DerivAlert Blog

Solving the Puzzle of OTC Derivatives Reporting

By Kishore Kumar Ramakrishnan
Originally published on Tabb Forum

The cornerstone of global over-the-counter derivative regulatory reforms aimed at mitigating systemic risk, reducing market abuse and enhancing the transparency is centered on the ability to report the OTC derivatives transaction data to trade repositories, regulators and governments alike.

To this extent, the Commodity Futures Trading Commission adopted the final rules around swap data reporting and real time reporting last December. The rule advocates the reporting of swap data by market participants such as swaps dealers, major swaps participants, futures commission merchants, derivatives clearing organizations and swap execution facilities to swaps data repositories, which are in turn responsible for disseminating a portion of that information to the public subsequently.

The timing and content of swap data reporting is primarily a function of a swap's characteristics (i.e., cleared vs. uncleared swaps), reporting counterparty and product type (i.e., interest-rate, credit, FX, equity or commodity swap), among other things. The effective date of complying with the final reporting and record keeping rules vary based on the product type and reporting counterparty and begins no earlier than July 7.

The rules may be complicated but taken step-by-step, are not incomprehensible.

OTC Derivatives Data Reporting and aggregation – Industry Approach
In accordance with the G-20 leaders’ agreement in Pittsburgh struck in September 2009, the Financial Stability Board, along with a working group led by representatives of the Committee on Payment and Settlement Systems, the International Organization of Securities Commissions and the European Commission, outlined 21 recommendations to address pertinent issues of OTC derivatives product standardization, central clearing, electronic trading and reporting of OTC trades to trade repositories.

In particular, recommendation 19 outlines the need to identify the minimum data reporting requirements – inclusive of cleared and uncleared OTC trades – to be reported to the trade repositories, which would in turn furnish the same to the public and regulators. Additionally, it outlines the need to develop a methodology and mechanism for aggregating the data on a global basis.

Consistent with this recommendation, CPSS and IOSCO jointly issued a consultation paper in August 2011 to develop a framework of OTC derivatives data reporting and aggregation requirements.

The report framed out guidelines around minimum data reporting requirements (e.g., inclusion of trade economics, counterparty information, underlying information, operational and event data), data access (e.g., access of data by market regulators, central banks, prudential supervisors and resolution authorities) and methodology and mechanism of data aggregation by creating a system of legal entity identifiers.

In all, 32 comments¹ were received and they were incorporated in the final CPSS-IOSCO report published in January.

The final report provides a detailed guideline on OTC derivative trade reporting and capturing:

1. Data reporting requirements:
   i.    Functional Reporting: segmented into collating trade repository operational data; product, counterparty and underlier information; trade economics, valuation and event data
   ii.    Data Field Reporting: Outlines the list of potential data fields required to be captured for each asset class such as commodity, credit, interest rate, forex and equity derivatives
2. Data collection approach:
   i.    Lifecycle Approach: Data is to be reported from inception throughout the life of the swap until the expiry or scheduled termination of the swap.
   ii.    Snapshot Approach: Data is to be reported from inception followed by periodic updates as and when the changes occur to the contract since the previous update.

OTC Derivatives Trade Reporting – the CFTC Approach
The final rules adopted by the CFTC in December 2011 on OTC trade reporting incorporates the aforementioned approaches toward OTC derivatives transaction data collection and reporting. The final CFTC rules require market participants to furnish swap data upon execution or shortly thereafter to a swap data repository, which in turn is required to disseminate a portion of that data to the public.

Reporting Counterparty
If a swap is executed outside a SEF (i.e., an off-facility swap), the CFTC advocates the use of a “designated reporting counterparty” to be responsible for reporting the swap creation, pricing and transaction information. However, if a swap is executed on a SEF or through a designated contract market, the counterparties will not be responsible for reporting the swap transaction data to an SDR. Instead, the SEF or DCM needs to report that data. The highest precedence for reporting counterparty is SD followed by MSP² and then all others.

Additionally, the final CFTC rule stipulates that:

• If a transaction occurs between a non-SD/MSP entity³ that is a financial entity and a non SD/MSP that is a non-financial entity, the reporting onus lies with the financial entity.
• If a transaction occurs between two non-SD/MSP’s, of which only one is a U.S. person, that person becomes the reporting counterparty.
• If both the counterparties are of the same status, the reporting counterparty definition needs to be agreed as part of the swap agreement for off-facility swaps and post-execution agreement for swaps executed on SEF/DCM platforms.

Reporting Data: Primary Economic Terms and Confirmation Data
“Swap creation data,” which includes both PET⁴ and confirmation data, needs to be reported to the repository by the reporting counterparty. The construct of a swap’s PET can be broken down into two components, swap transaction information and swap pricing information. Swap transaction and pricing information includes:

• Time and date of the swap execution
• Indicator whether the swap is cleared or uncleared type
• Timestamps
• Price information of the swap
• Execution venue
• Day count convention
• Underlying asset
• Unique product, counterparty and swap identifier
• Effective and end dates
• Notional and settlement currency
• Payment and reset frequency
• Indication of collateralization
• Indication of end-user exception

The swap transaction and pricing information, however, does not identify the counterparties involved in executing the swap trade. But the swap’s PET does include all the aforementioned data including the identity of the counterparties involved in the trade. The confirmation data includes the details of all terms agreed at the time of confirmation.

Recordkeeping Requirements
The final CFTC rule requires all market participants to keep “full complete and systematic” records, details of which are expected to be finalized in forthcoming CFTC releases. All such records are required to be kept in electronic form throughout the life of the swap and for five years following the termination of the swap. Records would be required to be readily accessible by the registered entity or counterparty in question via real time electronic access throughout the life of the swap and for two years following the final termination of the swap. In addition, the data must be retrievable within three business days.

Non-SD/MSP swap counterparties, by contrast, have the option of keeping their records in paper form even if they were created electronically. Such records must be retrievable within five business days for the period during which the records are required to be retained.

Ongoing Reporting
The final CFTC rule requires market participants to continue reporting swap data on an ongoing basis to the same SDR to which the swap was initially reported. Market participants may choose to furnish a “daily snapshot” of the PET of the swap or may opt to report upon any event that results in the change of the PET of the swap trade.

DCOs are responsible for reporting continuation data for any swap they clear, while the reporting counterparty for any uncleared swap is responsible for providing the continuation data to the SDR. The rule requires that a SD/MSP/DCO reporting counterparty report the continuation data on the same day a relevant change occurs [e.g., assignments and novations].

Non-SD/MSP reporting counterparties can report the continuation data on or before the second business day following the date of the relevant change during the first year of reporting and no later than first business day following the date of relevant changes thereafter.

Compliance Schedule
The compliance schedule recommended in the final rule follows a staggered approach⁵ based on the product type and reporting counterparty status. For all exchange-traded interest rate and credit swaps, the real time and SDR reporting compliance date is the later of July 16, 2012 or 60 days after the final rules defining swap, swap dealer and major swap participant are published in the Federal Register.

The real-time reporting requirement for off-facility interest rate and credit swaps is the later of July 7, 2012 or 60 days after defining the final rules of swap, SD and MSP.

CFTC to Discuss “Available to Trade” Provision for SEF and DCM

The CFTC announced on Tuesday that it will hold a public roundtable to discuss the “available to trade” provision of the Commodity Exchange Act in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The roundtable will be held at CFTC headquarters in D.C. at 9:30 AM, Monday, January 30 and will cover the following:

1)       The filing process for a designated contract market (DCM) or swap execution facility (SEF) to notify the Commission that it has determined that a swap is “available to trade”;

2)       the factors a DCM or SEF must consider to make an “available to trade” determination; and

3)       the meaning and parameters of “economically equivalent swap.

We’ve included the agenda for the roundtable below:

9:30 a.m. Introduction

9:40 a.m. Panel One: Procedure to Make a Swap Available to Trade

Panelists: Kevin Gould (Markit); Philip Weisberg (FXall); Thomas LaSala (Chicago Mercantile Exchange); Patrick McCarty (ICAP); Trabue Bland (IntercontinentalExchange); Stephen Humenik (Eris Exchange); Rich McVey (MarketAxess)

10:55 a.m. Intermission

11:00 a.m. Panel Two: Factors to Consider to Make a Swap Available to Trade

Panelists: Karl Cooper (NYSE Liffe); William Thum (Asset Management Group of the Securities Industry and Financial Markets Association); George Harrington (Bloomberg); Hugo Barth (Association of Institutional Investors); Michael Cosgrove (Wholesale Markets Brokers Association, Americas); Lee Olesky (Tradeweb); Evan Ard (Evolution Markets); Professor Charles Jones (Columbia Business School)

12:15 p.m. Intermission

12:20 p.m. Panel Three: Economically Equivalent Swaps

Panelists: Mark Szycher ( The Committee on Investment of Employee Benefit Assets); Dexter Senft (International Swaps and Derivatives Association); Keith Bailey (Barclays); James Cawley (Javelin Capital Markets); Professor Matthew Spiegel (Yale School of Management); Christian Martin (TeraExchange)

The meeting will be broadcast live on www.ctfc.gov. Call-in participants can follow on the phone by using the following dial-in:

US Toll-Free: 866-844-9416
International Toll Numbers: See Related Links
Passcode: 8082055

DerivAlert will be watching and will provide a reaction following the discussion.

Business Conduct for Swaps Trading: That’s in Dodd-Frank Too

By George Bollenbacher
Originally published on Tabb Forum 

Amid the Sturm und Drang of the Volcker Rule, the Commodity Futures Trading Commission continues to inch forward in implementing other pieces of Dodd-Frank.

Last week, in fact, the agency published the final version of the (take a deep breath) Business Conduct Standards for Swap Dealers and Major Swap Participants with Counterparties Rule. More easily called the BC Rule. As with most of the rules promulgated under Dodd-Frank, it is mostly on target with a few anomalies here and there.

The first anomaly appears early on in the definitions section. The BC Rule defines a counterparty as “any person who is a prospective counterparty to a swap.” Aside from being a circular definition (which would have gotten me into trouble in high school English), it could mean that, in the cleared space, the only counterparty to the swap dealer/major swap participant would be the derivatives clearing organization, or DCO.

This distinction is important because the rule has a later section on “know your counterparty.” The section requires a dealer (but not an MSP) to “obtain and retain a record of the essential facts concerning each counterparty whose identity is known to the swap dealer prior to the execution of the transaction.” The CFTC was at pains to point out that this requirement applies to trades on SEFs and DCMs, as long as the dealer knew who it was trading with at the time of the trade. In other words, even knowing the identity an instant before the trade triggers this obligation.

If counterparty only means the DCO, this requirement is no big deal. It becomes something of a nightmare, however, if counterparty refers to the other side of a trade, not the other side of a swap. One interesting possible outcome here is that dealers might restrict their quotes on SEFs and DCMs to brokers who keep the identity of their customers secret until after the trade is done.

This practice would parallel the current practice on exchanges, where brokers don’t generally reveal who they’re executing for, but that outcome may not be what the CFTC intended. In addition, the suitability requirement in the current exchange process rests with the executing broker, who wouldn’t be a counterparty to either the dealer or the customer in the SEF/DCM world. If the suitability requirement in this rule is defined by the counterparty arrangement, does it magically disappear if the broker doesn’t reveal the customer prior to the trade?

The second anomaly is a version of one I have discussed before and that is the roles and responsibilities of MSPs. Here are some things the BC Rule requires of MSPs:

• Obtain and retain the true name and address of each counterparty, the principal occupation or business of such counterparty as well as the name and address of any other person guaranteeing the performance of such counterparty and any person exercising any control with respect to the positions of such counterparty;
• Verify that a counterparty meets the eligibility standards for an eligible contract participant before offering to enter into or entering into a swap with that counterparty, including whether the counterparty is a Special Entity (SE);
• Disclose to any counterparty (other than a swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant) material information so that the counterparty can assess:
       (1) The risks of the particular swap, which may include market, credit, liquidity, foreign currency, legal, operational and any other applicable risks;
       (2) The characteristics of the particular swap, which shall include the economic terms of the swap, the terms relating to the operation of the swap and the rights and obligations of the parties during the term of the swap; and
       (3) The incentives and conflicts of interest that the major swap participant may have in connection with a particular swap, which shall include:
            (i) With respect to disclosure of the price of the swap, the price of the swap and the mid-market mark of the swap; and
            (ii) Any compensation or other incentive from any source other than the counterparty that the major swap participant may receive in connection with the swap.
• For uncleared swaps, provide the counterparty (other than a swap dealer, major swap participant, security-based swap dealer, or major security-based swap participant) with a daily mark, which shall be the mid-market mark of the swap and  disclose to the counterparty the methodology and assumptions used to prepare the daily mark plus some additional information;
• For cleared swaps, notify any counterparty (other than a swap dealer, major swap participant, securities-based swap dealer, or major securities-based swap participant) that they have the sole right to select the derivatives clearing organization at which the swap will be cleared;
• For uncleared swaps, notify any counterparty (other than a swap dealer, major swap participant, securities-based swap dealer, or major securities-based swap participant) that they:
       (1) May elect to require clearing of the swap; and
       (2) Shall have the sole right to select the derivatives clearing organization at which the swap will be cleared;
• For swaps where the counterparty is a SE, determine whether the SE has a fiduciary manager, has the appropriate expertise, has no conflicts of interest, and has not received contributions from the MSP;
• Have written policies and procedures for compliance with the BC Rule; and
• Implement and monitor compliance with the BC Rule;

Many of these requirements parallel the dealer requirements, even though an MSP could easily be something like an ERISA fund or a large endowment, which would never have the resources to do these things.

Needless to say, although the BC Rule was intended to normalize business conduct, in many cases it may have made conducting business harder, and may it have some impacts that the CFTC never intended.

FinReg Forecast: Nine Market Structure Predictions for 2012

By Jamie Selway
Originally published on Tabb Forum

As we enter the New Year – with hopes of better volumes and a bounce for our industry – we provide our annual list of market structure predictions below. Next, we mark the book on 2011’s blotter.

1. Tobin Tax Flirtations Fail. In the second half of 2011, one of the worst ideas lurking around financial markets – the “Tobin tax” on transactions – resurfaced in both the EU and U.S. While not new, the combination of revenue shortfalls in the face of growing obligations and populist appeals to residual anti-banker sentiment makes the danger clear and present to the industry. In the EU, the proposed Financial Transactions Tax comes close but is ultimately rejected. In the U.S., the efforts of Congressman Peter DeFazio (D-Ore.) and Senator Tom Harkin (D-Iowa) generate election year buzz but aren’t seriously considered. We close 2012 with no new taxes of this type on the global books.

2. Ex-CAT, a “Nothing Done” at SEC. As the Securities and Exchange Commission completes its docket of post-Flash Crash rulemaking – limit up/down and market-wide circuit breakers – it turns to an imposing list of Dodd-Frank to-dos. Then the approach of the presidential election brings about the usual Washington slow-down. The result: aside from approval of its Consolidated Audit Trail proposal, the SEC engages in no major equity market structure business. Moreover, by year end, at least one – and perhaps both – of SEC Chairman Mary Shapiro and Commodity Futures Trading Commission Chairman Gary Gensler have moved on from their respective agencies.

3. DirectEdge Trades. As EU authorities lean on NYSE Euronext and Deutsche Borse for derivatives-related concessions and render the deal less and less likely, the U.S. Department of Justice’s required remedy – divestiture of DirectEdge – happens regardless of the final outcome. Lost in the corporate tangle at Deutsche Borse (via Eurex) and possessing international aspirations of its own, DirectEdge management successfully argues for a sale of Eurex’s 31.5 percent stake. The buyer is a for¬eign exchange in search of a U.S. beachhead, as opposed to a domestic exchange or a consortium-minded group of market participants.

4. Maple-TMX: All Sap, No Syrup. Financial markets opened 2011 with a burst of exchange merger euphoria redolent of the “go-go” years of 2006 and 2007. Alas, regulators around the world pulled the punch bowl, leading to multiple failures and a single success (BATS-Chi-X Europe). In Canada, the Maple Acquisition Group – a consortium of 13 large financial institutions including four of the “big six” banks – launched a hostile offer for TMX in competition with the London Stock Exchange. While the price may be right for TMX shareholders, regulators claim another scalp toward the end of Q1.

Specifically, the Canadian Competition Bureau (CCB) intervenes, based on its discomfort with a potential (near) monopoly in equity listings, equity trading, equity clearing, fixed income clearing, derivative clearing, derivative trading, and equity trading data distribution (whew!), which would be created by the combination of TMX and Maple’s members stakes in Alpha (an alternative marketplace) and CDS (an equities and fixed income clearinghouse).

5. An Exchange Launches Spot FX. With the many negative headlines around its current custodian-centric market structure and lack of basic transparency, an increasing number of experienced electronic trading hands view FX as the “next big thing.” Although a handful of banks are at work modernizing FX approaches to meet equity-like standards, and high-frequency traders have begun trading FX in earnest, exchanges currently only have a role on the futures side. While the clearing issues aren’t straightforward – there’s no DTCC-style central counterparty in FX, just the bank-dominated CLS – an enterprising and intrepid exchange changes the landscape by launching a spot trading initiative.

6. An HFT Files an S-1. Over the past two or three years, much time and energy has been spent in an effort to define, if not understand, the high-frequency trader. These informational clouds part in 2012, as a large, mature HFT prepares for an initial public offering by filing an S-1 — the “holiest of holies” of business descriptors. Interested readers find what discerning market participants have known for a while: HFTs trade for tiny edge, deploy modest capital and do not warehouse risk. More “exchange error account” than market maker of yore, the industry and public’s fear and loathing of HFTs decreases with each bit of incremental transparency.

7. Alternatives Accelerate in Asia-Pacific. While the U.S. and EU spent much of 2011 in a state of market structure stasis, Asia-Pacific provided positive indications for the growth of alternative trading venues to traditional exchanges. This trend accelerates in 2012. By year-end, three important milestones are reached: PTSs account for 12 percent market share in Japan, Chi-X reaches 5 percent market share in Australia and South Korea provides a regulatory framework for a competitor — ei¬ther exchange or broker-sponsored dark pool — to KRX.

Further, a third marketplace files with the Australian Securities and Investments Commission to join the Australian fray. Legacy exchanges continue to respond — also at accelerated pace — to these threats via investment in technology and corporate combinations. More lunch-hour breaks go the way of the teletype machine.

8. Brazil to Competition: “Boa Vinda.” Institutional investor interest in Brazil continued to grow in 2011. Alas, Brazil remains an expensive place to trade, particularly in size. In December, Brazil’s Finance Ministry ended its 2 percent IOF tax on equities, clear progress toward better, cheaper trading. Next year, Brazil’s securities regulator, CVM, adds fuel to this fire by allowing competition to Bovespa. As usual, clearing is the sticky wicket, but imposition of an “open access” policy provides the path forward. DirectEdge and BATS have been outspoken about their appetites for a Brazilian business. More aspirants join them in 2012. While no competing marketplace launches in 2012, we end the year with a date certain and a good deal of investor interest.

9. ETFs Get Guardrails. On the back of both regulatory and political attention — not to mention considerable scapegoating for the high levels of equities volatility and correlation and poor condition of the equities business generally — the exchange-traded fund industry began to organize its defense last year. This proves timely because policymakers spring into action in 2012. Globally, regulators formally define the term “ETF,” with the consequence that complex, derivatives-based products need to find a new acronym.

In the EU, regulators push for hard and fast standards for swap-based products, such as a minimum number of counterparties and guidance around acceptable collateral. In the U.S., regulators explore the effect of the ETF boom on market quality and propose to replace the current “no action letter” method of registration with an ETF-tailored approach.

2011 Predictions Scorecard. Shorts of our crystal ball were rewarded handsomely last year. By our lights, we were correct on two, wrong on four and pushed on two.

On the plus side, with the help of the industry, the SEC is on the cusp of replacing single-stock circuit breakers with a “limit up/down” approach and updating the existing market-wide framework. Exchanges challenged internalizers last year in a few ways, most prominently NASDAQ’s aggressive taker/maker rates on BX and NYSE’s proposed RLP program.

We score our HFT call a push – the 2011 trading environment was definitely a speed bump, particularly May’s reverse Citigroup split, but regulators took no decisive HFT action and exchanges did not move on cancellation-related taxes. And while NYPC launched and made modest progress vis-à-vis CME in Eurodollars, ELX and IDCG end the year “unch’ed” in terms of ownership.

In terms of misses, the SEC neither extended its Market Access Rule to algorithms nor approved its Consolidated Audit Trail proposal – whether in slimmed-down, realistic form (read: no real-time data requirement) or otherwise. On Dodd-Frank implementation, the CFTC has made the most progress of its regulatory brethren by a wide margin, but many rule approvals came late in the year or remain for early 2012, and its new position limit scheme is headed for the courts.

Our near-sightedness was again evident where dark pools are concerned, as we got it precisely backwards on minimum order size outcomes in Canada and Australia, and few would characterize the future rules of engagement for EU internalization post-MiFID II as clear.

Dealer with a Capital “D”

By Kevin McPartland
Originally published on Tabb Forum

Competition among swaps dealers young and old will be fierce, yet what constitutes a “dealer” still remains unclear. Defining dealer is important because those who register as Swaps Dealers will face tougher scrutiny — including more reporting and higher capital requirements — from regulators. And since the Commodity Futures Trading Commission recently passed a few rules relating to Swap Dealer registration, I thought it would be a good time to review the issues.

There are two sides to the debate over what a dealer is: the regulatory definition and the practical definition. The most pronounced regulatory definition comes from the CFTC. 

According to the CFTC, activities that make someone a Swaps Dealer are:

1. Holding oneself out as a dealer in swaps or security-based swaps,
2. Making a market in swaps or security-based swaps,
3. Regularly entering into swaps or security-based swaps with counterparties as an ordinary course of business for one’s own account, or
4. Engaging in activity causing oneself to be commonly known in the trade as a dealer or market maker in swaps or security-based swaps.

Looking at this definition broadly, the most significant question is whether or not a firm that satisfies some, but not all, of these conditions should be required to register as a Swaps Dealer. Reporting, margin capital and other requirements for registered Swaps Dealers will likely be more onerous, so even firms that aspire to provide liquidity to clients will try to avoid the “capital S, capital D” label. It could be argued that being registered as a Swaps Dealer might act as an ironic competitive disadvantage. Principal Trading Groups (PTG), for example, fall into this bucket (see "Higher Frequency Swaps Trading: Market Making and Arbitrage," August 2011).

Activity No. 2 from the list above would lead you to believe that PTGs making markets in swaps must, in fact, register as dealers. The bulge-bracket global banks agree. If a PTG is making markets in 10-year interest rate swaps, shouldn’t they be forced to meet the same requirements that major banks have to meet?

TABB Group research has found that this is not the view taken by some regulators in Washington. The “dealer” title is intended for systemically important and highly interconnected firms that trade both cleared and non-cleared products. The CFTC proposal goes on to suggest that “dealers tend to be able to arrange customized terms for swaps or security-based swaps upon request, or to create new types of swaps or security-based swaps at the dealer’s own initiative.” None of those activities are, or likely ever will be, of interest to PTGs.

The story is different for banks and FCMs looking to get into the swaps market. In most cases, even if they could structure the business to avoid the Swap Dealer label doing so might not be such a good idea. More than 90 percent of participants in our U.S. Swaps Dealer study expect to register as Swaps Dealers, proof that even those who would prefer to avoid the additional regulatory oversight realize that registering is unavoidable and probably even necessary to grow in this business (see Exhibit). Whether rational or not, when clients are looking for a dealer to help with their swaps trading, they want a Dealer, not a Major Swaps Participant. Perception in this business is reality.

The more interesting debate is the practical definition of “swaps dealer.” As TABB Group sees it, there are four main roles that swaps dealers will need to fill going forward: executing (agency) broker, market maker, clearing broker and prime broker.

The first two roles describe what swaps dealers do today: Provide their clients with liquidity. In the new world, however, client facilitation and market making will likely be split in two, with the former helping clients find the liquidity they need on the appropriate SEF and the latter acting more as a standalone trading operation.

We’ve already established that PTG market makers shouldn’t have to register as Swap Dealers but what about an agency-only swaps dealer that offers client execution services but requires they clear elsewhere? In that vein, what about those firms that plan to offer clearing and custody services but not engage in active swaps trading?

As new rules hit the Federal Register in the coming months, these issues will start to become clearer. However, even when new regulations are final, identifying Swap Dealers from those simply looking for alpha with market making strategies will be complicated. The ultimate goal here should be to regulate systemically-important firms and ensure a more level playing field, not to place overly burdensome registration requirements on everyone looking to trade swaps.

Here’s to hoping.

Turning Dodd-Frank into an Opportunity

By George Bollenbacher
Originally published on Tabb Forum

LSOC it to Me

Originally published on derivatiViews

The derivatives world is full of acronyms. CDS, IRS, CCP, CVA. The list goes on. ISDA itself is an acronym, and a relatively popular one at that.

Well, we can now add another acronym to the mix:  LSOC. If you haven’t heard it yet, you are likely to, in the cleared swap world of the future in the United States. LSOC stands for “legally segregated, operationally commingled.” Under rules adopted by the CFTC (acronym alert!) last week, it is the basis for the complete legal segregation model, which determines how margin for cleared swaps will be held for the benefit of customers of a futures commission merchant (or, to cite another acronym, an FCM).

ISDA has been supportive of the LSOC approach since the very early days of the CFTC’s deliberations on customer margin for cleared trades. It is an approach to margin that bears similarities to the way that collateral has traditionally been held in the OTC derivatives business. The legal rights to collateral in OTC trades are clear under the widely-used ISDA credit support annexes backed by the legal opinions obtained by ISDA. Operationally, collateral provided for OTC trades may be commingled or even in some cases rehypothecated, but the legal rights of the provider of credit support are protected by the terms of the documentation.

The process followed by the CFTC in reaching its final rule last week is an example of effective dialogue among the CFTC and various interested parties. Soon after the Dodd-Frank Act (we’ll spare you the acronym) was passed, several market participants raised concerns with the CFTC that they could potentially find themselves less protected in margin arrangements for cleared swaps than for non-cleared OTC swaps, where they had  negotiated third-party custodial arrangements. They wanted to take advantage of the risk reduction offered by clearing their trades, but they did not want to forego the degree of protection for margin that they had so carefully negotiated for the collateral in their OTC trades.

Through an advanced notice of proposed rule making, proposed rules, roundtables and an ongoing dialogue with ISDA and other market participants, the CFTC worked this issue extensively. Swap clearing is a pillar of national and international approaches to regulatory reform, and margin and its treatment is a linchpin of clearing. It was important to get this right so that customers would not have to be concerned about the protection of their margin as they moved to the cleared swap world.

LSOC seeks to strike a balance by recognizing that while full legal segregation of collateral can provide the highest degree of protection, it can also create operational challenges where a third-party custodian is involved. Complete segregation through a third-party custodian also comes at a cost and some customers may take the view that the extra protection is not justified by that cost. Clear, robust legal rights are essential. If those are in place, greater flexibility on the operational side is acceptable. Maintaining legal segregation while allowing for commingling of margin for operational reasons—the LSOC approach in a nutshell—was the best result.

The CFTC will continue to consider the approach to margin in both the cleared swaps and futures worlds as the market builds experience with LSOC and more details are discovered regarding what happened at MF Global. ISDA and the industry will also assess its experience with LSOC and the other rules adopted by the CFTC last week. The dialogue that has been established through the CFTC’s consideration of LSOC will serve the CFTC and the industry well for the future.

The long and short of it is that LSOC is a good step in the right direction.

Citi’s Pandit Proposes Alternative to Basel III

Vikram Pandit, CEO of Citigroup, proposed a new approach to bank risk disclosure in a Financial Times opinion piece, published last week. In discussing the many options that have been proposed to support the safety of the financial system, Pandit calls for the following:

“What is needed is a way to compare apples with apples. Regulators should create a “benchmark” portfolio and require all financial institutions, not just banks, to measure risk against that. The benchmark portfolio would not actually exist on the balance sheet of any one institution. Rather, it would be a collection of real investments that stand in for the kinds of assets that most financial institutions actually hold at the time. What is more, its contents would be 100 per cent public.”

Pandit stated that since financial institutions currently only run hypothetical stress tests against their own portfolios, the results have no common denominator and the results often go undisclosed. A universal benchmark portfolio would give the industry a much needed frame of reference.  He goes on to say:

How a given company’s risk measurements perform against the benchmark portfolio tells the world how its management thinks about risk, and so just how conservative or risky its own portfolio probably is. An institution that cheerfully reports minimal expected losses from the benchmark portfolio in the event of a one-in-a-thousand market decline is probably understating the risk in its own portfolio. By contrast, one that predicts significant losses from the benchmark portfolio even from a routine decline is a firm that is very conservative about risk.

As the regulatory landscape continues to evolve and best practices emerge, would this solution be the easiest to implement? Who would oversee it and what assets would make up the portfolio?

Pandit closes the piece by stating the best way to avoid panic is to give the market the tools that discipline institutions for taking on too much risk. The financial industry itself on the cusp of a paradigm shift but will the regulators trust the banks to regulate themselves?

Q&A: Certainty of Clearing

Q&A with Elisabeth Kirby, Vice President, U.S. Markets, Tradeweb

Clearing of over-the-counter (OTC) derivatives has become a hot-button topic for reform-watchers. Unless the timeline changes, new rules proposed under the Dodd-Frank Act will require OTC derivatives trades to be cleared through a central counterparty in the second quarter of 2012. 

That has everyone in the $600 trillion swaps market, from interdealer brokers to clearing houses to dealers to electronic trading platforms asking lots of questions: Will clearinghouses be able to keep up with real-time volume?  Will new latencies crimp profit margins?  What impacts will increased transparency have on market structure?

For some insight into the ways in which swaps market participants are getting ready to trade in the new regulatory environment, DerivAlert turned to Elisabeth Kirby, vice president,U.S.markets at Tradeweb.  Kirby and her team have been working for the past several months on a tech solution to the new clearing challenge.  Their Certainty of Clearing solution guarantees that trades will clear by introducing a pre-trade credit-check mechanism into the trading workflow.  Kirby explains:

DerivAlert: Tell us about your Certainty of Clearing initiative; what is the goal at Tradeweb?

Kirby: Pre-trade certainty of clearing is meant to provide comfort to the parties of a trade that, once executed, the trade will behave as they expect it to by successfully clearing.  Between Dodd-Frank and EMIR, there is little doubt that interest rate and credit default swaps will need to be cleared at some point in the near future.  We’re trying to build an efficient solution that lets market participants integrate the clearing process directly into their trading routines.

DA: How does it work?

EK: Essentially, we’re building a pre-trade credit checking mechanism into the swaps trading process.  Clearing members will populate Tradeweb with pre-determined clearing limits for each account at the beginning of the day, which they can change day-to-day or intraday.  At the time of a trade, the customer will choose a clearing house and clearing member and the trade will be automatically checked against the credit level defined in the system by the clearing member.  If it is insufficient, Tradeweb sends a message to the clearing member asking them to approve the trade.  If it is not approved, the request-for-quote (RFQ) may still be sent, but it will be noted that clearing approval was not received.

DA: How has the marketplace reacted to your proposal?

EK: The response from both buy- and sell-side participants has been very positive.  The industry knows these changes are coming.  Whether they come in a few months or over the course of a few years, the market will need to adapt.  The key for participants is to preserve the market structure that allows them to profitably trade derivatives.  By introducing certainty of clearing, we’re creating a free market solution that doesn’t restrict any activity; it just offers an additional layer of transparency into the credit condition of your counterparties.  That’s valuable intelligence in any market.

DA: Is there any concern that securing Certainty of Clearing will add latency to the process?

EK: The big question right now concerning the clearing rules under Dodd-Frank is where the credit-checking mechanism that enables certainty of clearing will be housed.  There was initially talk of creating a centralized credit hub, but it is unclear who would build this and how long it would take to become operational.  Another option is to house the credit-check function at the clearing houses themselves, but there are fears of increased latency in that scenario.  The third option is to house the credit-check mechanism at the SEF level.

We believe this is the most efficient choice for the marketplace. Our Certainty of Clearing solution sets the stage for us to be able to deliver seamless credit-checks that are integrated directly into the trading workflow, while leveraging our existing connectivity to the clearing houses.  Market participants like that we’ve come up with something that’s scalable for whatever the regulations bring, but not restrictive in terms of workflow or disruptive to market structure.

DA: What is your timetable for implementation?

EK: The clearing portion of financial reform is expected to be phased in over a period of nine months starting in mid-2012.  However, we expect to have our Certainty of Clearing solution up and running with clients well in advance of the rule implementation.

Take Our Survey!  How do you think that will that affect the industry?  Take our survey here and we’ll report back on the results in a few weeks.

CFTC’s Sommers and O’Malia Attack Volcker Rule

When two CFTC commissioners call a financial rule “too complex,” just imagine how the industry will respond.  The seeds for a heated debate on the Volcker rule were planted, yesterday, when the CFTC approved a version of the rule by a three-two margin.

The rule, which is required by the Dodd-Frank Act, bans proprietary trading at banks, while also limiting their ownership of hedge funds and private equity funds.

While the CFTC vote to propose the Volcker Rule has made the biggest headlines, the bigger story may be in the two dissenting views among the commissioners. 

This is what commissioner Scott O’Malia had to say about the CFTC proposal:

 I do not support the commission's version of the Volcker rule. It is an unworkable solution that is entirely too complex and provides the commission with little or no means to enforce or to deter violations of this rule. Obviously we have to comply with the statute and do so in a responsible way, [but] my concern with this fatally flawed rule [is that] this rule does not do that.

He then went on to voice concern over unintended consequences emerging in the final rules:

I think in terms of pages, this might be our biggest day, which is not our proudest moment. It's ridiculous to do a thousand pages [of rule-making] in one day. It's just not possible to get it right, and we should take a more measured approach on considering the number of rules we consider in any one meeting.

Commissioner Jill Sommers, who joined O’Malia in voting against the rule, focused on the politics of the rulemaking process:

Had we planned it better we could have joined the October proposal. Unfortunately, we are proposing rules that are virtually identical to the other agencies' proposed rules well after they have been widely criticized and after many have called for those agencies to start over, including Paul Volcker.

All of this, of course, will become ammunition for financial firms, politicians, other regulators and lobbyists as they continue to challenge proposed financial reforms.  The first opponents firing a salvo on this front appear to be the Bank of Japan and the Japanese Financial Services Agency who have expressed concern over adverse impact of the Volcker rule on trading in Japanese government bonds.  Stay tuned for much more.