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When It Comes to Clearing, Go Big or Go Home

By Sol Steinberg, OTC Partners
Originally published on TABB Forum

There are a lot of OTC derivatives clearing providers screaming for recognition in the marketplace, but nothing speaks louder than true industry validation.

As financial technology evolves at an ever-increasing rate, new software vendors spring up like dandelions in summer. At the same time, existing providers take advantage of opportunities to expand into new verticals. While this innovation undoubtedly helps move the industry forward, it clearly adds an element of operational risk, as a multitude of unproven systems tout themselves as practical solutions.

This is particularly true in the complex arena of central counterparty clearing for OTC derivatives. Fortunately, there is a way to mitigate this risk.

New participants can develop and demonstrate powerful systems, but – regardless of how many bells and whistles they may offer – nothing speaks louder than true industry validation. By that, I am talking about accreditations such as LCH.Clearnet’s CCP2 certification program. As one of the architects of CCP2, the industry’s first certification program, I witnessed first-hand the difficulties encountered by investment firms as they sought technology partners to assist with clearing.

After the Lehman Brothers debacle, we saw an urgent need for a standardized certification program. The clearing world needed some sort of verification process that would help avoid further information leaks and prevent another massive collapse.

One part of the equation was regulatory, so we designed the program to help market participants comply with the new wave of CFTC requirements. The other important aim was to guarantee that a given provider is knowledgeable and possess demonstrated expertise with the correct systems and methods involved with OTC clearing. This is far more complicated and important than it may sound.

Margining, for example, is an extremely complex process, made even more difficult by the variations in margin rules employed by different brokers. However, with the ability to certify margins accurately, firms can know their precise requirements and, therefore, achieve far greater capital efficiency. This makes more money available for trading and could potentially produce billions of dollars in annual savings.

The benefits go beyond the clearing industry. An increase in capital market activity is essential to create economic growth, and when the U.S. economy grows, the world economy benefits.

Having spent my entire career working with OTC derivatives, I cannot emphasize enough how important it is to select a software provider that understands the intricacies of central counterparty clearing. This is especially true now, as regulatory mandates continue to increase throughout the financial sector, dramatically heightening the complexity of an already complicated process. With swaptions clearing set to begin in the not-too-distant future, the severity of this issue cannot be understated.

That’s why when it comes to choosing the right technology vendors, the first question should always be: “Are they certified?” Think about it – you wouldn’t choose an unaccredited doctor or an unlicensed pilot, so why would you expose your investment operations to the risks inherent in choosing an uncertified software provider?

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Made-Available-to-Trade Pushes Swaps On, and Off, SEFs

By Colby Jenkins, TABB Group
Originally published on TABB Forum

Even as SEF volumes have reached record highs in the wake of the Made-Available-to-Trade determinations, evidence suggests some users are ‘fine-tuning’ contracts in order to continue trading Off-SEF.

Since Made-Available-for-Trade (MAT) determinations came into effect in mid-February, there have been indications of both buy-side adoption of Swap Execution Facilities (SEF) as well as avoidance. Looking at a specific subset of the Interest Rate Swaps (IRS) market within the jurisdiction of the MAT determinations, there has been a particularly strong migration in volumes onto customer-facing SEFs, such as Bloomberg. But there also is anecdotal evidence of strategies designed to trade away from the new venues.

By the end of the sixth week of mandatory SEF trading, average monthly value traded On-SEF for IRS contracts bound by SEF execution mandates rose from a pre-MAT average of $540 billion to a record $824 billion. In notional terms, the volume of MAT Credit Default Swaps (CDS) traded On-SEF has grown by 350% since the first week of required SEF trading; during that same period, average value traded On-SEF for USD IRS grew just over 60%.

However, for smaller swaps users not already trading via SEFs, the MAT deadline represented a costly, cumbersome process of SEF on-boarding. As a result, TABB Group analyzed historical trade data looking for indications that some buy-side firms have resorted to “fine-tuning” required contracts in order to continue trading Off-SEF. We examined a spectrum of forward-starting and backward-starting swaps, as well as swaps with adjusted coupons, swaptions, package trades, and so-called “broken date” transactions, to see if there is a trend away from SEFs following the MAT determination. Indeed, a test for potency of SEF-execution mandates is the ease with which participants can manipulate the terms of would-be MAT contracts into equally standardized, yet non-mandated swaps.

What we discovered is that even for a limited subset of MAT contracts to which we applied our analysis, the evidence of “fine-tuning” is murky at best. While, in broad strokes, we did find that there was a significant growth in the combined notional volume traded in March for both forward-starting and backward-starting swaps, it is hard to describe the phenomenon as a trend (see Exhibit 1, below).

Exhibit 1: Notional Forward/Backward-Starting MAT IRS Off-SEF, $Bn

tabb 4 11 14

Looking to the SEF market share landscape, we see liquidity growing increasingly concentrated in the MAT trading environment. Specifically for credit default swaps trading On-SEF, this has been a trend since early SEF days, with dealer-to-client venues capturing the vast majority of liquidity. Within rates, however, we see a more significant shift recently, with Bloomberg capturing a majority of the newly mandated product set traded via SEF. Looking across both rates and credit, Bloomberg’s success is even more apparent (see Exhibit 2, below).

Exhibit 2: SEFs Ranked By Aggregate Notional Traded Week of  March 17-21 , $MM

tabb 4 11 14 2


Source: TABB Group, Clarus FT

We also examined changes in trade size and turnover as the swaps market becomes more electronic. Since the inception of MAT trading, there has been noticeable increase and decrease in turnover velocity for On-SEF and Off-SEF trades, respectively. Our analysis indicates that MAT determinations not only have influenced where a majority of rates contracts are being traded, but also changed the way in which these contracts trade. While trade sizes are falling and turnover rates are increasing On-SEF, for example, the opposite effect can be found Off-SEF. 

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OTC Derivatives Growing Pains

By Sol Steinberg, OTC Partners
Originally published on TABB Forum

SEFs have introduced an entirely new workflow to the OTC trading environment, and it’s not without its issues. Growing pains must be addressed for this market to mature and grow.

  • The swaps environment continues to undergo regulatory-induced reconstruction.  
  • The following selected items remain uncertain as the SEF market infrastructure takes form.


Block trades, which enjoy delayed reporting requirements and have capped notionals, provide a lesser degree of transparency around liquidity. Blocks are expected to be predominantly voice executed and can be done Off-SEF, but they still need to be reported to a SEF. 

Thresholds for blocks will increase this year, and levels in other markets such as exchanges may also be reviewed. Participants are not permitted to aggregate orders for the purpose of gaining block treatment.

Available Credit

Regulation stipulates a clearing member must credit-check each transaction to ensure clearing certainty; however, Off-SEF workflows function with the FCM performing checks after the trade has been submitted to the DCO. This is an issue, especially for MAT instruments, which must trade On-SEF, and where the SEF has an obligation to pre-check credit. Fundamentally, the question comes down to “when is the trade executed?” – on the phone between counterparties, On-SEF, or at the DCO?

Multi-Leg Trades With at Least One MAT Instrument

Package trades have a temporary reprieve from being executed On-SEF, given limit-checking capabilities are linear. While net risk can be small for a multi-leg trade, the trade risk can be sequenced such that a limit is breached. The solution is messaging capability to report packages as a single unit, as the FpML working group, SEFs, credit hubs and others are actively working on, with DCOs expected to support a standard by August.

Allocation: Pre vs. Post

Allocations are another challenge, where the choice is between pre-trade allocation or using the bunched order option. Clients prefer pre-trade allocations, given that bunched orders require additional agreements with varying costs, are not available to all, and are short of controls to ensure the trade economics remain consistent. Pre-trade allocations, however, are not ideal given that the trade may not be completely filled or details on splitting are not known at the time of the trade.

Access Impacting Volumes?

While impartial access to SEFs was addressed in November by the CFTC, activity to date has been concentrated among participants with direct access to the SEF. SEF volumes have been becoming concentrated among a few venues, particularly a couple of IDBs with the lion’s share of their business in spread trades for Interest Rate Swaps, and platforms with established desktop real estate in Credit Swaps. 

Volume is further impacted as dealers are trading less for their own book. Participants are flush with many portals to choose from, and with options for direct market access, agency trading or using broker systems to execute – activity is being rethought cautiously.

Important Upcoming Calendar Dates:

  • April 10:Blockhold threshold increases to 67%
  • May 15:Package Trade reprieve expires
  • June 30:Trade Submission reprieve expires
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CFTC Weekly Swaps Report: Over $215 Trillion in Interest Rate Swap Volume Cleared From March 10-14

As part of its efforts to encourage transparency in the swaps market, the CFTC developed a Weekly Swaps Report, which provides a detailed view of trading activity in the swaps market. 

The latest report shows that cleared notional outstanding volume stood at more than $215 trillion for interest rate swaps (IRS) and 2.4 trillion for credit default swaps (CDS) through the week ending March 14, 2014.  The full break-out of gross notional outstanding swaps volume can be accessed here; following is a snapshot:

CFTC 3 27 14

In terms of weekly dollar transaction volume, cleared IRS volume was approximately $3.22 trillion and cleared CDS volume was $255 billion through the second full week of March, as seen in the snapshot below:

CFTC 3 27 14 2

We’ll continue to keep track of the Weekly Swaps Report in monitoring the industry’s ongoing transition to regulated, electronic swaps trading.

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SEF 101 – Understanding the Role of a Swap Execution Facility (SEF)

A little over one month into the new world order of mandatory SEF trading, that three letter acronym already seems like it’s been around forever.  For those of you who’ve been following the ongoing derivatives reform discussion from the earliest days of Dodd-Frank, SEF and the trading mandates that go with it are now pretty well-entrenched in your vocabulary.  However, it’s been a while since we’ve taken a step back to provide a high-level primer on SEFs for those who haven’t been mired in the minutiae for the last few years of derivatives reform.

In the spirit of catching everyone up on the present state of play, Tradeweb Markets has just published a comprehensive overview on the past, present and future of SEFs called SEF 101 – Understanding the Role of a Swap Execution Facility.  To access the full article, click here.

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Bracing for a $2 Trillion Margin Call

By Will Rhode, TABB Group, and Sol Steinberg, OTC Partners
Originally published on TABB Forum

The buy side will need to deposit approximately $2 trillion in cash and other eligible assets at central counterparty clearinghouses in order to meet the new clearing requirements for swaps. In this collateral-hungry world, the ability to anticipate, source, deliver and reconcile funding requirements in real time will prove essential.

Before the financial crisis and reform, buy-side firms were content to use Excel spreadsheets, email confirmations, and manual processing to calculate their aggregate risk exposure and to manage their books and records for their OTC portfolios.  Counterparties would negotiate a valuation and make payments based on mutually agreed upon amounts. Trades would be confirmed with a simple: "You're done."

This is no longer an option. TABB estimates that the buy side will need to deposit approximately $2 trillion in cash and other eligible assets at central counterparty clearinghouses (CCPs) in order to meet the new clearing requirement for swaps. Capital is a scarce resource that cannot be squandered by overestimating a margin call. Efficient collateral usage will become an integral and growing factor in a firm’s financial and risk management strategy.

In a collateral-hungry world, the ability to anticipate, source, deliver and reconcile funding requirements in real time will prove essential. The more precise the buy side is in understanding risk, the better it will be at optimizing funding, with the potential to repurpose freed up capital to fund more lucrative trading opportunities. Historically, dealing with margin management was a reactive function conducted at the end of the trading cycle, performed within administrative and back-office operations, often manually.

Today, industry leaders on the buy side are upgrading their technology todeliver a holistic view of their global collateral assets so they can explore multiple sourcing and funding options in real time.Risk analytics, collateral optimization and faster trading processes will give these firms a competitive advantage. Some are finding that a front-to-back solution is in order, one that covers the entire OTC trade life cycle, across all groups. Meanwhile, others are stitching together disparate systems from multiple vendor and FCM-provided tools. Those furthest behind the curve are in pure catch-up mode, utilizing every available resource just to stay compliant.

The most impactful trends among bellwether firms include:

  • Straight-through-Processing (encompassing both trade execution and central clearing);
  • Independent margin calculation and swaps portfolio pricing tools;
  • Reconciliation tools that can account for margin call discrepancies, either at the CCP or clearing intermediary level, or both;
  • Transaction Cost Analysis (TCA) tools that can incorporate data from the trading process as well as feeding data from the back office into the trading process.

The aim of these initiatives is to optimize the entire workflow whereby all areas have a complete view of what’s going on with the trade. The pre-trade function is directly fed from the asset and ancillary services, while trade execution depends on pre-trade functionality, just as the back office relies on STP from the middle office. Every department is dependent on the next, and the optimal workflow creates a closed loop on risk and valuation data, as well as tactical information pertaining to TCA. Only with this level of workflow transparency and seamless connectivity can funding be optimized, latency minimized, trade costs reduced and Best Execution mandates properly satisfied.

That being said, there is a portion, perhaps even an unhealthy majority, of the buy side that is overwhelmed by the clearing mandate and that remains stubbornly passive in the face of the challenges ahead. Treating margin purely as a post-trade consideration, accepting CCP margin and swaps valuations as law with no efforts to validate those calculations, pre-funding their swaps portfolios to avoid intraday margin calls, and having no intention of implementing risk analytics or collateral optimization systems – these are just some of the mistakes that will lead to portfolio performance drag and, in the extreme, result in trade failures, breaks, losses, default scenarios, legal claims, and perhaps firm-wide failures.

While 2013 will be remembered for compliance, clearinghouse and Futures Commission Merchant (FCM) selection, as well as the basics of plumbing and testing, 2014 will be the year the buy side starts to take control of the capital commitment process. The introduction of new capital-oriented workflow tools will lay the groundwork for the ultimate goal of running a swaps portfolio that demonstrates both cross-product margining efficiency and versatility (in terms of product selection) that will have to be managed through an enhanced risk management process.

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CFTC Weekly Swaps Report: Over $214 Trillion in Interest Rate Swap Volume Cleared From March 3-7

As part of its efforts to encourage transparency in the swaps market, the CFTC developed a Weekly Swaps Report, which provides a detailed view of trading activity in the swaps market. 

The latest report shows that cleared notional outstanding volume stood at more than $214 trillion for interest rate swaps (IRS) and $2.3 trillion for credit default swaps (CDS) through the week ending March 7, 2014.  The full break-out of gross notional outstanding swaps volume can be accessed here; following is a snapshot:

swaps 3 20

In terms of weekly dollar transaction volume, cleared IRS volume was approximately $2.43 trillion and cleared CDS volume was $236 billion through the first full week of March, as seen in the snapshot below:

swaps 3 20 2

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Building Blocks for a Post-Reg NMS World

By Sayena Mostowfi, TABB Group
Originally published on TABB Forum

Many buy-side traders would like more opportunities to trade in blocks. But most current solutions have inherent limits in how much block trading they can facilitate. To unlock the potential for the block, the next generation of trading tools will need to address multiple requirements that are often at odds with one another as well as the business models and complexities of a post-Reg NMS equity market.

The buy side continues to value block trading as it did a decade ago, and yet the block percentage of overall volume has dropped significantly in the wake of the market structure changes of 2001-2007. While new solutions adjusting to a fragmented post-Reg NMS environment have enabled block trading volumes to stabilize, significant gaps remain between what could potentially trade as blocks, the volume the buy side wants to trade in blocks, and the actual block numbers.

TABB chart 3 20 14

With the rise of electronic trading, buy-side traders have adopted a variety of tools that attempt to provide anonymity and avoid information leakage. But the additional goal of sourcing block liquidity, naturals in particular, is incredibly valuable and extremely difficult to accomplish. There have been many attempts to deliver a block trading platform, each employing a combination of techniques to optimize order protection and matching rates.  

Cracking the block market, however, is a tall order, and the past decade has seen many attempts to solve for it. In order to facilitate block trading, a solution needs to try to solve for multiple requirements that are often at odds with one another, including enabling trusted counterparties and allowing for anonymity, sourcing liquidity and paying for services, quick matching engines and seamless workflow integration, and finally marrying electronic messaging with traditional sales trading.

Even within ring-fenced communities or with a trusted counterparty, the buy side has learned that it pays to be paranoid. The outstanding trust issues lead some traders to prefer to rein in their exposure to certain types of venues (limiting exposure to liquidity) and other traders to use all of them (limiting order size). Market macroeconomics also plays a role in the ability of traders to bring block-sized orders together. There is a dynamic and complex combination of factors that go into block trading volumes that cannot be viewed in a vacuum.

In addition to trust and seeking liquidity, buy-side firms must wrestle with the challenge of funding (via commissions) specific relationships for broader brokerage services. Thus, any attempt to increase block trading from its current levels has a better chance if it works within the traditional buy-side and sell-side sales and trading arrangements. The culmination of these reasons results in the dispersion of methods in executing block-sized order flow.

There is no technological panacea that will make trading more trustworthy. However, there are mechanisms that offer better protection to the buy side that will increase the number of interactions the buy side would have with its trusted counterparties. While early successes have been shown to have a ceiling in terms of the amount of block liquidity that can be brought under the roof of an independent venue, it is hard to imagine what buy-side traders would have done without them. New, innovative solutions – not targeted regulation – will need to address the business model tensions and market complexities.

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Central Clearing for OTC: A Schlieffen Plan for the Capital Markets?

By Thomas Krantz, Thomas Murray
Originally published on TABB Forum

The G20’s strategic goal of reining in OTC derivatives is laudable and necessary for protecting the world’s financial system. But leveraging central counterparties as part of the solution creates its own risks and, like Germany’s defence strategy at the onset of World War I, the G20's plan needs to be reconsidered and adapted to current realities.

Pittsburgh G20 Summit Declaration, September 2009:

“Improving over-the-counter derivatives markets: All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” (source: G20 Communique)

Schlieffen Plan, 1914:

“A plan intended to ensure German victory over a Franco-Russian alliance by holding off Russia with minimal strength and swiftly defeating France by a massive flanking movement through the Low Countries, devised by Alfred, Count von Schlieffen (1833-1913) in 1905.” (source: Collins Dictionary)      


Central counterparty (“CCP”) clearing of financial instruments is hardly a matter of war and peace, but given the calamitous socioeconomic role played by OTC derivatives in the financial crises that began to unfold across the world in 2007, the G20’s central strategic proposal to mitigate these risks deserves careful review. To do so, a comparison with one of history’s most rigorous military plans might not be out of line. (Perhaps it is reflecting on World War I as the centenary begins that leads our minds in this direction.)

Before turning to today’s financial matters, the Schlieffen plan merits explanation. The authorities charged with German defence had to respond to the country’s historic geographical dilemma of being in the middle of Europe: At almost all costs, a successful strategy would require the military’s resources not being split between east and west. And so in the years before World War I, the nation’s best thinkers put their minds to it. The plan assumed that France was weak and could be beaten quickly, and that Russia was much stronger, but would take longer to mobilise its army.

At the outbreak of World War I, the plan was put to the test. It began to go wrong almost immediately. On 30 July 1914, Russia mobilised its army, but France did not. Germany was forced to invent a pretext to declare war on France four days later. Things got worse when Britain declared war on Germany the following day because, in a Treaty signed in 1839, Britain was committed to defend Belgium. German men and materiel were mostly east of the Rhine and were readied for movement to the west, famously with a massive concentration set to cross the river at Cologne over a single railroad bridge at a time when few crossings existed. Despite the unexpected opening of the war, the Schlieffen Plan had to be executed because, well, that was the plan.

We cite Schlieffen in the context of the G20’s strategic defence of the global financial system not to criticise the G20; we simply state that strategy will only be effective when it can be properly executed, and the logistics and resources mobilised for the operation suit the needs. We will now turn to OTC derivatives and consider the G20’s three-pronged plan, especially as it affects CCPs, the market infrastructures we know well.

What we have learned about CCPs

Just more than two years ago, Thomas Murray was approached by six global banks to review the changing landscape for central counterparties to financial transactions. Following the G20 instruction in Pittsburgh, by late 2011 laws and regulations were already written, or at least well outlined, and one could see that central clearing – like much else in financial services – was about to undergo profound change. Our clients asked us to learn what we could about where the CCP segment might be going, and what the regulatory changes might mean for business planning as well as for these firms’ capital requirements.

We set about doing just that. With Thomas Murray leading, the banks formed into a working party and were joined by SWIFT, and the public documents and opinions of key global and national authorities were sought and included. We addressed six broad risk components: counterparty, treasury and liquidity, asset safety, financial, operational, and governance and transparency. The result is an exceptionally comprehensive set of data and analyses.

What we have found makes us uneasy about the new responsibilities CCPs are being asked to assume in order to accommodate privately traded financial contracts. We are not certain that these small institutions are fit for this purpose. Most have worked well, indeed very well, for assuming counterparty risk in cash securities, options and futures that are listed and traded on exchanges – but OTC is something else. Is there an echo in this of Schlieffen? Is channelling so much of the OTC contract counterparty risk into regulated CCPs the financial equivalent of that single railroad crossing over the Rhine, where men and materiel had to be “cleared” and sent west 100 years ago?

Thomas Murray has identified some 85 CCPs. Our coverage for now is 27 institutions and includes nearly all of the largest clearing houses around the world, the ones most likely to cause a disruption to the financial system if a default were to occur. The default risk is real: IOSCO’s global risk assessment released last October cited CCPs as one of four central concerns for potential disruption of the world’s financial system in the year ahead, and declared CCPs another category of financial institutions which are “too big to fail.” Given their modest size, an alternative way to state this is that CCPs are too central to capital markets operations to be allowed to fail.

What we do not know about CCPs

Thomas Murray has assembled a great deal of information on central clearing in a standardised format. However, there is much of fundamental importance about this segment that we do not know. To the best of our knowledge, no one else has put together answers to these questions in a world-wide, systematic way, either.

To start, we do not know how many employees work in the world’s CCPs. Many of them are legal structures for which the work is done by employees on contract elsewhere in the business group – for example, in a dedicated business department. Those CCPs that do have staff are often small, sometimes only a few dozen employees. That is all that has been required. Like the exchanges they complement, CCPs are skewed and the few largest have hundreds of employees. In terms of the number of persons honed in the complexities of clearing risk management as the asset mix changes, well, we do not have a figure for that, either. There cannot be many of them – perhaps a few in each clearing house. We therefore suppose that there is expertise concentration in the hands of a few dozen persons at most.

Similarly, we do not know what the clearing segment’s capital base is. Two very large institutions, the Chicago Mercantile Exchange and Korea Exchange, have their clearing business contained within the trading company. There is no separate balance sheet. Without a figure for capital set aside for central clearing, we cannot know what resources are available to withstand shocks – although clearing houses usually (but not invariably) are set up with guarantee funds and “waterfalls” of additional funding to run through as the lines of first defence in case of default, notably the margin posted by clearing members.

Without that overall capital base for the segment, we do not know how profitable this business might be. From our individual analyses, we note that this is entirely variable: Some CCPs have been set up as profit centres; others merely to clear trades at minimal fees that might not be in proportion to the business risks being run. There is no consistency. That should not be surprising, given that clearing houses were founded and grew up in the specific circumstances of agricultural futures trading, were found to be useful for financial derivatives as from the 1970s, and of general utility to the exchange sector in the decades that followed. Each is local in spirit, built for the circumstances in which it was established; when the analyses are set out side-by-side, they are a disparate community.

Little is written by clearing houses on the investment policy of their equity or the margin held to secure clearing member positions. CCPs are at all times vulnerable to liquidity problems: Can the assets deposited be turned to cash immediately; or, if not, over what period of time? It is well and good for regulation to mandate levels of available liquidity, but over the past six to seven years we have witnessed even the most actively traded asset classes freezing, notwithstanding central banks’ epochal distributions of cash.

Thomas Murray has not been able to unearth consistent information on margin methodology, the formulation of requests to trading counterparties for assets to offset the risk inherent in the trading position the CCP is assuming. How much margin is to be handed over to the clearing house? What is the quality of those assets? What are the open positions in the market for the asset classes the clearing house has taken on its books? We cannot calculate on an industry-wide basis the ratio of default fund to initial margin, yet that information is central to understanding the level of risk mutualisation.

The difference between centrally clearing an exchange-listed and traded product and an OTC instrument is how the price is formed, the transparency of the process, and the breadth and depth of participation. It is a different matter for a CCP to try to find prices in OTC, because by definition there is no organised market for those contracts. When it clears OTC, it must take the price from the participants only, with inherently less certainty, in particular when it comes to stress testing the effects of potential adverse market movement. We would think it is especially important to understand the hypotheses underlying those tests for this category of assets.

Finally, among the critical pieces of information missing, we must cite the question of resolution and recovery of a failed CCP. We have gathered some pieces of information, but not found more.

Where does this leave the G20 plan for OTC derivatives?

Is the forceful channelling of “standardised” OTC instruments into central clearing the right way to solve OTC risks? The Pittsburgh Declaration could not have been clearer: This is about OTC being pushed in various ways toward forms of regulation.

But why CCPs, which are structured for the public exchange environment? How did this come about anyway? Who gave heads of government the idea of reshuffling the risks in this manner? CCPs have never especially been on the public radar screen, though they were being followed episodically by the Group of Thirty, and later by the Committee on Payment and Settlement Systems at the BIS and IOSCO. In the autumn of 2009, to the best of our recollection and knowledge, CCPs in their majority were not volunteering to take this work on. Nor was it considered a coup to have this new flow of business coming through.

Is there a back-up? Returning to the Schlieffen Plan example and the abrupt discovery that the military needed to reverse the direction of trains going over that bridge in the face of unexpected circumstances, is the financial sphere about to be confronted with an analogous situation? Is OTC risk being “massed” for transfer into CCPs, as those troops and materiel were in Cologne one century ago?

Clearing “standardised” OTC contracts has and will continue to lead to risk reduction, supposing there can be a common global understanding of what “standardised” is. We wonder about the extent to which standardisation is even the issue: This seems to be a distraction from the difficulties of pricing risk, which to us is the key factor – and it is harder to do so without the interaction that comes from broad public involvement on an exchange, not easier. If products can be “standardised,” then why are they not listed and traded on an exchange anyway?

Concentrating risk in CCPs may make them fragile. Clearing houses can protect themselves in “normal” trading conditions, but only if the OTC trade price reported to the CCP is valid and the corresponding margin remains liquid. Then there is the problem of rapid-fire trading, meaning that risk positions are being modified at high speed throughout the trading day. How is one to request and receive margin, that essential asset that secures the system, when microsecond changes in counterparty positions are occurring? This affects all CCPs.

As to the other parts of the G20 strategy, if these contracts come to be traded on exchanges as well as other platforms, the liquidity required to find prices gets split. Also, trade reporting looks set to scatter massive data in varying formats across many repositories, making it hard – impossible? – to see how they can be reassembled into a coherent picture of counterparty positions, at least for the foreseeable future. Regarding additional capital requirements for OTC contracts that are not centrally cleared, this might be an invitation to transfer as much trading as possible to jurisdictions able to be less costly. We wish this were not the case.

From the words of the Pittsburgh Declaration and the public discourse that followed, the expectation is one of near elimination of OTC risk, to be accomplished by sending some trades to CCPs, reporting everything, and adding capital requirements for non-cleared OTC instruments. We are not sanguine that these approaches will work.


The strategic goal of reining in OTC derivatives is laudable and necessary for protecting the world’s financial system. G20 has got that right. Yet the G20’s request of using CCPs as part of the solution strikes us as odd. It prods the world’s CCPs, regulated institutions that have worked well to date, to remake themselves in order to accommodate risks being generated outside the regulatory perimeter. This is not a comfortable fit.

In our view, if two parties have a commercial justification to go outside the thousands of available publicly traded contracts, with their associated central clearing, and wish to take a position or cover a risk by dealing off-exchange, that should be perfectly acceptable, provided that they alone assume the risks of doing so. These positions should then be notified to capital markets and bank authorities in a way that the home country supervisors can summarise the counterparties’ global net exposures.

This G20 strategic response to the OTC problem, by pushing it part-way into the regulated perimeter of capital markets, looks like a poor match for doing more than netting out a portion of the OTC risk, the “standardised” parts, while scattering most of the price information across a multitude of differing platforms for some trading and diverse forms of reporting. In 2007-2008, the essential problem was information about what was “out there” and what it was worth – the G20 approach does not seem to us to advance in getting a comprehensive overview of OTC.

As 2014 progresses, we are no longer theorising about what to do. The G20 plan was put forward several years ago. Legislation and regulation have been drawn up, and the financial services industry is advancing into plan execution. We hope that the authorities and market participants will remain adaptable: Let us remember Schlieffen and the many other superbly crafted plans, all of which always needed to be adapted to circumstances.

Let us also watch over CCP risk profiles – these are central market infrastructure institutions, and they must be kept robust for the work they have performed well historically for regulated marketplaces. We strongly request that the clearing house risk managers themselves be the persons who choose what trades to take on, and how: They must be confident of the quality of the assets being introduced onto their balance sheets, their ready liquidity and their pricing.

Thomas Krantz is Senior Advisor Capital Markets at Thomas Murray, and former Secretary General of the World Federation of Exchanges. Thomas Murray is a private firm in London that specializes in post-trade market infrastructure analyses and advisory services. The views expressed in this article are those of the author. An abbreviated version of this article appeared in the Financial Times on 29 January 2014.

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Buy Side Does the Math – Adds Quants to Bolster E-Trading

By Adam Sussman, TABB Group
Originally published on TABB Forum

US buy-side equity trading desks are investing in automation and ramping up their quantitative skills to drive new efficiencies and enable execution capabilities on par with the sell side.

TABB analysts Sayena Mostowfi and Valerie Bogard contributed to this commentary.

The pace of change on the buy-side trading desk is accelerating. Technology, analytics and process are all undergoing transformations to adapt to competitive and structural shifts in the market at a time when commissions have declined 19% since 2010. But this is an industry known for being conservative in its embrace of change – electronic trading may have begun in the late 1990s with some early adopters, but it wasn’t until 2006 that the laggards of the industry finally capitulated, a full seven years later.

Nowadays, however, the adoption cycle has shortened significantly. Across 108 interviews with US-based asset managers, TABB Group has identified industry leaders who are using new technologies, analytics and trading processes to give their firms more of an edge. But there also is a middle majority of firms that recognize the threats of being behind and are actively engaged in bringing similar capabilities to their firms.

Technology is not only bringing more efficiency through automation; it also is seen as an area for cost savings. Firms are looking to consolidate the number of order and trading management systems within their organizations, particularly for more standardized and liquid instruments. The leading technology initiatives among asset managers offer a clear view of the various issues the industry is facing and how a cutting-edge firm approaches a problem, while a firm with limited means can achieve a close approximation (see Exhibit 1, below).

TABB 3 10 14

Source: TABB Group

Asset managers are also looking for efficiencies within their commission pools, some taking a more aggressive approach to funding Commission Sharing Agreements/soft dollar wallets. There has been a steady increase in the commission rate associated with funding a CSA, from 1.9¢ in 2012, to 2.3¢ this year. At the same time, the execution component of that commission fell from .9¢ to .8¢. This allows traders to route more flow electronically without having to worry about research budgets.

Thus, the use of electronic trading does not have as much of an impact on the total commission pool, since bellwether buy-side firms are more comfortable increasing the research component of a low-touch trade. TABB believes this trend will spread and that the rate differential between high-touch and low-touch will continue to narrow. As a result, it raises the ceiling on the low-touch market share that once existed.

Finally, leading buy-side trading desks are taking a thoughtful and measured approach to where and how their orders are routed to trading venues. While not everyone has the capability to do their own venue analysis, there is a group of analytically minded buy-side shops that work very closely with a couple of brokers to perform the same analysis once reserved for the largest firms.

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