.

The Future

All these factors come together to create a very different market than we are used to. Some of its features:

From principal to agency – We’ve already started to see this trend in derivatives, but it will spread to most markets. The increased bank capital requirements for holding positions, as well as the increased monitoring required under Volcker, is already leading banks to re-examine the profitability of principal trading. Some banks have already begun to shift to an agency model, and more will follow. That will lead to…

Reduced liquidity – As trading costs rise for everyone, everyone takes a sharp pencil to their trading strategies. Customers pare back their market usage, and dealers in turn pare back their market-making. Fewer customer trades and fewer market makers means it will be harder to move large blocks of almost every instrument, so spreads in most markets will widen. That will lead to…

Higher volatility – More agency trading and reduced liquidity will inevitably result in a jump in volatility. Reduced customer volume may counterbalance the drop in liquidity somewhat, but large customers will find it harder to get big trades done. This will all be exacerbated whenever the Fed starts withdrawing some of the $4 trillion of cash it pumped out, much of which went to the emerging markets. That will lead to…

Increased risk – Higher volatility and lower liquidity are the perfect formula for increased risk, which has been concentrated in a small number of institutions, particularly clearinghouses. The regulators have already begun to recognize the CCP risk concentration, and have begun to call for more CCP capital, but the volume of risk in derivative CCPs is not well understood, and it represents a narrow bottleneck through which everyone will have to pass, at perhaps the worst possible moment.

Much of the public discourse on market and regulatory reform has been about efforts to make the markets safer and more transparent. Taken individually, many of the recent changes have that as their objective, and regulators talk incessantly about how their efforts are achieving those goals. In reality, though, the combination of impacts may have had the opposite effect. Eventually the markets will find a new equilibrium, where customer demand is met by dealer readiness, but the road to that equilibrium will probably be pretty bumpy. The old adage of “hope for the best but prepare for the worst” might be the best formula for dealing with the markets of the immediate future.

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Clearing in Europe for Interest Rate Swaps is Coming

ESMA has now issued its final draft regulatory technical standards (RTS) that define the scope of interest rate swaps that must be cleared under European Markets Infrastructure Regulation (EMIR). Before applying, the RTS must be formally adopted and published*. This is expected to take place at some point in Q1 2015. The RTS will “enter into force” 20 days after they are published.

Mandatory clearing will be phased by type of counterparty. ESMA has proposed four categories. Assuming the RTS are formally adopted and published in Q1 2015, counterparties, including buy-side firms, who are direct clearing members will be classed as category 1, and will be required to start clearing in Q3 2015.

Institutional clients who are designated as category 2 counterparties are expected to start clearing by Q1 2016, and from Q3 2016 for category 3. EMIR mandatory clearing also applies to certain non-financial counterparties; it is expected that this will apply from Q1 2018.

 *  Note: This information is based on ESMA’s final draft RTS. There are ongoing discussions between EU policy makers about certain aspects of the RTS. Therefore, it is possible that there could be further changes before the RTS are formally adopted and published.


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All of the above instruments are limited to:

• Single currency settlement

• No optionality

• Constant or variable notional amounts

The EMIR clearing scope is almost identical to the CFTC’s US clearing mandate. The only exceptions are:

• 3D-3Y JPY FRA have a clearing mandate in the US but not under EMIR

• OIS in EUR, USD and GBP with a tenor of up to 3Y are mandatorily clearable in the EU, whereas the US mandate covers tenors up to 2Y


2 Timeline resized 600


3 Categories resized 600


Counterparties whose aggregate month-end average notional amount of non-cleared derivatives in the three months before the RTS enter into force is above €8 billion will be in category 2. Counterparties who fall below this threshold will be in category 3.


Frontloading is the requirement to centrally clear certain derivatives contracts entered into before the clearing obligation for the counterparty takes effect. Under ESMA’s final draft RTS, the main frontloading window would open after the formal adoption and publication of the RTS. ESMA has set out a minimum remaining maturity for each class of derivatives, which will have the effect of excluding certain contracts from the frontloading requirement.

The main frontloading requirement will apply to uncleared contracts entered into by counterparties in categories 1 and 2 following the formal adoption and publication of the RTS. Contracts that are close to expiring when the counterparty’s clearing obligation takes effect will be excluded from frontloading. Frontloading for category 3 counterparties is expected to apply only in very limited circumstances. NFC+s are not subject to frontloading.

Because of the different application of frontloading for categories 2 and 3, it will be important to establish which category you and/or your clients fall into before the front loading window opens.


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An E-Trading Treasury Market ‘Flash Crash’? Not So Fast

By Anthony J. Perrotta, Jr., TABB Group
Originally published on TABB Forum

Volatile swings in equity markets have been blamed on high-frequency trading strategies. On Oct. 15, the US Treasury market woke up and realized it was sleeping with the same enemy. But directing blame at technology and innovation merely diverts attention from the real problem – a structural imbalance in fixed income markets.

Franklin D. Roosevelt sat before Congress on a crisp December morning in 1941 and declared, “Yesterday, Dec. 7, 1941 – a date which will live in infamy – the United States of America was suddenly and deliberately attacked”; you know the rest. By invoking FDR’s words, I am not suggesting the assault on the US Treasury market on Oct. 15, 2014, was akin to the attack on Pearl Harbor. Instead, I am submitting for consideration the notion that the day should serve as a wakeup call for market participants and regulators.

The OTC fixed income markets are changing due to a variety of catalysts. Regulatory reform is forcing large banks to reassess their business models. Inflated government budgets, slow economic growth, and low inflation are making debt more attractive. Accommodative monetary policies are artificially keeping interest rates in check, fueling an unabated pipeline of debt issuance. Asset owners are increasingly growing larger and more concentrated. Investment philosophies are converging, becoming more symmetrical. It seems while the size of the market is growing, the universe of players that operate within that market is getting less diverse.

Combine the regulatory changes with the current market structure and you get a precarious and volatile cocktail. High-frequency trading, automation, and the electronification of execution are all convenient excuses – after the fact – for increased volatility in markets, but have almost nothing to do with the cause. That honor goes to structural imbalance – i.e., the declining ratio of liquidity provided to liquidity demanded, which has evolved since 2004. Nowhere is this more obvious than in corporate bonds, where the impact of dealer liquidity has declined by a factor of three over the past 10 years (see our report, “Corporate Bond Conundrum,” September 2014). Now we’re getting a taste of how this might be affecting the US Treasury market.

In October, the stage was set overnight in Europe, when weak economic data renewed concerns for a deteriorating global economy and Ebola fears permeated the market. Fund redemptions at PIMCO due to the announced departure of bond guru Bill Gross complicated the matter (i.e., the resultant proceeds had not yet been reinvested). The market was already biased toward a short-sided position, so the market was technically vulnerable.

The UST10Y was trading at 2.20% at 4:00am EST. When US retail sales for September came in weaker than expected, buyers emerged and the yield on the UST10Y fell steadily to 2.00% over the next hour, before suddenly dropping as low as 1.86% in a matter of minutes. Not long after, sellers instantly drove yields back to 2.0% before taking the remainder of the day to methodically work their way back to 2.15%. The Financial Times reported the move as a seven standard deviation break from the intraday norm. That certainly qualifies as an aberration (i.e., that type of move should only happen once every 1.6 billion years); but we are inclined to believe this is the beginning of a period in which situations such as this may become more prevalent.

The market is clamoring for a return of volatility, just not this kind of volatility. In the wake of such a drama-filled day, investors, dealers, and regulators are all seeking to identify the culprit responsible for this type of outlier trading session. In the court of public opinion, electronic trading appears to be the fall guy, but we think the focus may be directed entirely in the wrong place.

The true perpetrator is market structure. Under the current, principal-based risk model, liquidity providers – traditionally large banks with significant amounts of capital – provide liquidity on-demand (a.k.a. “immediacy”) to investors. As the amount of capital these banks have at their disposal and committed to market-making declines due to regulations imposed by the Dodd-Frank Act and Basel III Accords – including the Volcker Rule and the liquidity coverage ratio (LCR) – the likelihood of volatility increasing is greater. When viewed in conjunction with the fact that the US treasury market is now $12.2 trillion and the Fed has reduced the outstanding “float” of USTs through quantitative easing, the story gets more compelling. Factor in the notion that asset managers are more concentrated and larger, and the amount of on-demand liquidity requested can sometimes overwhelm the liquidity providing universe.

The development of electronic trading isn’t the cause of volatility, but it certainly can and will contribute to accelerated price movements when a dearth of liquidity exists. The fixed income markets are in the nascent stages of automation; not every market participant is operating with the same level of resources or technology. In fact, the disparity between market participants is probably akin to watching Ferraris zip past bicyclists on the way to the same destination. Undoubtedly, this contributed to the abnormal volatility we experience on that “day of infamy” in October.

The UST market was short from a position perspective, economic data was weak, people were afraid of Ebola, PIMCO redemptions had to be reinvested, Europe was receding, the float of USTs was precariously tight, and people were fleeing all at once to the only safe harbor – the US Treasury market.

Who dare step in front of that freight train barreling down the track? Typically, opportunity would present itself to a group of primary dealers that would continually short bonds into the updraft, knowing the move would eventually correct. Having capital and servicing clients in times of stress was once a profitable luxury; that aspect of the business is fading fast, and along with it, the willingness of dealers to commit to principal-based market-making … even in the homogenous and commoditized US Treasury market.

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What I Learned at SEFCON 5

By Tod Skarecky, Clarus
Originally published on Clarus Financial Technology blog

I had my doubts about SEFCON 5.  I had even told one of the sponsors weeks in advance, tongue in cheek, “SEF’s are live and ticking, what’s there to talk about?”  I knew better, and I indeed learned a few things.

I’ll detail a few of the hot topics.  Many of these came up multiple times in separate panels.


Order books are not very active yet.  RFQ’s remain the primary method of execution.  This came up multiple times.  My takeaway is as follows:

  • Deeper liquidity is on offer in RFQ in any size. Shawn Bernardo in particular discussed what an order book would look like a minute before numbers come out.

  • Nathan Jenner pointed out that in their CDX trading, he quoted 30-40 trades out of the 1,000 or so done in any given day are done on CLOB. So 3% done in the order book.

  • I’d surmise clients do like an order book, but only as one option of execution, and for any size they will go to a phone.

  • CDX is highly standardized and lends itself more to a CLOB. When the most active Interest Rate swap trades only 200 times in a day (spot starting, 10 year swap, as seen on SDRView), it does not lend itself to an order book as readily.

  • MAC contracts may be this standardized contract that gets the order books going.


There was an active debate particularly between Nathan Jenner of Bloomberg and Rana Chammaa of UBS regarding the agency model.  I’d boil this down to Bloomberg having a very successful marketplace in their SEF, but not providing FREE access to it.

I’m not clear on the legalities, but it seems there are some hurdles to agency trading on some venues.  I have heard that some SEF’s have had difficulty in the agency model but worked around it – I liken it to me providing agency access to Amazon – I’d have to log off and log back on to Amazon to get my client’s credit cards etc loaded before I buy that book for them.  However, add to those logistics the commercial model whereby Bloomberg’s SEF is on a terminal and you can begin to understand the underlying dispute.

However the discussion unraveled (including an abusive audience question) to the point where the agency model was questioned as valid.  My takeaway is that the model is indeed valid; while there are clients that will prefer to connect directly, there will ultimately need to be ways for smaller firms or firms that cannot justify the capital expense (in connectivity, legal, regulatory, etc) to access SEF liquidity.


Scott O’Malia returned to SEFCON under the ISDA umbrella and led a good panel specifically on this topic.  He put up some graphs that I frankly struggled to absorb fully, but I got the point:  Scott has some data to back up, beyond common sense, that EUR and USD liquidity pools are indeed fragmented.  To corroborate this, Dexter Senft of Morgan Stanley cited their own case of moving their swaps business to London.

For the newcomers to cross-border issues, I would summarize the problem as:

  • Europe favors “substituted compliance” – or as I’d put it “Trust the other jurisdiction to care as much as you do to police everything”.

  • America favors dual registration – or as I’d put it “you need a license from the CFTC to run that facility, and US firms can only interact with such licensed utilities”.

What I hadn’t appreciated was that the OTF/MTF concept will likely not be in effect until 2017, so we can generally forget about solving this until then, although Edwin Schooling of the FCA did say that its possible some early-bird registering ETF’s could try to become “equivalent”.  I wasn’t inspired.

One pretty horrific consequence of this is that firms like Virtu (presumably a US Floor Trader) are not able to trade in the European pool of liquidity, if I understood John Shay correctly.  I would infer Citadel and the other new entrants are in the same position – currently vying for the few hundred swaps a day.  I’d think that would make the 2nd tier of new entrants unable to justify entering the business.

Dexter Senft raised the “Elevator Rules” that were born at the previous year’s SEFCON.  He cited the case of cross-border rules going as far as prohibiting a European firm trading with another European firm when it requires any assistance from someone domiciled in the US.  I was fortunate to be sitting next to the CFTC member who wrote that rule (or footnote), who quietly told me that the real problem is that there are no record keeping requirements for that kind of arrangement.

In summary, cross-border seems as enigmatic as ever.


Some of the SEF order books are anonymous order books, but named post-trade give-ups.  In my opinion this topic has been a bit taboo, and this is really the first venue where I’ve seen it discussed openly.  The real problem here is that banks and clients are happily maintaining the dealer/client relationship structure, despite the all-to-all mantra.  Legally, nothing is keeping a “client” from joining an IDBSEF.  But the day that Hedge Fund ABC trades a swap with a G14 bank, someone might get upset.  I feel for the IDBs as it would seem their core business has been attacked.

It’s like being a real estate agent and being told that homebuyers can knock on your customers’ doors to look around their house.  You’re not happy because it trivializes your service; anyone can post a few pictures on the internet to match a buyer and a seller.  And your primary clients are not happy because they have un-screened riff-raff stopping by their house at dinner time to look around.  Poor analogy I know, but the core business of IDB’s is going to have to change.

It’s not clear to me if the named give-up is legal under the SEF rules.  I believe it is.  But because it jeopardizes the all-to-all structure, I think the CFTC will feel the need to step in.  Just how they do that, I don’t know.  Can they really dictate post-trade workflow for derivatives?


  • CFTC again justified some of the lack of progress on lack of funding. I truly am amazed at how much has been accomplished on such little budget.  It also astounds me that earlier that morning they fined multiple firms for 1.5 billion dollars, yet they have to run their agency on a fraction of that.  Surely they deserve a small commission on their enforcement!

  • NDF clearing mandate seems to be raising steam, yet with no timeline.

  • Massad claims he is open to the idea of changing the MAT process.

  • Marisol Collazo of the DTCC claimed the DTCC have an effort to clean up the data, and also referred to some trades she was aware of being double-reported to both DTCC and another SDR (presumably BSDR). That didn’t fill me with confidence.


All in all another great SEFCON.  I suspect we’ll have things to talk about for a few years to come.  I think it will need to go global and become SEF-OTF-MTF-CON at some point.

I look forward to next year, SEFCON 6.

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Overwhelmed by Regulation? You’re Not Alone

By Larry Tabb, TABB Group
Originally published on TABB Forum

Financial regulators worldwide are developing rules that often conflict with rules in other jurisdictions, creating a web of overlapping and conflicting requirements that are making life especially difficult for banks, other market participants and their technology vendors. This new regulatory culture is changing the way that banks think about their businesses.

This week we gathered 25 senior industry members for a roundtable discussion on governance, risk and compliance (GRC), sponsored by Cognizant and hosted by yours truly. GRC today is such a hot topic that while we expected 18 participants, seven additional, very senior industry professionals just showed up. (Thankfully, we are a friendly bunch and didn’t kick too many folks out on the street in this very cold New York weather.)

There was one clear takeaway from the meeting: Capital market firms are overwhelmed by regulation. Regulators worldwide, working within their proprietary jurisdictions, are developing rules that not only cover the entities they regulate, but that also often conflict with regulatory requirements in other jurisdictions. While, for the most part, this hasn’t manifested itself in regulatory infighting, it does create a web of overlapping and conflicting rules, making life especially difficult for banks, other market participants and their technology vendors.

This new regulatory culture is changing the way that banks think about their businesses. Banks’ high-level GRC requirements, capital thresholds, and lower risk and leverage facilities are forcing management to make strategic decisions about their business portfolios. High-capital-risk and low-return businesses are being shuttered, and virtually every new business opportunity is analyzed not only through the lens of profitability, but also for capital and financial risk – not to mention “A1/C1 Risk,” or the risk of being featured on the front page of the Wall Street Journal.

So what are firms doing?

From a strategic perspective, firms are developing governance infrastructure, including risk, compliance, audit, and surveillance policy, and oversight committees to ensure that they have the proper structure and focus on everything from business mix to running a clean, flexible, and compliant organization. While having an appropriate governance structure is critical, however, many executives now are focused on the tactical aspects of compliance.

From a tactical perspective, firms are focused on the day-to-day: ensuring that their operations – whether running a dark pool, setting up a swaps desk, or managing margin for OTC trading – are in compliance with their direct regulators. From a high-level perspective, their core challenges are protecting the organization both from outside threats (cybersecurity) and from internal threats (through access-level protocols); managing trading market, credit, liquidity, and infrastructure risk; and ensuring that their tactical regulatory and compliance programs support the intense scrutiny from a barrage of regulators.

The real challenge, however, is that many firms’ infrastructure is either aged or outsourced, and the ability to aggregate, analyze, monitor, and police this information is extremely difficult. To accomplish this, firms are attempting to extract, virtualize, normalize, and integrate their traditionally siloed information. While many firms would love to develop a consortium or outsource significant infrastructure to a third party, many others believe that the effort, expense, and risk in extricating themselves out of their legacy technologies is just a bridge too far. This leaves most firms with the options of finding vendors to help them focus on the tactical exercise of extract, virtualize, normalize, and integrate, or completely outsourcing their infrastructure to a third party. Few intermediate options currently exist.

One of the only saving graces our group saw on the horizon was regulatory burnout/change in political leadership. But while we have seen regulators back track on “skin in the game” mortgage rules, regulatory commissioners challenge some of the Dodd-Frank scriptures, and of course the tremendous shift in political composition of our legislative bodies, few if any senior members who participated in our discussion believed that this change would bring any significant short-term relief; and some are convinced that the dye already has been cast globally, and there would be little if any major strategic directional regulatory shift.

Based on the strong turnout for this roundtable, these issues clearly are top of mind for industry leaders. We look forward to continuing the discussion.

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SEFCON V: CFTC Chairman Massad Discusses Regulations; Extends Package Relief

In his speech at the SEFCON V Conference, CFTC Chairman Timothy Massad outlined the current and future state of affairs regarding swaps trading on regulated platforms. Massad conveyed a pro-markets sentiment in his remarks, continually emphasizing that regulations are not designed to quell the growth of swaps trading, rather they’re aimed at allowing the industry to flourish in a safe, efficient, technologically advanced manner.

After describing broad principles for regulation and noting that swap trading regulation was still in its infancy, he explained he does not want regulation to pose an undue burden on market participants:

“In regard to oversight, we want to make sure it is strong oversight because it promotes integrity and therefore confidence by participants. At the same time, we do not want that oversight to burden participants, particularly the users of these markets, unnecessarily. This is consistent with our general regulatory approach in futures.”

He went on to address specific marketplace concerns about package trades:

“…Packages have been an area of concern. Now, packages might more accurately be thought of as strategies involving multiple products, but whatever name you use, there is no doubt that different types of packages introduce significant complexities as we look to bring them into the SEF and DCM framework. And therefore, basically since the time of the first MAT determinations earlier this year, we have been working with market participants to figure out how to deal with packages in which one leg is a MAT swap. To enable that process, we issued no-action relief earlier this year. For some types of packages, the market has developed technical solutions, and the relief has expired. For others, however, more time is needed.

Consequently, at my direction, the CFTC staff this week have extended previously issued no-action relief so that we continue to work with market participants on phasing in trading for certain types of packages.”

Massad noted that there is a wide range of opinion regarding execution methods and market structure, and stated that “We look forward to listening to market participants on these and other issues that may arise.”

He also addressed cross-border issues, explaining that the CFTC is “committed to harmonizing our rules as much as possible” with its foreign counterparts in Europe and Asia so that firms are limited in their ability to shop for preferred regulatory framework.

To view Chairman Massad’s full remarks, please click here

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Price Making in Swaps and Sharpening Your Axe

By Amir Khwaja, Clarus
Originally published on TABB Forum

Market making in swaps is a business in the midst of significant change. Regulatory drivers are increasing cost and complexity; and while central clearing has helped, it has not yet simplified the business to one which is automated, high-volume and low cost.

When making prices, swap dealers have “usually had an axe,” meaning a bias to pay or receive fixed – a bias driven by the core interest rate position of their franchise or their customer base and colored by their own views on the yield curve.

In this article I will look at the added factor of initial margin in making prices. You could think of it as a “sharpening of the axe.”

Prices, Risk and P&L

A market maker needs to offer prices to the market, whether in response to an RFQ or as orders to a CLOB, and in so doing earn the bid/offer spread. When lifted on one side, they need to be able to find the hedge and perhaps adjust their subsequent prices. For trades larger than market size, it takes longer to find the hedge, and they may use Treasuries or futures until the swap hedge is found.

A trade that brings a market maker’s DV01 back toward zero is one that is worth attracting by changing the bid offer. And managing risk and making profit is key in being able to offer prices.

An Example

Let’s take two market makers, one currently long DV01 and one short DV01, as below:

content Amir1 resized 600

Which shows:

  • Market maker 6430B has a positive DV01; not shown is the fact that this is mostly in 9Y.

  • Market maker 8200F has a negative DV01; not shown is the fact that this is mostly in 5Y.

Each of these market makers should want to move its DV01 closer to zero, so they have trades they prefer to attract into their books.

  • Market maker 6430B would prefer to receive fixed, as this decreases the book’s DV01.

  • Market maker 8200F would prefer to pay fixed, as this decreases (to closer to zero) the book’s DV01

  • Both should adjust their bid-offers slightly to make them more likely to attract the appropriate trade.

Initial Margin

What does this have to do with initial margin?

Well I want to show that rather than looking just at DV01, the market maker could look at initial margin and come to the same answer – in fact, in some cases, a better answer than looking just at DV01.

We can run an Incremental initial margin analysis to determine the impact of paying and receiving on each book.

First for 6430B, assuming swaps in a CME Cleared account and the swap dealer is a client of an FCM:

content Amir2 resized 600

Which shows:

  • The impact of Pay/Rec in 100K DV01 size on specific tenors.

  • The What-If column is the stand-alone margin of these trades.

  • The Change is the more interesting column. It shows that a Pay Fix trade would increase the IM in all tenors.

  • While Receive Fix would decrease IM, except in the 2Y tenor.

  • And 10Y Rec Fix has the greatest reduction.

  • (Remember this is a book with a large 9Y position.)

This is consistent with our earlier statement that this market maker would prefer to receive fixed.

And the same analysis for 8200F:

content Amir3 resized 600

Which shows:

  • Pay Fixed in 5Y would reduce IM the most.

  • (Remember this is a book with a large 5Y position). 

What Does This Tell Us?

Does it tell us anything more than DV01 or DV01 by tenor?

Well, yes, because it helps us to quantifying by what fraction of a basis point we could sharpen our price to attract a trade.

A reduction in IM is a benefit, as it lowers the funding cost of collateral to cover the margin requirement. Assuming a funding cost and a term, we could quantify this benefit, and in many cases, it would be material enough to alter the bid-ask spread. Which could result in a more attractive price for a customer and so win business.

Of course, the opposite is also true; an increase in IM would cause us to worsen our price and could lose business.

There is also another benefit in using IM: the fact that it takes correlations between curve points and between curves in the same currency (basis) and curves in other currencies into account. The reduction in risk resulting from this is also quantified in the margin model.

I am not advocating replacing managing risk by DV01 by managing IM. After all, we only have to look at the lessons from the Financial Crisis of 2008 to know that use of a number of risk measures (gross and net, greeks, var and stress tests) and an understanding of the assumptions and meanings of these measures is critical to success.

What I am advocating is that quantifying incremental IM is a useful measure in making prices, managing risk and realizing P&L. It can assist the market maker or indeed be added as a step into an algorithm that responds to RFQs or streams prices to a CLOB.

A Final Thought

There is the question of whether funding cost of IM is charged down to a book level or taken at a global markets business level. As most firms will have a single house account at each CCP, it would seem to make sense to manage this at a global level. However, active trading and market knowledge is at the book level; and at this level, should we optimize just for the book level and ignore the global level?

The answer to that is complex and a topic for another day. For today I want to leave you with the thought that pre-trade incremental initial margin is an important measure.

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Examining China’s Emerging OTC Derivatives Market

By Sol Steinberg, OTC Partners
Originally published on TABB Forum

China is building an OTC derivatives market without the shackles of legacy systems. It’s commitment to global financial reform will give one of the world’s largest economies a swaps market designed from the ground up for transparency, regulatory oversight and management of systemic risk.

When members of the G20 met in Pittsburgh in 2009 in the wake of the global financial crisis, they committed to reforms that ushered in a more calculated approach to systemic risk in the financial industry, and along with it, a new market structure for over-the-counter (OTC) derivatives. Anchored by the principles of mandatory reporting of OTC derivatives transactions, mandatory clearing through central counterparties (CCPs) and mandatory trading on exchanges or electronic trading platforms, the new market G20 planned for the OTC derivatives space stressed transparency, risk controls, and improved protections against market abuses.

In some of the world’s most established OTC derivatives markets, those changes are well under way. In the U.S. OTC derivatives market, trade reporting and central clearing are well established, and trade volumes on US Swap Execution Facilities (SEFs) is building. Europe has passed the European Market Infrastructure Regulation and implemented trade reporting. Legislative frameworks are being finalized and adopted for rolling out central clearing and trading on automated platforms. Elsewhere, in markets like Singapore and Australia, similar progress is being made, with reforms achieving milestones on the path to market transformation.

In line with this global commitment, Chinese regulators have proposed a similar regulatory regime. In China, where interest rate swaps, credit default swaps and many of the instruments that make up global OTC derivatives markets have not been traditional tools of finance, the commitment of the Chinese regulators to the post-financial crisis system of reforms means China is essentially building an OTC derivatives market without the shackles of legacy systems. China’s commitment to global financial reform will essentially give one of the world’s largest economies a swaps market designed from the ground up for transparency, regulatory oversight and management of systemic risk.

Central Clearing

Beginning in 2014 with mandatory clearing by the Shanghai Clearing House of new RMB interest rate swaps with tenors of no more than five years, China is building central clearing into the foundation of a its interest rate swaps market. Through Shanghai Clearing House, China was the fifth country in Asia to begin OTC clearing after Australia, Hong Kong, Singapore and Japan. On its inaugural data of operations, Shanghai Clearing House cleared 59 interest rate swaps between 15 financial institutions worth a total notion amount of 5 billion yuan, equivalent to $827 million.

On July 1, clearing of Chinese yuan interest rate swaps became mandatory onshore in China for dealers and clients. Thirty-five direct clearing members were admitted prior to launch, including nine foreign banks: Bank of East Asia (China), BNP Paribas China, Citibank China, Credit Suisse, Shanghai branch, DBS China, Deutsche Bank China, HSBC China, OCBC China and Standard Chartered Bank China.

Some notable foreign banks did not make the cut prior to the launch of mandatory trading of yuan interest rates swaps. Of the foreign firms that were not on board, some hesitated to join because of compliance rules and others were rejected by Shanghai Clearing House for various reasons. Authorized institutions, licensed corporations and other Chinese persons who are counterparty to a clearing-eligible transaction are required to clear through a CCP if both entities have a clearing threshold and are not exempted from clearing obligations.

Trade reporting and confidentiality

China has moved aggressively on other G20 goals as well. In China, only one trade repository should be designated for the purposes of the mandatory reporting obligation. The reporting obligation for Chinese persons will remain unchanged – i.e., their reportable transactions will have to be reported if their positions exceed a specified reporting threshold, which will be assessed based on the total amount of gross positions held. For licensed corporations, and local authorized institutions, the reporting obligation will apply if they are counterparty to the transaction or the transaction has a Chinese nexus. For foreign authorized institutions, the reporting obligation will not apply if its Chinese branch is neither involved as a counterparty to, nor as an originator or executor of, the reportable transaction, or its Chinese branch is the originator or executor of the transaction, but the reportable transaction does not have a Chinese nexus. A T+2 reporting schedule will provide market participants some leeway to ensure they can meet reporting obligations.

Reporting to global trade repositories will not suffice for the purposes of any mandatory reporting obligation under Chinese law. Chinese law prohibits the disclosure of state secrets, and there is some lack of clarity as to the definition of state secrets. In fact, there are already reports that some US firms located in China have stopped trading with each other in China because of concern that reporting their trades to US trade repositories, as would be required by two US firms, would be a violation of Chinese privacy law. Due to concern that the mandatory reporting obligation may compel market players to breach confidentiality obligations under overseas laws, Chinese regulators will try to build in a degree of flexibility into regime to avoid this.

Forthcoming: mandatory trading and oversight clarifications and adjustments

As of April 2014 three jurisdictions – China, Indonesia and the US – reported having regulations requiring organized platform trading. That said, mandatory trading will not be imposed in China at the outset, but will be phased in at a later date. Once mandatory trading on designated facilities is in place, fines will be imposed for breaches of mandatory trading obligations that will be comparable to those of other major jurisdictions around the world.

Legislation will seek to clarify when failures to comply with trading and clearing and reporting obligations should be penalized and when they may be excused. Chinese regulators should be able to take disciplinary action against parties that breach their obligation and regulators are also proposing a civil penalty regime whereby civil or administrative fines might be imposed for compliance breaches.

Margin and capital requirements will be proposed, and Chinese regulators intend to impose higher capital and margin requirements for non-cleared OTC derivatives transactions.

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