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You’re Not Ready for MAR? Are You MAD?

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

Although a lot of time and money have been spent on getting ready for MiFID II, there is another regulation out there that is actually more dangerous: the E.U.’s Market Abuse Regulation, or MAR. Along with its sibling, the Market Abuse Directive, or MAD, they pose a double threat to market participants worldwide.

Although a lot of ink has been spilled, and a lot of money spent, on getting ready for MiFID II, there is another regulation out there that is actually more dangerous: the E.U.’s Market Abuse Regulation, or MAR. Along with its sibling, the Market Abuse Directive, or MAD, they pose a double threat to market participants worldwide.

The first threat has to do with timing. Although MiFID II is currently scheduled to go into effect in January 2017, and there has been lots of discussion about a one-year delay, MAR/MAD is scheduled for July 2016, and there has been no indication of a delay in it. Thus, it behooves every market participant to understand these regulations, their applicability and how to comply.

The second threat has to do with applicability. MAR says that it applies to any instrument traded on an E.U. venue, any instrument where the underlying trades on an E.U. venue, or any benchmark based on instruments traded on an E.U. venue. Importantly, it purports to apply to any market participant who trades these or who executes orders in them, no matter where the trade was done.

What the Rules Say

MAR/MAD covers two main subjects: insider trading and market manipulation. Let’s look at insider trading first.

Insider trading is covered in Chapter 2 of MAR and Article 3 of MAD. They define insider trading as: “where a person possesses inside information and uses that information by acquiring or disposing of, for its own account or for the account of a third party, directly or indirectly, financial instruments to which that information relates. The use of inside information by cancelling or amending an order” is also culpable. That last sentence is very important because it is distinctly different from the SEC’s approach, contained in Rule 10b-5. Rule 10b-5 says that trading on what it calls material non-public information is culpable, although CFTC Rule 180 prohibits attempts to manipulate, and MAR/MAD says that even attempting to trade on it is a violation.

MAD says: “that insider dealing, recommending or inducing another person to engage in insider dealing … , constitute criminal offences at least in serious cases and when committed intentionally.” Article 4 of MAR says that the monitoring and reporting obligation applies to “investment firms,” but doesn’t mention third-country firms as defined in MiFID II. Finally, MAR/MAD makes it clear that brokers who execute orders for customers, but don’t trade as principal, are responsible for monitoring customer order flow for suspicious activity.

Market manipulation is covered in Article 12 of MAR and Article 5 of MAD. MAR defines manipulation as “entering into a transaction, placing an order to trade or any other behaviour which:

  • “gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of, a financial instrument, a related spot commodity contract or an auctioned product based on emission allowances; or

  • “secures, or is likely to secure, the price of one or several financial instruments, a related spot commodity contract or an auctioned product based on emission allowances at an abnormal or artificial level;

  • “unless … such transaction, order or behaviour ha[s] been carried out for legitimate reasons, and conform with an accepted market practice.”

That’s not all it has to say, however. It also lists “any other activity or behavior, … which employs a fictitious device or any other form of deception or contrivance,” and “providing false or misleading inputs in relation to a benchmark.”

MAD has much the same definition, so at least there is some consistency there. It does call out that, “Member States shall take the necessary measures to ensure that the attempt to commit any of the offences referred to in Article 3(2) to (5) and (7) and Article 5 is punishable as a criminal offence.” So the E.U. regulators are pretty clear that unsuccessful attempts to manipulate the markets are as bad as successful ones. This raises one question, however, since the logic of enforcement has relied on the concept of damage to other market participants: If attempts to manipulate are unsuccessful, one wonders how the regulators will demonstrate damage.

Implications

The first implication is that, as with MiFID and Dodd-Frank, global market participants are facing different, and possibly competing, regulations from different regulators. For example, U.S. persons transacting in E.U. instruments will be subject to MAR/MAD, while E.U. persons transacting in U.S. instruments will be subject to SEC or CFTC rules. This is particularly important with insider trading because a recent decision by the U.S. Second Circuit Court of Appeals eliminated insider trading culpability if the tippee (the trader) did not know that the tipper (the insider) was gaining financially from the information. Since no such ruling has been made in the E.U., it is reasonable to conclude that comparable surveillance practices in the U.S. and E.U. will not necessarily turn up comparable infractions, even for identical activities.

The second implication is that surveillance systems need specific patterns and metrics in order to issue alerts, and no such metrics are contained in any of the rules or the accompanying Regulatory Technical Standards (RTSs) issued by ESMA. The RTSs, which are about five times as long as MAR and MAD combined, spend a lot of time talking about allowed procedures such as buy-backs, stabilizations and market soundings, but no time addressing metrics. In fact, all the documents tend to define manipulative behaviors in terms of intent, as opposed to results. That will very likely lead to two possible outcomes: 1) excessive false positives, or 2) a lot of missed manipulations.

A third implication is that the reporting formats are different between the U.S. suspicious activity report (SAR) and the E.U. suspicious trade or order report (STOR). A field-by-field analysis shows a significant number of fields in the STOR that aren’t in a SAR. For example: the name and position of the reporting person, the relationship of the reporter to the subject, the reasons for the suspicion, and the acting capacity of the reporting entity with respect to the subject.

Impacts

For U.S. market participants there are three major impacts of MAR/MAD: surveilling unexecuted orders, preparing STORs, and reconciling U.S. and E.U. approaches to insider trading.

Since Rule 10b-5 only applies to executed trades, complying with MAR/MAD will require introducing surveillance of unexecuted orders. To begin with, many trading systems either don’t keep unexecuted orders, or purge them after a short period. The same applies to dealer and multi-party networks. To the extent that those systems handle E.U. instruments and the parties are subject to MAR/MAD, order records will have to be retained and monitored.

Those systems that prepare and submit SARs in the U.S. will have to be updated to create and submit STORs. That will mean determining whether the systems even capture the extra data elements identified above, and then the STOR messages will have to be formatted and sent to the appropriate regulator.

Finally, any monitoring and reporting system will need different logic for reporting suspected insider trading in the U.S. and the E.U. Since reporting any suspicious behavior on the part of a client carries significant risk to the relationship, investment firms will be walking a tightrope in either domicile.

Hanging over all of these uncertainties is the biggest one – the fact that there are no metrics provided for determining when an activity is suspicious. As a result, firms will be left to grope their way down a dark corridor, trying to find a happy medium between over-reporting and missing an obvious event. Given the threat in MAR of being held criminally liable, it is no wonder that the prospect of implementing these rules by mid-July has left many firms not only unhappy, but downright angry.

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Financial Transaction Tax: Oversimplifying Complex Market Issues

By Kenneth J. Burke
Originally published on TABB Forum

In a recent editorial, the New York Times editorial board claims high-frequency trading hurts ordinary investors and market stability, adding that, ‘A well-designed financial transaction tax … would be a progressive way to raise substantial revenue without damaging the markets.’ But an FTT is too simplistic a proposal to deal with the markets’ much more complex issues.

A recent New York Times editorial by the paper’s editorial board, “The Need for a Tax on Financial Trading” (Jan. 28, 2016), brings to mind the old adage variously (but probably inaccurately) attributed to Abraham Lincoln and/or Mark Twain that, “It’s better to remain silent and be thought a fool than to speak and remove all doubt.”

In the piece, the editors state that, “A financial transaction tax — a per-trade charge on the buying and selling of stocks, bonds and derivatives — is an idea whose time has finally come.” They speak of the “windfall profits” high-frequency traders earn “on small and fleeting differences in prices at the expense of ordinary investors and market stability.” The presupposition that high-frequency trading creates a windfall is absurd – if just showing up availed one of the opportunity to trade profitably, the volumes would be vastly higher than they are.

For better or worse, the current market structure is a function of the post-Reg NMS environment, and the profitable participation of all market intermediaries is a function of the combination of what real investors are willing to pay for liquidity and the capital that speculators can afford to put at risk to achieve trying profits. Neither is unlimited.

As to its effect on ordinary investors, the editors must not be familiar with what has happened to the cost of trading stocks for the “ordinary investor” over the past 20 years – it’s just never been cheaper. The market stability question belies the fact that the SEC has implicitly made the tradeoff between volatility and low costs by allowing tick sizes to shrink and making it impossible for market making activities to profitably commit capital – nothing that an incremental tax would address.

The editors go on to assert that the effect of such a tax on trade volumes “is debatable,” mentioning one calculation of the tax that, at 10bps, would yield $66 billion with but a 7% decrease in volume – ignoring the fact that the preponderance of today’s volume likely is based upon profit margins less than that. Further, “The tax could bring $76 billion a year if it was set at 0.3 percent, but above that rate would probably decrease.” Is there any HFT activity that could be sustained with such a tax?

Finally, the editors go on to infer that institutional (“pension funds”) allocations to hedge funds are for speculative purposes and that they are de facto bad because some large funds (e.g., CALPERS) have recently begun to reduce allocations because they have begun to question the after-fee returns. This conflating of hedge funds, speculators and (by inference) HFTs is simply mindless.

As an aside, the Brookings Tax Policy Center study that the editors must have read to inspire the editorial suffers from much of the same myopic view of the realities of the current market structure and starts with the implication that the Great Recession could have been avoided by a transaction tax that would have discouraged “excessive risk-taking.” Why would they have read further?


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2015 – A Year in Market Milestones: Tradeweb’s Billy Hult

By Billy Hult, Tradeweb Markets
Originally published on TABB Forum

2015 will go down in history as a milestone year for global financial markets. Meanwhile, the marketplace has continued to evolve in significant ways that have drastically impacted trade workflows and the business of trading fixed income and derivatives. At the center of the global government bond marketplace, here are the most significant events influencing trading over the course of 2015.

2015 will go down in history as a milestone year for global financial markets. Consider the list of monumental, one-of-a-kind market events, which reads like the résumé of an outrageous political candidate known for his liberal use of superlatives:

  • Record low yields in German 10-year Bunds

  • Largest one-day increase in Greek government bond yields on Tradeweb

  • Widest 10-year U.S. Treasury swap spreads in history

  • Highest yields in over 5 years for short-term U.S. Treasury notes

There’s no question about it: In the years following the financial crisis, the rates markets have become a macroeconomic seismograph, delivering an immediate feedback loop for global activity and uncertainty. Consider the performance of Eurozone debt, where yields for core and peripheral countries appeared in an un-choreographed dance. And in the U.S., the Federal Reserve’s long awaited decision to raise interest rates kept investors on baited breath all year long as yields gyrated on short term Treasury debt.

Meanwhile, the marketplace has continued to evolve in significant ways that have drastically impacted trade workflows and the business of trading fixed income and derivatives. The corporate bond landscape is in a new renaissance for electronic trading, introducing new protocols and functionality into the marketplace, and the dialog on algorithmic and high frequency trading in rates has reached new highs as market participants evaluate new and different ways of engaging liquidity.

Over the past 12 months, Tradeweb Markets has kept a watchful eye on all these moves in fixed income markets as a means of benchmarking the magnitude of different monetary and geopolitical events. At the center of the global government bond marketplace, here are the most significant events influencing trading over the course of 2015:

Negative Government Bond Yields Throughout Europe

In January 2015, nearly one quarter of all Eurozone government bonds were yielding below zero percent.

This meant investors were paying for the privilege of lending to central banks. There were a number of reasons for this phenomenon. For one, the European Central Bank (ECB) had cut interest rates to below zero and initiated bond repurchasing to prop up the economy. And despite the negative yields, asset managers continued to hold fixed income instruments in their portfolios, keeping the bond-buying spigot open throughout the dislocation.

On January 22, the ECB announced its intention to purchase government bonds yielding above the deposit facility rate of -0.20% as part of its easing program that launched on March 9 – leading to a 33% increase in European government bond trading volume in January v. December 2014. Yields continued to fall, however, and the percentage of Euro-based government bonds with a negative yield increased to 38.03% on April 14. A sell-off set in and Euro area government bond yields moved upwards again, and the percentage of negative-yielding instruments fell back to 22.21% by June 10. On the same day, the 10-year Bund mid-yield closed at 1%–its highest level since September 23, 2014.

The summer brought speculation that the ECB would ease monetary policy further, and Mario Draghi announced that the governing council was ready to do so on September 3. Yields for bonds with shorter tenures plunged to new record lows by December 2, a day before the ECB lowered its deposit rate to

-0.30%, a move expanding the universe of bonds eligible for purchase under the ECB QE scheme.

The chart below depicts the bid yield on the 2-year German note over the past 12 months and shows the trend in stark relief, with negative yields for the entire 12-months of 2015.

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Negative Swap Spreads

In the U.S., one of the more notable market dislocations of 2015 has been the inversion of the 10-year interest rate swap spread, which turned negative in September and has stayed there ever since.

The 10-year interest rate swap spread measures the cost for investors to exchange floating-rate cash flows for fixed-rate cash flows in the interest rate swaps market. It had been falling since July of 2015 in anticipation of an interest rate increase by the Federal Reserve, but also in response to surging supplies of corporate debt and persistently low yields on U.S. Treasury securities.

The benchmark spread is calculated by adding the bid yield of the 10-year U.S. Treasury note to equivalent U.S. dollar denominated interest rate swap spreads. As the chart below indicates, 10-year swap spreads first went negative on September 25, closing at -1.75 basis points. The spread continued to widen to a record low of -16.75 basis points on November 20. Since then, the spread has been on a tightening trend, but is still holding in negative territory at -5.5 basis points.

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U.S. Treasury Yields Start to Climb on Fed Rate Rise

Perhaps the biggest market data event of the year was also the most hotly anticipated – the U.S. Federal Reserve ending its seven-year run of keeping the Federal Funds Rate at zero percent, with a historic decision to raise rates for the first time since 2006 on December 16, 2015.

The results were immediate as trading volume increased 10% from November. The bid yield on the 2-year U.S. Treasury note reached its highest level in more than five years, rising above 1.0% for the first time since May 3, 2010. A similar, but less dramatic move unfolded in the 10-year U.S. Treasury note, which closed at 2.29% on the day of the Fed announcement, up 2.3 basis points from the previous day.

The following chart depicts the 12-month trend in the 2-year U.S. Treasury yield as it has slowly climbed from a low of 0.444% in January to 1.064% in December.

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Central Bank Policy Divergence Widens Further

However, the U.S. Federal Reserve was the only major central bank to tighten monetary policy in 2015.

The ECB, on the other hand, boosted quantitative easing and other central banks maintained their own expansionary measures.

This divergence was highlighted in December 2015 when the Federal Reserve became the first major central bank to raise interest rates since the financial crisis, despite a low inflation rate of 0.5% in November. In contrast, the ECB announced it would extend quantitative easing until March 2017 at the least, and also cut its deposit facility rate to -0.30%. This move came amid low Euro area inflation – 0.1% in November – but promising GDP growth rose steadily from 1.2% in Q1 2015 to 1.6% in Q3 2015. European government bonds generally traded significantly lower than their US counterparts, with 32.26% of the total issued amount yielding less than zero as of December 2.

Similarly, the Bank of England and the Bank of Japan maintained their asset purchasing programs in 2015, worth £375 billion and ¥80 trillion respectively, while Sweden’s Riksbank boosted its own plan by another 65 billion kronor (€6.9 billion) in October.

Political Uncertainty Tests Europe’s Peripheral Economies

A year of political uncertainty exposed a drop in public support for bailout commitments and strict deficit reduction targets in Greece, Portugal and Spain amid bond market volatility.

The threat of a Greek exit from the Eurozone, following the nation’s default on its rescue loan from the International Monetary Fund, increased as the newly-elected anti-austerity government sought to renegotiate the terms of its bailout. On June 29, at the height of speculation over how Greece would move forward, yields on the 10-year Greek government bond surged to their highest levels since 2012, when the nation’s debt was restructured. Yields on the Greek 10-year bond closed at 15.43% on June 29, after rising 462 basis points in a single day. It was the largest one-day yield move since electronic trading of Greek government bonds began on Tradeweb in 2001. The upward spike continued until its peak of 19.23% on July 8, when a bailout package was finally announced.

Meanwhile in Portugal, Socialist leader António Costa was appointed prime minister on November 25, ending six weeks of political uncertainty after October’s inconclusive election result. Yields on Portuguese 10-year bond rose to 2.85% on November 9, but finished the year at 2.52%, nearly a full percentage point above its lowest closing value of 1.54% on March 16.

Meanwhile in Spain, the December 20 election left the country without clear leadership as the incumbent Popular Party failed to secure a majority. The Spanish 10-year government bond finished 17 basis points higher over the year at 1.77% – comfortably between its lowest closing mid-yield of 1.08% on March 11 and the highest closing mid-yield of 2.37% on June 15.

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Regulation Sharpens Focus in Europe and Asia

2015 saw the European Securities and Markets Authority (ESMA) make considerable progress in writing the rules that will implement mandatory clearing and trading for OTC derivatives. On December 21, the regulatory technical standards (RTS) went live for the first instruments mandated to clear under the European Market Infrastructure Regulation (EMIR).

Additionally, ESMA further developed and consulted on rules to implement the Markets in Financial Instruments Directive II (MiFID II) and Markets in Financial Instruments Regulation (MiFIR). These rules include specific aspects of the new pre- and post-trade transparency for numerous asset classes, including OTC derivatives and ETFs, as well as a mandatory trading obligation for derivatives. And on September 28, ESMA delivered its final RTS to the European Commission, which are expected to be adopted during the first half of 2016.

However, the industry widely expects delays to the January 2017 implementation of these rules so that regulators gain ample time to build the necessary systems and infrastructure for surveillance and monitoring. Market participants and trading venues haven’t slowed down in the meantime, working together to interpret available rules and information in preparation for the transition to a new regulatory regime.

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Japan was the first country in Asia to introduce mandatory electronic trading for specified OTC instruments on September 1, 2015. The Financial Services Agency now requires institutions with derivatives positions greater than ¥6 trillion to execute 5-, 7- and 10-year yen swaps on regulated Electronic Trading Platforms (ETPs), which must then publish trade-related information.

The first transactions under the new regime were completed on the same day the rules came into force. And e-trading has grown rapidly, with more than ¥2 trillion traded across five different ETPs in September, led by Tradeweb accounting for ¥765 billion alone (ClarusFT data).

Elsewhere, authorities in Australia are developing proposals for their own electronic trading mandate, while legislators in Hong Kong and Singapore have been drawing up requirements for reporting and clearing. In Singapore, even though the country’s Monetary Authority previously stated that it does not intend to introduce an e-trading mandate for derivatives, it has nevertheless proposed putting in place the necessary legal framework for its potential implementation. We’ll continue to see greater implementation of new regulations in 2016 as clearing obligations come into effect and approval of new rules are expected before the third quarter.

Innovation Grows in Transaction Cost Analysis

As electronic trading has driven greater efficiency in the fixed income workflow, the availability of new information to interpret and manage trading activity continues to increase the focus on business performance. Compounded by upcoming regulatory reform in some regions and demand for improved compliance and monitoring tools, transaction cost analysis (TCA) for the bond markets is beginning to take hold.

In the equities markets, firms have had access to analytical solutions for TCA for years. However, the availability of such tools in the fixed income space has only just come to the forefront, as more robust trading information has become more readily available and tracked in electronic workflows.

With real critical mass in electronic trading of government bonds, firms like Tradeweb have begun to introduce new analytics that help institutions better understand their trading activity and support efforts to ensure best execution. Connecting the point of execution directly with systems to process and view TCA has introduced a new level of transparency into fixed income trading desks. Most importantly, this new information is helping organizations continue to become more intelligent and efficient in their counterparty selection and discovery of liquidity. And on the back-end, risk and compliance managers have a real view of trading activity, benchmarked against aggregate market data, like Tradeweb’s composite pricing and other post-trade reports.

However, there is new ground to cover as TCA offerings continue to expand beyond government bonds, European credit, covered bonds, supranationals, agencies and sovereigns. As new regulation increases the quality and availability of post-trade information around the globe, we’ll continue to see new applications for TCA to enhance best execution and overall trading operations.

Popularity in Fixed Income ETFs Climbs Higher

Exchange-traded funds (ETFs) have enjoyed consistent, fast-paced growth in assets since their launch more than two decades ago, exceeding $3 trillion in assets worldwide in May 2015. However, ETF liquidity and the way in which it trades has continued to evolve in different ways.

Now in its fourth year, the Tradeweb European-listed ETF marketplace represents one of the largest venues for ETF trading in Europe. European ETF volume surpassed €112 billion on Tradeweb in 2015, with nearly one third of the overall activity resulting from the growing use of fixed income ETFs in Q4. This represents an interesting trend in how market participants are leveraging request-for-quote and other protocols to gain best execution in an otherwise fragmented marketplace.

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Off-exchange trading continues to gain traction with the institutional fixed income community as they have begun accessing greater levels of liquidity through new trading protocols. And investors are quickly learning about the liquidity benefits of fixed income ETFs as they seek new ways of managing risk, especially in the corporate bond market.

Tradeweb is working with the industry to help support this crossover in trading of traditional equities products by fixed income investors, and partnered with BlackRock iShares and State Street to help develop new standards for analysis, evaluation, and calculations for converting yield, spread and duration with fixed income ETFs into identical terms for the underlying bonds.

Investors are also taking advantage of new post-trade reporting and access to dealer axes on venues like Tradeweb, introducing new data to inform better counterparty identification and improve access to liquidity. This has been so impactful, hit rates have shown to increase by five percent when sending a request-for-quote to axed dealers, and by ten percent when trading fixed income ETFs. And as market participants prepare to trade ETFs under MiFID II in Europe, we’ll continue to see even greater adoption of e-trading ahead of mandatory reporting coming into effect.

Derivatives Trading Outlook for 2016

2015 was a banner year for the electronification of derivatives markets, and some of the key issues and advances in swap trading seen to date may serve as indications for what’s next in the twelve months ahead. Market participants are leveraging new tools to source liquidity and optimize portfolios, while keeping a watchful eye on regulatory reforms in Europe and Asia. Average daily trading volumes on Tradeweb have increased to more than USD $30 billion on TW SEF. In addition, the platform has seen approximately 75% of D2C block trading, as of October 2015, according to ClarusFT.

The factors driving this growth include increased use of tools like buy-side compression, which helps improve line-item management at derivatives clearing organizations (DCOs), and the adoption of products like market-agreed coupon (MAC) swaps, that offer standardization to ease the process of rolling positions.

We expect innovation will continue in the U.S., Europe and Asia. Japan has already had a successful launch of electronic trading platforms (ETPs), and in the near future European market participants will focus their resources on the upcoming clearing mandate and the eventual trading and reporting reforms under MiFID II.

As swap trading continues to adapt to new regulatory requirements and we continue to see an increase in electronic trading, technological solutions are helping increase transparency, efficiency and compliance for all participants.

Record Corporate Bond Issuance Amid Rising E-trading

Bond sales by investment grade American corporations eclipsed the $1 trillion mark by September of last year, putting 2015 squarely on track for a record-setting pace of corporate bond issuance in the U.S. A similar trend has played out around the world, with the notional dollar value of global bond sales topping $2 trillion in December, not quite a record, but among the top four most active years for global bond deals in the last two decades.

The drivers of this trend are no mystery. Seven straight years of record-low interest rates have made the allure of cheap debt too hard to ignore for companies looking to raise funds and incremental improvements in the economy have given yield-starved investors the confidence they need to buy corporate debt.

Increasingly, the task of creating liquidity in the enormous market for corporate bonds is falling to electronic trading platforms. According to a December report from Greenwich Associates, the share of investment-grade bonds that trade electronically has doubled over the past two years and now makes up 20% of total market volume.3

Firms like Tradeweb are helping to drive this adoption with new methods of counterparty identification and streamlining trade workflows. For example, integrating its U.S. credit platform with its Treasuries marketplace, Tradeweb has deployed the industry’s first fully automated Treasury spotting tool. This significantly reduces a relatively manual and tedious process for hedging the interest rate risk of corporate bond trades, while reducing the likelihood of human error in the process. As we approach the brave new world of a rising rate environment, tools that improve the overall workflow and aid in the discovery of liquidity will gain even greater relevance in supporting greater efficiency in the marketplace.

Evolution and Progress of Algorithmic Trading in Fixed Income

Algorithmic trading firms now account for 60% of activity in electronic Treasury trading, up from 45% in 2012, according to TABB Group research appearing in The Wall Street Journal. That’s a staggering number when you consider that the market for U.S. Treasuries, arguably the most liquid market in the world, is currently valued at about $12.7 trillion.

The growing presence of algorithmic traders in the Treasury market has been met with a combination of enthusiasm and caution on Wall Street. Proponents of the tech-enabled approach to rapid-fire trading have consistently shown that the increased order flow they create has improved liquidity and makes pricing less volatile.

Regulators haven’t been as clear-cut in their support for the algorithmic evolution of Treasury trading, and have been hard at work since the “flash crash” in Treasuries on October 14, 2014. But this November, the Commodity Futures Trading Commission (CFTC) proposed new rules as part of its regulation on automated trading (Reg AT) that will allow regulators to inspect the source code algorithmic traders use to guide their trading activity without a subpoena – a new step forward in oversight of the market. Trading industry groups have voiced concern that the rule exposes algorithmic traders’ proprietary information to third party security risk and could potentially undermine competitive advantage.

Though buy- and sell-side demand, and liquidity within the institutional marketplace remains rooted in disclosed, request-for-quote trading, the debate over all forms of electronic trading in rates markets is bound to grow in the coming years.

Looking Ahead to 2016

While it’s impossible to predict the future, many of the issues that drove such significant market moves this year are still very much a factor for the year ahead. With stimulus still being pumped into European markets, a great deal of fixed income supply still owned by the U.S. Federal Reserve and continued concerns about market liquidity prevalent across all corners of the financial marketplace, it’s a safe bet that we haven’t seen the end of recent volatility.

This feeling of uncertainty is familiar, like when the industry first began working on reform under Dodd-Frank over five years ago: a commitment to preparation and improved operational performance. Whereas derivatives continue to provide market participants with effective risk management, access to efficient trading tools on SEFs will result in increased adoption of solutions like buy-side compression, and standardized instruments such as market-agreed coupon (MAC) swaps. When new products are made available to trade on SEFs, the scale of e-trading will increase.

Meanwhile, the global credit marketplace is warming up to new operational efficiencies afforded by electronic trading. We’re still in the early stages, but clients have begun to leverage a range of new technology to improve their ability to source liquidity, gain quality execution, and improve workflows at lower costs.

Similarly, trading in U.S. Treasuries will continue to hold its share of the spotlight, especially as the roles of market participants are changing and influencing liquidity. As the leading venue supporting Treasury trading in the institutional, wholesale and retail communities, we’re looking forward to leading the technical revolution by providing more efficient solutions, more liquid trading platforms, and more connections to more industry participants.

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The Future of Swaps Trading: Are We All Missing Something?

By Radi Khasawneh, TABB Group
Originally published on TABB Forum

The Bank of England’s recent analysis of swaps market structure may miss the fact that coming global regulatory changes will alter flows and liquidity over the next two years.

The implementation of the Dodd-Frank reforms in the U.S. has resulted in a tangible decline in execution costs and disintermediation of interdealer-brokers, according to a report published by the Bank of England (BOE) this week. The flip side of this has been a fragmentation of the market along regional lines, the report claims.

The conclusions of the report, based on data from LCH.Clearnet SwapClear, back up the conclusion of reports published periodically by the International Swaps and Derivatives Association (ISDA) since the advent of swap execution facilities (SEFs). These have shown that moving the most liquid interest rate swap contracts and currencies onto transparent and cleared venues has increased so-called fragmentation – the likelihood that parties in the same region choose to trade with each other (particularly interdealer) has increased. (In fact, the latest ISDA report uses more up-to-date data, for those of you interested in tracking the more permanent trend.) The BOE analysis is supplemented by publicly available Depository Trust and Clearing Corporation (DTCC) data, which does indeed show a growing trend toward cleared contracts overall (Exhibit 1, below).

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Source: TABB Group, DTCC GTR

TABB Group has been tracking and covering the evolving swap market story for a while, but the BOE authors have added a new twist: They have put numbers on decreasing transaction costs in the US market since transparency standards came into force. According to their research, execution costs in USD mandated contracts have dropped by $7 million, to $13 million daily, when compared to euro-denominated equivalents in the time period covered (January 2013 to December 2014).

CFTC commissioner Chris Giancarlo, who issued a white paper a year ago criticizing the implementation of swap markets regulation and calling for a reexamination of the Dodd-Frank Execution Mandate, is criticizing the causality implied by the BOE paper. “The reduction in the cost of swaps execution came about through aggressive competition and price discounting in the industry, which is a natural evolution of the market,” Giancarlo told the Financial Times. “Neither Dodd-Frank nor the CFTC swaps trading rules were written with the goal of reducing the cost of trading swaps.”

This is all well and good, but surely a reduction in trading costs and an increase in price transparency and disintermediation are signs of a healthy market? Even more important, how does that square with regional fragmentation and the lack of flow seeking to take advantage of any cost arbitrage (signs of a “sickly” market)? The answer to this seeming contradiction, as ever, appears to come down to the elephant in the room: regulatory uncertainty. Lack of mutual recognition and significant differences in approach have left end users and buy-side firms reluctant to trade with counterparties across borders, particularly when the clearing piece of the puzzle is still up in the air.

On Jan. 14, press reports indicated that European and U.S. regulators are finally close to agreeing to “equivalence” in clearing rules and margin and capital treatment for swaps. Veterans of this process could be forgiven for giving a big shrug to this news – there has been a rollercoaster of optimism and pessimism over this for the past two years; but the crucial difference here is that it seems that the U.S. side is expected to have won a long-running dispute to get European recognition for its margin and settlement method (in particular, allowing U.S. T+1 contracts).

There are many moving parts to the differences in approach, but could such an agreement actually reverse the fragmentation trend we are undoubtedly seeing at the moment and ultimately lead to much more flexibility in clearing choices at firms? Should that be the end point, then the period since 2013 will be seen as an interim Dark Age before a Renaissance of global transparency and price discovery emerges.

The pressure on banks is set only to increase, as the Basel Committee for Banking Supervision (BCBS) laid out rules last week to increase capital costs for international banks under a revised framework for its Fundamental Review of the Trading Book, with a reduced but hefty market risk charge for swaps held on bank trading books. There therefore remains a significant liquidity risk that also undermines the apparent healthy reaction of the market to these reforms. Fundamentally, the only thing we can know at this point (ahead of European implementation) is that it would be dangerous to draw strong conclusions before global markets catch up to the U.S.



 

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Fixed Income Markets in the New Year: Ring in the Changes

By Colby Jenkins, TABB Group
Originally published on TABB Forum

Empirical data make it clear that over the past eight years, over-the-counter fixed income markets have continued to expand. But the data may belie the fact that this growth has been built on a fractured foundation, as increasing regulatory scrutiny and electronification and growing liquidity concerns continue to transform business models.

If last year is any indication, 2016 is poised to be another year of major change for the fixed income OTC markets. Empirical data continues to tell a compelling story: The numbers make it clear that over the past eight years, over-the-counter fixed income markets have continued to expand. But the data may belie the fact that this growth has been built on a fractured foundation.

Outstanding notional sizes of global debt markets surged – both the U.S. corporate bond and U.S. Treasury market continue to break annual records in notional outstanding (see Exhibit 1, below), growing by 77% and 207%, respectively, since 2005. But the debate as to whether liquidity in OTC fixed income markets is waning is certain to be carried on in 2016, as the effects of Basel III and other regulatory changes combine with shareholder demand for increased return on capital to alter business models.

Exhibit 1: U.S. Corporate Bond and U.S. Treasury Security Markets Notional Outstanding

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Source: TABB Group, SIFMA

Efficiency needs and cost concerns are fueling an increased use of technology across the marketplace, irrespective of asset class. As a result, a new breed of market-maker is emerging. In some arenas where products are suited, electronic trading is surging, while in others, growing illiquidity is causing participants to rely more heavily on relationships as the search for assets becomes an archeological dig (see Exhibit 2, below).

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Source: TABB Group

Meanwhile, the list of provocative, thought-provoking business drivers in today’s OTC fixed income markets also continues to grow – potential problems in search of solutions. Among these, aggressive regulatory reform, accommodative central bank monetary policies, the consolidation of assets under management, the proliferation of electronic trading, weakening credit fundamentals, and declining bid/ask spreads coupled with increased liquidity premiums are perennial challenges keeping the market off an even keel.



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Tracing Time: Clarifying MiFID II/MiFIR Timestamp Requirements

By Victor Yodaiken, FSMLabs
Originally published on TABB Forum

Recent ESMA guidance clarifies time-stamping and clock synchronization requirements under MiFID II/MiFIR, making it clear that regulators are not interested in running an experiment and are not willing to settle for window dressing.

At the end of 2015, European regulators issued wide ranging “guidelines” on the new MiFIR rules that show that, when it comes to time-stamping and clock synchronization, regulators are:

  1. Not interested in running a science experiment. They want useful data on trading records based on existing technology. In particular, they reiterated (against quite a loud marketing effort to the contrary) that GPS and GNSS time sources are acceptable alternatives to feeds from the national timing labs.
  2. Serious about timestamp data integrity and not willing to settle for window dressing. There was a rather sharp reminder that the existence of a high-quality time source somewhere in a trading facility was nowhere near enough – time has to be synchronized at all points, and market participants need to document and monitor their end-to-end time synchronization technology.

The draft standards had already made it reasonably clear that satellite time sources were acceptable – and the cost-benefit analysis was particularly emphatic on that point. But there was an energetic campaign by a number of parties to convince the markets that not only were direct or somehow “authenticated” feeds from the national labs the only acceptable sources of time, but that connecting to one of those feeds was sufficient to meet time synchronization requirements.

The recent guideline addresses both of these points head on. First, there is an unambiguous declaration:

“The use of the time source of the U.S. Global Positioning System (GPS) or any other global navigation satellite system such as the Russian GLONASS or European Galileo satellite system when it becomes operational is also acceptable to record reportable events.

Following this is a warning that should apply to other time sources as well: that just having an accurate time source is not sufficient. Accuracy is needed at “any point within the domain system boundary where time is measured”:

“For the purposes of Article 4 of the MiFIR RTS 25, for users of a satellite system, even though the first point at which the system design, functioning and specifications should be considered is on the receiver (e.g. the model of the GPS receiver and the designed accuracy of the GPS receiver) used to obtain the timestamp message from the satellite, the accuracy required under in the RTS shall apply to any point within the domain system boundary where time is measured.”

It is made abundantly clear in the rest of this guideline (and in the draft regulations) that regulators want a comprehensive tracking of when decisions were made and when data was received or sent. Such tracking depends on end-to-end data integrity, and time is now part of the data that has to be right. Just having a high-quality satellite or terrestrial time source feeding into a data center or a rack of computers is nowhere near sufficient to assure that the computer servers that receive customer orders or issue orders to trading venues, or the counterparty server computers inside the trading venues are using reliable timestamps.

Even if one had a super-accurate time-feed straight from a cesium clock in a national lab coming into a data center, there is still a long path between that feed and the software that is generating trading operations. And sometimes feeds fail. Sometimes the switches and routers in the network can fail or introduce timing errors. Network cards, cables, operating system software, and time-sync software can all introduce errors.

Market participants that want accurate time at “any point within the domain system boundary where time is measured” need technology and procedures to test, to alert, to fail-over if possible, and to otherwise monitor time synchronization. The guidance shows that ESMA regulators have been thinking about that path and will not be satisfied with “we pay for a time feed” as evidence of meeting the standard:

“Operators of trading venues and their members or participants shall establish a system of traceability of their business clocks to UTC. This includes ensuring that their systems operate within the granularity and a maximum tolerated divergence from UTC as per RTS 25. Operators of trading venues and their members or participants shall be able to evidence that their systems meet the requirements. They shall be able to do so by documenting the system design, it’s functioning and specifications. Furthermore operators of trading venues and their members or participants shall evidence that the crucial system components used meet the accuracy standard levels on granularity and maximum divergence of UTC as guaranteed and specified by the manufacturer of such system components (component specifications shall meet the required accuracy levels) and that these system components are installed in compliance with the manufacturer’s installation guidelines.” (emphasis added)

The takeaway lessons are, at least so far, that complying with the new regulations is going to need some work, but nothing miraculous. And buying a GPS clock or a terrestrial time feed is something that should happen in the context of a comprehensive plan.


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December 2015 Swaps Volume in 10 Charts

By Amir Khwaja, Clarus Financial Technology
Originally published on TABB Forum

USD Interest Rate Swaps volume traded on-SEF in December 2015 was just slightly higher than October and November volumes. But compression activity picked up. Clarus examines the numbers.

Happy New Year. Continuing with our monthly review series, let’s take a look at Interest Rate Swap volumes in December 2015.

First, the highlights:

  • On-SEF USD IRS Dec. 2015 volume was similar to Nov. 2015;

  • With Outrights and Curve trades higher, and Spreadovers and Butterflys lower.

  • The Fed Rate Rise on Dec. 16 had no material impact on monthly volumes.

  • USD Swap Curve was up 15 bps across the term structure.

  • USD SEF Compression volumes were back up from Nov. lows and close to Sept. volumes.

  • CME–LCH Basis Spreads tightened.

  • CME-LCH Switch trade volume was $50 billion, down from Nov., but above the monthly average.

  • Global Cleared Volumes in G4 Ccys were lower than in Nov. and similar to Sept.

Onto the charts, data and details.

USD IRS On-SEF

Let’s start by looking at gross-notional volume of On-SEF USD IRS Fixed vs. Float, and only trades that are price forming – so Outrights, Spreadovers, Curve and Butterflys:

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Showing that:

  • December gross notional is >$1.175 trillion.

  • (Recall: Capped trade rules mean this is understated, as the full size of block trades is not disclosed.)

  • Just above Nov. and Oct., and just below Sept.

  • So the Fed Rate Rise on Dec. 16 happened as expected and had no impact on volumes.

  • Compared to Dec. 2014, gross notional is down 14%.

  • Recall: Nov. 2015 was 25% higher than Nov. 2014, so a case of up one month and down the next.

And splitting by package type and showing DV01 (adjusted for curves and flys):


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Showing that:

  • Outright trades DV01 was higher than Oct. and Nov. and similar to Sept.

  • Curve trades DV01 was higher than each of the prior three months.

  • Spreadover and Butterfly DV01 was lower than each of the prior three months

  • Overall $525 million of DV01 was traded in the month.

  • (Recall: Capped trade rules mean this is understated.)

And gross notional of non-price forming trades; Compression and Rolls:

content clarus3 (1) resized 600

Showing that:

  • Compression activity is back up from Nov lows.

  • At >$208 billion in Dec., vs >$136 billion in Nov. and >$285 billion in Oct.

  • IMM Rolls volume in Dec. are similar to Sept. (the prior roll month).

USD IRS Prices

Let’s now take a look at what happened to USD Swap prices in the month:

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Showing a rise of 15 bps across most tenors; not much of a surprise there, as consistent with the Fed Rate Rise.

CME-LCH Basis Spreads and Volumes

CME-LCH Basis Spreads tightened during the month. Let’s look at the Tradition page from 31 Dec.:

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Showing that all tenors were lower than Nov. highs and Nov. month end. (See November Review.)

And what about CME-LCH Switch trade volumes?

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Showing that at $50 billion gross notional, they are down from the $75 billion high in Nov. but remain well above $35 billion monthly average of Sept. and prior months in 2015. Clearly, for a two-way market to trade, there are participants with different positions and opinions on the direction of the spread.

Market-share wise, Tradition just slightly ahead of ICAP this month.

EUR, GBP, JPY Swaps

Let’s also take a look at On-SEF volumes of IRS in the other three major currencies:

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Showing that for price-forming trades, EUR volumes were higher than prior months, while the overall gross notional in these three currencies of >$177b in Dec. is just 15% of the USD volume.

And then looking at SEF Compression activity:

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Shows that Dec., while down from Nov., is still well above prior months, and EUR in particular is the highest of any month in our period.

SEF Market Share

Usually we now look next at market share, but I am going to leave that to the upcoming Review of 2015.

Global Cleared Volumes

So let’s end with Global Cleared Swap Volumes for EUR, GBP, JPY & USD Swaps:

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Showing that Dec. is down from Nov. and comparable with Sept. volumes.

LCH SwapClear volume is lower in Dec. than in Nov.

CME volume in Dec. appears higher than Nov., but drilling down into this:

content clarus10 resized 600

Shows a large $2 trillion on Dec. 2.

Last time we saw such a large figure was Sept. 2, and that was due to TriOptima Compression – given that it is exactly 3 months later, this suggests another quarterly compression run. In fact, by looking at CME Open Interest, we can indeed see that this drops from the end of Nov. to the end of Dec. by just over $2 trillion, confirming our hypothesis.

We would then estimate the CME volume in Dec. was approximately $1.3 trillion, lower than Nov. and similar to its Oct. figure.

LCH SwapClear at $14.2 trillion in Dec, is also down from Nov and similar to its Sep figure.

JSCC at $400 billion in Dec. is similar to its Oct. figure.

 

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Good Intentions, Unintended Consequences: Tax Reform Threatens Options Market

By Callie Bost, TABB Group
Originally published on TABB Forum

New rules on the taxation of derivatives could have negative consequences on listed options demand, raise costs for the industry and ultimately reduce trading volume.

Stringent regulations on risk-taking and capital have been the bane of options traders’ existence over the past several years. Soon, they’ll have another obstacle to worry about: new rules on the taxation of derivatives.

Two tax proposals and one recently passed tax regulation could curb pockets of volume in the US listed options market and create compliance headaches for brokerages.

These proposals are part of Washington’s promise to simplify the U.S. tax system, eliminate loopholes, and save money both for individuals and businesses. On the surface, the plans present constructive goals; but in practice, they could have negative consequences on listed options demand, raise costs for the industry and ultimately reduce trading volume.

One proposal could impede one of the fastest-growing demographics of the options market: flow from individual retirement accounts (IRAs). The Department of Labor’s (DOL’s) fiduciary rule, which is expected to be implemented this year, is intended to safeguard investors’ retirement accounts from advisors’ conflicts of interest through a broader definition of a fiduciary under the Employee Retirement Income Security Act (ERISA). However, if the proposal is enacted, it could categorize brokerages as fiduciaries, which would require them to drastically change their business models and limit them from trading listed options. Self-directed investors who employ common options strategies, such as buying puts and selling covered calls, could be stripped of these resources.

A plan introduced by former House Representative David Camp could hold severe consequences for all listed options traders. The Tax Reform Act of 2014, also known as the Camp Proposal, promises sweeping tax reform through simpler individual income and business tax systems, lower tax rates for most individuals, and fewer tax breaks and incentives. The rule proves challenging for the options market through its language on the uniform taxation of derivatives. Currently, it would require all options positions on stock to be labeled as mark-to-market, and all gains on the stock would be treated and taxed as ordinary income. If enacted, the Camp Proposal could turn trading straddles into a tax nightmare for investors and discourage them from prudently protecting their portfolios.

Tax reform in the U.S. will also have international repercussions. Section 871(m) of the Internal Revenue Code, which was finalized in September 2015, will establish a withholding tax for foreign investors trading equity derivatives connected to U.S. securities around their dividend payout dates. The plan was created out of concern that overseas traders were dodging the withholding tax on U.S. securities’ dividend payouts through carefully timed equity swaps. While the rule provides guidelines on what kinds of options can be subject to the withholding tax, its language is somewhat ambiguous and leaves interpretation up to brokerages that are required to track and report their customers’ tax statuses. Foreign investors will likely have to reduce their U.S. options trading to avoid unnecessary and overwhelming taxation once the rule comes into effect next year.

While Washington’s intentions for tax reform are well-meaning, the secondary effects of these rules are harmful for options market participants. Ultimately, these plans punish investors who have been using listed options in a responsible manner and present unnecessary stumbling blocks for the whole industry.

 

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The Waiting Game: 5 Themes That Will Define Capital Markets in 2016

By Larry Tabb, TABB Group
Originally published on TABB Forum

Stuck between financial regulation and the next presidential election, 2016 will be a year of waiting – waiting on market structure reform, waiting on higher rates, waiting to see if disruptive fintech actually disrupts, and waiting on the next commander in chief. As the year plays out, the impact of these drivers will come into greater focus. Larry Tabb offers five themes that will define the capital markets in 2016.

2016 will be challenging for capital markets firms, but the challenges will not be insurmountable. Stuck between financial regulation and the next presidential election, 2016 will be a year of waiting – waiting on market structure reform, waiting on higher rates, waiting to see if disruptive fintech actually disrupts, and waiting on the next commander in chief. While few, if any, of these issues will be fully resolved in 2016, as the year plays out, the impact of these drivers will come into greater focus. Here are five themes that will define 2016.

1. The Election

It comes as no surprise that the majority of Americans believe our current election process is a mess. Virtually unlimited spending, the devolution of the Republican Party, and the rise of the anti-politician will make 2016 a year of political bombardment, as SuperPacs, political talk shows and late night comedians’ lampoons will make it impossible to ignore the US presidential election.

Through this rancor, I believe Hillary will wind up victorious – that is, unless a dark horse unexpectedly appears out of the shadows. While not particularly likable and viewed as untrustworthy by many, voter demographics, experience, name recognition, and the mess that is the Republican Party should enable Hillary to seize the mantle. Just look at the leading Republican candidates: Trump, Cruz, Rubio and Carson. Two are anti-politicians, one is less liked than Hillary, and the other is losing traction rather than gaining it. That said, even though the Republican Party is a mess, the election won’t be a landslide, with the victor winning by less than 5% of the popular vote. Who would have guessed that we would be pining for the days of Romney and McCain?

While a Republican would be better for the industry, Hillary shouldn’t be so bad. Given that Hillary is a Senator from New York, lives in Westchester, and has a history of working with the industry, and given the industry’s contributions to both her campaign and Clinton Global, it would be hard to see her take a drastic turn against Wall Street. That said, the good times of the ’90s and early ’00s are gone. It will be years before we see those days again.

Though she was tough on banks in her now infamous New York Times OpEd, this was more about political posturing and a call for campaign contributions. If elected, I believe she either will backtrack on many of these proposals or, more likely, have a very difficult time getting many of these planks through Congress, which will continue to be either Republican-controlled or -dominated.

The bottom line for the elections: The status quo will remain, with no sweeping victories, defeats and/or financial industry mandates. And we most certainly won’t be replacing the national anthem with Kumbaya any time soon.

2. FinReg – Still Dominating the Agenda

Regardless of who wins the election, gutting, or even rolling back, Dodd-Frank will be very challenging. And even if Dodd-Frank is gutted, getting the Basel Committee to reform Basel III/IV will be virtually impossible. While we may see some small changes to swaps trading regulation and some process changes (but not much) on extraterritorial regulation/substituted compliance, expecting the G20 derivatives rules for swaps to just go away or for the CFPB to pack it in would be like expecting the Mets, Jets and Islanders to all win 2016 world championships. Good luck with that.

Financial regulation will continue its push to make banks safer by boosting transparency, upping capital charges, increasing product standardization, ratcheting up stress tests, and generally limiting banks’ financial/capital markets activities. Basically, more of the same.

The focus in the US will be Basel III compliance, finalizing and adopting the SEC version of Title 7 swaps reform – which, by the way, is substantially different than the CFTC version – and what seems to be a never-ending stream of compliance challenges stemming from dark pool mischief, collusion, spoofing and market manipulation that the regulators will increasingly use to prosecute misbehavior (both real and perceived).

While the US will be drowning in compliance and regulatory issues, however, Europe will assume the regulatory focus. With EMIR’s implementation gaining steam and the MiFID II rules in final stages of approval, Europe, while two to three years behind the US in terms of financial reform, will be entering that critical phase of rule finalization, on-boarding, and conceptualizing the reality of new requirements’ impact.

While the world embraces financial regulation, the market’s No. 1 question will be about liquidity provision. As banks get weighed down by the anchor of financial regulation, two things can occur: First, banks find a way around the regulations by creating new and different products, or by developing a new governance structure that enables them to circumvent the most significant rules and capital charges; or second, they don’t.

If banks can’t get around finreg, which is the most likely scenario, bank liquidity will continue to drain from the market and risk will be transferred to investors, while the intermediary function is taken over by firms that are not as heavily regulated. While intermediary liquidity pools will decline, the newer and less-regulated firms that fill these gaps will have much better technology and connectivity. This will leave the market with thinner capital cushions and faster turnover rates.

Though banks will be safer, we expect greater market instability and volatility, especially given the rising rate environment. While we expect more high-yield funds to crater, the impact will fall on investors, not financial institutions. We don’t expect anything nearly as pernicious as the credit crisis, but an increasing number of volatile moments will plague the markets like a death by a thousand cuts.

3. Rates and Fixed Income Market Structure

The Federal Reserve has finally raised rates, albeit by only 25 basis points. In 2016, according to experts, rates will go up by 100 or so basis points. This most likely won’t create panic in the streets. We will, however, see some of the more precarious funds fail, not unlike Third Avenue. This also will be a test for the vast array of new credit trading platforms. While we don’t expect these new platforms to take over the market in 2016, we do expect a few to gain traction. This will be the boost that they need to refine their business models, hone their matching modes, push the buy- and sell-sides to at least test their platforms, and keep them in business.

While the rising rate environment will float some of these boats, however, it will be harder for the others to stay in business. We expect liquidity in these platforms to centralize around a few winners. Platforms that obtain client traction will generate a buzz, attracting more players and more liquidity, and the old saw “liquidity begets liquidity” will be the operative phrase for 2016.

On the rates side, we will continue to see technology-enabled market makers displace traditional market makers. More flow will be electronically traded, and the market increasingly will look more like equities than bonds.

As both rates and credit become more electronic (albeit in different ways), we will see the role of regulators change. Securities regulators historically have kept their distance from traditionally OTC markets. As more bonds (and currencies) trade on-screen, it will be easier for regulators to see how well brokers/dealers are treating their clients and how best execution rules can be applied to OTC markets. This will put an increased focus on broker/dealer behaviors and increase the number of enforcement actions. “Last look” will end, and by the end of the year, we will be one step closer to an agency-style market for fixed income products.

4. Equities Market Structure – Change Around the Edges

Equities market structure, unfortunately, will remain in the headlines. Fixing the ETP challenges demonstrated by the chaos of August 24 will be the first priority for the SEC, following the very interesting fact-filled but analysis-void paper it put out in December. Though not extensive, we should see changes to the opening process, the calculation of indices, and the tinkering of limit-up/limit-down thresholds for ETPs. While not radical, these changes will challenge some existing businesses and create opportunities for others.

Talking about shifting opportunities, IEX will eventually become an exchange. It needs to. If it doesn’t, it will be hard to keep its investors happy. While I don’t think that the SEC will force IEX to eliminate the speed bump, I am not sure regulators will greenlight the exchange as it currently stands; IEX may have to put its router on the same side of the speed bump as other brokers, or make other concessions to comply with Reg NMS/fair access rules.

If IEX is approved with either the speed bump and/or the router bypassing the speed bump, we will certainly see a few of the smaller exchanges change their structure to encompass similar, but not exactly the same, features as IEX. This will create a mess and leave routing firms stuck trying to decipher the location of real liquidity, its current price, how to negotiate each market given their peculiarities, and how to compensate for all of these new market structures in their routing strategies. While IEX advantages are supposedly tipped toward investors, what is to stop someone from subtly changing the model deleteriously?

Outside of the exchange brouhaha, regulators will continue to push transparency. We saw the SEC put out a proposal in November on ATS-N, and there are discussions around extending Rule 605/606 reports to cover institutional flows. Hand in hand with global regulators, equity transparency issues will continue to be front and center.

On the dark pool front, we will see regulators finally tie up the loose ends on outstanding dark pool settlements, but that won’t be the end of it. We will see a number of other dark pool investigations/settlements, as there are rumors of other enforcement actions circulating. The SEC also will finalize and implement ATS-N dark pool disclosure rules, which, of course, will create more compliance challenges and fines.

On the “kick it down the road” side, I am not optimistic that we will see much progress on the CAT. While regulators winnowed the field from six to three bidders in 2015, we still don’t have an SEC CAT czar, and it just seems as if the CAT has not been a major SEC priority.

With the delay of MiFID II, we see debate, confusion, and eventually some finality. Regulators will relent on strict separation of payment for research and trading commissions by allowing CSAs, but that won’t alleviate the challenges that European investors, brokers, and providers will have in ascertaining cost, quantifying value, and paying providers. The double volume caps will remain, but they will be very hard to enforce given the inability to collect data and to manage the reference price and large-in-scale exceptions, not to mention the lack of clean and consolidated data.

While MiFID will challenge the equity business, the European fixed income markets will be thrown into a tizzy as they come to grips with what transparency and accessibility really mean in the fixed income markets. This will be especially poignant given a US rate rise and the increasing pressure Basel III will place on European banks. This will certainly come back to bite Europe, especially if volatility picks up.

5. Fintech

While the talk around the industry will continue to revolve around regulation and enforcement, the excitement around fintech will increase. Though we are years away from a credible blockchain alternative, we will see factions develop in various target markets – including smart contracts, clearing/settlement, payments, securities lending, and back-office automation. While the smoke from blockchain initiatives will increase, however, we are still too early to see much fire. There will be deals, and proofs of concept, but wide-scale adoption is still years away.

Robo-advisors will continue to gain traction, but again, true disruption remains years away. Given it has taken almost 20 years for ETFs to hit the $2 trillion mark, we won’t see robos pressuring traditional managers in 2016. That is at least five to 10 years off, if at all.

That said, cloud, compliance, cyber security, and big data will continue to push ahead. While not the most sexy of topics, many of these technologies are battle-tested and can demonstrate realistic value propositions today.

Opportunities for the Fleet of Foot

In the macro, 2016 will be a challenging environment for banks, as regulation – including capital rules and the Volcker Rule – and enforcement actions will keep them on their heels. This will also impact hedge funds. Hedge funds had a pretty lousy 2015, and 2016 will remain challenging. Leverage will be hard to get and expensive. While the direction of rates will be more certain, it will be harder to take advantage of them without prime brokers’ balance sheets opening up. Long-only funds will continue to be pressured by ETFs, whose low cost structure will continue to prove problematic for traditional brokers.

As banks’ and brokers’ comp models remain under pressure, talent will continue to move toward firms without the heavy regulatory burden, oversight, and hurdles. This will push market making and HFT firms to begin courting traditional investors. While this won’t reach a flood in 2016, it will be the start of a long process as the industry shifts away from a banking model to the more traditional brokerage/investment banking model popular in the 80s and 90s.

One thing that can derail this process (and improve the industry outlook) is a way of better obtaining leverage, outside of the traditional bank/repo model. If we can develop/create leverage outside of the large banks/prime brokerage model, or novate financing risk through repo clearing or another mechanism, market making/dealer desks and other intermediaries will be able to be more active in the market without as much counterparty risk. This would be a significant help not only to banks, brokers, and hedge funds, but also to investors of all stripes, who would enjoy greater liquidity, better asset pricing and less execution risk. That said, we don’t expect this problem to be solved before the 2017 ball drops in Times Square either.

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Derivalert’s Top 10 News Stories of the Year: 2015

DerivAlert.org celebrated its fifth anniversary this year, a milestone that we’re proud to have reached. The newsletter was conceived to help bring some direction to the enormous amount of OTC derivatives reform news that was coming from all corners right around the time that Dodd-Frank was being implemented. Once the rulebooks were written, and the laws were passed the assumption was that the need for a compass to guide market participants through the new derivatives landscape would eventually fade away. It hasn’t. 

As of this writing, the European Securities and Markets Authority (ESMA) has asked for a one-year delay in implementing the Markets in Financial Instruments Directive (MiFID II), which would push the deadline for Europe’s major OTC derivatives trading regulations out to 2018.  In the U.S., the Commodity Futures Trading Commission (CFTC) has proposed brand new rules regulating the use of derivatives in mutual funds and exchange traded funds (ETFs).  The agency also continues to juggle continued challenges concerning cross-border recognition of trading rules and continued no-action relief in implementing rules for package trades.

Amidst all this, DerivAlert has continued to grow its audience over the last five years:  2015 was our biggest year to-date in terms of total readership, number of news stories and commentaries posted and engagement with our social channels.

So, what were the biggest stories that kept all of you coming back for more over the course of the year? Here they are in descending order, as chosen by you, the DerivAlert reader, our top ten news stories of 2015:

10) Are Central Counterparties the Next Systemic Threat?
October 14, 2015 (American Banker) – Since the Group of 20 nations agreed in 2009 to route most over-the-counter derivatives through central counterparties (CCPs) regulators have been increasingly concerned that those centers could pose a catastrophic risk to financial stability if they fail. But a years-long standoff between regulators in the U.S. and Europe over how to regulate the swaps market is also stalling initiatives to shore up CCPs and to keep the international swaps market afloat. The stalemate is making the situation worse, especially considering that an enormous proportion of the entire global swaps market flows through just a handful of CCPs.

http://www.derivalert.org/news/bid/107694/Are-Central-Counterparties-the-Next-Systemic-Threat

9) Hidden Price Pressures Grow in Euro Swap Markets
September 8, 2015 (Risk) -- Users of euro interest rate swaps should expect bid/offer spreads to widen, dealers are warning – a consequence of shrinking liquidity in the markets banks use to hedge, such as the Bund future. Fierce competition and a drive to internalize more flow has shielded clients so far. Clients appear to be getting an increasingly good deal in the euro interest rate swap market, as liquidity drains from the products traditionally used by dealers to hedge themselves – a phenomenon that is driving up risk and cost for the sell side, but has so far hardly touched the bid/offer spreads charged to customers.

http://www.derivalert.org/news/bid/107537/Hidden-Price-Pressures-Grow-in-Euro-Swap-Markets

8) U.S. Fund Managers Brace for SEC Proposal on Derivatives
December 11, 2015 (Reuters) -- A potential move by the U.S. Securities and Exchange Commission (SEC) to broaden regulation of derivatives use has industry officials worried it could hamper the ability of exchange-traded funds and mutual funds to amp up returns. The SEC put the derivatives question on the agenda for its meeting on December 11, noting only that it would consider a proposed rule governing how funds use derivatives.

http://www.derivalert.org/news/bid/107948/U-S-Fund-Managers-Brace-for-SEC-Proposal-on-Derivatives

7) Lackluster CLOB Participation Needs Trading Incentives
March 25, 2015 (GlobalCapital) -- Active trading on central limit order books (CLOBs) needs larger liquidity providers and better incentives for more dealers and buyside firms to actively participate, say market participants. While the issues preventing adequate liquidity in CLOB trading platforms on swaps execution facilities (SEFs) are clear, determining how market participants will navigate the requirements to migrate away from request for quote (RFQ) and voice broking systems continues to elude both buy­-side and sell­-side players.

http://www.derivalert.org/news/bid/106690/Lacklustre-CLOB-Participation-Needs-Trading-Incentives

6) SEFs: The Road Ahead
March 17, 2015 (Markets Media) – For swap execution facilities (SEFs), volumes are expected to continue trending higher, but there remain some question marks pertaining to the framework of the business as set forth by the U.S. Commodity Futures Trading Commission. As participants and observers of the SEF space await a clearing of the regulatory smoke, SEFs themselves are moving ahead with initiatives to attract order flow.

http://www.derivalert.org/news/bid/106644/SEFs-The-Road-Ahead

5) U.S. Swap Dealers Warm to Dodd-Frank – ISDA
November 24, 2015 (FOW) -- Electronic trading and clearing have become the new norm for the U.S. credit default and interest rate swap markets as the Dodd-Frank regulatory reforms take hold, according to data published by industry body the International Swaps and Derivatives Association (ISDA). ISDA said the proportion of interest rate swaps traded electronically increased in the third quarter to almost 60% of the market by notional volume.

http://www.derivalert.org/news/bid/107878/U-S-Swap-Dealers-Warm-to-Dodd-Frank-ISDA

4) CFTC May Need to ‘Step In’ to End MAT Drought
April 22, 2015 (Risk) – The CFTC may need to take “a greater role” in extending the list of swaps required to trade on new platforms, one of its commissioner’s top staffers has warned – a response to a 13-month drought in requests from the SEFs themselves.  The comments about what is known as the made-available-to-trade (MAT) process came during a panel discussion at the ISDA annual meeting in Montreal.

http://www.derivalert.org/news/bid/106864/CFTC-May-Need-to-Step-In-to-End-MAT-Drought-Reinhart

3) Wall Street Poised for Swaps Collateral Victory at CFTC
November 25, 2015 (Bloomberg Business) -- Wall Street banks may be close to winning one of their biggest lobbying fights this year by beating back U.S. requirements that would have led to billions of dollars of additional costs on derivatives trading. The CFTC is considering a parallel version of a rule approved by banking regulators in October that governs how much collateral must be posted between divisions of the same bank, according to people with knowledge of the matter who asked not be identified because the rule isn’t public yet. The banking regulators softened the requirements from an earlier proposal leaving Wall Street looking to the CFTC to endorse that move.


http://www.derivalert.org/news/bid/107885/Wall-Street-Poised-for-Swaps-Collateral-Victory-at-CFTC

2) SEF Leaders Say Global Harmonization of Swaps Regulations is Pipe Dream
October 27, 2015 (Waters Technology) -- Implementation of MiFID II is roughly 15 months away, and with it comes a burning question: Will the U.S. and Europe be able to come to a mutual recognition of regulations for the swaps market? Douglas Friedman, general counsel for Tradeweb Markets, said the problem originates from assumptions by many that because the U.S. started earlier than Europe on swaps trading reform, European regulations would largely mirror what the U.S. did.

http://www.derivalert.org/news/bid/107754/SEF-Leaders-Say-Global-Harmonization-of-Swaps-Regulations-Is-Pipe-Dream

1) ESMA Makes Case for MiFID II Delay
November 18, 2015 (Financial News) -- Europe's top markets watchdog has outlined why it believes a delay to the reform of Europe's trading rulebook is necessary - and suggested a number of ways to postpone the reforms. The delay was originally suggested at a hearing in the European Parliament on November 10 when Steven Maijoor, chairman of ESMA, raised concerns about whether there was enough time to implement the revisions of MiFID II by January 3, 2017, as originally planned.

http://www.derivalert.org/news/bid/107849/ESMA-Makes-Case-for-MiFID-II-Delay

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