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Dodd-Frank: What Works, What Doesn’t and What Can Be Done About It?

The five-year anniversary of the Dodd-Frank Act has inspired a number of industry experts  to revisit the law’s impacts on the financial industry.  The latest of these is a blog post from  Stephen Cecchetti, Professor of International Economics at the Brandeis International Business School and Kermit Schoenholtz, Professor of Management Practice in the Department of Economics at New York University’s Stern School of Business. Both professors describe Dodd-Frank as a mixed success and acknowledge that Dodd-Frank has limited some risk in the financial system, but worry the regulation does not address larger problems. They write:

“Together, these changes are making the financial system more resilient, but the system is still far from safe. And the reforms will not reduce the likelihood of the next crisis to an acceptably low level…From the start, DF has contained critical holes and created mechanisms that reinforced poor incentives. It is also overloaded with costly regulations that were unlikely to make the system safer, even if fully implemented. And, because it is so complex, full implementation remains a long way from complete – even as we mark its fifth birthday.”

Six of the key components the professors say are missing from Dodd-Frank are:

  • a streamlining of the regulatory structure

  • a restructuring of the government-sponsored enterprises (GSEs)

  • a reform of systemically important markets (like money market mutual funds and repo)

  • effective pricing of government guarantees

  • a resolution mechanism that promotes proper incentives; and

  • a shift to regulation by economic function rather than legal form

The full post from Professors Cecchetti and Schoenholtz can be read here.

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Platform Proliferation: Déjà Vu All Over Again?

By Anthony J. Perotta, TABB Group
Originally published on TABB Forum

We’ve borne witness to this scene before – necessity stirring the entrepreneurial zeal of electronic trading innovators. Many platforms stepped forward; few survived. Back then, the market’s message was clear: Solve a problem, or die trying. Given that the current issue facing everyone may be rooted in market structure, today’s innovators have their work cut out for them.

The development of the internet ushered in many innovations. In financial markets, the technology paved the way for the proliferation of electronic trading and the rise of platforms. For fixed income, in particular, more than 85 alternative trading systems (ATS) and electronic communication networks (ECN) were introduced, utilizing both multi-dealer (MDP) and single-dealer (SDP) concepts servicing institutional dealers and investors.

As quickly as these entrepreneurial ventures arose, many were eradicated in a few short years, leaving a core group of participants to solidify franchises that persist through today. Many of the platforms that avoided the purge did so by solving a clear and obvious problem – a seemingly important requirement when wanting to perpetuate a business. Platforms wanting to garner favor with investors are wise to be particularly focused on this salient point.

Many things have developed out of the wake of the financial crisis, but the one persistently capturing the attention of market participants and the media is the dearth of liquidity. As such, alternative sources of liquidity have become all the rage. This has precipitated a renaissance of sorts in the electronic trading space across fixed income markets.

In the U.S. corporate bond market, liquidity issues have been exacerbated by the changing regulatory environment, the growing weight of assets under management (AuM), the reduction in on-demand trading that dealers provide, and the inherent lack of homogeneity. The days of immediacy (at least, for larger trades) and the unabated use of dealer balance sheet are seemingly gone. Investor appetite is being satiated by a relentless flow of new issues. But illiquidity still pervades 98.5% of the secondary market. The ratio of dealer liquidity (as defined by the capital large banks commit to secondary market-making in IG and HY markets) has fallen from 2.3% to just above 1.2%, a 48% decline.  

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Execution venues are busy introducing trading protocols purporting to solve the problem. MarketAxess currently owns most of the electronic market share (about 15% of the total market), but the solution it provided in 2002 (the list-based, electronic request-for-quote, or “e-RFQ”) facilitates cash flow trades requiring immediacy. These tend to be odd-lots (TABB estimates the average e-RFQ to be approximately $480K). The real problem beguiling the market is the inability to move off-the-run issues (approximately 24,000 outstanding CUSIPs) for notional trade sizes greater than $2 million.

It has taken several years to get new platforms to the deployment stage, but competition finally is developing. Imbedded institutional fixed income platforms such as Tradeweb and Bloomberg are now being joined by upstarts such as TruMid, Electronifie, and Bondcube. Retail ATSs such as KCG Bondpoint and TMC Bonds are diversifying their models, offering connectivity to large asset managers. Established equity trading venues such as Liquidnet and ITG are also getting into the game, as are European platforms including MTS/ In total, there are almost two dozen trading platforms or electronic models servicing the corporate bond landscape, jockeying for market share.

Skepticism abounds. Adoption has been slow. Asset managers are eager to consider alternatives, but their behavior remains mired in the past. We often hear the narrative, “market structure is changing.” But the reality is that market structure remains stubbornly intact. Voice-driven trading is still the primary modus operandi for larger and bespoke trades, and e-RFQ is the protocol dominating odd-lot trading.

There is an undercurrent that ultimately might pave the way for structural change – the market is subconsciously migrating to an order-driven model. Our research indicates “riskless principal” (often incorrectly termed “agency”) trading has risen dramatically over the past year. We estimate that approximately 30%-40% of investment-grade and as much as 70% of high-yield trades are executed following the receipt of an order. While dealers are eschewing execution and inventory risk, they remain intimately involved in the process of risk transfer as the critical link facilitating distribution, protecting information leakage, and providing pricing data. As the corporate bond market starts to resemble an exercise in archaeology, dealers represent those armed with picks, shovels, and toothbrushes.

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Electronic trading venues believe they are the efficient answer to the laborious “dig”; many aspire to become the agents of risk transfer for investors. MarketAxess has launched “Open Trading,” which allows investors to anonymously reveal their indications of interest (IOI) to the entire market. The platform endeavors to use its vast connectivity as a substitute for the search and distribution process that dealers have traditionally provided. The company reported that 9% of all U.S. trades utilize the protocol, but there are undoubtedly questions to be answered. For instance, what happens when an investor tests the market with an anonymous IOI and finds no takers? Do they have the luxury of asking for and receiving immediacy from dealers (who presumably have nowhere to go with the bonds, since their clients have all passed)? The evolution toward new trading behaviors and protocols is undoubtedly going to be filled with interesting challenges.

In reality, the “problems” plaguing the corporate bond market today are not as pronounced as the narrative would have us believe. Large asset managers report they are acclimating to illiquidity by altering their trading and investment strategies. Inflows find their way into new issues, and dealers are providing bids (or can source bids from other investors) when selling is required. The fear is in the unknown – what happens when rates rise and the demand to invest in bonds starts to fade? Will there be an orderly exit, or a rush to the exit? Large investors are quick to acknowledge the market is more vulnerable to extreme volatility and price dislocation.

The proliferation of platforms is a healthy and constructive development for the market. Competition, even if only in the ideas being put forth, ultimately spurs innovation. The key to any of these platforms succeeding lies in whether they can identify a problem and remediate it. Given the issue facing everyone may be rooted in market structure, these firms have their work cut out for them. History has shown runways get short quickly in this world. Solve a problem, or die trying.


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Data Tsunami to Drive Increase in Compliance Costs

By Shagun Bali, TABB Group
Originally published on TABB Forum

A cross-organizational, proactive approach to risk and compliance functions will transform regulatory necessity into a definitive business advantage. But institutions simply do not have the systems or control of data they need to make complex analytics an integral part of workflow or enable information to pass back and forth within different functions. As a result, TABB Group forecasts global compliance market spend will rise as much as 8% in 2015, reaching $2.6 billion.

The institutional capital markets are dealing with the aftermath of one of the most aggressive periods of regulatory intervention since the Great Depression. The costs and consequences of non-compliance within financial services are greater than ever before. In addition, the industry is going through tough times with thinner margins, all-time low volumes and low investor confidence. As a result, firms are dealing with new realities: Do more with less and adhere to stricter regulations. Existing legacy processes and technology across the front, middle and back office do not help meet these goals. Traditional risk and compliance data management techniques have largely failed to meet internal expectations and regulatory requirements.

As regulations continue to toughen, compliance departments will face challenges in terms of managing large volumes of data and the increasing costs associated with storing, retrieving, analyzing and producing that data in a consistent, unified and efficient manner. Governance, risk management and compliance (GRC) regulations have made it imperative for all functions and businesses within financial institutions to share information more readily and rapidly in order to meet regulatory requirements and support and improve investment decision-making as a whole.

The cost of compliance and the corresponding failure to maintain a compliant institution is going up. TABB Group forecasts global compliance market spend will rise 7.5% to 8% in 2015, reaching $2.592 billion from $2.430 billion in 2014, and growing at a similar pace for 2016. FINRA and SEC data also support the argument that the cost of compliance and compliance failure is on the rise. FINRA fines are at their highest levels since 2007/2008, and FINRA regulatory fees are near all-time high levels (see chart, below).

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Source: FINRA / TABB Group; SEC/TABB Group

For the effective aggregation of data, institutions need to streamline their application portfolios, standardize and normalize data more effectively, and ensure the rapid integration and sharing of data across systems. With a holistic view of data, the ability to harness synergies across the reporting requirements under new regulations offers tremendous opportunities. A cross-organizational, proactive approach to risk and compliance functions will transform regulatory necessity into a definitive business advantage. However, institutions simply do not have the systems or control of data they need to make complex analytics an integral part of workflow or enable information to pass back and forth within different functions.

Having said that, enterprise-wide compliance requires a push from top management. Visionary leaders need to introduce a new and efficient architectural paradigm that enables a holistic and unified view of internal and external data. Executives need to push the idea of working with vendors and automating parts of the compliance process. This will help save money and time for the institution as a whole.

The vendor solutions overall point to an increasingly dynamic and innovative GRC market. AxiomSL is aggressively working across the globe to help its clients automate regulatory reporting that would ease the burden on compliance departments. Bloomberg Vault is leading the market for trade reconstruction required to comply with CFTC rules. BWise has created a process-based approach for deploying the GRC platform that saves time and effort. NICE Actimize has created a differentiated offering for communications surveillance and voice analytics that are required to comply with the Dodd-Frank Act in the US. Protegent is helping its clients meet regulatory pressure by analyzing internal and structured data sets before they make the leap to analyzing external data sources.

Vendors still have much further to go to integrate with internal and external data sources, as well as to make ”social” a truly central part of the compliance reporting. Stronger analytics offerings related to risk management and alpha generation are also increasingly important to financial institutions, moving beyond the simple reporting functions of the past to robust visualization and true functionality related to ”Big Data.” These, along with more flexible deployment models and institution-specific workflow design, have presented clear opportunities for vendors to distinguish themselves.

Investments are inevitable for the infrastructure necessary to meet the distinct regulatory challenges associated with trade reconstruction (integrating structured and unstructured data). Those that make the real-time analysis and exchange of data part of their everyday workflow across the front-, middle- and back-office functions will be primed for both compliance and profitable growth.  The sooner IT leaders act to address these challenges, the more successful they will be in meeting the compliance and data management requirements of this new era.

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Chairman Massad Preps for 5-Year Anniversary of Dodd-Frank with Series of Updates on CFTC Progress

CFTC Chairman Timothy Massad has been talking anniversaries in a series of recent speeches.  Using the upcoming five-year anniversary of Dodd-Frank and his own one-year tenure at the CFTC as a springboard, Massad offered progress reports on his agency’s achievements over the last few years. 

Speaking last week before the Global Exchange and Brokerage Conference and this week at the FIA International Derivatives Conference, Massad highlighted the key areas where he will continue to focus in the months and years ahead.

Following were some of the key topics he addressed: 

  • Central clearing of standardized swaps

    • Ensuring the strength and security of clearinghouses themselves through recovery and resolution planning is a top priority

    • Cross-border recognition of clearinghouses with Europe has yet to be resolved but can be done without market disruption

  • Oversight of the largest market participants

    • The next step in the effort to de-risk swap dealers is to review swap dealer de minimis thresholds; the CFTC is seeking public comment

    • Margin requirements for uncleared swaps is another major area of focus, both for transactions with other swap dealers and with financial institutions

  • Regular reporting

    • All transactions, cleared or uncleared, must be reported to swap data repositories (SDRs), and this will be an international effort

  • Transparent trading

    • Trading on Swap Execution Facilities (SEFs) is happening, but more work can be done specifically in the areas of simplifying trade confirmations, reporting obligations and the made-available-to-trade determination process

    • Cross-border harmonization is also an issue in this area

  • Responding to changes in the market

    • Electronic and automated trading now represents the majority of trading, with “well over 50 percent of trading in U.S. financial markets,” and in futures markets, it’s over 70 percent

    • Rise of this type of trading has brought benefits like more efficient execution and lower spreads, but it has changed the nature of regulatory responsibilities; CFTC is currently considering potential registration requirement for algorithmic trading

Access Massad’s full speeches here

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FCM Crisis Becomes Opportunity as Positive Factors Emerge

By Radi Khasawneh, TABB Group
Originally published on TABB Forum

High-profile exits from some parts of Futures Commission Merchant’s clearing businesses have given the impression that the business model is fundamentally flawed. But policymakers and technology providers are combining to bring support to beleaguered FCMs as the focus shifts to capacity.

High-profile exits from some parts of Futures Commission Merchant’s (FCMs) clearing businesses have given the impression that the business model is fundamentally flawed. But comments at this year’s FIA IDX conference in London underline the fact that reductions in clearing capacity and balance sheets have led to an industry-wide push to support and effect change that could fundamentally alter the playing field over the coming year.

Most important, Timothy Massad, chairman of the US CFTC, hinted that the fraught process of agreeing to equivalence for US and European clearing entities is much closer to being completed than it was a year ago. At that time, TABB Group published a commentary (“Crunch Time for Clearinghouses as Regulators and Participants Shift Focus”) that referred to Massad’s ex-colleague Ananda Radhakrishnan’s comments about granting temporary relief to European entities (also referred to inMassad’s speech). Equivalence, alongside implementation of mandatory clearing in Europe, could do much to reinvigorate the flagging European side of the equation. This would bolster volumes and revenues for global businesses that can no longer support unprofitable operations, but much more needs to be done. Equivalence would do much to clear up the messy uncertainty that has left regional franchises in inefficient silos.

TABB Group’s recently published report, “The FCM Business 2015: Overcoming Industry Adversity,” highlighted the fact that nearly 90% of FCMs interviewed cited national regulatory leverage and capital rules (such as the enhanced Supplementary Leverage Ratio and Globally Systemically Important Bank rules in the US) as major concerns for the coming year. Forcing banks to account for derivatives and client funds as part of their obligations has made a difficult business impossible for some, and second-tier banks have restricted or exited balance sheet-intensive businesses such as clearing for over the counter (OTC) swaps.

As top-rank FCMs focus on their more profitable clients and preserving their margins to comply with internal return on investment/return on equity hurdles imposed by senior management, there is a competitive opportunity for challengers to capture market share and deploy their balance sheet capacity (exhibit 1, below).

Exhibit 1: Strategic Considerations for FCMs in 2015

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Source: TABB Group

Significant hurdles remain, particularly in the OTC market, where risk transfer and regulatory costs have meant a fresh round of conversations about re-pricing with existing clients. The focus on profitable and capital-efficient futures volumes means the barrier to entry remains high for new entrants, as clients seek full-service partners. Credit rating strength and balance sheet strength remain key differentiators for clients, meaning that so-called “non-bank” FCMs have a mountain to climb if they want to achieve the kind of scale necessary to achieve consistent profit and a stable client base. Outsourcing of technology management, and revenue and head count sharing at FCMs within prime services divisions at banks can both provide a partial solution to this problem.

Established dealer FCMs are consolidating and building out their offerings, and a recovery in the interest rate environment would aid profitability. But a gradual rebalancing of the clearing pie is far more likely than a revolutionary shift. The conciliatory attitude from national regulators and overwhelming support from large clients in a final push to get a more lenient interpretation of capital rules is welcome and, in TABB Group’s view, critical to creating a sustainable market infrastructure for the future.

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

By Colby Jenkins, TABB Group
Originally published on TABB Forum

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

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

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

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

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

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

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

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

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

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Source: TABB Group, ISDA

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

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

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

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

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Source: CME Group, ERIS, TABB Group

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

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

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

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Cleared for Launch: A New Era for OTC Derivatives

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

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

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

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

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

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

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

Buy-side clearing challenges

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

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

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

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

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

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

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

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

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

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

Alternative approaches

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

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

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

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

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

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

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

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

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

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

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

Supporting roles

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

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

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

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

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

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

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

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

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

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

He first spoke to the need for the clearinghouse model:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The second NAL (Letter 15-25) extends:

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

The proposed rule:

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

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


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

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

The answer:

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

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

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

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

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

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

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

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

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

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

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

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

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

Looking at the Spreadsheet

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

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

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

Where does that leave us?

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

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

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

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

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

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

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

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

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

To read his full testimony, please click here

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