Regulations following the global financial crisis established central clearing as an important focus to reduce global systemic risk. However, each major financial center around the world has taken a slightly different approach to implementation. In a recent report from the Bank of England’s Financial Market Infrastructure Directorate entitled Over-the-Counter (OTC) Derivatives, Central Clearing and Financial Stability, Arshadur Rahman , from the Bank’s Financial Market Structure Infrastructure Directorate, outlines the current state of play and hurdles ahead on the road to central clearing in Europe.
Following are some highlights from his research.
The European Union (E.U.) currently lags behind Japan, which first made central clearing effective on November 1, 2012, and the United States, whose mandate was effective on March 11, 2013. Europe is set to begin implementation of its clearing obligation for interest rate swaps (IRS) in 2016.
What will be cleared?
Regulators in different jurisdictions have focused on five different contracts when considering the clearing obligation: IRS, basis swaps, forward rate agreements (FRAs), overnight index swaps (OIS), and credit default swap (CDS) index contracts.
The characteristics used for selecting what classes of OTC derivatives should be cleared on central counterparties (CCPs) are their degree of standardization, volume, and liquidity as well as fair and accurate pricing information.
What will support and what will hurt the movement towards central clearing?
Although central clearing is expected to increase in the future, not all contracts will transition to the world of central clearing seamlessly.
One major factor limiting the full scale transition to central clearing is liquidity. Specifically, the report describes market concentration – “whether there are a sufficient number of active market participants to enable a CCP to exit a derivatives position inherited from a defaulting clearing member” – as an important part of derivatives market liquidity.
Another serious concern is the overall availability of clearing. Economies of scale in the delivery of clearing services leads to a small number of CCPs. Likewise, there is a relatively small number of clearing members for these CCPs, and even fewer that offer client clearing, an issue that could hamper accessibility and create a build-up of risk within the CCPs themselves.
In addition, not all derivatives are appropriate for clearing. Contracts that fall outside of the clearing mandate will be subject to new bilateral margin requirements. In some jurisdictions, including most that fall under the authority of the Bank of England’s Financial Stability Board (FSB), derivatives that are not centrally cleared will face higher capital requirements, which could impact liquidity.
How the clearing mandate is implemented across national boundaries will likewise factor into adoption, as a considerable portion of OTC derivatives activity occurs outside the home jurisdiction of the CCP clearing for a market where at least one overseas participant is involved.
Current market conditions
Currently, basic, or “plain vanilla,” IRS contracts are the most clearable types of derivatives and the most frequently cleared. Specifically, for the U.S, $90 trillion of IRS contracts, or 50 percent, are cleared, and that number continues to grow (see chart below):
In addition, these charts indicate that OIS, basis swaps and FRAs have considerable potential for central clearing, as do a large portion of CDS index contracts for both U.S. and European corporations. Single-name CDS also have potential, but there are possible liquidity limitations for these contracts, which could inhibit their clearing prospects.
To read the report in full, including a discussion of risk management practices for systemically important CCPs and how to ensure resiliency, click here.
By Terence Faherty, Broadridge
Originally published on TABB Forum
Many capital markets firms are struggling to increase profitability, as regulatory compliance requirements have forced sell-side banks to scale back market-making activities and buy-side firms are challenged to differentiate beyond simply beating performance benchmarks. Forward-looking firms are prioritizing trade expense management, transparency, and enhanced client service to increase profitability.
Despite an improving financial outlook, many capital markets institutions are struggling to increase profitability. Regulatory compliance requirements have forced sell-side banks to scale back market-making activities, resulting in loss of trading revenue. Buy-side firms face their own challenges: active management continues to lose market share to passive and managers have to differentiate beyond simply beating performance benchmarks. Providing vanilla execution services or generating alpha is no longer enough in this market, and forward-looking firms are prioritizing cost control, transparency, and enhanced client service.
Providing Liquidity No Longer Translates into Profits
Five years into the Dodd-Frank Act, less than 60% of its rules have been finalized. Simply put, firms are still not reaping any dividend from their spending on systemic risk. As a result of implementing Basel III, EMIR, the Volcker Rule, and other regulations, margins continue to be squeezed by mandatory compliance projects. Some of the SIFI-designated banks have lost as much as 15 percentage points of return on equity and have struggled to gain back lost ground (Figure 1, below). Macro-prudential regulation, designed to reduce systemic risk, has had the unintended consequence of pummeling profitability.
With profitability levels flatlining, many banks have been forced to scale back market-making activities, contributing to a structural lack of liquidity. This will only become more acute as volatility increases. As banks retreat from market making, liquidity will further fragment or even evaporate. Lacking access to the pools of liquidity they need, investors are consequently turning to technology to squeeze additional liquidity from shrinking inventory. In doing so, investors hope to complement traditional “broker-guided” liquidity with “technology-enabled” liquidity.
Cost-cutting and efficiency drivers are moving to center stage as banks, brokers, and managers reinvent their operating models to realign with a business environment in which traditional high-margin products and services have disappeared. Firms need to maximize insight into these new cost and revenue patterns in order to survive and eventually thrive.
Figure 1: Return on Equity and Tier-1 Capital Ratio of Global Systemically Important Banks (Average of 14 Major Banks, 2004–2013)
Global Fragmentation Is Driving Complexity of Trade Expense Management
The changing nature of trade execution is not just a challenge to front-office business models. Global fragmentation of the trading and clearing landscape has increased the complexity of trade execution and reduced the transparency of trade expense management. Triggered by monetary policy and geopolitical tremors, volatility in bond markets has upset the post-crisis calm and exposed the weakness of market liquidity. In the past two years, the fixed income market has seen large yield swings and bond fund outflows in response to geopolitics and central bank policy. As a result, primary dealers, which typically maintain an inventory of securities and supply liquidity to investors in a quote-driven market, have cut their bond positions to one-fifth of 2008 levels. The net result is that trades have been fragmented into smaller pieces, resulting in lower overall trading volume, smaller bid/ask sizes, and higher spreads, none of which bodes well for the future health of the market (Figure 2, below).
This also impacts the complexity required to monitor the cost of trading and settlement, as trading strategies are more fragmented and dispersed across multiple venues, global markets, and alternative products. Maintaining the right quality and granularity of data to service customers is becoming more difficult, and measuring KPIs, SLA, and P&L is a growing challenge for analysts and BI teams.
Figure 2: Fragmentation: Large Bond Trades Are Sliced into Smaller, More Numerous Pieces (Investment Grade and High-Yield Debt, US Corporate Bond Market, Q1 2006–Q3 2014)
Source: FINRA Trade Reporting and Compliance Engine (TRACE) Fact Books; CEB analysi
Enable Low-Cost and Transparent Investment Products
Traditional investing—active management supported by autonomous, specialized teams—is quickly losing ground. As noted in Figure 3, low, passives and alternatives will form one-third of global assets by 2020, up from one-fifth in 2012. Additionally, investor appetite for outcomes-based investment solutions vastly outstripped tepid growth in traditional equity and bond funds after the 2008 financial crisis and these solutions continue to grow quickly (Figure 4, below). Standing out by beating benchmarks is no longer enough. Asset managers need to reinvest and adapt to a world in which alpha no longer rules.
Historically, investment teams have been divided into separate regions, asset classes, and products. However, this structure makes analysis and transparency more difficult because it encourages operational and information silos. Subdivisions within asset classes further exacerbate the problem and create more data discrepancies across operations, investment, and distribution. One of the biggest obstacles to scalable process optimization is the fragmented nature of the IT landscape in capital markets. As trading and investment desks require niche solutions that understand the nuances of asset class and domain specialization, the result is a patchwork of operational data stores with their own metrics, logs, and audit capabilities.
The expensive and painful data integration effort required to aggregate and analyze these datasets has meant KPI management and operational optimization has been a patchwork of inconsistent reporting and business intelligence tools. In this environment, investors’ and regulators’ push for transparent and low-cost investment products is a fundamental challenge. In order to remain competitive, all funds must harvest and publish more detailed analytics around cost structure, tariffs, and other drivers of transparency to effectively support low-cost investment products.
Figure 3: Global Assets Under Management of Passive, Active, and Alternative Investments (In Trillions of USD, 2012 vs. 2020E)
Source: PwC, with data from ICI, Lipper, Hedge Fund Research, Preqin, The City UK, and Towers Watson
Figure 4: US Net Fund Flows (In Billions of USD, 2008–2012)
Source: McKinsey, “Searching for Profitable Growth in Asset Management”; CEB analysis
*Includes target date/risk, tax managed, inflation protected bonds (TIPS), principal protected & 529 college savings (all in funds).
Balance Multi-Asset Investment and Single View of the Customer Priorities
With rates of return on vanilla portfolios at all-time lows, investors are increasingly moving into emerging markets and non-traditional asset classes. This diversification of trading involves breaking through asset-class and business-line silos to support multi-asset risk and return strategies. The process begins at the back end, where access to accurate, standardized, and complete client data has the potential to improve risk and compliance management as well as service delivery (Figure 5, below). By making data usability a top priority, firms can then equip client-facing staff with the means to accelerate service cycles and produce better analytic outcomes that drive efficient business decisions.
The prevalence of multi-asset trading is a net positive, as product silos have historically obstructed the data needed to track profitability, liquidity, and risk. Moving to strategies that cut across asset classes will encourage a shift toward consolidating back-office client data in order to execute trades and properly asset allocate—activities that filter up into the front-office. Creating a single view of client exposure in this interconnected product landscape is critical to optimized position management. Without credible global multi-asset capabilities, firms cannot capitalize on clients’ appetite for trading these products.
Figure 5: Enterprise Analytics Schematic (Illustrative)
Source: CEB analysis
Driven by markets and regulators, financial institutions face structural changes to their businesses, reengineering of operations, and increasing threats to profits. Regulators are creating a capital and liquidity roadmap that will dictate the structure of the industry and place added pressure on corporate balance sheets. Since margins, volumes, and revenue growth will remain under pressure, firms must be operationally efficient, more focused on transparency, and agile enough to capitalize on the new opportunities this market environment brings.
Addressing attendees of the 3rd Annual OTC Derivatives Conference in London on September 29th, CFTC Chairman Timothy Massad discussed the progress made so far in reducing the systemic risk that amplified the damage resulting from the financial crisis. Acknowledging that there is still much work to do be done, Massad outlined some of his agency’s biggest achievements and discussed areas where he hoped to see progress soon.
Following are some highlights from his speech.
Strength of clearinghouses
While Massad considers central clearing to be “one of the great innovations of the financial system,” he says it is not an answer to all problems. He believes the focus needs to remain on ensuring the strength of clearinghouses to further reduce risk. To ensure proper risk management, he said, the CFTC performs a daily review of clearing members and traders, examining margin models, stress and back testing, and compliance procedures. By emphasizing transparency, Massad believes all clearinghouses can properly manage risk.
While the European Union (E.U.) has granted regulatory equivalence to numerous other jurisdictions, like those Australia, Mexico, Canada, and several in Asia, it has not done so for U.S. clearinghouses. The sticking points are differences in margin methodologies. Massad emphasizes the general result of the margining process and notes that, according to international criteria, U.S. margining is just as thorough. He notes the need for continued negotiation and appears hopeful for progress from the review being undertaken by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) that might lead to recognition from the E.U.
Leverage ratio and collateral fixes proposed
Massad was explicit in his endorsement of the supplementary leverage ratio (SLR) for banks, though he does think that bank capital requirements need to be tweaked. Specifically, Massad proposed that cash collateral collected by banks to cover initial losses on trade in the event of a default can avoid being treated as an additional exposure under the leverage ratio if the bank meets certain conditions. Among those conditions: banks would need to agree to give up any investment income or interest that the make on clients’ collateral.
Margin for uncleared swaps
Though central clearing for swaps is becoming standard, there will always be some swaps that should not and will not fall under a clearing mandate. The CFTC’s proposal requires swap dealers to post and collect margin for uncleared swaps with other dealers and with some counterparties. At the same time, it exempts some specific end-users. Massad notes that he is working with both banking and international regulators to harmonize margin rules. He believes that once rules are finalized, potentially at the end of 2015, the agency will reintroduce rules for capital requirements for swap dealers and significant market players.
Swap data reporting
Massad proposed a fix to the swap data reporting process designed to reduce reporting costs and improve the quality of swap data. Citing an example of where the current system can be unnecessarily cumbersome, Massad shared the following scenario:
“Here’s an example of a problem: If a swap is transacted on a SEF, it is reported to an SDR. If that ‘alpha’ swap is then cleared, the so-called ‘beta’ and ‘gamma’ swaps that are created as a result are also reported. But those two new swaps might be reported to a different SDR, and there might not be any record of the termination of the original alpha swap.”
Under the new proposal, which the CFTC plans to explain in detail later this year, Massad said his focus was on clarifying reporting obligations and ensuring accurate valuations of swaps so trades can be traced from execution through clearing.
Massad also highlighted ISDA and Clarus Financial data, which show that the majority of interest rate swaps and credit default swaps are now trading on SEFs. He noted that there are still several rules that need to be fine-tuned to improve SEF trading. The areas the agency is still examining are package trades, for which Massad announced his intent to extend no-action relief through late 2016, and the “made available to trade” – or MAT – determination process. Massad said the CFTC is “considering” playing an expanded role in identifying which products are MAT’d on SEFs following suggestions from several market participants.
To read his speech in full, please click here.
By Geoff Cole and Jackie Colella, Sapient Global Markets
Originally published on TABB Forum
While the majority of buy-side firms expect their derivatives volumes and trades to substantially rise over the next three years, many are not yet fully prepared for the changes to come. For asset managers looking to continually innovate, the revamping of governance models and approval processes specific to derivatives will be central to balancing the time-to-market pressures against operational risk.
A recent survey by Sapient Global Markets found that while the majority of buy-side firms expect their derivatives volumes and trades to substantially rise over the next three years, many are not yet fully prepared for the changes to come.
The issues investment managers face to effectively and efficiently implement a new derivative instrument type became clear: enabling the trading of a new instrument type to quickly support a portfolio manager request, while taking into account technology restraints and mitigating operational and reputational risks, requires significant due diligence and a robust yet flexible governance model to support the process.
The current state of governance models and practices
The investment management industry is struggling to determine the proper level of operational and legal due diligence necessary to create a level of comfort appropriate for firms to trade new derivative products while balancing investment managers’ desire to be the first to market with a new product offering that offers a unique exposure or risk management approach.
Many firms have governance committee(s) responsible for approving the operational aspects of new instruments; however, the process for implementing the changes varies widely from firm to firm. In most cases, different committees are responsible for approving derivative usage on a portfolio or fund level, but most committees only approve operational capability in terms of whether or not the instrument can be traded operationally. While the majority of firms review derivative usage bi-weekly or once a month, at many firms the committee convenes on an as-needed, ad-hoc basis to review any new issues that arise with a portfolio manager’s new instrument request.
Firms should consider implementing a dedicated, fully resourced derivatives team with appropriate product knowledge and capacity levels specific to the new instruments, markets and products to be launched. This team should support the lifecycle of onboarding a new derivative instrument type, including capabilities such as legal and client services. In addition, reviews should be conducted on a regular basis.
They should determine the level of efficiency in the current process for assessing “readiness to trade” a new instrument type. Incorporating a streamlined process to approve and implement a new derivative instrument is paramount to mitigating operational risk and reducing time to market for new products and investment strategies. In our experience, the governance structure is far from streamlined and challenges/backlogs exist in operations and technology, primarily due to:
Derivatives trading discussions (including new instrument types) usually occur at the portfolio manager/trading level; by the time operations is informed, the process is already behind.
The number of internal and external entities and departments required to support the implementation and enable trading for a new derivative instrument type reduces the ability of operations to respond in a timely manner.
Technology is adequate with multiple workarounds in place, but does not or will not scale well with increased volumes or complexity in the future. It often is the biggest inhibitor in the implementation of new derivatives.
Finding the right balance
Asset managers are searching for the right balance between enabling portfolio managers and investment teams to express their investment desires through any means possible (including usage of derivatives) and achieving the optimum level of operational control and reputational risk management.
The issues experienced by firms in facilitating the availability of a new derivative is magnified by the complexities of the lifecycle of derivative trading. The pre- and post-trade process for onboarding a new derivative at asset managers can include:
Portfolio managers, but also some product management teams, initiate the request to enable trading of a new derivative instrument type
In few cases, automated workflows and electronic voting for approval exist detailing the change controls necessary to efficiently onboard a complex instrument.
Counterparty information was the most critical information needed to trade a new derivative instrument along with projected volumes, underliers, currencies and markets.
Very few firms have a streamlined process in place for onboarding a new derivative instrument type; in most cases, many different departments are given a task with little or no accountability.
The due diligence needed to manage master umbrella agreements is cumbersome and requires qualified staffing with knowledge of the intricacies of derivatives documentation. Client sophistication must also be taken into consideration to best calibrate the level of handholding required through the documentation updates required to enable the trading of a new derivative instrument within a portfolio.
In discussions with asset managers around whether derivative trading in client accounts occurs under an umbrella master agreement, or their clients negotiate their own agreements, a small number said their clients negotiate their own agreements with counterparties. If an investment manager chooses to trade a new derivative not stipulated in the original client-negotiated agreement, it may take weeks or months to have all the paperwork completed, delaying capitalizing on that derivative trade.
Regulatory Implications & Constraints
The amplification of new regulatory requirements for trading and clearing of derivatives has created greater challenges with firms’ legal review and documentation processes, changing the legal review and documentation process in numerous ways:
Additional “touch points” requiring clients to sign off on each new requirement add weeks to months for documents to be returned.
Extra legal team resources are needed (in terms of experience and capacity) to review regulatory changes.
Most changes occur only in the documentation.
Because the regulatory environment may change such that if the firm already has authorization to trade, firms may “inform” rather than “request” approval from the client.
Regulatory mandates in Europe are especially challenging for derivatives.
Balancing Time to Market with Operational Risk
It can take anywhere from three weeks to one year to completely onboard a new derivative instrument type. Most are traded with manual workarounds without taking into account post-trade operational processing, including settlement, collateral management and even client reporting. In many cases, an instrument that is too complex for existing systems can delay implementation to over a year and sometimes lead to the decision not to make the instrument type available to portfolio managers at all. Such cases can create a negative client experience, significantly delay new product launches and cause significant frustration for front-office personnel.
While many firms complete a full end-to-end testing of any new derivative instrument, in some cases, this testing is completed for only one specific business area. If multiple order management systems exist, there may be increased operational and business risk in the trade lifecycle if another business unit subsequently attempts to trade the newly enabled derivative instrument.
Reliance on standard vendor packages for trading and risk management may provide out-of-the-box support for most instruments, but changes to interfaces and configuration may be more complex than anticipated or require close coordination with the software providers. The bulk of the testing effort is often directed at the accounting system, given its criticality for fund pricing and reporting. However, there are many other links in the chain that require significant analysis and testing in order to properly enable a new derivative instrument across the front-to-back investment infrastructure.
Essentially, each new instrument request becomes a joint business and technology project, requiring scope, funding and prioritization against all other IT projects, which can also prolong the period between the request to trade and the first execution.
Improving the governance model and practices
For asset managers looking to continually innovate, the revamping of governance models and approval processes will be central to balancing the time-to-market pressures against operational risk. This is also require investment in workflow tools for transparency and tracking, dedicated derivatives/new instrument due diligence teams and the active involvement of operations teams, to enable the necessary cultural change to support the usage of more complex product types.
These changes are often overlooked dimensions of a robust target operating model (TOM) initiative that can address the definition of roles, responsibilities and accountability, as well as identify opportunities for improvement and investment across a firm and integrate with the firm’s data and architecture.
As product innovation accelerates, fee and cost pressures persist and competition for assets increases, asset managers must tie all of the capabilities supporting derivatives – including legal, client service, collateral management, risk management, reporting and project management – together in the form of a nimble and responsive governance model to enable a true competitive advantage.
Improvements in governance models and practices must also take into consideration future industry, market and regulatory shifts. Specifically, asset managers should:
Determine if using Special Investment Vehicles (SIVs) across accounts is a viable option, based on client account structure.
Understand the potential challenges and develop strategic mitigation plans to ensure BCBS 269 compliance changes for cleared versus non-cleared derivatives.
Prepare for other regulatory change focused on increasing oversight of asset managers, such as the SEC’s proposal requiring funds to report on their use of complex derivatives products.
Assess the use of off-the-shelf (cleared) derivatives to model exposure to OTC derivatives, thereby employing the most cost-effective instruments to gain the same exposure.
Define a target operating model to ensure the ability to adapt to industry changes as well as unforeseen market and regulatory fluctuations across investment, operations and technology.
Provide all personnel with appropriate derivatives knowledge through education and training.
Dedicate appropriate resources to the management and supervision of derivatives-related initiatives.
Turning challenges into opportunities
As product innovation accelerates and competition for assets increases, derivatives usage will continue to grow in both volume and complexity.
While most firms recognize this, investment and operational improvement has typically been directed toward front-to-back trade flow improvements. Most have reactive governance structures, which is a major contributor to the time lag it takes to assess and approve a new derivative instrument that need to be refreshed. However, during our research it emerged that no investment manager was continuously improving its governance structures, suggesting it has not been recognized as a vital investment area.
Yet it is clear that derivatives are a valuable tool for product innovation and delivering outperformance in a risk-controlled manner. The opportunity exists to refresh or realign governance structures to better support organizational growth in accordance with derivatives usage plans. Adopting new practices for governance and operational risk management specific to derivatives can help asset managers reduce time to market and more quickly respond to portfolio managers’ needs.
By Jodi Burns and David Lawlor, Thomson Reuters
Originally published on TABB Forum
With less than 18 months until MiFID II takes effect in Europe, the industry needs to come to grips with its reporting and trading requirements if it is to be fully compliant by 2017. Here’s a road map of where to start.
In the specter of financial market reform, it would be easy to dismiss the recast Markets in Financial Instruments Directive (MiFID II) as an inconsequential afterthought, tying up loose ends that were omitted from the original MiFID rulebook, which was implemented in 2007, and the more recent European Market Infrastructure Regulation (EMIR).
But to do so would be to vastly underestimate the scale and scope of MiFID II and its accompanying regulation, MiFIR. Together, they will impact a wide range of institutions across asset classes, going much further than the G-20’s commitment on derivatives reform, which included central clearing, trade reporting and use of organized trading platforms. MiFID II adds position limits for commodity derivatives, for example, as well controls on algorithmic trading.
This is a regulatory project that is far more onerous than even the US Dodd-Frank Act, which has consumed the resources of market participants as they have progressed their compliance efforts over the past five years. On top of the wide scope, the timescale of these rules is an even greater challenge. MiFID II and MiFIR have been in force since mid-2014, although the rules won’t actually apply until January 3, 2017. That might sound a long way off, but in practice it leaves very little time for participants to get all of the necessary processes and resources in place to meet these requirements.
Adding to the complexity, the European Securities and Markets Authority (ESMA), which is responsible for drafting the technical standards, has consulted with the industry but is not expected to deliver its final standards to the European Commission for adoption until September 2015, once they have been reviewed by Commission lawyers. That brings a layer of uncertainty to the process, as the industry prepares for rules that could still change.
But whatever the size and type of your business, if you are active in European financial markets, you cannot afford to wait until you have final rules in hand to prepare for MiFID II. The complexity of these requirements means such an approach risks running out of time next year, and leaves open the possibility of noncompliance in 2017.
In this article, we focus on two key components of the proposed rules – transparency and organized trading. This doesn’t constitute an all-inclusive guide to compliance, but it should at least help make sense of complex legal texts, providing the beginnings of a road map on where to start.
MiFID II extends the transparency regime that was created for equity instruments in the original directive, adding reporting requirements for bonds and derivatives. Those requirements include both trade reporting, whereby trades must be reported publicly in close to real time, and transaction reporting, whereby trades must be reported to regulators no later than the close of the following working day.
The trade reporting obligation rests with the venue where the trade takes place, which could range from an independent regulated platform to a so-called “systematic internalizer” (SI) – typically a bank that has sufficient flow to match buy and sell orders internally. Derivatives trade data must be published within 15 minutes of execution, marking a step change for those platforms that have never had to report in the past.
With its pre-trade and post-trade reporting obligations, MiFID II will propel a slew of market data into the public domain that never existed before, including pre-trade prices and post-trade information. In the early days, data fragmentation is likely to be the biggest challenge and there will be a need for robust aggregation of reported data to build a meaningful picture for public consumption. How that aggregation will be delivered has yet to be determined.
While the burden of trade reporting is likely to rest predominantly with trading platforms and those banks that register as SIs under MiFID II, transaction reporting will have a much wider impact, requiring asset management firms to report their trades to regulators as well as their bank counterparts.
In this, the experience of EMIR may help guide asset managers, as those firms that use derivatives have had to report their activity to registered trade repositories since February 2014, fulfilling the onerous requirement for dual-side reporting, in which every trade must be reported by both counterparties.
But whatever the experience of EMIR, MiFIR transaction reporting is likely to be even tougher, with 81 information fields required to be filled out for every trade. That means firms will need real-time access to large amounts of market data and reference data, as well as “legal entity identifiers” – numerical codes used to identify those firms involved in the trade.
Submitting transaction reports to regulators will come at a significant cost to the industry, particularly for smaller firms that may not already have reporting infrastructure in place. At this stage, the priority for market participants is to determine exactly how they will be affected by the reporting obligations and then to assess what technology and resources will be needed to meet those obligations.
When it comes to organized trading requirements, MiFID II fulfils the G-20 commitment that standardized OTC derivatives should be traded on regulated platforms where appropriate. In the US, the Dodd-Frank Act created swap execution facilities to meet that requirement, but MiFID II includes a wider range of platform types, including regulated markets, multilateral trading facilities (MTFs), organized trading facilities (OTFs) and SIs.
Not all products will need to be traded on these regulated platforms, but all market participants need to understand the MiFID trading rules and determine what their strategy will be. For large banks, the priority is to determine whether they wish to register as an SI, which will come with certain transparency and conduct obligations. If they decide not to do so, their internalized flow would need to fall below a certain threshold, which may mean directing more business towards MTFs and OTFs.
Smaller banks will be less likely to become SIs, but they will still need to determine how to conduct their trading business under MiFID II and what proportion of trades will be executed on MTFs and OTFs. To some extent, that will depend on what products are mandated to trade on organized platforms, which will be determined by ESMA in due course on the basis of the liquidity and whether it is already subject to the EMIR clearing obligation.
As an industry, we do not yet have all of the answers on MiFID II and we hope for greater clarity once ESMA’s technical standards have been published. But awareness and readiness still varies significantly from one firm to another, which is a cause for some concern. As 2017 draws ever closer, now is the time to start preparing.
By Lewis Richardson, Fidessa
Originally published on TABB Forum
The Asian derivatives markets increasingly are the destination of choice for firms across the derivatives spectrum. But bear traps remain for the unwary. How can you choose the safest path through the woods of this asset class in Asia?
Derivatives markets in Asia are basking in global attention, with exchanges, clearing houses, brokers, international investors and vendors all piling in to local markets. Between August 2014 and August 2015, trading in SGX China A50 futures more than doubled. (Source: SGX).
Global exchanges are even going native to some degree, with ICE, for example, localizing its contract size and introducing domestic clearing in the Asian time zone. RMB and gold futures are on offer locally, as well as Mini Brent and Mini Gasoil futures. Seeing these global derivatives powerhouses reshape themselves for Asia demonstrates clearly the opportunities on offer here, and interest in trading in Asia is unlikely to wane any time soon.
European bond products are now being traded on ICE, and Eurex is planning to start clearing bonds in the Asian time zone in the next couple of years; opportunities abound for both local and international firms to expand their businesses and investments. As competition heats up between rival exchanges, even greater choice will become available. The key is taking advantage of this while avoiding the bear traps peculiar to the region.
Growth in the region is reflected in the annual growth of 27% in total F&O volume traded (Source: FOW).
The first challenge is regulatory. American and European institutions used to dealing with a single regulator will find plenty of new challenges to navigate in the treacherous terrain of Asian regulation. Regulators here can be even trickier than ESMA or the SEC. In Singapore, the MAS made some unprecedented demands of SGX after a systems outage. In Hong Kong, market participants have to answer long questionnaires about their use of technology and back-testing of algos. In Malaysia, equities and derivatives rules are completely un-harmonized – all securities activity must be completely onshore, yet derivatives are all remote.
The speed of regulatory change can also be frightening for those used to the lumbering processes in other regions. Asian regulators can – and do – move the goalposts in a single day, whereas in Europe it has taken seven years so far, with no end in sight. Being ready for Asia’s blistering pace is vital for success in this part of the world.
There’s plenty of innovation in derivatives, but regulators here have been taking a dim view of some more out-there solutions. Brokers and banks have been asked very directly to provide certainty around the security and storage of financial information – all regulators have rules on this, none of which are exactly the same, but all of which are relatively onerous.
Different clearing regimes require different approaches as well, so getting the middle and back office piece right is very important. While regional brokers localize their operation by allocating head count into the region, many larger firms outsource their middle office to places such as London – which means these companies are unlikely to be tooled up to meet nuanced Asian requirements. Technology developed for the big US and EU markets will need tweaking to meet Asian needs. The good news here is, a firm that has solved this conundrum for Asia has met the highest global regulatory hygiene requirements and so can legitimately claim the gold standard.
Once the regulators are satisfied, the nature of doing business in Asia continues to be challenging. Getting the balance right between direct market membership and trading through a local broker is important to ensure a cost-effective solution. Accessing global markets efficiently is important, as clients will be trading CME and ICE as much or more than local exchanges. Yet as the global exchanges begin to offer local trading and clearing, trading ICE can mean two different things.
This raises an interesting point. Clients now can choose which regimes to trade in, throwing up the question of regulatory arbitrage. There could be plenty of good reasons to choose one venue over another, and these reasons will differ from client to client. Having intimate global knowledge of each regime and its benefits and pitfalls will be a great selling point for firms willing to invest the time to understand this complex landscape. On top of this, offering a seamless and smooth end-user experience will be a very enticing proposition indeed.
By Christian Voigt, Fidessa
Originally published on TABB Forum
Under MiFID II, Brussels will introduce quantitative Systematic Internalizer thresholds and a double volume cap for equities dark trading. Will more firms opt for the SI route as a result?
Looking back at MiFID I, the Systematic Internaliser (SI) didn’t really take off, resulting in a meagre 1-2% market share in the FTSE 100 today. Many E.U. countries had different models to execute or internalise order flow, leaving the SI model on the shelf like a dented can of beans.
Under MiFID II, Brussels will take a stricter approach by introducing quantitative SI thresholds and having a double volume cap for equities dark trading. This leads to the question: What will markets look like in 2017 if more firms opt for the SI route?
It mostly depends on whether firms will truly embrace the SI regime and start to compete on the attractiveness of their quotes, or whether they see the publication of quotes as a regulatory burden that provides no business value.
What might tip the scale and enable SIs to escape their trajectory of low market share and be propelled to new heights is the MiFID II tick size regime. Whilst all trading venues will be restricted by a harmonized minimum tick size, an SI will be able to offer sub-tick price improvements as a competitive edge. Let’s see whether SIs will capitalize on their second chance.
By Thomas Schiebe, Sapient Global Markets
Originally published on TABB Forum
As the costs of central clearing, collateral reporting and margining continue to rise, firms will need to evolve their operating models, architecture and legacy collateral management solutions in order to remain competitive and protect revenues. While driven in part by regulation, there are a number of converging trends influencing the desire to increase efficiency and reduce costs.
Regulatory reform – in the shape of European Market Infrastructure Regulation (EMIR) and the Dodd-Frank Act in the United States, together with upcoming rules from the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) on margin requirements of non-centrally cleared derivatives – is transforming collateral management.
Complexity and cost are both rising due to higher volumes of required collateral, increased margin calls and interaction with more counterparties. With such a significant evolution of the market underway, firms are facing up to the challenge of managing eligible collateral and assessing its availability as well as the systems and processes used to support the collateral management function.
Many market participants have attempted to bring together fragmented systems, manual processes and siloed approaches for collateral management in order to ensure compliance with various regulatory requirements. However, as the costs of central clearing, collateral reporting and margining continue to rise, firms will need to bring efficiency to several areas of their collateral management process in order to remain competitive and protect revenues.
While driven in part by regulation, there are a number of converging trends influencing the desire to increase efficiency and reduce costs.
1. Collateral Segregation
While requirements in the exchange-traded derivatives business are well established, margin requirements in the over-the-counter (OTC) business are undergoing significant changes; plus, each regulation has its own definition of how customers should be protected. For example, the Dodd-Frank Act allows for legally segregated but operationally commingled (LSOC) customer assets, whereas EMIR requires providing the customer options between omnibus accounts and individual segregation. Segregation of cash collateral is a cumbersome process but is required within the new regulatory environment for initial margin requirements. These different requirements need to be implemented and these costs need to be accurately transferred to products and/or business units.
Implementing multiple types of available segregation forms based on client types and products, particularly in the OTC space, may become challenging. Based on the complexity and lack of complete regulatory harmonization across the globe, institutions should begin the necessary impact analyses immediately. The effects on risk, margin, collateral, settlement, processes and systems can be far reaching.
Demand for collateral has increased, yet circulation of existing collateral has decreased, in part due to regulations such as the EMIR implementation of the BCBS/IOSCO proposals that explicitly prohibit the re-use of received collateral. According to economists at the International Monetary Fund, declining confidence in issuers and counterparties has reduced the circulation rate of collateral between counterparties from three times its original value in 2007 to just 2.4 times today. With issuance of highly rated securitized debt also shrinking, predictions of a worldwide collateral shortfall are possible.
This puts greater pressure on firms to identify eligible collateral, locate it and then match it with the collateral demands they face. If they lack the collateral eligible to meet one of those demands, they have to work out how to obtain it. Mismanaging collateral can damage performance and reputations, as well as increase costs.
3. Cross-Asset Netting
Netting on counterparty exposures decreases the amount of collateral a firm must maintain to cover credit risk and protect the balance sheet. Being able to perform pre-trade scenario analysis of counterparty usage and execution can offer significant cost savings to firms.
Unfortunately, tools to perform efficient cross-asset netting are still in development because technical standards have not been finalized by regulators. Once available and adopted by market participants, firms will be able to more easily estimate exposure and the impact of a trade and make cost-effective decisions as to which counterparties through which to trade and clear.
4. Collateral Optimization
As collateral resource management becomes established as a dedicated business line, it has become obvious that optimization is required. The “optimization” of collateral seeks to make the best use of available assets. Using algorithms, applying compression/netting across assets or simple prioritization rules can reduce costs and improve liquidity. For service providers, optimization can also mean generating increased revenue by offering collateral funding and transformation services.
In order to achieve optimization, firms must have sufficient levels of automation and straight-through processing, as well as technology in place to help identify eligible collateral, prioritize its use, and deliver the lowest cost, mutually acceptable form of collateral across an entire firm.
New regulations now require derivatives market participants to post collateral with counterparties for both cleared and uncleared transactions. This makes it imperative for firms to have systems in place to know exactly what eligible collateral they have available to meet a collateral call—a requirement that could be problematic for some firms. A Sapient Global Markets’ survey revealed that only 51% of market participants have a complete view of their entire inventory of eligible assets to be posted as collateral across business units.
If a firm does not have sufficient, available assets, it can either borrow from a firm through a straight-forward lending agreement, or for a fee, have its lower-grade assets (with significant haircuts applied) transformed into eligible assets. Such transformation services create a new revenue stream for those that can source high-quality collateral and deliver it to clients that need it.
Managing Collateral in an Evolving Market
As the markets continue to transform and adapt to the new regulatory regimes, it will be interesting to see how the collateral management function evolves. We’re already seeing many institutions accepting bonds as non-cash collateral, with an appetite to extend the assets that are considered eligible in order to meet the increased demand for collateral. But differing regulatory definitions of assets that qualify as collateral and specific eligibility criteria set by central counterparties (CCPs), clearing brokers and counterparties in the case of non-cleared trades significantly increase both the complexity of non-cash collateral and also the requirements for collateral management systems.
To date, firms have implemented tactical solutions to meet regulatory mandates in various jurisdictions, but as the regulations solidify, they will need to adapt these tactical efforts and begin implementing strategic solutions. Different segregation models, margin requirements, restrictions on re-hypothecations, bifurcated portfolios with both centrally and non-centrally cleared OTC derivatives, limitations on eligible collateral and increases in liquidity ratios all raise the complexity and costs.
Firms will have to evolve their operating models, architecture and legacy collateral management solutions, which range from simple spreadsheets to more complex systems. Depending on the availability of technology funding and internal expertise, a firm has three options:
For firms with their own proprietary collateral management systems, updating those systems may make the most sense, given the level of custom functionality included and compatibility with other internal systems. However, collateral management success will hinge on a firm’s ability to remove siloed approaches and transform their systems into a full-blown collateral management platform. A platform that consolidates the collateral management function across all asset types and provides an entity-wide overview of all available and eligible collateral.
A vendor software solution can be an ideal option for firms that do not have—or do not wish to spend—the resources to build and maintain in-house systems or want to add features and functionality to their collateral management that go beyond the capabilities of their existing, proprietary systems. Vendor systems are continuous updated to adhere to the latest regulatory requirements and often include usability features, enhancements and new algorithms requested by customers.
Depending on a firm’s business model and structure, outsourcing can be an effective option to save on operating and maintenance costs. Outsourcing allows a firm to leverage a third party’s targeted expertise and economies of scale for collateral management functions, such as reconciliation, reporting, liquidity management and dispute management.
Collateral management as it currently is known will no longer exist within a few years. Market participants are already exploring new revenue streams through transformation services, efficiencies with cross-asset netting, bringing improvements to processes such as dispute management and communication, and reducing costs by implementing collateral optimization strategies.
We are already seeing this shift, with some early adopters integrating collateral management within their treasury departments. As an increasing number of firms recognize the opportunities to reduce costs and increase profitability, the evolution from an administrative back-office function to a more front-office, revenue-generating function will accelerate. That, in turn, will have a significant impact on the systems and processes required to support the demand to optimize collateral rather than simply administering or managing this process.
By Radi Khasawneh, TABB Group
Originally published on TABB Forum
A regulatory rethink of bank leverage ratios could make the clearing business more attractive, reinvigorating competition and helping redistribute concentrated clearing flows and the associated risk.
News last week that global regulators are meeting to reconsider the consequences of imposing bank leverage ratios is good news for the clearing industry. In May, the TABB Group view was that it was clear that this would have to be re-examined at some point, given the level of concern by Futures Commission Merchants (FCMs) about the effect of these changes on the economics of their business.
Nearly 90% of FCMs interviewed for TABB’s May study, “The FCM Business 2015: Overcoming Industry Adversity,” 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. As currently formulated, the negative effect of the rules on the over-the-counter (OTC) swap clearing business seems far too proscriptive, leading us to the conclusion that the intermediaries will require more encouragement to provide clearing services as reform transforms the global markets. That view has been backed by members of the Futures Industry Association as well, as efforts are made to reduce the requirement to account for derivative positions on a gross basis and account for collateral received from clients on balance sheets.
In the meantime, as mandatory clearing rules, recently finalized for Europe, come into force in the two most important regions, clearing behavior has become more entrenched in familiar patterns (see Exhibits 1 and 2, below).
So far, rather than diversify the product and client mix at CCPs, clearing houses have largely continued to dominate in their traditional areas. Take the above clearing flows as an example – looking at the clearing house breakdown, interest rate swap clearing has largely been dominated by LCH.Clearnet as the dealer clearer of choice, and the CME has remained a significant participant, maintaining its position as a buy-side clearer; meanwhile, ICE has long been the CDS clearer of choice. Market shares calculated by Clarus Financial show that this dynamic has persisted, creating a potential problem in terms of so-called concentration risk.
In addition, a material difference in quoted prices has emerged this year between LCH.Clearnet and the CME for USD IRS based on the cost of clearing. Clarus data shows that, on average, $8 billion of switch trades were enacted a week between May 18 and July 10 via interdealer brokers to take advantage of this price disparity. As a result, LCH.Clearnet has attracted up to 70% of new IRS trades, a much higher portion than its historical average against the CME, which has a much higher percentage of buy-side participants versus the more balanced dealer/buy-side mix of clearing clients at LCH.Clearnet.
The point here is not the breakdown between the clearing firms as much as the lack of growth elsewhere. These types of dynamics, which tend to concentrate risk at a clearer, have meant a necessary focus on default and resolution schemes at the clearing houses.
In the absence of meaningful dispersion of clearing flows, it is clear differences between the cost of clearing can create a redirection of flow, as already has been seen with LCH.Clearnet and the CME – in the future, this could be to a new entrant or to an expanded offering from other venues. This would be a positive for all market participants, as more options would exist, and the FCMs themselves would be more encouraged to widen access to clearing (crucially, at an affordable price point), resulting in a greater fragmentation of clearing flow and, consequently, risk.
This is a new phenomenon, and is generally a healthy sign for the market as a whole – as long as there is true competition among all clearing houses offering similar product choice. It is a good sign that market participants finally are beginning to analyze their cost of clearing on a more systematic basis and are beginning to make clearing choices on this basis. And a change in the regulatory framework could help spur further competition.
In the interim, the situation is similar to the rise of towns during the expansion of the railroads in the U.S. “old west”: People have invested significant sums in building the infrastructure necessary to attract more people to their area, but only time will tell which towns prosper and which wither away.
By Matthew Hodgson, Mosaic Smart Data
Originally published on TABB Forum
Regulation is rapidly increasing transparency across financial markets, enhancing audit requirements and ensuring effective market surveillance. However, the mounting cost of compliance continues to squeeze sell-side banks, which have been facing declining FICC revenues and higher capital costs. With the introduction of MiFID II set for January 2017, technology – and particularly data analytics – could hold the key to developing competitive advantage in this new regulatory reality.
Since the financial crisis in 2008, regulation has played a key role in transforming the structure of capital markets and the manner of counterparty interaction. The requirements imposed have enabled regulatory bodies, such as the FCA, FINRA and SEC, to introduce more effective monitoring and superior levels of transparency across foreign exchange (FX), fixed income, equities and commodity markets.
Driven by regulatory change, trading activity has migrated away from opaque voice based markets toward a model based on transparency and risk mitigation on electronic venues, with market participants increasingly required to report and clear trades through CCPs.
The playing field for sell-side sales and trading teams is shifting permanently from relationship-driven to electronic message-based banking.
While the structural benefits of reform to the financial ecosystem are wholly apparent, however, the cost of compliance for individual firms has increased significantly, with sell-side banks bearing the lion’s share of the burden. As a result, the ability of these institutions to hold trading inventory and operate as liquidity providers has been increasingly constrained by regulatory capital requirements and mounting pressures on fixed costs.
According to the Economist, FICC revenues have fallen by 48% among the world’s largest banks over the four-year period between 2009 and 2013, and the downward trajectory is expected to continue. This has much to do with the desire from the Central Bank community to keep long-term interest rates low through quantitative easing, thus depressing trading activity, but also the weight of regulation. Current industry research indicates that these sell-side institutions will continue to experience fixed income balance sheet declines of between 10%-15% over the next 2 years and as much as 15%-25% out of flow rates.
Facing the Challenge
- Banks’ FICC revenues have already declined by 48%
- Cost-to-income ratio (CIR) remains above 70%
- Fixed income balance sheets set to decline by further 10%-15%
These challenges have arisen as a result of two prominent factors:
- A sharp rise in regulatory oversight, with banks now having to post increased regulatory capital to cover potential losses; and
- Tighter spreads associated with electronic trading having a detrimental impact on revenue. While this provides enormous benefits for the wider market, this decline in margins has resulted in banks having to turn over their balance sheets at a faster rate, as the cost of warehousing risk has becomes increasingly prohibitive.
Adding to the current concerns, the implementation of MiFID II will further reshape the regulatory landscape, posing new challenges for banks, specifically by changing the way in which bonds, derivatives and ETFs are traded on electronic platforms. While full details are yet to be finalized, proof of best execution is a regulatory certainty, and the new rules will force players to adjust their market models toward a hybrid-agency model. This will be especially relevant for banks that cannot afford the capital costs of maintaining inventory. Clearly, many of the lessons learned from the equity markets will now be applicable to the FICC markets, with specific emphasis on being able to measure execution performance in both a principal and agency environment.
Marching Out of Step
Despite the growth, adoption rates in electronic trading, a key component of financial technology, remains inconsistent, with significant discrepancies between FX, equities and fixed income, as well as across geographical lines. The fixed income market, for example, has transitioned at a slower pace by comparison, with 57% of volume executed electronically in Europe and only 12% in the US in 2014, according to Greenwich Associates. However, sell-side fixed income volume executed electronically continues to increase, as data from Celent demonstrates:
Observing the US IRS market, which has been directly impacted by Dodd-Frank, in the chart below, it is apparent that the migration to electronic venues can be relatively immediate. In the dealer-to-client market, SEF (electronic) market share rose from ~10% in January 2014 to the current ~60% (March 2015), with further electonification anticipated. The implication for European markets with the upcoming MiFID II implementation in January 2017 is apparent.
Old Heads. Young Minds
Although a cliché, every cloud has a silver lining, and this could well be the case for FICC markets. The financial crisis and subsequent regulation proved to be extremely important in ushering in the current wave of creativity and fintech innovation, causing banks and other financial institutions to rethink their strategies. Many are coming to the realization that they need to partner with emerging innovators. As such, finance and technology has become synonymous, and data analytics, in particular, is moving to the forefront of efforts to provide new solutions to ongoing market challenges, such as trade reporting, risk management and audit requirements. Moreover, a profound and atomic understanding of client activity and behavior will define winners and losers in the coming years.
With technology front and center in today’s financial marketplace, the debate remains as to how to effectively identify and deploy new technology, leading to the perennial question of: Should we build in-house or purchase from a specialist vendor?
Building in-house solutions has its benefits, but it takes significant time and resources. With budgets and margins under real pressure, many firms are unable to meet this challenge by deploying internal teams to address the overwhelming tidal wave of change. By opting for the latter, banks have been able to cut their time to market by years, quickly and efficiently adhering to new market rules and meeting best practice legislation.
Another significant advantage for banks in outsourcing technology to third-party providers is to keep pace and engage with the rapidly evolving fintech landscape. As a result, they are now looking to technology vendors to bridge the gap and ensure sales and trading teams have access to the best and most competitive tools.
By tapping into fintech clusters such as London and New York, banks are capitalizing on the highly focused and outcome-based delivery of these companies. As a consequence, it is not surprising that global investment in financial technology ventures has more than tripled, from less than US$930 million in 2008, to more than US$2.97 billion in 2013.
Smart Data Is the New Currency
Within the fintech sector, the field of data analytics has quickly become the new opportunity in financial markets. This comes at a time when banks are beginning to recognize the competitive advantage that can be gained from partnering with specialist technology vendors.
However, challenges persist. While electronic trading has generated a torrent of transaction data, the industry currently lacks the necessary processing tools for effective aggregation, standardization and analysis. This has become crucially important to sell-side firms at a time when strategy differentiation by market, client type or geographical region is becoming common practice as a means to achieve unique competitive advantage.
Furthermore, market fragmentation, as a result of the proliferation of electronic venues, has effectively fractured liquidity and trading volumes in some markets, rendering the standardization of trade data more challenging.
Only by gaining control of an abundance of available data and deriving actionable intelligence will banks be able to focus on identifying new opportunities and generate the highest returns in the markets they choose to compete in and be able to navigate the new regulations and operational challenges ahead.
The pace of change in the field of data analytics is rapid. As technology vendors continue to work toward providing easy-to-use tools that can be quickly integrated into existing systems, it is the ability to harness predictive analytics based on historical patterns that remains at the cutting edge. For a FICC-trading bank, this could provide answers to questions such as: Which clients am I anticipating seeing in the market today? Or, What products do I think clients will likely be trading?
The business advantages that can be harnessed by predictive analytics are significant and will act as a differentiating factor in performance. In a recent Harvard Business School article, leading academic and analytics guru Thomas Davenport argued that we are now entering the era of Analytics 3.0, where its predecessors were Business Intelligence (1.0) and Big Data (2.0). Gartner has been predicted that by 2017, firms with predictive analytics in place will be 20% more profitable than those without.
As the FICC trading ecosystem continues to evolve, sell-side institutions must focus on how to apply technology at the intersection of trading, regulatory compliance and operational efficiency to maintain and grow market share within a profitable client universe. The entrepreneurship and financial creativity of yesteryear, which is being restricted by regulatory codes of conduct led by global government agencies, can only be replaced by the granularity of understanding that intelligent data analytics delivers.
In what has become a challenging environment for all, the real question is how quickly the industry can adapt.