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Crunch Time for Clearinghouses as Regulators and Participants Shift Focus

By Radi Khasawneh, TABB Group
Originally published on TABB Forum

The concentration of risk among central counterparties in the new global market structure must be accompanied by a proportional increase in transparency and reporting at the CCPs.

We are at the implementation phase of a global regulatory shift that will force the majority of swaps into clearing. The idea behind the push was to give regulators a cleaner view of risk in the derivatives world; but ever since the intention was announced by the G20 in 2009, market participants (Lloyd Blankfein among them) have long been concerned that this in itself may be creating additional systemic risk.

After all, if most trades have to go through a limited pool of central counterparties (CCPs), the potential for a significant market shock increases. Conceptually, there are safeguards to prevent this concentration of risk in a handful of venues. Future Commission Merchants (FCMs) that facilitate clearing demand and post margin, and all clearing members contribute to the default funds that are there to minimize the fallout of a default.

TABB Group’s view has been that there is not necessarily a problem with this; but that the increase in the importance of CCPs in the new market structure must be accompanied by a proportional increase in transparency and reporting at the CCPs. Many of the safeguards are dependent on proprietary and often opaque modelling. They are owned or operated by a mixture of dealers and exchanges, meaning that everyone’s risks should be aligned – but a further level of assurance is necessary.

News earlier this month that indicated that two leading clearinghouses have agreed to provide additional disclosure on their default fund and all-important margin requirement models is therefore highly encouraging. This paves the way to the establishment of a formal disclosure standard by the International Organization of Securities Commissions (IOSCO) later this year.

This will go a long way to alleviating the still glaring differences in global clearing margin requirements and disclosure standards, analyzed in a recent TABB Group report, “Global Collateral Standards 2014: Breaking Through Regional Silos.” In that report, we pointed out that short-term fragmentation (with multiple entities split geographically) was likely to give way to consolidation and standardization over time. Regional clearinghouses cannot simply do their own thing and march to the local regulator’s tune, and huge differences remain in margin treatment globally (see Exhibit 1, below).

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Sources: Company reports, TABB Group

It is far more preferable that this comes from the clearinghouses themselves and, in fact, the efforts of many global clearinghouses to attract increasing flow across different products in order to boost margin efficiencies increases the complexity of the modelling question, making it even more crucial.

This is an inherently healthy process, but there are problems. Primarily, the problem is a political one, and the lack of clear progress on the issue of equivalence between the US and Europe is a particular concern. In June, comments on a panel at the IDX conference by the CFTC’s Ananda Radhakrishnan caused a stir when he said that he was tired of granting cross-border clearing exemptions for European CCPs, and that it would be simpler if they moved clearing operations to their jurisdiction.

So where does that leave us now? We still believe that standardized and periodic disclosure within a global and equivalent framework is the most likely outcome – probably facilitated by an increase in global tie-ups and cooperation agreements between the CCPs themselves. The need for assurance on the systemic issue is critical to all, and the CCPs themselves have begun to more stridently make the case for the benefits of the new system. Last week, Eurex (owned by Deutsche Boerse) published a white paper laying out the benefits of the new system versus the bilateral model. This in itself merely supports the moves by global governments to date, and increased transparency into risk models will help the case.

This all is a sign that CCPs are getting more used to the idea of operating in an open environment, a welcome and necessary step. A bit of pragmatism on all sides will go a great way to untangling the balkanized system we have today. 

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What Is a Basis Point Worth?

By Edward Talisse, Chelsea Global Advisors
Originally published on TABB Forum

Ten years ago, no one wanted to inconvenience themselves to try to pick up a few basis points. But today's investors are falling over themselves to collect those very same basis points. Here are 6 risky strategies to combat a flattening yield curve – and why you probably should avoid them.

Ten years ago I started working in Japan as a fixed income sales trader for an international investment bank. I was frequently called upon to travel to other parts of Asia, including Beijing, Hong Kong, Seoul, Singapore and Sydney. My mandate was to invite clients to explore the many money making opportunities available to them by trading the (G4) U.S., German, U.K. or Japanese yield curve.

The touchstone recommendation always seemed to be some combination of going long or short U.S Treasuries and establishing an offsetting position in like maturity German Bunds. Most of our trade ideas were simple variations of a basic mean reversion strategy – optimistic to pick up a few basis points along the way.

After my pitch, I was frequently met by the same incredulous reaction: "Eddie, we are not interested in making a few basis points. ... We want full points, preferably in multiples of 10." No one wanted to inconvenience themselves and stoop down to try to pick up 10, 20 or even 50 basis points! Of course, being in Asia, the clients were always very professional and extremely polite, but my colleagues and I usually left empty handed. We did not win a lot of new business out there. 

Back then 10y yields ranged between 4.25% and 5.25% in the U.S., U.K. and Germany and about 1.75% in Japan – so maybe some investors could afford to ignore a few basis points here and there. Well, we have all moved on since 2004 and 10y yields now range between just 0.53% in Japan and 2.72% in the U.K., with the U.S. and German yields sandwiched in the middle. Today's investors are less finicky and are now falling over themselves to collect those very same basis points.

So what do you do when you are now faced with a diminutive and none-too-generous yield curve – and you need income? Here are some (very risky) strategies:

  1. Sell a Tail- increase leverage and borrow on margin; borrowing money to increase long exposure is effectively selling the left tail in a distribution of potential outcomes.
  2. Sell Volatility- sell options outright and or engage in covered call writing.
  3. Sell Convexity- or go long instruments like MBS or callable bonds.
  4. Sell Quality- that is, go long lower rated, more risky instruments, such as High Yield.
  5. Sell Liquidity- that is, buy highly illiquid instruments like Emerging Market debt denominated in local currency.
  6. Buy Structured Products- that is doing all of the above in one handy trade.

The concern, in my view, is that all of these alternatives are now almost completely exhausted. Look at a table of Bond Benchmark Performance and you will see that just about every index is near its 52-week low in spread. That means you don't get many basis points (forget about full points!) by engaging in the highly risky strategies numbered above.

As an asset class, risky bonds look, well ... very risky. The upside is measured in basis points, while the downside is measured in points.

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A Simpler View of Complex Markets – Q&A with Fidessa’s David Polen

Whoever said technology would make our lives easier didn’t trade futures and options on five or six different exchanges spread out across a dozen different time zones.  Thanks in large part to universal connectivity market participants can access liquidity in virtually any asset class anywhere in the world.  But with that capability comes a great deal of complexity.  Different regulatory regimes, trade processing requirements and various technical intricacies give each asset class in each market around the world a unique set of rules that can challenge even the most sophisticated market participants.

Recognizing the need for global reach without the technical and regulatory complexity that comes along with it, Fidessa is hard at work to help guide clients in the new world order of electronic trading.   DerivAlert caught up with David Polen, global head of electronic execution to discuss how the industry is simplifying global markets.

DerivAlert: You’re in a new role at Fidessa as global head of electronic execution. Tell us more about the direction you’re headed

David Polen: This is all about taking the next step in helping our clients access markets more efficiently than they ever could have done before.  Whether you are trading Treasurys in New York, equities in Brazil, or futures and options in Japan and Australia, you want to have a reliable framework.  We want to make accessing these markets as consistent as possible so our clients can focus on trading instead of navigating technicalities.

DA: Ironically, just as technology has made it easier than ever to trade electronically around the globe, regulatory reform made it more complex than ever to execute trades; is that phenomenon driving your thinking at Fidessa? 

DP: Fundamentally, we’re dealing with market structure issues and compliance issues.  You need to be able to understand how those variables work together before you can start to make it simple and give clients a normalized view of hundreds of different markets.  That’s the value we’re bringing: we’ve organically solved many of the most challenging execution issues from a compliance perspective so we can bring all of these markets together in one place electronically.

DA: What markets are you currently serving and where do you see yourself expanding?

DP: For electronic execution, we cover equities, futures and options, liquid equity options and Treasurys across 220 markets around the globe.  We’re continuing to expand this list into several asset classes. Swap Execution Facilities (SEFs), for example, are an area where we see tremendous potential.  We believe the buy-side wants to be able to trade electronically globally, and brokers want to facilitate those global trades instead of running different stacks for each market. 

DA: How are you improving efficiency for brokers in these markets; can you give us an example?

DP: Let’s take futures, for example. For a client located in Chicago, whether that client wants to execute a trade on the CME or wants to execute in Hong Kong, they send a Direct Market Access request into the Fidessa cloud in Chicago and, using co-location hubs located around the world, we provide access to over 40 futures markets with very low latency.  We can make that experience very consistent with what they are doing in equities, Treasurys, etc.  And then we can provide post-trade analytics that let them benchmark performance.  It’s really about making the workflow more efficient for our clients so they can focus on the markets.

DA: What do you see coming down the pike over the next year to eighteen months?

DP: We’re committed to continuing to expand into new asset classes, in a world that is moving quickly into electronic trading.  Our philosophy is that there is enormous value in giving our customers a consistent execution framework and a simple, normalized view of these markets so they can focus on their business and value-add instead of infrastructure issues.

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Collateral Damage: Regulatory Fallout Is Transforming Collateral Management

By Thomas Schiebe and Neil Wright, Sapient Global Market
Originally published on TABB Forum

Regulatory reform has transformed collateral management into a complex, costly exercise involving higher volumes of collateral, increased margin calls, and interaction with more counterparties. But while fewer than half of market participants feel strongly that their institutions have efficient processes for collateral management, there are opportunities for quick wins.

New legislation around the globe – including Dodd-Frank, EMIR, and Basel III – has created a tangled web of rules designed to increase market stability and resiliency, enhance transparency and accountability, and reduce counterparty, operational, and liquidity risk. The fallout of regulatory reform for most banks and capital market participants has transformed collateral management into a complex, costly exercise involving higher volumes of collateral, increased margin calls, and interaction with more counterparties.

A recent Sapient Global Markets survey examined some of the key issues for firms, including collateral availability, strategies, dispute management, and the systems and process used to support the collateral management function.

That survey revealed that 95% of respondents expect the amount of OTC clients with collateral agreements to increase, as well as the amount of daily collateral calls. Additionally, more than half expect disputes to significantly increase as a result of new participants in the collateral space.

With such a significant evolution of the market underway, these results are unsurprising. Many market participants have cobbled together fragmented systems, manual processes, and siloed approaches for collateral management in order to ensure compliance with various regulatory requirements. Unfortunately, such efforts have made managing and processing collateral a very inefficient and costly component of their businesses. In fact, fewer than half (45%) of participants in that survey felt strongly that their institutions have efficient processes for collateral management, particularly in the area of communication and dispute management.

While regulatory change continues to drive firms’ investments in new technology and infrastructure, there are also a number of trends influencing the desire to increase efficiency and reduce costs, the most prominent of which we’ll discuss in further detail below.


At the same time that demand for collateral has increased, circulation of existing collateral has decreased. 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.

Technology and efficient processes play a critical part in steering clear of shortfalls.

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 cross asset netting are still in development as technical standards have not been finalized by regulators. Once available, firms will be able to more easily estimate exposure and the impact of a trade and make cost-effective decisions as to which counterparties to trade and clear through.

Collateral Optimization

When it comes to collateral management, it seems that everyone is striving to achieve optimization. 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. The 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.

Given the revenue potential, more than half (66%) of custodians surveyed intend to offer or already have a partial transformation service.

How to achieve greater efficiency

While traditionally, collateral management has been an administrative, back-office function set up as a cost center, the business model is changing dramatically, driven by new regulations and cost pressures. As a result, market participants are currently 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. Successful execution requires solid planning, advanced technology, and improved processes.

To realize quick wins and be highly effective in reorganization, reprocessing and reengineering, firms should focus on six key areas: inventory management, risk management, data management, reporting and analysis, dispute management, and communication standards.

These six elements, alongside the various challenges to implementing collateral management systems, are discussed in further detail in a Sapient Global Markets white paper, available to download here.

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Does Risk Come Mostly From Volatility, or From Correlations?

By Damian Handzy, Investor Analytics
Originally published on Quant Forum

When it comes to risk attribution, most people look at the contributions made by different asset classes, sectors or investment strategies. But very few look to assign attribution to volatility and correlation.

When it comes to risk attribution, most people look at the contributions made by different asset classes, sectors or investment strategies. Some look at factors such as momentum or size. But very few look to assign attribution to two of the very inputs into most Value-at-Risk calculations: volatility and correlation.

Part of the reason is that the various approaches to calculating VaR don’t lend themselves to isolating these two parts very easily. But a closely related quantity – the square of the VaR number – can indeed be separated into two additive parts: one purely dependent on volatility and the other on correlations.

Investor Analytics’ white paper on this topic, “The Russo Ratio: Decoupling Volatility and Correlation” (which can be downloaded here), introduces three new analytics: CCR – the Correlation Contribution to Risk; VCR – the Volatility Contribution to Risk; and the Russo Ratio – CCR/VCR, which provides a compact way of understanding how much diversification benefit is inherent in the portfolio. The paper explains these measures and analyzes three different portfolios using these new measures to show the effects of low and high diversification.

The Volatility Contribution to Risk is always a positive number, since volatility always increases a portfolio’s risk. The Correlation Contribution to Risk can be either positive or negative, reflecting the potential lowering of risk through diversification. As a percent of total, it is therefore possible to have more than 100% coming from volatility, with a negative percent coming from correlation. For example, in the white paper we show periods of time in early 2005 when an asset-class diverse portfolio showed 110% risk from volatility with -10% risk from correlations. For a given portfolio, we show that the Russo Ratio of CCR/VCR is remarkably stable over time.

This Russo Ratio has a lower limit of -1, reflecting perfect hedging in which the correlations reduce the volatility risk perfectly. Values between -1 and zero represent partial hedging situations in which the correlations partially reduce the risk. Values near zero imply that the correlations don’t reduce or contribute to risk – that all the portfolio’s risk comes from volatility. While the Russo Ratio has no theoretical upper bound, values above 1 indicate that correlations contribute the bulk of a portfolio’s risk.

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We received a number of interesting comments about the paper. While almost everyone had never seen such a decoupling of volatility and correlation, one correspondent indicated that he had implemented something very similar about 10 years ago while managing risk for a prominent hedge fund.

Several managers shared the view that CCR, VCR and the Russo Ratio are most useful when viewed over time to gain both familiarity with the values and to quickly identify outliers. In addition, one correspondent indicated that this is a new way of looking at risk information that can have an advantage in certain situations.

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An Inside Peek at Volcker Rule Enforcement

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

The OCC’s recently published Volcker Rule examiners’ manual offers a look at how regulators are going to approach the rule’s enforcement. It looks like we should expect a good deal of confusion, and possibly some contention.

After the final version of the Volcker Rule was published in December and banks began to prepare for the July 15, 2015, effective date, the only remaining question was how it would be enforced. That enforcement is up to the examiners of the various agencies. Recently, the Office of the Comptroller of the Currency (OCC) published a 26-page Volcker Rule examiners’ manual, which may be an inside peek into how the regulators are going to approach enforcement.

The Objectives

Here are some of the objectives it sets for examiners:

  • Assess the bank’s progress toward identifying the [banks] that engage in activities subject to the regulations.
  • Assess the bank’s progress toward identifying its proprietary trading. 
    • The bank must identify purchases and sales of financial instruments for specified short-term purposes.
    • The bank must identify the trading desks (the smallest discrete unit of organization) responsible for the short-term trading identified above. Trading desks may span multiple legal entities or geographic locations.
    • For each trading desk, the bank must determine on which permitted activities the desk will rely to conduct its proprietary trading.
  • Assess the bank’s progress toward identifying its ownership interests in covered funds.
  • Assess the bank’s progress toward identifying the covered funds that the bank sponsors or advises.
  • Assess the bank’s progress toward identifying its ownership interests in and sponsorships of entities that rely on one of the regulations’ exclusions from the definition of covered fund.
  • Assess the bank’s progress toward establishing a compliance program.
  • Assess the bank’s plan for avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies.

Given the newness of the Volcker Rule, it is perhaps indicative that these objectives discuss a bank’s progress and plans, instead of its conformance. However, we should expect the instructions to move pretty quickly to assessing the bank’s conformance.

Specific Instructions

Within the document, there are some specific instructions that are both pertinent and perhaps informative of the general approach. For example (these are only a small fraction of what the manual requires):

  • Under a section entitled, Assess the bank’s progress toward reporting metrics as and when required, we see:Some banks may combine previously delineated trading desks into a single trading desk.
    • Multiple units with disparate strategies being combined into a single desk, however, could suggest a bank’s attempt to dilute the ability of the metrics to monitor proprietary trading. Relevant factors for identifying trading desks include whether the trading desk is managed and operated as an individual unit and whether the profit and loss of employees engaged in a particular activity is attributed at that level.
  • Under Assess the bank’s ability to calculate the required metrics we see:
    • This metric requires the bank to “tag” each trade as customer-facing or not. Inter-dealer trading typically does not count as customer-facing because a [bank] with trading assets and liabilities of $50 billion or more is not a customer unless the bank documents why it is appropriate to treat the counterparty as a customer. Trading conducted anonymously on an anonymous exchange or similar trading facility open to a broad range of market participants is customer-facing regardless of the counterparty.
    • For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values.
    • For comprehensive profit and loss (P&L) attribution, determine whether bank systems can segregate P&L into the required three categories:
    • Determine whether the bank’s systems can report risk sensitivities on a sufficiently granular basis to account for a preponderance of the expected price variation in the trading desk’s holdings.
  • Assess the bank’s progress toward using the metrics to monitor for impermissible proprietary trading.
    • Determine whether the bank consistently applies, across its trading desks, methodologies for calculating sensitivities to a common factor shared by multiple trading desks (e.g., an equity price factor) so that these sensitivities can be compared across trading desks.
  • Assess the bank’s policy for reviewing activities and positions whose metrics indicate a heightened risk of impermissible proprietary trading.
  • Assess the bank’s progress toward identifying its market-making-related activities, market-maker inventory, and reasonably expected near-term demand (RENTD).
    • Assess the bank’s progress toward developing a process for measuring and documenting RENTD for each market-making desk.
    • Demonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks of or associated with financial instruments in which the trading desk makes a market, including through block trades.
  • Assess the bank’s progress toward establishing and implementing an internal compliance program.
  • Assess the bank’s progress toward developing procedures and controls to continuously review, monitor, and manage risk-mitigating hedging activity to ensure that the bank meets the requirements of the risk-mitigating hedging exemption. Note that under the regulations the risk-mitigating hedging activity cannot be designed to:
    • reduce risks associated with – the bank’s assets or liabilities generally.
    • general market movements or broad economic conditions.
    • profit in the case of a general economic downturn.
    • counterbalance revenue declines generally.
    • arbitrage market imbalances unrelated to the risks resulting from the positions lawfully held by the bank.
  • Assess the bank’s progress toward developing systems and processes to create and retain the hedging documentation for at least five years and in a manner that allows the bank to produce promptly those records to the OCC.

There is much more in the manual than we have listed here, of course. But these excerpts can give us some insights into how the regulators are approaching the VR. For example:

  • The regulators are aware of the opportunity, and perhaps desire, to obfuscate compliance with the rules. Several places in the instructions warn examiners to make sure that efforts are “meaningful,” particularly around the metrics.
  • In most of the more difficult areas of the metrics – for example, the inventory aging and turnover categories – the instructions appear to offer no additional help. On the question of how to apply inventory aging and turnover, the instructions simply say:
    For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values. (For options, value means delta-adjusted notional value; for other interest rate derivatives, value means 10-year bond equivalent value).
    There is nothing about what to do if a bank opened a position, or opened and closed the position on the same day, which would result in a turnover ratio of ∞. Either the regulators haven’t identified these problems yet or don’t yet have an answer.
  • The instructions don’t give any guidance on how examiners are to determine that a bank stands ready to buy or sell those instruments that trade infrequently or are new to the market. Here, again, the regulators may not have identified the uncertainty, or may not have an answer.

Overall, the instructions mostly parrot the rule itself, without clarifying many of the complexities and uncertainties around enforcement. If this is an indication of the preparations examiners will get for their very difficult tasks, we should expect a good deal of confusion, and possibly some contention. Thus it behooves banks to start a dialog now with their assigned examiners about how they will apply these instructions and what the results will be.

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4 Steps to Volcker Compliance: A Bank’s Guide to Regulatory Change

By John Sampson and Michael Barnes, Ernst & Young
Originally published on TABB Forum

Volcker Rule compliance requires a thorough inventory of funds and entities with specific explanations as to why they are or are not covered funds under Volcker. But banks that install a precise compliance program should be able to operate efficiently in the new environment. Here are 4 steps to Volcker compliance and 9 tips to consider along the way.

On Dec. 10, 2013, banks awoke to the release of the final Volcker Rule — impacting how they operate, the investments that they make and the services that they provide. Banks no longer have the freedom to organize and provide services once permitted during the days of the Gramm-Leach-Bliley Act. Instead, they’ve been prescribed a dose of stringent regulation, significantly changing the world in which they can operate by impacting their abilities to own and to provide services to funds and other subsidiaries. Fortunately, a well-designed, thoughtfully implemented Volcker-compliant program will allow banks to manage their funds successfully in the new landscape.


The Volcker Rule restricts both banks’ ownership in funds and their ability to enter into transactions with funds. Banks with more than US$10 billion in consolidated assets must have a detailed fund compliance plan in place by July 22, 2015. In the interim, banks must have a conformance period plan that addresses the required actions that need to occur between now and July 22, 2015, to ensure they’re compliant with the Volcker Rule. Banks can apply to the Federal Reserve to extend the conformance period for illiquid funds.


Ownership interest

The Volcker Rule significantly restricts banks from owning hedge funds or private equity funds — which necessitates clarity related to the definition of ownership of hedge funds and private equity funds. Unfortunately, the Volcker Rule is complex and requires detailed analysis. The Volcker Rule constructs a complex, layered approach for banks to define ownership and prohibited funds. There are eight ownership characteristics that attempt to capture the “economic sense” of ownership by mainly focusing on participation in the potential upside and economic downside of the entity. These characteristics maintain a logic sequence that captures ownership.

The definition of funds would be relatively straightforward except for the Volcker Rule’s 14 distinct exceptions. While these traps are at times exasperating, they can also represent important avenues for reducing the Volcker Rule’s impact. A bank’s Volcker Rule funds’ compliance program must analyze its entities using these traps to determine the Volcker Rule’s applicability.


The Volcker Rule limits a bank’s ability to provide services to covered funds through Sections 23A and 23B of the Federal Reserve Act, which are written to limit a bank’s transactions with affiliates and to ensure arm’s-length pricing on transactions between the bank and its affiliates. Under the Volcker Rule, a bank can only provide certain “prime brokerage” services to “sponsored-covered” funds in which another bank-covered fund has made an investment. This new restriction is colloquially referred to as the “Super 23A” restriction and will present new obstacles to banks that provide prime brokerage, administration or custodial services to funds that they also manage.

Compliance program

The Volcker Rule has specific compliance program requirements, and it requires the individual business managers to take responsibility for compliance. The Volcker Rule compliance program requires a thorough inventory of funds and entities with specific explanations as to why they are or are not covered funds under Volcker. There must be specific procedures and controls regarding the monitoring of entity ownership interest, disposition plans, transactions with covered funds and remediation in the event of a Volcker violation. Finally, the chief executive officer (CEO) must annually attest that the bank has a reasonably designed compliance program to comply with the Volcker Rule for banks with more than US$50 billion in consolidated assets.

The Compliance Path

Compliance with the Volcker Rule for covered funds can be initiated through the following four distinct steps:

  • Step 1: Banks need to survey their entities and the services that they provide them.
  • Step 2: Banks need to categorize entities and services as permissible under the Volcker Rule, or as impermissible, thus necessitating changes to become permissible.
  • Step 3: Banks need to conform existing entities to the Volcker Rule by disposing of, or transforming, the entities and/or services.
  • Step 4: Banks need to implement a Volcker Rule compliance program to ensure that entities and services comply with the Volcker Rule going forward.


The goal of surveying is threefold. Banks need a complete inventory of all funds, entities and activities that the Volcker Rule could cover. The second goal is to identify which funds or entities the bank owns under the Volcker Rule and which transactions are entered into with those funds and entities. The final goal is to collect sufficient information to determine if the identified entities and activities are covered funds or transactions under the Volcker Rule, or qualify for an exemption.

Generally, Volcker Rule-covered funds are bank entities that would require registration under the Investment Company Act of 1940 (40 Act), if they were offered in the US, except for the exemptions provided by Sections 3(c)(1) and 3(c)(7). In addition to hedge and private equity funds, banks used these exemptions to establish a joint venture, acquisition, securitization and countless other entities in order to avoid 40 Act registrations. Until the Volcker Rule, there was little consequence of 3(c)(1) or 3(c)(7) categorization. As a result, banks may have difficulty in ascertaining exactly which entities are 3(c)(1) and 3(c)(7), and why the entities are qualified for those exemptions. Banks must ask themselves if that’s the right exemption to use, or if it was the most expedient. This assessment could be an overwhelming task, but must be performed or the banks risk divesting permissible assets.

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Figure 1: Survey Characteristics

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The flowchart above illustrates the start of the decision process. The Volcker Rule considers an entity “guilty until proven innocent,” so each step of the process requires careful consideration and documentation.

Compounding the surveying problem is the Volcker Rule’s broad definition of ownership interest, which includes investing in certain debt securities. Under the Volcker Rule, an ownership interest either:

  • Has an equity or ownership interest.
  • Has the right to remove the entity’s management or investment adviser.
  • Has the right to receive a share of income from the entity.
  • Has the right to receive the underlying assets after other investors have been redeemed.
  • Has the right to receive the excess spread between the payments on the entity’s underlying assets and the amounts due to investors.
  • Provides that the interest payable by the entity could be reduced based upon losses in the underlying assets.
  • Receives interest in a pass-through basis or determined by the performance of the underlying asset.
  • Represents a synthetic right to receive any of the above.

The Volcker Rule ownership definition includes investing in structured debt securities. Identifying covered funds poses issues because of the different exemptions. Conceptually, banks should easily identify 3(c)(1) and 3(c)(7), but the final Volcker Rule contains at least 14 different exemptions, including:

  • Would be able to use another exemption from the 40 Act registration, such as (3(c)(5) or Securities and Exchange Commission (SEC) Rule 3a-1.
  • Is a foreign public fund (retail undertakings for collective investments in transferable securities [UCITS]).
  • Is a joint venture.
  • Is a wholly owned subsidiary.
  • Is an acquisition vehicle.
  • Is a foreign pension or investment company.
  • Is a vehicle established to hold bank-owned life insurance.
  • Is a loan securitization.
  • Is a qualifying asset-backed commercial paper conduit.
  • Is a qualifying covered bond.
  • Is a small business investment company (SBIC) or public welfare fund.
  • Is a registered investment company.
  • Is the entity of a separate account at an insurance company.
  • Is an issuer in relation to a Federal Deposit Insurance Corporation (FDIC) receivership.

As one can see, these exceptions to the Volcker Rule contain considerable conditions.

These exemptions are powerful, as they allow many in-the-course-of-ordinary-business entities, such as equipment-leasing vehicles, to avoid capture under the Volcker Rule. The downside is that a bank needs a robust survey when it begins to examine its Volcker Rule entities and activities.


Banks can use the survey results to categorize their entities and activities under the Volcker Rule. The Volcker Rule will clearly affect some entities and activities, such as true hedge funds and private equity funds. The Volcker Rule will leave other entities and activities unscathed, such as registered investment companies. The most difficult category is when there are multiple possible Volcker Rule categories for a single fund. This category requires extensive analysis and thought about how to re-categorize entities and activities to maximize the strategic value to the bank and its balance sheet.


Conformance requires taking existing prohibited entities and activities and bringing them into conformance with the Volcker Rule. The options are to dispose or to transform. Many banks probably will reduce the size of their hedge fund and private equity investments due to the conflicts between retaining the incentive and management fees and the limits on the 3% investment amount.

Transformation requires creative thinking. Despite its draconian consequences, the Volcker Rule’s exemptions, its treatment of foreign banks, a captive insurance company’s ability to own covered funds, and the continuance of the merchant banking exemption provide opportunities to re-categorize entities and activities in order to conform to the Volcker Rule. Time spent reviewing the survey results and the Volcker Rule will be time well spent.

Conformance is the toughest step in this plan. Entities and activities will need to be terminated and/or restructured, which could result in the uprooting of people and operations. The Volcker Rule will alter flexibility in future operations. The decisions around Volcker Rule entities and activities are difficult and carry far-reaching consequences.

Compliance Program

The conformance period deals with how banks will become fund compliant with the Volcker Rule by July, 22, 2015. Banks must consider how they will operate in this new regulatory world going forward, knowing that future Volcker Rule compliance requires a robust program. Business managers are the first line of defense, but the compliance program touches risk, accounting, legal and compliance, before finally arriving at the CEO and the board. The Volcker Rule requires strict compliance going forward.

Figure 2: Volcker Rule compliance program

tabb 6 17 14 3

The Volcker Rule requires meticulous documentation. Banks need to maintain an inventory of entities and transactions and their Volcker Rule status. The Volcker Rule presumes transactions and entities are impermissible unless proven otherwise.

Volcker Rule funds’ compliance involves all areas of a bank. The first line of defense is the business managers who own the compliance responsibilities. The Volcker Rule emphasizes this responsibility by requiring CEO certification in large banks. The second line of defense is the business support functions – e.g., compliance, finance and accounting – which oversee the compliance programs and ensure that managers follow required procedures. The third line of defense is internal audit that periodically, and at least annually, reviews and tests the effectiveness of the Volcker Rule compliance program. All of this is overseen by the board of directors, who manage Volcker Rule compliance and ensure that the bank allocates sufficient resources to Volcker Rule compliance. The Volcker Rule sets out extremely prescriptive compliance procedures so that a risky venture won’t slip through the process.

There is life in Volcker Rule fund compliance dystopia. Banks that read the Volcker Rule carefully and install a precise, thoughtful compliance program should be able to operate efficiently in the new environment. Nonetheless, as management explores the Volcker Rule in depth, it should remember the following nine considerations:

  1. You are not alone. Private equity and venture technology partnerships may have to be converted into direct investments. Joint ventures may have to limit the number of investors contractually. All banks and investment managers that have banks as their investors in hedge and private equity funds face Volcker Rule issues. Addressing these issues will require flexibility and ingenuity. Investment managers, which are already under pressure to increase asset size, should be willing to examine alternative structures in order to retain investments.
  2. Show that you get it. Regulators want to see that the regulated respect the regulations. Those institutions that install a thorough Volcker Rule compliance program will influence events as they move forward. Those that don’t will be negatively impacted.
  3. Lead from the top. Volcker Rule compliance is a tough task which will require difficult firm-wide and personnel decisions. If the CEO and the board lead and get involved, the company will follow. Volcker Rule compliance will be quicker and cheaper for banks than if Volcker Rule compliance is another regulatory chore imposed by the regulators.
  4. Interact with the regulators. The Volcker Rule represents the collective ideas of Governors of the Federal Reserve, Office of the Comptroller of the Currency, FDIC, the SEC and the Commodity Futures Trading Commission. The five agencies may have a difficult time making decisions as they seek to avoid regulatory arbitrage. Nonetheless, the more interactions that management has with its regulators, the more the regulators will appreciate the efforts that bank management is making, and subsequent decisions will be easier.
  5. Embrace change. You can be certain that just as you near a point of comfort with your Volcker Rule funds project, someone will raise another costly, frustrating point. Volcker compliance will be a long, expensive, challenging process. Don’t get discouraged.
  6. Leverage existing efforts. As a consequence of regulatory efforts such as Form ADV, Form PF, Form CPO-PQR and the Alternative Investment Fund Managers Directive, banks have collected much information that is directly transferable to the Volcker Rule. In the early stages of the Volcker Rule effort, it is important to identify and leverage this work.
  7. Talk with your peers. The Volcker Rule is uncharted territory. All banks are in the same position and facing the same challenges. Frequent discussions with peer institutions will shed light on emerging best practices, or address an issue and find a solution.
  8. Consult wisely and often. The Volcker Rule is an interesting mix of legal and operational issues. Banks that seek advice often from the proper places will have a better chance of succeeding.
  9. In uncertainty there may be prosperity. Volcker Rule compliance will necessitate the sale and restructuring of funds and the transfer of activities to third parties. As these events unfold, banks that get in front of them will have opportunities to facilitate these transactions. Banks can use their own Volcker Rule experiences to help others, particularly private equity and hedge fund managers looking for new investors, and asset-backed securities issuers looking to initiate additional transactions.

The state of uncertainty is never a pleasant place to be. The key to getting out of it is individual proactive efforts that make the situation better. If banks lead the initiative in framing the actuality of Volcker Rule fund compliance, they can better control the outcome.

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ESMA Wants to Hear From You

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

The European Securities and Markets Authority laid out its views on the future of the European markets in two papers totaling more than 800 pages. But the regulator has more questions than answers. Here are some of the key points on critical derivatives issues, including safeguarding client assets, best execution, and sponsored access.

On May 22, ESMA published two documents, totaling more than 800 pages, on the next steps in the MiFID journey. One is the Consultation Paper on MiFID/MiFIR Technical Advice; the other is a Discussion Paper on MiFID/MiFIR draft RTS/ITS. Together, they lay out ESMA’s views on the future of markets in Europe, so they are pretty much required summer reading. In addition, ESMA specifically solicits comments on the both papers by Aug. 1. That deadline has already caused some public comment.

According to the introduction, the discussion paper “seeks stakeholders’ views on key elements of future ESMA technical standards. On the basis of responses and feedback received, ESMA will prepare a subsequent Consultation Paper that will include the draft technical standards for submission to the Commission.” Meanwhile, the purpose of the consultation paper is “to consult interested parties for the purpose of producing its technical advice to the Commission.” Perhaps the regulator could have served both purposes in one document, but it chose to issue two.

Given my particular interest in derivatives reform, I’ll be concentrating on that aspect of the two documents. There is, however, much more to them, including subjects such as HFT, research conflicts of interest and something ESMA calls microstructure. But let’s dig into the derivatives aspects of these documents.

Safeguarding Client Assets

In light of the recent collapse of two clearing firms in the US, we can start with the consultation paper’s section on safeguarding of client assets (p.52). According to the paper:

“ESMA proposes introducing additional requirements in respect of both client instruments and client funds. ESMA is proposing that firms should have proper and specific governance in place to ensure the safeguarding of client assets. More specifically, ESMA proposes addressing concerns around inappropriate lending of, and liens over client assets; and restricting any inappropriate activity in this area; increasing disclosure to clients; and addressing, through diversification, the contagion risk to client funds that occurs when held exclusively in group banks.”

One area of concentration is title transfer collateral arrangements (TTCA), which is the ESMA language for rehypothecation. It says:

“In order to mitigate the risk of blanket use of TTCA that amounts to bypassing the safeguarding requirements required by MiFID II, one measure could be to require investment firms to consider and to be able to demonstrate the appropriateness of any TTCA …; they should not be able to rely on TTCA as a means of bypassing MiFID safeguarding requirements. Under such a measure, firms may still make use of TTCA, provided that they have considered and are able to demonstrate the appropriateness of TTCA.” 

Thus it looks like ESMA may be contemplating a more active role in administering the segregation of client assets, much like the CFTC has done. (By the way, safeguarding customer assets was also a major subject of discussion in the recent meeting of the CFTC’s Global Markets Advisory Committee.)

Best Execution

The consultation document has an entire section on best execution, starting with the MiFID II blanket statement:

“Member States shall require that investment firms take all sufficient steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order.”(p.150)  

That statement either assumes that every transaction is being done as agent, or it requires that principal transactions be done at the “best possible result” for the customer. If the latter, that will be a significant change in the markets, assuming one could determine the “best possible result” for the customer at any point in time.

In its discussion, the consultation document says:

“Adequate disclosure of appropriate information, both prior to the provision of services and on request by a client, is a key element of the best execution obligation. … This principle applies equally to firms that execute orders directly and to those that receive and transmit or place orders for execution by another entity.”

So this looks somewhat similar to the notorious midmark requirement in the CFTC’s external business conduct rule. In addition, ESMA appears to be planning to require disclosure of “third party payments” – i.e., rebates from trading venues to executing brokers.

Exchange Trading for Derivatives

The discussion paper is much more specific about derivatives than the consultation document; for example, in the section on “The Trading Obligation for Derivatives” (p.185). In describing the process of mandating exchange trading for swap classes, the document says:

“The trading obligation process will not require the generation of general technical standards. Instead, ESMA will mostly respond to decisions taken under the clearing obligation. In effect, ESMA will have gained a new, long term task to be conducted on a routine basis.”

The process of requiring exchange trading of derivatives is set out in Section 32 of MiFIR, and the discussion document specifies that:

“Whether or not a class (or sub-class) of derivatives should be made subject to the trading obligation will be determined by two main factors:

  • The Venue Test. Whether a class or sub-class is admitted to trading on a venue. 
  • The Liquidity Test. Whether they are also ‘sufficiently liquid’ and there is sufficient third party buying and selling interest (in ESMA’s view, any ‘sufficiently liquid’ class or sub-class will also have sufficient third party buying and selling interest, and this would be taken into account as part of any liquidity assessment). 

“This means that before being considered for the trading obligation, any class (or sub-class) must not only be subject to the clearing obligation but must be traded on at least one trading venue and be considered sufficiently liquid to trade only ‘on venue.’ ”

Perhaps the most relevant implication of this section is the possibility that the trading obligation criteria may be different between the US and the EU. In particular, will the US liquidity test be more or less stringent that the EU one? And if they are, and it results in a product being MAT in the US but not obligated in the EU (or vice versa), is the same arrangement as in clearing (strictest rule applies) in effect here? Do you want to comment on that?

Direct/Sponsored Market Access

The consultation paper has a section on direct electronic access (DEA), which appears to be equivalent to sponsored access in the US (p.235). MiFID II defines DEA as an “arrangement where a member or participant or client of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue.” Although DEA may not be much of an issue currently, it is likely to become one as listed trading of swaps expands and matures. In particular, as we see the CFTC’s rule on recordkeeping by exchange members evolving, SEF membership may not be attractive for large end users, as many have already said.

Here ESMA provides more questions than answers in the document. Such as:

“Given that [automated order routing] AOR arrangements and DEA might pose the same risks to the markets ESMA requests the views of market participants on whether it would be appropriate to consider AOR as falling within the DEA definition.

“Additionally, ESMA requests the views of market participants about how to further clarify the definition of DEA (and as a consequence, those of DMA and SA) to capture all types of arrangements that might meet this definition.

“ESMA is interested to know the views of market participants on whether it may be possible to use [electronic order transmission] interfaces to perform algorithmic or high frequency trading strategies.”

So ESMA has lots of questions, and most of them are substantive. Anyone who trades, or plans to trade, in EU markets needs to read and respond. So pour a fresh cup of coffee, find a comfy chair, and get to it.

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CFTC Commissioner O’Malia Focuses on Swap Execution Facilities at 12th Technology Advisory Committee

The CFTC is training its sights on increasing buy-side participation on swap execution facilities (SEFs), according to remarks made Tuesday by CFTC Commissioner Scott O’Malia. At the 12th Meeting of the Technology Advisory Committee (TAC), Commissioner O’Malia underscored the importance of testing the impact of the CFTC’s SEF rules, and encouraged TAC members who operate SEFs to share their experiences.

“I would like to know whether the Commission’s rules have created a barrier to trading on SEFs and are forcing market participants to turn to alternative execution solutions,” O’Malia stated at the gathering.

O’Malia called upon Tod Skarecky of Clarus Financial Technology to provide an overview of SEF trading to help the Commission identify the recent developments in trading, as well as Wendy Yun, Managing Director, Goldman Sachs Asset Management and Michael O’Brien, Director of Global Trading, Eaton Vance, to provide the buy-side perspective.

To read O’Malia’s complete remarks, click here.

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Danger Ahead: Cross-Border Swaps Rules Further Fracture Market

By Sol Steinberg, OTC Partners
Originally published on TABB Forum

Even as the CFTC moves to finalize rules governing foreign-based swap clearinghouses and swap execution facilities, the harmonization of global swaps regulations remains a challenge, threatening to further fragment the trading process.

With more than 50% of global swaps transactions occurring across borders, harmonizing international rules has been a point of contention throughout the overhaul of the global financial framework. Last week, the Global Markets Advisory Committee (GMAC) of the Commodity Futures Trading Commission (CFTC) met to discuss international regulatory requirements. The two-part meeting focused on issues related to the regulatory treatment of foreign-based swap clearinghouses and swap execution facilities (SEFs). However, it seemed more like a game of tit-for-tat, as U.S officials and their foreign counterparts took turns criticizing each other for not doing enough to facilitate cross-border swaps clearing and trading by harmonizing standards.

Foreign-Based Swap Clearinghouses

Regarding foreign-based swap clearinghouses, the CFTC has almost completed a proposal that would exempt foreign designated clearing organizations (DCOs) from compliance with CFTC requirements, provided the DCOs in question are subject to comparable and comprehensive regulation and supervision in their home jurisdictions. Exemptions would be based on a DCO’s ability to meet the international standards spelled out in the CPSS-IOSCO Principles for Financial Market Infrastructures.

However, officials from Europe and Japan were quick to point out that there are important differences between international swaps clearing rules that could preclude DCOs from meeting the “comparable and comprehensive regulation and supervision” criteria. Consequently, they urged the CFTC to evaluate the various regulatory regimes based on the intended outcomes of the rules, not the actual details. They also implored the Commission to consider granting jurisdictional exemptions rather than individual ones.

That argument lost a bit of its impact when U.S. panelists, including CFTC Commissioner Scott O’Malia, pointed out that the EU does not appear to be making a sufficient effort to grant similar authorizations to non-EU clearinghouses, which must demonstrate equivalence with EU clearing rules by Dec. 15, 2014. In fact, non-European firms are already suffering competitively due to the threat of potential, significant economic disincentives that would go into effect in less than seven months.

The other important issue raised by market participants on both sides of the Atlantic is that DCOs exempted under the CFTC’s proposal would only be permitted to provide clearing services to U.S. persons or institutions. They could not, however, provide clearing services to the customers of those institutions. According to critics, such a stipulation runs counter to the Commission’s calls for reciprocity between regulatory regimes and would violate the principle of fair and open access contemplated by CPSS-IOSCO.

In its defense, the CFTC said the rule is necessary to ensure that U.S. citizens are protected under U.S. bankruptcy law. Additionally, other proponents argued that the limitation would prevent large portions of the U.S. dollar-denominated swap and foreign exchange markets from moving beyond the oversight of U.S. regulatory authorities.

Even with the exemptions, qualifying DCOs would still be required to file a variety of daily, monthly and event-specific reports with the CFTC, highlighting everything from initial and variation margin on deposit for U.S. clients, to U.S. person aggregate clearing volume and average open interest, to U.S. clearing members, to changes in licenses or home country regulatory requirements, to disciplinary actions, to defaults by futures commission merchants (FCMs).

Swap Execution Facilities

While the CFTC’s proposal for foreign-based swap clearinghouses is almost complete, much more needs to be done in the area of swap execution facilities. In the U.S., all swaps trading is conducted via SEF; however, at present there are no comparable foreign trading platforms for swaps that even can be assessed for equivalence. This has caused substantial fragmentation of the market, with participants tending to trade only on local venues. It also precludes any possibility of a mutual recognition approach.

As an interim step, the CFTC is offering temporary relief for multilateral trading facilities (MTFs) during the transition to the new regulatory regime established under the Markets in Financial Instruments Directive. However, none have yet requested such relief, so this step is widely considered a failure.

Making matters worse, there is no long-term solution to this problem. According to CFTC officials, the Commission is working on a more permanent solution; however, at this point it is only being described as a “term sheet.” Although there were no details, foreign officials suggested that differences in market practices necessitate an exemption approach for foreign trading venues like the one being proposed for foreign-based swaps clearinghouses.

The lack of a long-term solution sets up a dangerous situation. It only perpetuates further fragmentation of the trading process, which sets the stage for even more disastrous outcomes during market crises. Moreover, it has aroused concern that some swap dealers may be removing parent company guarantees on foreign affiliates so that they can trade through those affiliates without exposing themselves to CFTC authority.

Despite the gravity of the situation and repeated requests that it move more quickly to address the problem, the Commission said it would likely continue relying on an interim solution, rather than finalizing a long-term trading venue exemption. It also vowed to look into any questionable practices regarding parent company guarantees.

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