By Mark Jennis, DTCC
Originally published on TABB Forum
The success of the G20 agreement finalized in Sept. 2009 to enhance transparency and increase market stability while reducing counterparty, operational and liquidity risk will be largely dependent on the efficient management and effective allocation of collateral. The industry’s ability to meet this challenge, however, rests on cross-border collaboration and the development of holistic, industry-wide solutions.
Collateral has always been crucial to the efficient functioning of funding and capital markets and, in turn, essential for economic growth. Prompted by the G20’s reform agenda, however, the introduction of central clearing and increased margin requirements for non-centrally cleared derivatives has put a strain on the ability of market participants to manage their collateral processes, largely due to a combination of outdated and siloed collateral management systems and collateral fragmentation.
In fact, a recent academic study published in June 2014 by the London School of Economics (LSE) highlighted the increasing occurrence of collateral bottlenecks due to weaknesses in financial market infrastructure. These weaknesses lead to eligible collateral becoming immobilized in one part of the system and unattainable by credit-worthy borrowers that need access to their inventory of collateral for central clearing purposes and increased margin requirements for bilateral transactions. Additionally, such borrowers also need to track and optimize their available collateral, including assets held at other banks and custodians, to fulfil their investment and trading strategies. In today’s marketplace, the ability to successfully analyze the collateral implications of a trade before it is executed is paramount and enables more efficient management of the available assets.
Firms, having fully grasped their collateral obligations, are becoming increasingly concerned about their ability to comply with new regulations governing the use of derivatives, including Dodd-Frank and the European Market Infrastructure Regulation (EMIR). They now have a heightened level of awareness of the need to review their processes to account for new margin and collateral requirements for both cleared and non-cleared derivatives transactions, which will bring efficiency to their collateral management processes, enabling them to remain competitive and drive down costs. This has been made even more important now that assessments of available collateral have to be made in real time for transactions that are centrally cleared.
A large number of firms, however, are still using outdated processes and fragmented systems to manage their collateral. Indeed, too often, collateral is managed in silos across an organization – both geographic silos and across business lines. This makes it almost impossible to have a holistic view of what securities are in use and where securities collateral is at any given time. The net result: a sub-optimal collateral processing environment that is costly and by definition an environment that does not maximize the collateral possibilities of the firm’s entire portfolio.
There are currently a plethora of automated collateral management solutions encompassing everything from portfolio margining to collateral optimization, all attempting to address the different components of the collateral challenge. However, the sell side, buy side, central securities depositories (CSDs) and custodians alike all recognize that these fragmented solutions only address parts of the problem.
For firms that use fragmented and legacy systems, it is essential that they review their processes to ensure they can manage workflow changes – in many cases, legacy systems will no longer be flexible enough to adapt to the new regulatory requirements. Firms should therefore consider the impact of using these types of systems from an investment, trading and operations perspective. Perhaps an alternative would be to instead look at holistic solutions and offerings that can address these problems and help ensure compliance with collateral and clearing requirements worldwide.
Second, while reviewing processes and implementing collateral management solutions at an individual firm level is crucial, collateral mobility needs to be addressed at an industry-wide level. Given that its supply is finite, collateral must be able to move smoothly and efficiently throughout the financial markets – a collateral bottleneck in one part of the system can have a knock-on effect across the markets and risk choking the global flow of liquidity. Just as individual car owners do not control the traffic light system for the safe movement of traffic and reduction of congestion, nor can derivatives users be expected to manage global collateral mobility.
Recognizing that the industry requires a solution to address both the scale and efficiency of the collateral management challenge, DTCC has been working on a key initiative, by leveraging infrastructure enhanced through a partnership with Euroclear. The joint venture will create a global Collateral Management Utility (CMU) that will follow the development of a Margin Transit Utility (MTU). [Note: Certain aspects of the MTU and CMU are subject to regulatory approval.]
The MTU, which is in advanced stages of development, will leverage DTCC-developed infrastructure, and will offer straight-through-processing possibilities for margin obligations. Using electronic margin calls between market participants, the MTU will utilize Omgeo’s ALERT database to enrich the agreed margin calls with the standing settlement instructions for cash and securities transfers and pledges, and then automatically generate and send the appropriate delivery/receipt, segregation and/or safekeeping instructions to the applicable depositories and/or custodians. The service culminates with the investment managers, Futures Commission Merchants (FCMs), and General Clearing Members (GCMs), dealers, and clearinghouses receiving electronic settlement status and record-keeping reports for all collateral movements.
This facility will mitigate systemic risk and provide significant additional risk and cost benefits to both sell-side and buy-side market participants by increasing scalability and operating efficiency, and providing greater transparency across collateral activity. Longer term, the solution will connect collateral data with information reported to the DTCC Global Trade Repository (GTR), providing a complete view of risk exposures in the event of a future market crisis.
As envisioned, the CMU will harness the open architecture of Euroclear’s Collateral Highway and enable users on both sides of the Atlantic to consolidate assets under a single inventory and collateral management system. This provides them the possibility to optimally allocate mutualized assets to meet exposure obligations in both the European and North American time zones. Collateral processing is done across a single virtual pool even though the assets remain on the books of each depository, with each opening accounts in the other depository. Collateral allocations will seamlessly integrate with other settlement obligations at the relevant depository, significantly reducing the risk of blockages and settlement failures during market stress conditions.
The CMU will address the pressing problem of accessing collateral globally and automatically coordinate collateral settlements and substitutions with other settlement activity. Market participants often cite sub-optimal collateral mobility, allocation and settlement coordination as issues at a global level, and the CMU will fill this gap.
While the new derivatives trading and clearing environment will benefit the market and increase investor confidence in the long term, in the short term, firms must be equipped to adapt to these changes. The key to doing so is for market participants to understand their impact and to be able to prepare by implementing holistic and community-based infrastructure solutions. To that end, DTCC is continuing to collaborate with industry partners to develop solutions that address the operational challenges and risks associated with the increased demand for collateral.
There was a great business myth circulating the stressed-out halls of corporate America around the time Lehman Brothers was starting to collapse. It suggested that the Chinese character for ‘crisis’ was the same as ‘opportunity.’
Though it made some people feel better at the time, it turns out it’s not actually true. As many linguistics experts have since pointed out, the character in question doesn’t translate to opportunity in the literal sense. However, history may have proven the linguists wrong. The financial crisis of 2008-2009 which set in motion an unprecedented fury of regulatory reforms and endless predictions about the demise of the capital markets as we know them, has indeed created some new opportunities.
According to Will Rhode, the new global head of capital markets research at Boston Consulting Group (BCG), many of those opportunities are just beginning to reveal themselves now. He should know; his own career path has mirrored the evolution of post-reform financial markets as he’s made his way from Tabb Group, where he was a point man on derivatives reform from 2010-2014, to BCG where he’s now tasked with helping financial firms adapt to new regulatory changes.
We were able sit down with Rhode after he settled into his new role to hear his thoughts on the real-world impacts of the last several years of financial reforms.
DerivAlert: You recently joined BCG after spending four years – arguably the most volatile four years for derivatives reform – overseeing fixed income research at Tabb Group, tell us a bit about that transition and what you’re doing in your new role.
Will Rhode: Tabb Group actually launched its fixed income practice on the back of Dodd-Frank. Like many other market participants, they responded to the sheer magnitude of that single piece of legislation which impacted markets in such a degree that it justified a dedicated research effort. The implicit understanding at the time was that this was going to impact big businesses in every way: new businesses would emerge, like SEFs, different businesses would move to different customer segments, banks would have to adapt in a number of ways to service their clients, compete with each other and remain relevant.
The transition to BCG followed that cycle of rule writing, and implementation to the point where now we’re in the thick of things in terms of real management change. With a strategic advisory firm of BCG’s caliber, we can now focus on how to help clients in the banking sector adapt.
DA: What is your big picture perspective on the last four years of market reforms, starting with Dodd-Frank and, now, with SEF volumes starting to take off and a general sense of some “new” normalcy returning to derivatives markets?
WR: The net result, when all is said and done is that derivatives reform – Dodd-Frank specifically – wedged a foot in the door to a regulated marketplace. It didn’t blow it off the hinges, but it opened things up a bit. Incrementally, the door will open more and more. Electronic execution will continue to increase. Workflow tools will smooth over and introduce straight-through-processing, market participants will discover new efficiencies in terms of digesting clearing, among other things.
Depending on your lens, it can seem like not much has changed because there was no big bang. Because of all of the drama in the preamble, you expected an explosion. The industry has done a good job of managing a phased-in approach so there was no fundamental event to undermine the transition. Kudos to the industry and the CFTC for the collaboration, their ability to build the pipes and actually implement changes that haven’t resulted in a seismic shift to market structure that would threaten liquidity.
DA: How do you see the trading in derivatives evolving over the next five years?
WR: Increased electronification will change pricing models, ways in which transparency and competition are promoted, and who becomes the winners and losers. SEFs have not reduced the number of dealers; they are not dealers; they are venues. You might expect some execution margins to compress, but the obvious inherent segue is that costs would also compress as a result of the increased efficiency. Over time, the profitability metrics for financial firms trading derivatives in a post Dodd-Frank world may be the same, if not better.
DA: We’ve been hearing a lot lately about the rise of compression-style trading. In fact, you were recently quoted in Wall Street & Technology making the case that central clearing under Dodd-Frank has become more expensive for the buy-side. What role do you see compression playing in the growth of SEF trading volumes?
WR: Dealer-to-dealer compression cycles have been in use for many years, but that was easier because there were only 14 major dealers. The reason why this phenomenon is interesting now is that we are seeing the emergence of a kind of decentralized compression. It would have been more difficult for a central clearing house to organize this, but with tools provided by SEFs, we’re seeing the capability to execute straight-through processing from the buy-side. Compression is a necessary operational tool to operate in a centrally cleared environment, managing complex portfolios and associated costs.
DA: Let’s talk for a minute about Europe: the EMIR trade reporting deadline took effect a couple of weeks ago; how do you see European derivatives reform playing out versus what we’ve seen so far in the U.S.?
WR: This topic is near and dear for me because I started off with Tabb in Europe and observed the introduction of the early evolution of European financial markets reform. It was a very different process than what occurred in the US. MiFID, for example, was meant to cover transparency across all asset classes and then it was refined to cover equities alone. Then, it was repurposed again to serve as the transparency piece of the G20 reforms across all asset classes. By virtue of having to be repurposed so many times, the rules are much less specifically designed for derivatives. Add the fact that you have 27 member states each with regulation-hating members and several other overseeing bodies. You can start to see why the implementation process has been slower and made it more difficult to harmonize with established regimes.
DA: For those who’ve been really challenged by derivatives reform, do you see a light at the end of the tunnel?
WR: We really are living through a renaissance in the capital markets industry right now. It’s a very interesting time for all of us. Years and years from now, people will look back on this period as the catalyst to so many new ways of doing business, the development of new markets, new opportunities. I believe we’re going to see a lot more entrepreneurial behavior as a result.
By Krishnan Ranganathan, Nomura
Originally published on TABB Forum
The US and Europe are responsible for nearly all outstanding open positions in OTC derivatives worldwide. Why is compliance with confirmation mandates so onerous, and how can the industry move toward more timely confirmations?
According to data published by DTCC, as of May 2014, out of the total open positions of all OTC derivatives transactions across jurisdictions, Europe contributed to 68% and the US to 29%. Asia’s share was a meager 3%. The derivatives markets in the US and Europe are governed by two key regulations: the Dodd-Frank Act (DFA) and the European Market Infrastructure Regulations (EMIR), respectively.
With effect from Sept. 1, 2014, the confirmations execution timeline for all five asset classes – Credit, Rates, FX, Equities and Commodities – becomes more aggressive, moving to T+1 for Financial Counterparties (FCs) and Non-Financial Counterparties exceeding the Clearing Threshold (NFC+s), and to T+2 for Non-Financial Counterparties below the Clearing Thresholds (NFC-s).
The previous Fed-driven industry standards allowed for more relaxed Issuance and Execution deadlines, where Execution of Confirms would sometimes take as long as T+30. Fed targets (DFA) do differentiate between Issuance and Execution, while EMIR does not and only looks at complete Execution of a confirmation agreement.
Based on data available, the industry average for compliance rate in Europe for electronic and paper combined is in the below range:
Of course, the above numbers are by no means sacrosanct, since different firms use different assumptions; but nevertheless, they are a good indicator of where the industry stands with respect to this requirement.
So what makes compliance such an onerous task? There are various contributory factors for confirmations not being able to be executed in a ‘timely’ manner. Some of the issues faced by counterparties could broadly be summarized as follows:
Standardization of templates is still a far cry, specifically for Equities, and this is where the compliance rates are woefully low. Firms do not have standard templates for structured, bespoke and complex trades for Equity products. Largely structured terms are not eligible for electronic confirmation. There are many clients with which the MCA (Master Confirmation Agreement)/bilateral agreements have been negotiated but not yet executed. In case of highly exotic trades, post-trade negotiation due to terms not agreed beforehand contribute to delays.
A significant percentage of paper volumes in FX are caused by deliverable Vanilla Options and Simple Exotics. There is no market-wide master agreement in place for these products. This imposes a limitation in terms of widening the MCA coverage, as the industry has to solely depend on paper confirmations. At least for complex and bespoke paper trades, it is important to pre-agree on the Confirmation terms to facilitate “dispatch” of confirmation on T+0. The industry is taking steps to fast track the execution of ISDA-published MCAs, while there should also be a constant endeavor to standardize more and more products.
There are certain operational bottlenecks that cannot be underestimated. In the majority of cases, Confirms are processed in batches and signed at one shot with total disregard to their chronology. There are delays on account of client-side novations or something as straightforward as delayed allocations. Absence of proper backup and contingency planning when authorized signatories go on leave or fall sick can delay the whole process. The bespoke and demanding nature of some client requests has a cascading effect on the execution of Confirms within the prescribed timelines. It is not uncommon for certain buy-side clients to ask for a confirmation in a different language or perhaps a franked or printed version. Of course, not to forget a few clients awaiting payment instructions before executing a confirmation!
The electronic platforms cater only to a limited number of products. Add to this the long lead time to on-board new products. Also, some platforms cannot accommodate certain life cycle events. It is very difficult to push smaller clients (e.g., NFC-s) and corporates or counterparties doing an occasional trade to use electronic platforms even where the product is eligible. Smaller clients often lack the infrastructure and have limited trading volumes to accept/receive electronic confirmations where the running costs attributable to a few platforms are extremely prohibitive. Absence of an industry or regulatory initiative to transition clients on to the electronic platforms adds to the problem.
There are many clients, especially the ones based outside the US and the EU, or even the smaller firms based in the EU, that are ignorant of the regulatory timeframes as applicable to them. They believe they are exempted because they are either domiciled outside the US or the EU or do not belong to the category of so-called “broker-dealers.” There is a growing need for client training sessions and more effective dialogues between the regulators to increase awareness of regulatory requirements.
So how do we achieve compliance? For confirmations to be executed in a ‘timely’ manner, in the strictest sense, there is need for a coordinated and concerted effort across the industry in specific target areas – be it in improving front-office discipline to reduce amends and late booking, pushing ‘existing’ clients to move to electronic platforms for applicable products while considering no ‘new’ paper-based clients, pre-agreeing the confirmation terms to facilitate early dispatch, etc., and not to forget conducting extensive client awareness sessions, to name just a few.
The sell side is rising up to the challenge by following a two-pronged approach. One which is short-term by adding additional headcount to ensure confirmations are dispatched on T+0 and returned by T+1. The other, which is strategic and longer term, is significant investment in template standardization (particularly for Equities) across the industry, as well as technological solutions, in order to reduce the reliance on extra manpower.
The buy side, on the other hand, is at the receiving end due to pressure to utilize electronic matching platforms for eligible trades. There is also pressure on them to execute confirmations once the transaction has been completed. This means buy-side firms are enhancing their business processes and augmenting their resource count to meet this new demand.
By Christian Voigt, Fidessa
Originally published on TABB Forum
OTC trading is still seeking a suitable home under MiFID II. Without one, markets might lose this liquidity permanently.
With MiFID II’s stated aim to push OTC trading (where appropriate) onto regulated platforms, European market structure is undergoing considerable upheaval. As the first round of Level 2 consultation has just finished, it’s now time to define what OTC trading is appropriate and where it can be executed. While double volume caps somewhat restrict the use of transparency waivers, Systematic Internalisers (SIs) appear to be a possible home for some OTC trading. However, reading through the discussion paper and some of the responses, this is not so certain anymore.
For example, under the new SI regime, ESMA considers disclosing the SI’s identity in the post-trade information. It’s uncertain whether a broker, once categorised as an SI, can execute other OTC trades outside that regime. In addition, some market participants argue that riskless principal trades cannot be executed under an SI regime because this contradicts the bilateral nature of SIs.
Adding all that together, and assuming the worst, the attraction of becoming an SI could wane. With all of this uncertainty, OTC trading is still seeking a suitable home under MiFID II. Without one, markets might lose this liquidity permanently.
By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum
A well-known legal case in the commercial banking sector may have significant implications for clearing houses and other swaps market participants.
On Sept. 16, the New York Court of Appeals will hear arguments on a case that is rather well known in commercial banking circles, but perhaps less so in the swaps markets. As it turns out, the case may have significant implications for swaps market participants, including clearing houses.
The case itself, Motorola Credit Corp v. Standard Chartered Bank, nominally involves the question of whether a US branch of a foreign bank is considered a “separate entity” from the foreign bank. New York law has long held that to be true, but the Appeals Court is reviewing that holding in light of this case.
In the case, Motorola has been pursuing a defaulted debt by seeking to garnishee funds held by Standard Chartered offshore – specifically in the UAE. The UAE authorities have refused to recognize the garnishment, and have blocked the funds. Thus the question before the court is whether claims adjudicated in New York are payable by a New York branch of a foreign bank, even if the assets in question are held offshore, and the claim is rejected by the offshore regulators.
Recognizing that the appellate decision will have a big impact on financial markets, SIFMA has filed an amicus brief in the case. It makes several arguments:
- That “separate entity” has been part of New York law for almost 100 years and should not be reversed.
- That reversing it would prompt a wave of creditors’ claims in New York solely for the purpose of attaching assets, and
- Reversing it would expose New York banks to double liability, where they would have to make payments in NY and not be able to secure the funds overseas.
The fact that the case appears to hinge on whether a NY branch is a separate entity from the parent bank could lead to some interesting implications for the swaps markets. To begin with, no such rule ever was promulgated by the legislature or a banking regulator. Instead, it has been part of a series of court rulings dating back as far as 1916. And these rulings almost always dealt with commercial banking activities such as taking deposits and making loans, not trading or settling transactions, and certainly not swaps transactions.
Not having a law or regulation, and relying on court decisions, leaves everyone in something of a state of flux on this issue. In some ways, of course, the separate entity rule is demonstrably false. If I make a deposit at a New York branch of Citibank and withdraw some of it from the London or Paris branches, there is no thought that I might not be able to access the money because I changed branches. In this instance, the branch where I made the deposit isn’t a “separate entity” from the bank itself; it’s just a place where I do business with the bank.
But what about in trading – and trading swaps, in particular? According to the SIFMA brief:
“Federal securities laws treat bank branches as separate entities in several respects,” such as “the exemption given to banks from general registration requirements for securities.”
In addition, SIFMA points out that:
“U.S. branches are required to maintain reserves with the Federal Reserve Bank only with respect to their reservable deposits in the U.S. branch, not deposits of the foreign bank outside the United States.” [emphasis provided]
Still, that mostly is about commercial banking transactions. And that is how the Appellate Court is thinking about it, I suspect. But what the court decides could impact swaps trading. The CFTC has had an ongoing discussion with other regulators about how and to whom its rules and enforcement apply. In fact, almost every regulator worldwide has been staking out its claim on whom it regulates, and the status of branches has been a central part of those discussions. The CFTC, in particular, generated both comment and legal action when it proposed to treat US branches of foreign banks differently from foreign branches of US banks.
So the New York Court of Appeals may not be thinking much about how its decision will affect US branches of foreign banks in the swaps world, but we should. For example, in what capacity is the US branch of a foreign swap dealer acting in such areas as margin movement and settlements? If a foreign bank is acting as an FCM for a foreign customer at a US CCP, how much access does the CCP have to customer funds if the customer defaults?
The whole concept of the national regulation of a global market has been fraught with complications, and even some recriminations. If we end up with a state court ruling, based on prior court decisions instead of legislation or regulation, that complicates everything, we will be even further away from sanity than we are now. So be sure to reserve your seat in the courtroom on Sept. 16.
By Miles Reucroft, Thomas Murray
Originally published on TABB Forum
There is a prevailing attitude among global regulators that central clearing is the silver bullet to the previous financial woes. But concentrating risk from around the markets in one place could lead to a disaster. Deciding which products should and should not be cleared, and what collateral can be posted against those trades, is key to avoiding a crisis, says OpenGamma’s Mas Nakachi.
This is the second article in a series based on Thomas Murray’s exclusive interview with OpenGamma’s Mas Nakachi. Part 1 can be viewed here.
Mandatory central clearing has been a globally unanimous regulatory response to the financial crises that hit post-2008. Positioning a buyer to every seller and a seller to every buyer at the centre of financial markets is the route to ensuring that all trades are completed efficiently and safely. It encourages competition and new market participants, and places a layer of unanimity into the trading space.
These clearing houses, or CCPs, will also act as risk concentrators. Risk is being taken from around the markets and placed into one location. This in itself creates one great big risk. So is this the right way to go?
“You are taking risk from everywhere and putting it into a few places and ideally watching those places very closely,” says Mas Nakachi, CEO of OpenGamma. “The problem, of course, is if anything goes wrong at any of those ‘few’ places, then we will have to get automatic weapons and gold bars and run into the forest! It would be a very different world very quickly.”
In short, CCPs are ‘too big to fail.’ If one were to fail, then government bailouts would be essential, which is a direction that everyone was keen to move away from. “There is no danger currently, so any failure would be down to unforeseen consequences,” says Nakachi. “It is very difficult to predict, longer term, what will happen. We are concentrating a lot of risk and monitoring it closely, but what happens in a time of market stress is still somewhat unknown.”
It is the unknowns that have left many questioning the wisdom of concentrating so much risk into CCPs. It is, after all, rarely the foreseen consequences that cause financial crises.
The other fear is the handling of certain types of derivatives trades through CCPs. “No one should be pushing bespoke trades through a clearing house,” explains Nakachi. “Clearing houses should only trade highly liquid, highly fungible products that can be unwound in times of market stress. The clearing members or clearing member pool also has to be sufficient to take down the risk when one or two firms default. That is the whole point around not taking in certain types of trades.
“There has been a lot of debate around swaptions, for example. Certain dealers are adamant that clearing them should never happen, whereas other firms say that, if it is done correctly, it should happen right away. The point is that either way, there is a spectrum of financial products at which point you draw the line. Where that line should be varies according to the individual, but there is some line somewhere that needs to be drawn that says, ‘This product is too illiquid.’ It’s clear: Certain products should never go through a clearing house.”
The regulatory appetite for central clearing, however, is large. Whilst no one would ever put it so, there is a prevailing attitude that clearing is the silver bullet to the previous financial woes. Which products to put through clearing is a big issue and, as Nakachi points out, opinion is divided as to what should be excluded from clearing. It is the unwinding of trades that is the central point here. If a trade is too complex to be simply unwound, then losses will continue to mount.
In short, central clearing is the right way to go, but only for the right products. Some products are too complex and too bespoke and, therefore, carry a larger inherent risk that CCPs and their clearing members simply should not be exposed to. Deciding which products should and should not be cleared, and what collateral can be posted against those trades that are to be cleared, is another regulatory challenge and another risk in the space.
By Jorgen Vuust Jensen, SimCorp
Originally published on TABB Forum
Seventy-nine percent of capital markets firms report that they still rely heavily on spreadsheets and manual processes when processing derivatives, and 84% cite the need to create workarounds to support derivatives in their current middle- and back-office operations.
An increasingly global emphasis on derivatives strategies by asset managers has made the need for straight-through-processing (STP) greater than ever before. In a highly competitive industry, a firm with investment management systems characterized by a high degree of automated workflows and processes is in a better position than competitors that still contend with manual processes and workarounds. However, a new SimCorp poll shows that a large number of firms are still at the mercy of their legacy systems, using manual processes when processing derivatives.
SimCorp recently conducted a survey of nearly 150 executives from capital market firms in North America to measure how important STP processing is and the current conditions that firms are working with. The poll revealed that 74% consider STP to be extremely important when it comes to derivatives processing. However, further poll results indicate that these needs are not being met by their current systems – 84% of respondents cited the need to create workarounds to support derivatives in their current middle- and back-office operations. Seventy-nine percent reported they still rely heavily on spreadsheets and manual processes when processing derivatives. Furthermore, 82% require at least two months to model and launch new derivatives products, and sometimes significantly longer, utilizing their current systems.
The findings of the survey demonstrate that firms are being exposed to major and unnecessary risk and as they continue to employ manual processes in a rapidly changing industry. As the study suggests, firms are conscious of new and improved solutions that will help them achieve a strong competitive advantage and improve the functions of their firm, but there is a major struggle to determine how they should move ahead with implementing these brand-new solutions.
The changes in the OTC derivative space increasingly drive the need for front-to-back STP, and it is imperative that operations teams consolidate STP throughout the derivatives lifecycle in order to increase efficiency, reduce processing time, and cease dependency on spreadsheets and manual “systems.” STP assimilation also helps firms to provide transparent audit streams and ensure proper reporting to management.
The challenges in the derivatives market – ranging from regulatory demands to rapidly changing market conditions – make the case for STP even stronger. Since individual derivatives trades can have a considerable effect on the portfolio, especially in terms of exposure to several market factors, it is extremely important to have updated technology in place to integrate the process, provide optimal data operability and ultimately increase portfolio performance.
Capital market firms are essentially aware of the significant benefits of STP but seem hesitant to implement the process. As new market requirements continue to emerge, it has become crucial for asset managers to evaluate and update their IT infrastructure to include automation – which in turn will shorten processing cycles and increase efficiency, thus securing a competitive market edge.
By Amir Khwaja, Clarus Financial Technology
Originally published on TABB Forum
Swaps compression trades reduce line items, clearing fees and margin. But they come at a price. And determining whether they are cost-effective depends on the details.
In my recent article, “Swaps Compression and Compaction on TrueEX and Tradeweb SEFs,” I looked at the mechanics of these trades and the evidence in SEF and SDR figures, and stated that the benefit was to reduce line items and clearing fees. In this article, in order to determine whether the cost-benefit in terms of fees and margin is a positive factor on the benefit of reducing portfolio complexity by removing line items, I am going to take a deeper look at just the impact of compression on clearing fees and margin.
Client Clearing Fees
For clients, the first set of fees are those charged by their FCMs or clearing brokers.
Such fees typically consist of a new-trade ticket fee, a periodic maintenance fee and a portfolio charge – the latter for the funding cost implications of a segregated account, financial resource utilization and funding of default fund contributions.
The most convenient public disclosure on OTC clearing fees is that required by EMIR. On the assumption that such fees are similar to those charged to US firms under Dodd-Frank, let’s see what a few of these state:
- Barclays Fees, £750 per new trade, £75 per quarter, 100 bps on Initial Margin
- JP Morgan Fees, $1,500 per trade, 60 bps on Initial Margin
- Citi Fees, $750 per trade, 50 bps on Initial Margin
The list shows a wide variation in list prices; however, we can be sure that after negotiation, actual prices will converge – provided a minimum annual revenue threshold of around $250,000 is met.
Let’s assume a client can negotiate a $500-per-ticket fee and 60 bps on IM.
Clearing House Fees
Clearing house fees are passed on by FCMs to clients under two types of plans: a standard plan and a high-turnover one.
- CME OTC IRS fees are $0.25-$24 per million for a trade and then $2.00 per million, per annum, per line item and volume discounts.
- LCH SwapClear fees are $0.9-$18 per million for a new trade and then $3.00 per million, per trade, per annum.
- Both CME & LCH are the same: $25 per ticket plus a monthly charge of 10 bps, annualized, on IM.
A client not only has the funding cost of the Initial Margin requirement, but as we see above, the clearing fees also have a component linked to the IM. Consequently, IM is an important and significant determinant of the overall cost.
Compression - A Simple Example
Let’s now look at an example of compression costs and savings in action.
Assume we just have a single 2Y Swap of $100 million receive fixed in our portfolio, which we executed one week ago and that we now no longer need.
What is the cost of the compression?
As we know from my prior blog, this involves entering into a new swap with the same terms but opposite direction (pay fixed) to the existing swap.
- Let’s first assume there is no explicit execution fee (not unreasonable?), so we are left with clearing and SDR reporting costs.
- Consequently, we need to pay $500 for client clearing fees and $250 for CME or $225 for LCH (assuming the standard plan).
- For SDR reporting, let’s assume $15 per trade.
- So $765 for CME and $740 for LCH.
- Let’s call this $750.
And what is the saving?
- First, we will not have to incur the annual clearing house charge of $200 for CME or $300 for LCH, which for two years is $400 or $600 respectively.
- Second, we no longer have an IM requirement, as the net risk of the two trades is zero.
- Which means that we no longer need to fund the IM requirement and will not have to pay 60bps on IM to our FCM.
- So the saving is either $400 or $600, plus the reduction in funding cost and the IM fee saving.
To proceed we need to determine the IM for our 2Y Swap, which we do in Clarus’s CHARM, as below:
Then, for arguments sake, let’s assume our funding rate is 2% more than the interest we earn on the margin deposit.
So our monthly funding cost is $750 for CME and $950 for LCH, at least for the first month.
After that, IM decreases as our 2Y Swap ages, mainly as DV01 decreases with remaining maturity (a 1Y Swap has less than half the DV01 of a 2Y). As a rough approximation, let’s assume that the average IM over the life of our 2Y Swap is 40% of the IM at inception. Our funding cost over 2Y is then $7,200 for CME and $9,000 for LCH.
Using the same 40% assumption for average IM over the 2Y, we can also estimate the 60bps per annum of IM as $5,400 for CME and $6,800 for LCH.
Bringing all the above figures together:
- Cost of compression trades is $750.
- Benefit over the 2 years is $13,000 for CME and $16,500 for LCH.
So very clearly in this case the cost-benefit of compression is firmly in the positive.
However, in this simple example, given that the DV01 of the 2Y trade is approximately $20,000, the business imperative to neutralize this DV01 is of more importance than the cost benefit of compression.
Consequently, the decision to do compression is not determined by the cost-benefit of compression per se, but simply the use of compression to neutralize the DV01.
Compression - Another Example
Let’s now construct another example, one in which we have already decided to hedge the original Swap, one week later with a new 2Y swap (on-the-run and par), and we are now left with two Swaps with a small difference in fixed rate (e.g., 0.1 bps) and a 1-week mismatch in maturity dates.
We could choose to let these trades run down to maturity. However, let’s see whether compression is also worthwhile in this case.
Cost of compression:
- Enter into two trades to offset the two existing ones.
- So $1,000 in client clearing fees and $500 for CME or $450 for LCH.
- For SDR reporting, let’s assume $15 per trade, so $30 in total.
- A total of $1,530 for CME and $1,480 for LCH.
- Let’s call this $1,500.
- No annual maintenance charge for the two trades, so $800 for CME or $1,200 for LCH.
- Reduction in funding cost and IM fee?
In this case, the reduction in funding costs is much less significant, simply because the 2 original trades are already almost but not quite perfectly hedged – except for 0.1 bps on fixed rate and 1-week maturity mismatch.
In fact, if we construct an account with these two original trades and run in CHARM, we get the following:
So we can see that there is still in fact a small Initial Margin – much less than we had before, but material nonetheless.
The funding cost of this (using the same 2% and 40%) over the 2 years is then $400 for CME and $970 for LCH.
And the 60 bps of IM over 2 years is $300 for CME and $700 for LCH.
Bringing all the above figures together:
- Cost of compression trades is $1,500.
- Benefit over the 2 years is $1,100 for CME and $2,300 for LCH.
So in this case, for CME the cost-benefit is not positive, while for LCH it still is.
However, if we were not on a standard plan but a high-turnover plan, our cost of compression would be just $1,100 as the clearing house fee would be $25 and the 10bps on IM.
This moves the cost-benefit toward positive territory for CME – as would a greater mismatch than 1-week and a greater difference than 0.1 bps.
So we can see that even with seemingly hedged portfolios, there is a cost-benefit in compression to get rid of the residual risk.
Compression - A Portfolio Example
Now, in the real world, we would not be looking at simple portfolios with just our 2Y Swap trade, but a portfolio with many existing trades.
In this case, compression to reduce line items in itself would generate significant savings in the clearing house maintenance charge (and even more savings if our FCM also charges this, as Barclays states).
Let’s say we had 100 line items with gross notional of $5 billion, and an average size of $50 million per trade.
The annual maintenance for these would be $10,000 for CME and $15,000 for LCH – not massive, but it still adds up over the life of these trades, which may be 5Y or 10Y or 30Y.
Meanwhile, the reduction in Initial Margin should be determined as the marginal impact on the portfolio margin of the compression trades.
I won't go into the details of this now, except to note that in some cases it may not be a reduction but an increase in margin and so not a saving but a cost! (If you are interested in details on the portfolio example, please send me an email).
For a compaction, in which we are seeking to not change the risk (or the margin), there would be no reduction in margin. So in this case, the focus is simply on the clearing fees, both the new-trade fees and the reduction in annual maintenance fees.
Very detailed, so thank you for sticking with it. (Any errors in the above calculations are all mine, so please let me know if you find any.)
Compression trades have a cost, as they are new trades that must be cleared.
The cost is in client clearing fees per trade paid to the FCM and clearing house fees.
The reduction in line items reduces portfolio complexity and often is the prime reason for compression.
While the new compression trades attract a new-trade clearing fee, the fact that they net down (extinguish) the existing trades means that there is no longer an annual maintenance fee payable to the clearing house.
The greater the number of trades (line items) removed, the greater this benefit.
Another benefit, often greater, is the reduction in Initial Margin, as this determines both funding cost and the FCM portfolio charge.
By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum
Banks may be ready for the Volcker Rule, but their technology vendors may not be. And that could be a big problem.
With the compliance date for the Volcker Rule just under a year away, most banks are fully involved in getting ready. But their technology vendors may be way behind – if they are even aware of the rule’s implications for their products. Unless tech companies get on the stick, banks may find that many of their compliance efforts are compromised, if not rendered ineffective, by technology partners.
First Things First
To understand the VR’s impact on technology, we first have to understand its structure. After exempting certain securities (US governments, munis and foreign sovereigns), the rule says no US bank – no matter how small – can trade as principal in any other instruments unless it has an exemption. In addition, the determination of whether a trade is exempt is up to the bank’s examiners, and will be made after the fact. The OCC has recently issued a guide for examiners and the five relevant agencies also have issued a set of FAQs that give us some insights into how the rule will be enforced. When we read them with the rule itself and the preamble, we get a clear picture of what is needed.
To begin with, every trade a bank transacts in a non-exempt instrument will have to be defensible to an examiner, possibly years after the fact. Needless to say, banks are worried about both intentional and inadvertent violations, which could get them into hot water with their regulators, and are placing a premium on automated ways of:
- Linking trades to exemptions.
- Alerting management when a potential violation occurs.
Those two requirements are where technology comes in.
There are four main exemptions, all with different justifications and requirements:
- Liquidity management
Since a single trading desk may execute trades under more than one exemption, and more than one desk may trade in the same instrument, the first requirement is a field to identify which exemption applies, such as (L)iquidity, (U)nderwriting, (M)arket-making, (H)edging, or (N)/A (for exempt securities). We should note that two trades in the same instrument might have different exemption codes. Making this a required field would prevent trades being entered without an exemption, and maintaining a list of exempt securities would allow the booking system to verify that ‘N’ coded trades are actually in those securities.
There are two other exemptions that need to be addressed: repo and securities lending. But these trades are usually done in special systems and may not need the linkage in the previous paragraph. However, examiners may require that repo and sec lending systems have built-in functions, such as requiring a two-sided trade for repos, in order to prevent a bank from using those systems to book prohibited trades.
The rules, instructions and FAQs all spend considerable time on the definition of a trading desk: “The smallest discrete unit of organization of a banking entity that purchases or sells financial instruments.”
The FAQ allows trading desks to book trades into more than one legal entity, but, “If a single trading desk books positions in different affiliated legal entities, it must have records that identify all positions included in the trading desk’s financial exposure and the legal entities where such positions are held.” Thus each trade will probably have to identify both which legal entity it was for, and which trading desk executed it.
Finally, the rule places a heavy emphasis on policies and procedures (P&Ps), and the examiners will be expected to judge the permissibility of individual trades primarily on whether they follow the P&Ps. There are different P&Ps for each exemption, but they all require three things:
- Specification of allowed instruments
- Specification of which desks may trade them
- Position and risk limits for each desk.
So another enhancement for trade booking systems will be checking that:
- the instrument is allowed,
- that the right trading desk is doing the trade, and
- the trade leaves the desk within its position and risk limits.
Although this exemption has generated the least public scrutiny, it is important because it applies to pretty much any US bank, unless it restricts its liquidity portfolio to exempt instruments. The liquidity exemption requires a management plan that specifies:
- which instruments can be purchased
- the aggregate size of the portfolio, and
- that the purchase is “not for the purpose of short-term resale, benefitting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging a position taken for such short-term purposes.”
The rule specifically calls for “internal controls, analysis, and independent testing to ensure that the purchase and sale of securities” comply with the P&Ps, which function would logically fall under the various trade booking systems.
The typical logic process for entering a liquidity purchase would then be:
- If exemption = L,
- If instrument is on allowed list,
- If desk is allowed under exemption L,
- If aggregate position after trade < limit,
- Then allow trade,
- Else return alert.
One additional check, applied to sales under the ‘L’ exemption, would be whether the total number of sales in a specified period exceeds a set limit, defined either in absolute amount or a percentage of the portfolio. This would alert management that examiners may question whether the portfolio is being managed to benefit from short-term price movements.
In addition to the P&P requirements above, the underwriting requirement makes the first mention of something that will also appear in market-making – the “reasonably expected near-term demand” or RENTD. The rule – and the examination instructions – place a heavy emphasis on showing that position sizes conform to the RENTD at the time. The examiners’ instructions indicate that the RENTD should be based on a “[d]emonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks of or associated with financial instruments in which the trading desk makes a market, including through block trades.”
Obviously, the RENTD can change over time, particularly when instruments are new to the market or fall out of favor. Thus the bank will need to keep a record of its RENTD analysis at the time of the trade, probably in a document management system. The ideal arrangement would then be for the trade booking system to have at least one additional field for a reference to that RENTD analysis. For trades where the exemption code is ‘U’ or ‘M,’ having that field empty should raise an alert.
Finally, the underwriting exemption requires that the P&Ps specify the “[p]eriod of time a security may be held.” Any position management system used for underwriting should have an alert function if positions with an exemption code of ‘U’ remain on the books for significantly longer than the P&P holding period.
The market-making exemption has received the most press coverage and commentary, largely because it will be the most difficult for examiners to verify. Partly for that reason the rule specifies seven metrics that large banks must start capturing and keeping as of July 1, 2014. They are:
- Risk and Position Limits and Usage;
- Risk Factor Sensitivities;
- Value-at-Risk and Stress VaR;
- Comprehensive Profit and Loss Attribution;
- Inventory Turnover;
- Inventory Aging; and
- Customer-Facing Trade Ratio
We are not going to go into the tech requirements for capturing and storing the metrics here, but banks will have to be able to link trades and positions to those metrics after the fact, in case an examiner questions the exemption. Of more value, though, would be alerts in cases where the metrics suddenly deviate from acceptable norms, or in cases where a trade is at odds with the metrics.
As with underwriting, alerts are needed where the trade has no link to a RENTD document. And, of course, the combination of instrument and trading desk needs to be checked against the P&Ps. The examiners’ manual also refers to the holding period as a criterion, so the bank may want an alert where a position with an exemption code of ‘M’ is unchanged for an extended period (say, a month) which should reflect against the inventory turnover metric.
Of all the exemptions, hedging will require the biggest changes to a bank’s business processes and technology. To begin with, the only things that can be hedged are “the specific risks to the banking entity.” So, no hedging of positions or portfolios, only risks. In addition, the rule requires “analysis, including correlation analysis, and independent testing designed to ensure that the positions, techniques and strategies that may be used for hedging” are correlated to the risk. Finally, the rule requires that the hedge “[i]s subject to continuing review, monitoring and management” throughout its life.
We can see that any position where the exemption code is ‘H’ will need a link to the documentation of the risk being hedged, perhaps using the same field used for the RENTD link in underwriting and market-making, since RENTD doesn’t apply to hedging. In addition, the rule requires documentation of “[t]he specific risk-mitigating strategy that the purchase or sale is designed to fulfill,” so that additional link will be needed in the trade record as well, unless the risk and the strategy are contained in the same document. Given that there is a history of banks or traders claiming that a trade was a hedge when it wasn’t, a few additional checks may be needed, such as a large number of positions referring to the same risk documentation.
What can’t be hedged? The examiners’ manual indicates that the following are NOT hedges under the exemption:
- Reducing risks associated with:
- the bank’s assets or liabilities generally; or
- general market movements or broad economic conditions;
- Profiting in the case of a general economic downturn;
- Counterbalancing revenue declines generally; or
- Arbitraging market imbalances unrelated to the risks resulting from the positions lawfully held by the bank.
Other than that, the rule allows the hedging of any banking risk, as long as it is quantifiable and correlated. Given the wide range of risks that could be hedged, the correlation function might be fairly complicated, and monitoring that correlation might be a stretch for the usual bank technology. This is an area where creative technologists might capture a significant market share and profit.
Of course, everyone knows the myriad of separate systems that a typical bank runs in its trading businesses, and this part of the VR doesn’t promise to simplify that any. Banks will have to determine where and how they will store the documentation that the VR requires, and tech vendors will probably have to build interfaces, calls and APIs to wherever it is stored. In addition, banks will have to determine how important automated monitoring and alerts are to them, and be prepared to pay for such functionality from vendors or build it themselves.
In the end, solving the technology hurdles inherent in the proprietary trading part of the VR will be a group effort, and should probably include the regulators to make sure any development will satisfy their mandates. At this point, though, if banks aren’t actively engaging their tech vendors with a set of requirements, they should expect some unpleasant surprises come next spring.
By Amir Khwaja, Clarus Financial Technology
Originally published on TABB Forum
The industry is seeing increasing volumes of cleared swap compression trades. But what are the mechanics of such trades?
Let’s start with the rational for compression trades. Every cleared swap trade shows up as a line item on a Clearing Statement, and over time we have more and more of these line items, each one attracting a Clearing Fee. The majority of these swaps start as MAT swaps (par coupons and on-the-run tenors), but as they age, they become non-par coupons and broken-date tenors. For some firms these trades may already have served their business purpose.
As termination is only available in the bilateral world, for cleared swaps the appropriate mechanism to get rid of these trades is to enter into equal and opposite trades. “Equal” meaning all the terms of the trade match (start date, end date, notional, fixed rate, floating rate, etc.) and “opposite” meaning pay instead of receive, or vice-versa.
When the clearinghouse sees these new equal and opposite trades, it nets them with the originals, meaning that we are left with nothing, or a reduced notional. This is exactly analogous to what happens when we buy or sell a Futures contract. So compression results in fewer line items and lower clearing fees.
Compression vs. Compaction
It should also be obvious that by entering into new offsetting trades, we are changing the risk and consequently the margin in the cleared account. This means that the transaction needs to be credit checked before proceeding.
Compaction refers to the fact that at the same time as compression, we enter into new swaps that seek to preserve the risk of the initial trades. So we still end up with fewer line items, but without materially changing the risk position or margin. Or conceivably changing risk to a desired goal.
The business process is as follows:
A customer identifies a list of cleared trades that it would like to compress/compact.
This list of trades is loaded onto a SEF, credit checked and sent to dealers.
Dealers quote to enter into opposite trades, in essence an NPV for the list.
The customer agrees to execute with a chosen dealer.
The whole list is transacted in one go, with the NPV being paid or received by the customer.
The resulting executed trades are reported to an SDR and sent to a clearinghouse.
The clearinghouse extinguishes line items (in its overnight batch).
The next day the customer’s clearing statement shows fewer line items, resulting in lower clearing fees.
Note: CME and LCH are planning on relaxing the need to match the fixed rate exactly by introducing coupon blending approaches. One result of this is that the NPV will no longer be as large (so less cash changes hands) and another that more swap line items will net together.
Differences to TriOptima
For those of you familiar with TriOptima’s triReduce compression service, which has been running for many years in bilateral swaps trading, the differences should now be obvious. TriReduce is a service in which participants agree to terminate existing swaps with no change in market risk (or within a tolerance). The result of the multilateral compression cycle is binding and everyone then terminates their bilateral swaps. Note that these terminations are also reported to SDRs.
Let’s now look at some real figures reported in the most recent two weeks by two SEFs. Using Clarus’s SEFView, we can isolate just trueEx and Tradeweb and do so for IRD:Vanilla in USD.
Which shows $22.674 billion reported by trueEX over seven business days in this 10-day period.
We know that for trueEX the reported volumes are exclusively from its PTC platform.
If we were to drill down on the July 14, 2014, figure of $2.589 billion, we would see that this is reported as a 2Y tenor transaction, but with no other details.
However, we know that these trades would also have been reported to an SDR.
Using SDRView Pro, we can select July 14 and instead of Spot, pick the sub-type “Old” (meaning trades with effective date prior to our chosen date of July14 ).
Sorting by time, we find the following four 2Y trades:
From which we can see that:
These 4 trades were all executed at 16:00 LON or 11:00 NY.
The original trades were 2Y swaps when executed in Dec. 2013.
The fixed rates these were executed at are 0.399, 0.43, 0.43 and 0.385.
Two of the trades are capped at $460 million.
So the total of the 4 trades is $1.34 billion, instead of the $2.5 billion shown in SEFView.
In addition if we were to drill down on these trades, we would see that two of them had additional fees of $471,115 and $866,852. These are the aforementioned NPVs, exchanged by the parties to enter into the offsetting swaps – which we could check by revaluing these trades on 14-July, on which date they would be 1Y and 5-months tenor.
Tradeweb on July 14, 2014, reported $37 billion, a much higher figure than on any other day in the period.
Let’s drill down on this figure:
From which we can see that:
2Y has $15.8 billion.
3Y has $11.6 billion.
1Y has $5.6 billion.
Each of which are much higher than other tenors.
Each of which are much higher than other days for these tenors.
The total of these three tenors is $33.2 billion.
Can we find these trades in SDRView? Let’s try:
Sure enough, we can see:
92 trades with $20.8 billion gross notional.
Remember that 4 of these are the trueEX deals (with $1.34 billion).
So we have 88 trades with $19.53 billion.
All of these are executed at 21:07 LON or 4:07 NYC, so we can assume they were transacted as one list.
21 of the trades are capped, so we know the gross notional is higher than $19.5 billion.
In addition, if we drill down we find that only one of the trades has an additional fee, which is $3,276,805. We can assume that this is the NPV that changed hands for these 88 trades to be transacted to offset the existing aged 88 trades.
And the overall gross notional must have been close to $33 billion for these trades – probably a little less, as the Tradeweb SEFView volumes probably include other 1Y, 2Y & 3Y trades.
In my recent blog, A Six Month Review of Swap Volumes, I noted the sharp rise of Tradeweb volumes in June. We can now presume that some part of this was due to Compression and Compaction trades.
Compression and Compaction trade volumes are now significant.
These trades serve to reduce line items and clearing fees, by removing trades that are no longer needed.
The mechanics involve executing new trades with matching terms and opposite direction – which clearinghouses then net (extinguish) in an analogous manner to futures.
SEFs are natural platforms for automating the data and process that needs to flow back and forth between parties.
TrueEX launched its PTC service in Dec. 2013 and has shown good volume each week.
Tradeweb launched its compression platform in Nov. 2013 and executed significant volume in June and July, which accounts for part of its recent increase in IRD volumes relative to other SEFs.
SDRView can be used to see the compression activity, including the executed trade list and associated price (NPV).
New transparency for us all. Provided we have the time and tools to become informed.