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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

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.

AGENCY & SPONSORED ACCESS

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.

CROSS BORDER & FRACTURED 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.

ANONYMITY

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?

OTHER NOTABLES

  • 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.

GREAT DAY

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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QCCP Status – The Race, the Chase, and the Wait

By Xiang Li, Thomas Murray
Originally published on TABB Forum

The Race – authorities fired the starting gun five years ago

Six months after the European Commission extended the transitional period, the deadline is looming again for a Central Counterparty to be classed as a QCCP (Qualifying CCP), which means it is licensed to operate as a CCP in European Union. The Dec. 15, 2014, deadline is almost upon us, as stipulated under Article 497 of the Capital Requirements Regulation (CRR), which comes into effect that day. There are discussions regarding what might happen when the transitional relief period runs out; there could be knock-on consequences for the capital that clearing members are required to hold.

EU-based clearing houses have had to present their credentials to ESMA for reauthorisation to operate as a QCCP. Clearing houses outside the EU wishing to maintain existing business relationships within the EU have been required to submit applications to be recognised by ESMA.

There is a link between the Q status and reauthorisation/recognition under EMIR, the European Market Infrastructure Regulation. The Basel III capital requirements for bank exposures mean that the Q clearing houses must: (i) be regulated according to the Principles for Financial Market Infrastructures; (ii) make available the calculation of hypothetical capital (KCCP), the prefunded default fund contributions from all clearing members (DFCM), and the CCP’s own contributions to the default fund (DFCCP) in order to enable a clearing member to calculate its capital requirement and; (iii) be licensed to operate as a CCP.

Requirement (iii), in Europe, comes in the form of reauthorisation by ESMA. CRR defines a QCCP as a central counterparty that has been either reauthorised or recognised under EMIR. This implies that ESMA would take (i) and (ii) into consideration and its authorisation or recognition is effectively a ‘QCCP licence’ in the EU.

This is the race CCP operators have been running for several years now, with those hurdles to jump. I hope you are following this so far...

The Chase

The clearing houses are chasing the Q. Here is what they are running from: When the CRR provisions come into effect on Dec. 15, 2014, the capital for exposures to a non-QCCP will be prohibitively high, to the point that clearing members may even withdraw their membership.

In addition to ESMA authorising CCPs within Europe, the European Commission must assess whether clearing houses outside the EU operate under “equivalent regulatory regimes.” Failure by the EC to recognise a third country’s regulatory regime as equivalent will mean that ESMA cannot assess a third-country CCP application for recognition as a QCCP, which will have the same impact on a non-QCCP anywhere in terms of European-based clearing members’ capital costs. It will not matter if the clearing bank is a branch of a European organisation or a locally incorporated subsidiary. The difference in capital costs will be devastating.

The chase has required considerable administrative and organisational running and jumping. In September 2013, NASDAQ OMX Clearing was split off into a separate legal entity from its exchange owner as part of its EMIR compliance obligations. The regulation requires a CCP to have its own legal structure. Legal separation could ring-fence the risks and enable various stakeholders to analyse the capital adequacy of the CCP in a transparent manner. The Spanish CCP, BME Clearing, also became independent from its exchange.

Asset safety is another area that has seen significant changes. All EU-based CCPs are obliged to at least offer the option of individual segregation of client assets. This is widely viewed as the safest and clearest way to manage, but it is costly and may take a long time to implement. The EU CCPs had no choice if they wanted to stay in the game. For example, CC&G in Italy announced its plan to construct the EMIR-compliant account structure in June 2013, and then spent almost a year in implementation and testing.

For clearing houses outside Europe that realised at the last minute that they had to obtain EU recognition, it was quite a rush to submit their application by September last year. According to the list published by ESMA, most of the major CCPs outside the EU have sent in their documents. For many of them, the “Q” is forcing them to observe the Principles for Financial Market Infrastructures before their local regulator requires them to do so. Similarly to their European counterparts, these other clearers are undergoing a variety of changes to adapt to the new regulatory landscape, such as refining margin methodology, introducing “skin-in-the game” by putting their own money at risk, boosting their capital base, eliminating low-quality collateral, etc.

These intertwined regulations – EMIR, CRR, Basel III, PFMIs and the others – are laying a considerable burden on these market infrastructures. The positive side is that those CCPs that reacted swiftly and wisely in their chase for “Q” are becoming stronger and more robust.

I hope that you are still following this story …

The Wait

For some, the race is over. The following European-based CCPs have been reauthorised by ESMA:

  • NASDAQ OMX Clearing AB (18 March 2014)
  • European Central Counterparty N.V. (1 April 2014)
  • KDPW_CCP (8 April 2014)
  • Eurex Clearing (10 April 2014)
  • Cassa di Compensazione e Garanzia S.p.A. (CC&G) (20 May 2014)
  • LCH.Clearnet SA (22 May 2014)
  • European Commodity Clearing (11 June 2014)
  • LCH.Clearnet Ltd (12 June 2014)
  • Keler_CCP (4 July 2014)
  • CME Clearing Europe Ltd (4 August 2014)
  • CCP Austria (CCP.A) (14 August 2014)
  • LME Clear Ltd (3 September 2014)
  • BME Clearing (16 September 2014)

The major name missing on the list is ICE Clear Europe, the UK-based CCP that is supervised by the Bank of England. On Oct. 7, 2014, ICE Clear Europe issued a circular amending its rules and procedures, with many to become applicable upon receiving reauthorisation from ESMA. In a related Financial Times article on Oct. 10, 2014, it was reported that ICE Clear Europe has resubmitted its EMIR-application to the Bank of England and expects to receive its authorisation and Q at the end of the year, or early in 2015.

There was little news in relation to non-EU clearing house recognition until Oct. 30. In a statement on June 27, 2014, European Union Commissioner Michel Barnier stated his intentions to “shortly” propose the adoption of equivalence decisions for five jurisdictions, namely Japan, Singapore, Australia, Hong Kong and India. However, when the first four jurisdictions were announced to be “equivalent” on Oct. 30, 2014, India was left out. Since the primary condition of recognition has been met, that of the jurisdiction itself, the prospect of the CCPs in these four jurisdictions being treated as QCCPs by means of ESMA recognition is bright. Given that less than two months remain until the deadline, it is unclear what is occurring in relation to the other applications. Might they perhaps all be recognised all in one go? We wait.

At an FIA conference in Geneva on Sept. 23, 2014, Martin Merlin of the Commission’s Directorate for Internal Market and Services, remarked that: “The commission is considering a further six month extension of the deadline.”

It is unclear when this six month extension would begin because, according to the CRR Article 497:

“The Commission (EC) may adopt an implementing act under Article 5 of Regulation (EU) No. 182/2011 extending the transitional provisions in paragraphs 1 and 2 of this Article by a further six months, in exceptional circumstances where it is necessary and proportionate to avoid disruption to international financial markets.”

The extension resulted in the latest deadline of Dec. 15. As far as we read it, the regulation currently does not provide any additional provisions for extensions in exceptional circumstances.

The only extension that may be possible is the three-month provision that permits clearing members to treat a CCP as a QCCP following the end of the transitional period, or if the CCP no longer meets the criteria to be classed as a QCCP. This was clarified in a European Banking Authority (EBA) Q&A. In this situation for both European and TC-CCPs that have not been authorisation and/or received recognition, respectively, they can be treated as a QCCP until March 15, 2015, the purpose of the extra months being to enable clearing members to leave in an orderly fashion. In addition, theoretically it would also provide the regulators with extra time to authorise/recognise a CCP. Beyond this date, it is unclear where any additional time for any further administrative purpose could be found.

The main objective now is to ensure that CCPs are authorised and recognised pursuant to EMIR as soon as possible in order to prevent the derivatives market from becoming fragmented, a concern that was highlighted by the Managed Funds Association (MFA) in response to an ESMA consultation paper on the clearing obligation under EMIR.

What we do not know is how EMIR and its effects fit into the regulatory changes underway in other jurisdictions. In particular, the lack of recognition of the US market would cut off European banks from major US derivative markets. 

And so after the race and the chase, we wait. 

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CFTC Chairman Massad Addresses Cross-Border Issues, Extends Package Relief

In a speech to the Futures Industry of America, CFTC Chairman Timothy Massad discussed current and future regulation of derivatives. Ticking through a long list of agenda items that included a recap of regulatory activity to-date and deep-dive on cybersecurity, the Chairman’s most actionable comments centered on cross-border regulation and the upcoming extension of no-action relief to package transactions.

Noting that the CFTC and its staff have led all other G-20 nations in writing OTC derivatives rules, Massad acknowledged that it will be impossible to achieve full scale harmonization until all other jurisdiction have finalized their own laws.  He explained:

“So let’s remember that we are in a unique historical situation: the OTC derivatives industry grew up to be a global industry without any oversight or national regulation. Now, as the financial crisis exposed weaknesses in this global market we are seeking to regulate it through the actions of the various G-20 nations, each of which has its own legal traditions, regulatory philosophy, administrative process, and political dynamics. Although the G-20 nations have agreed on basic principles for regulating swaps, there will inevitably be differences in the specific rules as reforms are implemented, including in timing of implementation. This is something I regard as a glass half full, not half empty. We are making progress, but it will take time.

Indeed, the timing of implementation of reforms alone is a simple but critical issue in solving these cross-border issues. We wrote most of our rules faster than other jurisdictions and made many substituted compliance determinations last December. More will eventually follow. But you can’t make substituted compliance determinations until other jurisdictions have written their rules or passed their laws.”

Massad went on to note that he supports the recommendations of the CFTC staff that no-action relief on cross-border guidance, which is set to expire at the end of this year, be extended for the time being:

“We at the CFTC are also aware that the no-action relief that was granted with respect to the further cross border guidance we issued last November 14 will expire at the end of the year. This pertains to when a foreign swap dealer that engages in certain conduct in the United States is subject to U.S. transaction requirements. Earlier this year, the Commission asked for comment on that advisory. We are still considering those comments, as well as the relationship of this issue to other cross-border issues. Therefore, the staff is recommending that we extend this relief for the time being, and I support that recommendation so that we have the necessary time to consider these issues.”

Finally, Massad also announced that the CFTC would be extending no-action relief for SEF trading of package trades:

“I also wish to announce that CFTC Staff have recommended extending the no-action relief previously provided in order to phase-in the requirement to trade on SEFs swaps executed as part of certain package transactions—that is, transactions involving a swap that is required to be traded on a SEF and some other swap or other product. Over the last year, we have been phasing in the trading requirement as it pertains to swaps that are part of various types of packages. We recognize the market needs a bit more time on certain remaining packages, and I expect the staff will issue the letter shortly.”

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

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Buy Side Drives Back-to-Back SEF Volume Records

By Colby Jenkins, TABB Group
Originally published on TABB Forum

While regulatory factors continue to push interest rate swap volumes on-SEF, the return of volatility is driving natural demand for swaps.

On-SEF notional volumes for cleared interest rate swaps (IRS) in October peaked at $2.9  trillion, beating the previous month’s record by just more than $83 billion, setting a new all-time record for monthly SEF trading activity (see Exhibit 1, below). This total represents a 31% jump above the previous YTD 2014 average and a 95% increase from the 2013 monthly notional average traded.

Exhibit 1: Cleared IRS Monthly Notional Volumes, (Ex-FRA)

Source: TABB Group, ISDA

TABB Group has tracked trading data since SEF trading went live a little more than a year ago. Within this period, we have consistently observed a pronounced, expected uptick in IRS activity correlating to conventional quarterly IMM dates. March, June, and September all were record-breaking months in 2014. With the exception of May (which may have been driven by no-action relief expirations for package trades), months in between all saw significant dips in activity. What is unique about October is that it is the first time in 2014 in which a new record for activity was set the month following the quarterly IMM month.  

The question is: What drove October’s surge? Two significant regulatory factors were at play in October. The October Federal Open Market Committee (FOMC) signaled the end of QE3, a stimulus program that has in many ways provided a six-year safety net for the market. The uncertainty the end of QE3 will surely generate, coupled with the eventual hike in interest rates, will likely mean a long-awaited return of volatility and, with it, a natural demand for swaps. The strong uptick in October may be the first wave of this new demand.

Similar to the volume spike that occurred in May, impending no-action relief expiration for package transactions involving a Made-Available-to-Trade (MAT) swap also may have been a factor in October’s record volumes. On Nov. 15, the final no-action relief for package transactions involving a MAT swap and a future (invoice spread) will expire. What we might be seeing in October is a slight easing-in on the part of investors looking to continue their use of these contracts.

Market share data for October support the case for the buy side’s growing demand influence. Taking the average between the two most recent record-breaking months (October and September) and comparing to an average across July and August, Dealer-to-Customer volume grew by just under 50%. This growth is a significant contrast to the 37% overall growth in notional volume among Dealer-to-Dealer (D2D) SEFs for the same period (see Exhibit 2, below). The strong growth in client flow in the context of the lesser increase in dealer activity indicates that the buy side’s appetite for IRS clearly has room to grow.

Exhibit 2: D2D vs D2C Recent Notional Growth

Source: TABB Group, Clarus FT

Looking to the rest of this year, Nov. 15 represents a significant step forward for the SEF market, regardless of whether the final no-action expiration will have a significant notional impact. Can the market keep this momentum? Data suggests that the market has much room to grow, although the next couple of months historically are a time of stagnation. 

We are only weeks away from concluding the initial Made-Available-to-Trade (MAT) implementation process. As we step into the next stage of the process, there is considerable pressure on SEF operators and regulators alike to responsibly expand the current scope of MAT mandates – although the real pressure is on the regulators to discern which contracts are truly ready, as struggling SEFs have economic incentives to push as many mandates though as possible.

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Swap Standardization: The Rise of MAC?

By Tod Skarecky, Clarus
Originally published on TABB Forum

Earlier in October, I predicted that, just as the CDS market moved to standardized contracts a few years ago, the day would come when the interest rate market would move to a standardized world, namely in the form of Market Agreed Coupon contracts, or MAC.

The logic behind the prediction:

  • Managing line items in a cleared world is easier because they naturally compress, ala futures.

  • Additional swap line items of swaps are a Basel III no-no.

  • Standardization promotes liquidity; and liquidity promotes more liquidity.

  • Firms looking to take a view on 5YR risk want to have the luxury of getting in today and getting out tomorrow without any residual basis risk.

  • Firms looking to hedge specific dates may determine that the cost savings and liquidity in MAC contracts outweigh the associate basis risk.

Over the past couple months, Clarus CEO Amir Khwaja has written a few articles (here and here) in which he observes the size of the MAC market as well as the roll activity on a couple of SEFs. Here, I wanted to take a larger look at the activity over the past year to see if we can make out any real growth.

Brief History

First, a brief history lesson on MAC contracts:

  • April 2013:MAC contracts developed and launched by SIFMA and ISDA.

  • November 2013:Bloomberg announces it is the first SEF to execute a MAC contract.

  • December 2013:ISDA announces CUSIPs are available for MAC contracts to aid in communication between participants.

  • February 2014:Tradeweb’s MAT submission goes into effect, explicitly making USD MAC contracts made-available-to-trade (next 2 International Money Market-dated MACs).

  • April 2014: ISDA announces the publication of a MAC confirmation with standard terms.

MAC contracts are really pretty easy to get your head around:

  • Standard coupons. Just see the SIFMA website for fixed rates (e.g., the 5YR USD MAC is currently 2.25%).

  • Standard IMM start dates.

  • Standard tenors.

  • They have CME and LCH CUSIPs (and ISINs), just like a security.

The only possible confusion is the quoting convention, which seems to be either in bond price format, a decimal variation thereof, or a classic PV. To convert between them:

  • Given a Decimal Price of say 100.9375

  • Bond Price: Convert 0.9375 into 32nds by dividing by .03125, hence bond price = 100-30

  • PV: (Price – 100) * Notional/100

The notional in the PV calc is positive for receiver swap, negative for a payer. Pretty easy.

The Past Year

So to begin, let’s take a look at the activity of all MAC transactions since the start of 2014. Each point represents that week’s activity both on- and off-SEF. The orange line is the notional traded, and the blue line is the number of trades in that week:

C1

MAC Contracts reported within the SDR activity

This seems to tell us there has been only a slight adoption of MAC contracts over the course of the year, starting with a couple hundred per week earlier in the year, maybe hitting a “few” hundred in October. The large spikes reflect the quarterly roll activity. Of course, if you are like most people, you have no idea what 10 billion dollars of fixed/float swaps means. So below, I chart these notional and trade counts as a % of the overall.

C2

MAC Contracts as a % of all USD Fixed/Float Activity

Not so much in it. Less than 5% all year long. And notably, not much growth.

How About On-SEF?

Let’s now look at just the on-SEF activity. Here, we can more notably see a trend. Once again the quarterly rolls are pronounced, but we can more readily make out some degree of growth of MAC trading:

C3

MAC Activity On-SEF

So where is the MAC activity on-SEF? You can quite clearly make out the Tradeweb (blue) and Bloomberg (red) bars above, and I’ve also included the Eris Standard swap futures (yellow) in this picture as a reference. However, in the table below, you can also see that both GFI and TrueEx have just begun putting through numbers in October:

C4

MAC on SEF

Rumor has it that GFI and Javelin will have their order book for MAC contracts up and running sometime in November. Other rumors have more MAC order books within the IDBs popping up shortly thereafter. Which begs the question: With what can be seen as fairly subdued overall growth in MAC, why is everyone betting there will be a demand for a MAC order book? I think it goes back to the points that I listed out to begin the article; it just makes sense that these products will gain traction soon.

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