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Pro-Reform Reconsideration of the CFTC Swaps Trading Rules: Return to Dodd-Frank – A White Paper by CFTC Commissioner Giancarlo

By J.C. Giancarlo, CFTC
Originally published on TABB Forum

In a new white paper, CFTC Commissioner J. Christopher Giancarlo analyzes flaws in the CFTC’s implementation of its swaps trading regulatory framework under Title VII of the Dodd-Frank Act and proposes a more effective alternative. He identifies the adverse consequences of the flawed swaps trading rules and proposes an alternative swaps trading framework that better aligns with swaps market dynamics and is more true to congressional intent.

The views expressed in this Executive Summary and White Paper reflect the views of Commissioner J. Christopher Giancarlo and do not necessarily reflect the views of the Commodity Futures Trading Commission (CFTC), other CFTC Commissioners or CFTC staff.

Read the full White Paper at the end of this executive summary.

Market participants are encouraged to submit their comments and feedback below.This White Paper is written by Commodity Futures Trading Commission (CFTC or Commission) Commissioner J. Christopher Giancarlo, a public supporter of the swaps market reforms passed by Congress in Title VII of the Dodd-Frank Act, namely clearing swaps through central counterparties, reporting swaps to trade repositories and executing swaps transactions on regulated trading platforms. The author supports the CFTC’s implementation of the first two reforms, but is critical of the CFTC’s implementation of the third, as explained in this White Paper.

This paper (a) analyzes flaws in the CFTC’s implementation of its swaps trading regulatory framework under Title VII of the Dodd-Frank Act and (b) proposes a more effective alternative.This paper begins with a broad overview of the complex structure of the global swaps market. It then reviews the clear legislative provisions of Title VII of the Dodd-Frank Act. Next, it reviews in detail the Commission’s flawed implementation of the Dodd-Frank Act’s swaps trading provisions. This paper asserts that there is a fundamental mismatch between the CFTC’s swaps trading regulatory framework and the distinct liquidity and trading dynamics of the global swaps market. It explains that the Commission’s framework is highly over-engineered, disproportionately modeled on the U.S. futures market and biased against both human discretion and technological innovation. As such, the CFTC’s framework does not accord with the letter or spirit of the Dodd-Frank Act.   This paper identifies the following adverse consequences of the flawed swaps trading rules:

  • Driving global market participants away from transacting with entities subject to CFTC swaps regulation. 
  • Fragmenting swaps trading into numerous artificial market segments.
  • Increasing market liquidity risk.
  • Making it highly expensive and burdensome to operate SEFs.
  • Hindering swaps market technological innovation. 
  • Opening the U.S. swaps market to algorithmic and high-frequency trading.
  • Wasting taxpayer money when the CFTC is seeking additional resources. 
  • Jeopardizing relations with foreign regulators.
  • Threatening U.S. job creation and human discretion in swaps execution.
  • Increasing market fragility and the systemic risk that the Dodd-Frank regulatory reform was predicating on reducing.

This White Paper proposes an alternative swaps trading framework that is pro-reform. It offers a comprehensive, cohesive and flexible alternative that better aligns with swaps market dynamics and is more true to congressional intent. The framework is built upon five clear tenets:

  • Comprehensiveness: Subject the broadest range of U.S. swaps trading activity to CFTC oversight.
  • Cohesiveness: Remove artificial segmentation of swaps trading and regulate all CFTC swaps trading in a holistic fashion.
  • Flexibility: Return to the Dodd-Frank Act’s express prescription for flexibility in swaps trading by permitting trade execution through “any means of interstate commerce,” allowing organic development of swaps products and market structure, accommodating beneficial swaps market practices and respecting the general nature of core principles.
  • Professionalism: Raise standards of professionalism in the swaps market by establishing requirements for product and market knowledge, professionalism and ethical behavior for swaps market personnel.
  • Transparency: Increase transparency through a balanced focus on promoting swaps trading and market liquidity as Congress intended.
This White Paper asserts that its pro-reform agenda would yield a broad range of benefits. It would:
  • Align with congressional intent to promote swaps trading under CFTC regulation.
  • Promote vibrant swaps markets by regulating swaps trading in a manner well matched to underlying market dynamics.
  • Reduce global and domestic fragmentation in the swaps market.
  • Foster market liquidity.
  • Reduce burdensome legal and compliance costs of registering and operating CFTC-registered SEFs.
  • Encourage technological innovation to better serve market participants and preserve jobs of U.S.-based support personnel.
  • Free up CFTC resources and save taxpayer money at a time of large federal budget deficits.
  • Provide another opportunity for the CFTC to coordinate with other jurisdictions that are implementing their own swaps trading rules.
  • Reverse the increasing fragility of the U.S. swaps market by allowing organic development and growth for greater U.S. economic health and prosperity.
Of Note:
  1. Commissioner Giancarlo asserts that the CFTC’s swaps trading rules do not accord with Title VII of the Dodd-Frank Act. He calls for greater adherence to the express language of Title VII in conformance with congressional intent.
  2. Commissioner Giancarlo contends that the CFTC’s swaps trading rules increase rather than decrease the systemic risk that the Dodd-Frank Act was premised on reducing.
  3. Commissioner Giancarlo contends that the CFTC’s restrictive and over-engineered swaps trading rules have failed to achieve their ostensible objective of meaningful pre-trade price transparency.
  4. Commissioner Giancarlo contends that the CFTC’s swaps trading rules add unprecedented regulatory complexity without meaningful benefit wasting taxpayer money at a time when the CFTC is seeking additional funding.
  5. Commissioner Giancarlo contends that the CFTC’s rules open the U.S. swaps market to algorithmic and high-frequency trading that is not otherwise present.
  6. Commissioner Giancarlo is the first CFTC Commissioner to call for and put forth a proposal to raise the standards of professional conduct for swaps market personnel.
  7. Commissioner Giancarlo proposes a comprehensive, cohesive and transparent swaps trading framework that is pro-reform and better aligns with swaps market dynamics and the express provisions of Title VII of the Dodd-Frank Act.

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CCPs: Risky Is as Risky Does

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

Has mandatory clearing for swaps concentrated risk in the CCPs and made them too big to fail? Two recent industry papers bring into sharper focus the debate that has been raging under the surface of the markets.

Recent white papers by the CME (Clearing – Balancing CCP and Member Contributions with Exposures) and ISDA (CCP Default Management, Recovery and Continuity: A Proposed Recovery Framework) bring into sharper focus a debate that has been raging under the surface of the markets: Has the introduction of mandatory clearing for swaps concentrated risk in the CCPs and made them too big to fail? As with any document published by a participant in a debate, we have to remember who wrote these, but they should help clarify this important topic.

The crux of the debate is about how much capital (in whatever form) is necessary to ensure the safety of the cleared swaps market, and who should put up the bulk of it. Since everyone is now aware of the extent to which increased capital requirements raise the costs of trading, everyone should expect all the market participants to argue that any additional capital should come from any other class but theirs. And that just about sums up this debate.

There are, of course, compelling arguments on both sides. For the CME’s part, after saying that “CCPs are fundamentally risk managers responsible for ensuring the overall safety and soundness of their markets,” it goes on to say, “Ensuring that market participants and clearing firms have the proper skin in the game is one of the most critical roles of a CCP.” This sets the stage for most of the CME’s argument: that recent financial failures were due to the perpetrators not having the same exposure as their customers or the government – i.e., not having skin in the game.

The CME argues that the waterfall approach, in which increasing losses tap into ever more general pools of money – from the customer’s IM to the clearing member’s IM, to the clearing member’s part of the default fund, to the default fund in general, to assessments on members – serves not only to spread the risk appropriately but also to discourage risky behavior. CME concludes that:

“The discussion of skin in the game should focus largely on the amount of skin in the game that each clearing member must contribute to the waterfall, including IM, concentration margin, default fund, and assessments. A clearing member’s skin in the game should scale with the exposures they bring to the CCP.”

ISDA says:

“Effective default management is predicated on the ability of a CCP to transfer the defaulted clearing member’s (CM’s) positions to solvent CMs in order to re-establish a matched book. The primary tool to re-establish a matched book is a voluntary portfolio auction, which is already built into the default management process (DMP) of many leading CCPs. In trying to achieve this objective, a CCP has loss-absorbing resources available that include the defunct CM’s pre-funded default resources (its initial margin (IM) and its contribution to the default fund (DF)), as well as mutualized resources. Such default resources are organized and consumed in the order of a pre-defined default waterfall (DW).”

One of its footnotes postulates that:

“Any calls to CMs should be pre-defined, limited, reasonable and quantifiable. Without certainty regarding exposures, clearing as a business becomes problematic because CMs would be deprived of the ability to quantify their risk exposures. Also, multiple assessment calls on non-defaulting CMs at a time of stress could become a significant source of pro-cyclicality with systemic consequences that could threaten the viability of remaining CMs.”

So ISDA is focused on the auction process for moving the customer positions from a defaulting CM to a solvent one, without much focus on default prevention. But, as they say, an ounce of prevention is worth a pound of cure.

So it is appropriate now to take a closer look at how swaps clearing actually works, and see if we can determine how risk is created and then managed. The first thing to understand is that in the omnibus model, the clearing member truly stands between the CCP and the customer that is actually creating the risk. Unless the CCP maintains separate accounts for each customer, it performs no KYC, does no credit checking, and assigns no limits to each customer. It knows which positions and margin are proprietary to the clearing member and which are customer positions, but nothing about which customer has which positions. In other words, the CCP is relying totally on the clearing member’s risk management. No wonder they want the members to have lots of skin in the game.

However, there are several other considerations, at least in the minds of market participants. One is that providing clearing services is very much a volume business, in the same way that custody or payment clearing is. Volume businesses always tend toward concentration, since higher volume leads to lower costs. But since clearing is also about risk, this phenomenon automatically tends toward risk concentration.

The second consideration is the typical pattern of financial disasters. The risk always starts out as manageable, and the forecast is rosy. Then a few things start to go wrong, and the victim makes a few “temporary” adjustments to rectify the situation. Then those start to go wrong, and even more questionable measures are taken. All the while, everyone in the know makes sure nobody else knows, because making it public will only make it worse. Then, under further deterioration, some blatantly illegal things are done, just before the wave breaks and everyone finds out how bad things are. Except that the public panic makes it significantly worse.

One implication of this scenario is that, as vigilant as a counterparty may be, it might not see the cracks in the façade until the edifice is already falling down. In the bilateral world, firms deal with this risk by limiting their exposure to any party to only what they would be comfortable losing. Obviously, customers can open accounts with multiple counterparties and thus build up gargantuan positions; but at least the risk is spread out, based on each firm’s risk appetite.

Clearing adds a few wrinkles to this scenario, but some aspects remain the same. Assuming the customer opens accounts at several clearing firms, and each of them independently does its own due diligence, the same opportunity for a market meltdown exists. And it is likely that the distant rumblings of trouble would be as muted as in the bilateral world, until it all comes out. So far, no difference.

The big question is: What happens when it does come out. Assuming that this one customer represents, say, 70% of the positions on the losing side, everyone would immediately ask, “Where were those positions cleared?” Now, instead of having them spread out among many firms, they all appear in one place, the CCP. And the resolution plans of many CCPs indicate that they could use the VM expected to be paid on the winning positions to cover the losses.

Knowing that, customers would rush to withdraw their segregated balances from the clearing members, and the members from the CCP, and we start to have lines around the block. It all looks worse, though, if the culprit is a clearing firm itself. In that case, one could be sure that it would have already accessed all of its IM, default contributions, and any other cash, and possibly its customers’ cash as well.

As grim as this scenario is, it has already happened on a minor scale. The point is that the swaps markets are huge. The fixed-float outstanding notional is still around $400 trillion, as far as I can tell, so a 100 bp move in short rates represents a full-fledged earthquake in terms of VM. Who actually holds all those positions? Nobody knows – not the regulators, not the CCPs, not the clearing firms, nobody.

So in the end, skin in the game may give some folks comfort, but not me. The only way to guard against the dreaded creeping, mushrooming default is transparency and good business practices on the part of the clearing firms. In some ways, the CCPs may simply be very interested bystanders, and then everyone’s skin is in the game. So risky probably is as risky does.

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ESMA's Draft Regulatory Technical Standards for Interest Rate Swaps Are Changing

In a recent letter, the European Commission outlined its intention to endorse ESMA’s draft regulatory technical standards (RTS), which set out which interest rate swaps will be subject to mandatory clearing under EMIR. However, before formally doing so, the European Commission has asked ESMA to make some amendments in specific areas. These include:

  • Postponing the calculation period for counterparties to determine whether they are in category 2 or 3  

  • Clarifying that the calculation for investment funds should be made at fund, rather than group, level

  • Delaying the start of the frontloading window to allow counterparties more time to prepare

Although there no proposed changes to the scope of instruments that will be subject to mandatory clearing, it is now anticipated that the final rules will apply (“enter into force” *) later than originally estimated impacting the clearing start date for each type of counterparty.

Assuming the RTS enter into force in early April 2015, the following timeline will apply:


* Note: The RTS will “enter into force” 20 days after they are published in the Official Journal


Category 2 or 3 determination

Counterparties whose aggregate month-end average notional amount of non-cleared derivatives in the three months following the publication of the RTS in the Official Journal is above 8bn EUR will be classified as Category 2. The calculation period excludes the month of publication. Counterparties who fall below this threshold will be in Category 3.

By way of example, if the final RTS are published in the Official Journal in March 2015, the three month-end calculations would now include April, May and June 2015 exposure.

Calculation threshold for investment funds

The letter clarified that the calculation for investment funds should be carried out for each single fund, rather than at group level, as long as, in the event of fund insolvency or bankruptcy, the funds are distinct legal entities.

Delay to the start of frontloading

Frontloading is the requirement to centrally clear certain derivatives contracts entered into before the clearing obligation for the counterparty takes effect. The start date of frontloading for interest rate swaps has been delayed to give counterparties more time to prepare for its implementation.

For Category 1 counterparties, the frontloading window will open two months after the RTS enter into force. For Category 2 counterparties, this will now be five months after the RTS apply.

It is the intention that Category 3 and 4 counterparties are not subject to the frontloading requirement.

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CFTC Is Kicking the Extra Point

By Sol Steinberg, OTC Partners
Originally published on TABB Forum

Recent rule changes by the CFTC indicate that the Commission has largely crossed the goal line with respect to OTC reform and is now in the process of ‘fine-tuning’ regulatory requirements in the US. Cross-border harmonization, however, remains a critical challenge.

With ESMA recently taking significant steps to catch up with the financial market reforms that have been implemented by U.S regulators, it’s a good time to stop and reflect on where we are, where we’ve been, and all that’s been accomplished since the financial crisis.

Here in the U.S., the last significant regulatory moves were the changes to the rules governing Residual Interest, Recordkeeping Requirements, and Forwards With Volumetric Optionality, which were proposed by the CFTC in November 2014. Given that this is Super Bowl week, I liken these moves — all of which were approved by the Commission — to setting up for the extra point after the game-winning scoring drive. The strategies of Bill Belichick and Pete Carroll have all come down to this, and now we’re just waiting for Gostowski or Hauschka to end the game.

The odds-makers say it’s going to be Hauschka; but for the purpose of this analogy it really doesn’t matter. The point is, the game is almost over. That latest round of proposed rules changes, which are detailed below, fall into the realm of “fine-tuning.” That’s how they were characterized by CFTC Chairman Timothy Massad, and he was right.

The Commission’s actions between 2010 and 2013 were highly effective and cannot be overstated. Four years ago, the $700 trillion OTC derivatives market was largely unregulated, but now most of the truly hard work is complete. Thanks to former Commissioners Gary Gensler, Bart Chilton, and Scott O’Malia (the longest-serving commissioner in CFTC history), we’ve crossed the goal-line of regulation.

However, the credit cannot go to the regulators alone. Industry figures such as Dan Maguire, Jeff Sprecher, and Sean Tully deserve great appreciation for their efforts in helping create a realistic regulatory framework to govern the massive and unwieldy OTC derivatives space.

Now that we’ve made it into the end-zone, so to speak, rules changes like those proposed in November are akin to kicking the extra point. The only difference is that we are likely to see several more extra points as we move forward and continue dealing at the edges of regulation.

That’s not to say these recent adjustments are insignificant. In fact, they are quite important.

New Rules Changes

Residual Interest Deadline

The first change affects Rule 1.22, which was created to help ensure that the funds deposited by customers with Futures Commission Merchants (FCMs) remain safe by prohibiting FCMs from using the funds of one customer for the benefit of another customer. Pursuant to the rule, FCMs are obliged to maintain their own capital when customers are required to post additional margin but have not yet done so. The FCM must now deposit those additional funds by close of business (6:00 pm Eastern Time) the next day following a trade.

The rule also stipulated that, on Dec. 31, 2018, the deadline would automatically move to start of business (9:00 am Eastern Time) the day after a trade if the Commission failed to take any action beforehand. That automatic termination of the phase-in compliance period has now been removed, and the Commission may only revise the Residual Interest Deadline through a separate rulemaking.

I strongly support this change. Moving the deadline to the start of business — thus requiring customers, mainly farmers, to pre-fund margin accounts — has the potential to create larger losses in the event of another failure along the lines of MF Global or Peregrine Financial.

This situation, however, illustrates how important it is to ensure that policy properly balances the Commission’s intentions. I speak specifically about the goal of strengthening FCM risk-management requirements while guaranteeing adequate accessibility to the derivatives marketplace and continued market liquidity. Under certain circumstances, these goals can be at odds with each other. Each one must, therefore, be approached with a conscious understanding of how it affects the other.

This rule change was unanimously approved by the four members of the Commission, each of whom commented to varying degrees:


“An earlier residual interest deadline better protects customers from one another, in line with the statute, but we want to make sure we move deliberately so that the model works best for customers in light of all of their interests, since the deadline will affect how much margin customers have to post and when.”


“This has the effect of increasing certainty to FCMs that any further change to the deadline would occur only following the robust procedures associated with a rulemaking, in addition to the already required study and roundtable, which is an outcome I support.

“The resulting certainty provided to the FCM community outweighs the potential value of incentivizing FCMs to improve their margin-collection practices to comply with a future, time-of–settlement deadline.”


“Without [this change], the so-called and, perhaps, misnamed ‘customer protection’ rule finalized in October 2013 would likely result in significant harm to the core constituents of this Commission: the American agriculture producers who use futures to manage the everyday risk associated with farming and ranching.

“As it stands, the rule will cause farmers and ranchers to prefund their futures margin accounts due to onerous requirements forcing FCMs to hold large amounts of cash in order to pay clearinghouses at the start of trading on the next business day. Without revision, the increased costs of pre-funding accounts will likely drive many small and medium-sized agricultural producers out of the marketplace. It would likely force a further reduction in the already strained FCM community that serves the agricultural community.”

Recordkeeping Requirements

The second rule change approved by the Commission clarifies the definition of how transaction records must be “identifiable.” Under the latest proposal, members of DCMs and SEFs that are not registered with the Commission do not have to keep text messages or store their other records in a manner that is identifiable and searchable by transaction. Additionally, CTAs do not have to record oral communications regarding their swap transactions.

This is another small but extremely important move by the Commission. I applaud the CFTC for recognizing that the costs of complying with certain aspects of the rule as it is currently written might exceed the potential benefits for certain market participants. The important thing to consider here is that the costs of maintaining those records would ultimately be passed along, via transaction fees, to those whom the rule seeks to protect: the customers.

However, the changes provide an incomplete sense of accomplishment. Yes, they achieve an important element of clarity; but they do not address concerns that the rule may be needlessly onerous and may hurt small FCMs, which are already burdened by low interest rates and increasing regulatory requirements. We see this painfully illustrated in the fact that there are currently about half as many FCMs serving our nation’s farmers as there were a few years ago.

The amendments to Regulation 1.35 were approved three to one, with Giancarlo opposed.


“The revisions to Rule 1.35 that the Commission is proposing today go a long way towards addressing the Rule’s difficulties. Unfortunately, they do not go far enough. The proposed Rule text raises unanswered questions. It continues to contain provisions that may be difficult or overly burdensome in practice for certain covered entities. In my opinion, many of the problems stem from imprecise construction and definition in the legal drafting.

“Without healthy FCMs serving their customers, the everyday costs of groceries and winter heating fuel will rise for American families… In implementing the Dodd Frank Act, I am conscious that the stated purpose, and indeed its official title purports to reform ‘Wall Street.’ Instead, we are harming ‘Main Street’ by forcing burdensome new compliance costs onto our country grain elevators, farmers, and small FCMs.

“Rather than facilitating the collection of useful records to use in investigations and enforcement actions, the underlying rule and the lack of sufficient relief provided in today’s proposal will instead result in senseless cost increases. Increased costs may even curtail the use of sound risk management tools needed to help farmers hedge the risks — and there are many — of growing the crops that feed and fuel our nation.”

Forwards With Embedded Optionality

The third and final rule change approved by the CFTC clarifies its interpretation of the seven-part test that is used to determine if an agreement, contract or transaction with embedded volumetric optionality would be considered a forward contract. The clarifications are designed to address concerns raised by utilities and other commercials as to whether these contracts should be treated as physical forwards or as swaps. This is a key distinction, as physical forwards are not subject to CFTC jurisdiction, while swaps are.

The clarifications spelled out in this rule change were essential. Over the past year, it appears that a number of participants have withdrawn from the market because of the ambiguities in the rule as it is currently written. This resulted in inferior execution for commercial firms and seems to have had a negative impact on electricity and gas consumers.

The proposed rule changes were approved unanimously by the four Commissioners:


“I appreciate that a number of market participants and end-users want clarity regarding which volumetric options qualify as forwards and, therefore, are excluded from our jurisdiction. I am sympathetic to these concerns and agree we should try to make our guidance on this point clearer.

“Yet, I worry that the current proposal as written goes too far and will cause too many options to be incorrectly regarded as forwards. I think the trade option exemption provides a much clearer and cleaner approach to address the issues raised regarding volumetric optionality. I hope the Commission can consider revising our trade option regulations soon.”


“The bottom line is that such uncertainty in the seven-part test increased transaction costs for commercial firms and limited their access to an effective risk-management tool.

“Today’s proposal should go a long way towards providing commercial firms adequate guidance.”


“Without [this change], the so-called and, perhaps, misnamed ‘customer protection’ rule finalized in October 2013 would likely result in significant harm to the core constituents of this Commission: the American agriculture producers who use futures to manage the everyday risk associated with farming and ranching.

“As it stands, the rule will cause farmers and ranchers to prefund their futures margin accounts due to onerous requirements forcing FCMs to hold large amounts of cash in order to pay clearinghouses at the start of trading on the next business day. Without revision, the increased costs of pre-funding accounts will likely drive many small and medium-sized agricultural producers out of the marketplace. It would likely force a further reduction in the already strained FCM community that serves the agricultural community.”

The Road Ahead

Now that most of the difficult regulatory work is finished (see Appendix A for a full list of CFTC rulemakings), the Commission will have a much simpler job in 2015. I don’t foresee any major changes in the near future; just more “fine-tuning” to keep everything running smoothly.

I see proof of this in the fact that only one of the Commissioners who had a hand in the major regulatory initiatives of 2010 through 2013 — J. Christopher Giancarlo — remains in place. All the other key figures have moved on.  

We can expect to see more amendments to rules that have automatic deadlines for implementation of higher standards, such as the Residual Interest Rule discussed above. In particular, I anticipate that the threshold for determining when a firm must register as a swap dealer, which will automatically drop from $8 billion to $3 billion in 2017, will be one of the areas that are fine-tuned in the coming months. We should also expect to see more amendments to the rules governing package transactions and position limits.

The biggest task I foresee for the CFTC over the next few years is to increase cooperation with other regulatory bodies around the world. Chairman Massad echoed this sentiment earlier this month when he said, “We have agreed to consider changes that would further harmonize our rules with European rules governing these clearinghouses. This would in turn facilitate their recognition of our U.S. clearinghouses.”

At the moment, the CFTC is continuing to consider how to apply its rules to swaps trades between non-U.S. entities that are arranged, negotiated, or executed in the U.S. While I’m glad to see the Commission taking steps toward global cooperation, I question whether we have the right people in place to accomplish this in the most efficient manner. None of the current Commissioners have substantial experience dealing with international regulatory agencies.

As a result, I would advise the Commission to rely on industry ambassadors, such as the ones acknowledge above, to help push the new global market initiative. With more and more new requirements going into effect, this will be the key regulatory issue in the months and years ahead, so its importance cannot be overstated.

We’re already seeing increased emphasis in this area, as exemplified by Federal Reserve Governor Jerome Powell’s recent call for more coordinated global regulation of derivatives clearinghouses. Specifically, Powell said, “We need transparent, actionable and effective plans for dealing with financial shocks that do not leave either an explicit or implicit role for the government.”

I fully agree. Over the past few years, central clearing of standardized derivatives has brought more transparency to the market. However, it has also increased the damage that could be caused by the failure of a large clearinghouse. In order to ensure that clearinghouses do not become the new “too-big-to-fail” entities, they must increase their liquidity, transparency and ability to withstand shocks without government bailouts.

Consequently, global regulators should consider establishing coordinated, standardized stress tests for clearers, and the results of those tests should be made public.

Appendix A

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TABB Group to Host Fixed Income Forum: January 29

On January 29, TABB Group will host the Fixed Income 2015: Perfect Storm Navigating the Confluence conference. Bringing together both public and private industry figures, this event will encompass a wide range of topics, from liquidity to regulatory challenges to automated trading, designed to ascertain the changing nature of the fixed income markets.

Tradeweb CEO Lee Olesky will take part in a panel entitled “A View From The Top: The New Trading Landscape.” Along with other industry experts, he will discuss changes to the industry from 2014 and explore what the driving forces will be in 2015.

Among the other industry leaders participating in the conference are Michael Buchanan, Head of Global Credit at Western Asset Management Company; Sam Priyadarshi, Head of Fixed Income Derivatives at Vanguard; and CFTC Commissioner J. Christopher Giancarlo. 

DerivAlert will be on hand, reporting live from the event.  Follow us on Twitter @DerivAlert for live tweets from the floor, or click here to register.

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A Review of 2014 U.S. Swap Volumes

By Amir Khwaja, Clarus
Originally published on Clarus

In this article I will review 2014 Swap volumes and do so in a similar format to my July article; A Six Month Review of Swap Volumes. As usual our universe is not global but specific to the United States. It consists of trades reported to US Swap Data Repositories, either executed On a Swap Execution Facility or Off Facility.

2014 was a very significant year for the Swap market.

Significant as for the first time for this OTC market it became mandatory to execute Swaps on a regulated venue. From February 2014, most Vanilla IRS (spot, par) were required to be executed On a SEF.

There was much concern on what this would mean for volumes: would trading move off-shore or from Swaps to Futures.

Lets see what the data shows.


Starting by using SDRView Res to show gross notional in On SEF USD IRS by month.


Which shows:

  • After the low point of mandatory execution in Feb, a steady pick-up in volumes
  • Around $1 trillion a month traded each month in the first half of the year
  • A significant pick-up (> 40%) in volumes from September
  • September, October and December showing record On SEF Volumes
  • With > $1.5 trillion traded in each of these months
  • (For details see the earlier articles for DecNov , Oct and Sep).

We know the increased volume from September onwards was driven by increased Interest Rate Volatility and the need for market participants to hedge or re-position their portfolios.

So nothing in the data here to suggest trading moved off-shore or to Futures.



And what of the three other G4 major currencies?


Again a similar pattern to USD with record months in September and October, just December showing low volumes.

Overall the aggregate volume in these three currencies remains below 20% of the USD volume, reflecting the fact that majority of trading in these currencies is taking place in London, Europe and Tokyo. Trade reporting and public dissemination outside the US is lagging (see my articles on the status in Europe and Japan) and so is not currently useful for our purposes.

For Cleared Swaps we have recently started collecting volumes direct from all Clearing Houses, see Tod’s article on Transparency in Clearing Data. As we build up sufficient history in our CCPView product, we will use this as another data source to shed light on global volume trends. (Make sure you subscribe to our newsletter to be kept informed).



Lets now take a quick look at Off SEF Volumes.


Which shows a very similar profile to On SEF.

Surprising as given the expiry of package exemptions for mandatory clearing, we would have expected a drop in volumes relative to On SEF over the course of the year. One reason for not seeing this drop is the spikes in reported trades on specific days (see November) which are clearly not the result of actual trading activity. If we were to exclude these, we would see On SEF volume between 50-60% of total volume, as we would expect given the large volume of Forward Start Swaps that are traded.



Lets move on to looking at Swap prices over the year. Using SDRFix we can see the change in the major tenors.


Which shows that between 1-Jan and 31-Dec:

  • 2Y and 3Y Swap Rates increased 40 bps
  • 5Y Swap Rate did not change
  • 10Y Swap Rate dropped 78 bps
  • 30Y Swap Rate dropped 119 bps
  • (A good time for US based folks to re-mortgage?)

So a flattening of the yield curve with 5Y as the pivot point. Very different from a rise in the whole term structure that many of us would have have expected back in Jan 2014.

And lets look at the daily price history of the 5Y and 30Y tenors.


Which shows:

  • 5Y Rates generally in the 1.6 to 1.8 range
  • 5Y Rates with large moves out of this range in Sep and Oct
  • 5Y High to Low of 50 bps
  • 30Y Rates on a steady decline over the year
  • 30Y Rates down from 3.9 to 2.7

So certainly in 2014 and particularly the last 4 months, we have seen increased interest rate volatility. A trend we would expect to continue as we get closer to the point that the Federal Reserve starts to raise Interest rates.



Lets now use SEFView to see which SEFs have gained and lost share in 2014.


Which shows:

  • Increased volumes in Sep, Oct and Dec
  • $2 trillion in 5Y Swap Equivalent transacted in Dec alone
  • A case of “A Rising Tide Lifts All Boats?”
  • Just that BBG and DW/TW rising much more than others
  • We know for TW part of the reason is the success of their compression list trading
  • Which in some months is up to 30% of TW volumes
  • BBG has more recently offered compression lis trading, so it is not a big component of their volumes

And focusing on market share:


Which shows that in 2014:

  • The winners are clearly BBG and DW/TW.
  • BBG has increased its share from 14% in Jan to 33% in Dec
  • DW/TW has increased from 5% to 32%
  • (Both have added compression/list trading over the year)
  • IDBs have seen significant falls in share
  • Tradition from 24% to 12%
  • TP from 23% to 7%
  • ICAP/IGDL from 18% to 11%
  • The rest don’t show any real change
  • Except for TrueEx, which shows a gain from its successful package trade offering

So we can say that the Top 5 Venues (BBG, DW/TW, Tradition, ICAP, TP) have 95% of the market. Or that the Top 4 have 88% and the Top 3 have 77% market share. Is there room for 3, 4, 5 or more venues in USD IRS?

One would not have thought so.

At least not without significant differentiation between the venues.

For instance we know that the IDB platforms have major shares in Basis Swaps, OIS Swaps, FRAs and Swaptions, each of which could justify a smaller share of vanilla IRS. We also know that services like TrueEx package terminations and allocations and TW and BBG compression list trading provide differentiation. So new innovations may allow firms to remain competitive.

However we would still expect to see some SEF consolidation in 2015. Either exists from the market or mergers.


2014 was a a significant year for US Swaps trading as On SEF became mandatory.

There was a concern that this would result in a drop in market volumes.

The data shows that this did not happen.

Sep, Oct and Dec were record months for On SEF volumes in USD IRS.

Interest Rate Volatility was much higher in September driving these volumes.

The Swap Curve flattened over the year, pivoting on the 5Y, with short rates up 40bps and long down 118 bps.

Higher volumes benefited most of the SEFs.

Bloomberg and Tradeweb both gained significant share over the IDBs.

Each has just over 30% of the volume in Dec 2014.

The Top 4 venues had 88% market share in Dec 2014.

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The Top 11 Themes That Defined Fixed Income in 2014: Tradeweb

By Billy Hult, Tradeweb Markets
Originally published on TABB Forum

The maturation of SEFs, the evolution of regulations in Europe in Asia, economic recovery, central bank policy and oil all are among the trends and themes that defined the global fixed income markets in 2014. Tradeweb president Billy Hult puts it all in perspective, and offers a preview for 2015.

Welcome to Tradeweb's third annual review of the top themes in the global fixed income markets. 2014 saw a wide range of economic, political and regulatory events, from the divergence in central bank policies to the continued growth of the exchange-traded funds industry. As a leading fixed income and derivatives electronic marketplace, we were in a unique position to observe the key developments in 2014 that shaped the markets in anticipation of the New Year.

1. SEF Trading Comes of Age

Following the launch of swap execution facilities (SEFs) in late 2013, the derivatives trading industry saw the gradual implementation of new reform by the U.S. Commodities Futures Trading Commission (CFTC), with trading of certain swaps being designated as Made Available to Trade (MAT) on SEFs in February. The CFTC then mandated that package transactions begin trading on SEFs in March, leading to extraordinary growth in electronic trading volume over the following months. During that time, market share for e-trading of U.S. dollar interest rate swaps (IRS) increased from less than 10% of overall volume prior to reform, to about 50% of all IRS trades. However, the CFTC provided additional no-action relief from the SEF trading mandate for the next wave of package trades until early 2015.

The transition to SEF trading also introduced new innovation for electronic derivatives trading, including sponsored access to SEFs through an introducing agent, and compression trading for quickly netting or terminating trades at their derivatives clearing organization. Year to date, more than $690 billion in notional volume has been traded on TW SEF via compression. New Market Agreed Coupon (MAC) swaps also became a required transaction in February, and experienced strong growth in volume with more than $200 billion being traded on Tradeweb in 2014.

2. Regulation in Europe and Asia is Taking Shape

Many of the details around trading regulations outside of the U.S. are still being determined, leading to uncertainty as to what the impact will be in practice. In Europe, reporting obligations for over-the-counter (OTC) and exchange-traded derivatives under the European Market Infrastructure Regulation (EMIR) started on Feb. 12. The rules relating to the mandatory clearing of certain derivatives under EMIR are expected to be finalized in 2015.

The European Securities and Markets Authority (ESMA) has proposed that the clearing obligation be phased in by type of counterparty over time. Mandatory clearing of IRS is likely to start in the fourth quarter of 2015 for Category 1 market participants (clearing members), with clearing for the first category of members to begin in the second quarter of 2016. The clearing obligation for credit default swaps (CDS) is expected to start shortly after.

ESMA is also in the process of consulting on draft detailed rules under the Markets in Financial Instruments Directive (MiFID II) and Regulation (MiFIR), which jointly replace and significantly expand the current MiFID legislation. The new legislation was politically agreed early in 2014, but the complete set of rules will not apply until Jan. 3, 2017. MiFID II and MiFIR incorporate the trading of standardized OTC derivatives as required by the G20 commitments, but also cover a broader range of instruments, such as fixed income securities and exchange-traded funds (ETFs).

In the Asia-Pacific region, regulators began offering more clarity on derivatives regulation. Australia made progress in developing its proposals, while Japan’s Financial Services Agency (FSA) continued to engage with market participants toward defining the scope of reform. The first electronically traded and JSCC-cleared yen swap transaction by a Japanese bank was executed on Tradeweb in June, highlighting that Japanese firms are preparing for implementation of local derivatives trading rules, published in July.

3. The Path to Economic Recovery Becomes Less Clear

The second half of 2013 set the scene for a long-awaited turning point in the course of global economic recovery. It was followed by stronger economic data, raised growth forecasts and credit rating upgrades at the start of the New Year. The World Bank predicted more robust growth for 2014, and the International Monetary Fund raised its global growth outlook to 3.7% and upgraded forecasts for the U.S., UK and the Eurozone. Europe’s peripheral economies were among the primary beneficiaries of buoyed investor sentiment in the fixed income markets.

Borrowing costs for peripheral governments continued a downward trajectory, dropping below pre-crisis levels in most cases. Greece returned to the financial markets after a four-year absence, issuing a 5-year government bond in April. A month later, Portugal became the second Eurozone state after Ireland to exit its bailout program without a precautionary credit line.

However, rising geopolitical tensions and softer economic data, particularly in the latter part of 2014, increased investor concerns over the sustainability of economic recovery amid deflationary pressures in certain regions of the globe. Japan’s economy shrank in the second and third quarters, and Germany cut its 2014 and 2015 growth forecasts in October.

Furthermore, Italy found itself back in recession after its economy contracted in the first three quarters of the year. After Greece’s 10-year government bond yield dropped to its lowest level (5.51%) since December 2009 on Sept. 5, fears over the country’s political and financial stability re-emerged, sending yields back up to 9.43% on Dec. 30.

The U.S., though, seems to be on an upward path still: in December, its third-quarter GDP growth was revised up to 5% on an annualized basis. 

4. Central Banks Adjust Monetary Policy

Central bank monetary policy diverged further in 2014, reflecting an uneven pace of economic recovery across different countries and regions. The U.S. Federal Reserve ended its third round of quantitative easing (QE3) in October, but kept interest rates low. In the bond market, 2014 began with the bid yield on the U.S. 10-year Treasury note hitting a year-high of 3.03% on Jan. 2. On Oct. 15, 10-year note yields saw their biggest one-day decline since 2009, briefly falling to 1.86%, the lowest intraday bid yield since May 2013. After closing at a low of 2.07% on Dec. 16, the 10-year ended the year at 2.17%, more than 125 basis points lower than many economists predicted at the beginning of 2014.

In contrast, the Bank of Japan (BoJ) voted to boost its target amount of annual asset purchases from between ¥60 and ¥70 trillion to ¥80 trillion at its Oct. 31 meeting. The BoJ also said it would buy longer-dated debt, and triple its purchases of ETFs and real estate investment trusts (REITs). The country’s benchmark 10-year bond began the year at a high with a mid-yield of 0.72% on January 6; however, it subsequently declined to a low of 0.31% on December 25.

The Bank of England (BoE) updated its “forward guidance” policy in February, which previously tied a potential interest rate rise to an unemployment rate of below 7%. The BoE left interest rates and Gilt purchases unchanged, as UK inflation fell to a 12-year low of 1% in November. Mid-yields for 10-year Gilts reached a 2014 high of 3.03% on January 2 and trended downward to reach a year low of 1.75% on Dec. 31.

Meanwhile, deflationary fears prompted the European Central Bank to adopt a set of measures to help protect the eurozone’s fragile recovery. These included deeper interest rate cuts, a package of cheap loans for banks to improve lending to the non-financial private sector, and purchases of asset-backed securities and covered bonds. 

5. Oil Prices and Geopolitical Tensions

In its latest assessment of global financial risks, the BoE warned that the decline in oil prices could heighten geopolitical tensions, trigger defaults by U.S. shale oil and gas firms, and destabilize Eurozone inflation expectations. There has already been evidence of this in 2014: Russia’s central bank raised its interest rate from 10.5% to 17% to combat the depreciation of the national currency and stave off deflation, on the same day the BoE’s Financial Stability Report was published. Russia’s economy has been affected by international sanctions over the country’s escalating tensions with Ukraine, as well as plunging oil prices. The yield on Russia’s U.S. dollar-denominated bond maturing in September 2023 spiked to 7.79% on December 16, its highest level in the year. Ukrainian bond yields also suffered in 2014 as the yield on the country’s 04/23 dollar-denominated bond climbed to a year-high of 17.58%, also on December 16. Fears that the country may need to restructure its debts have been gradually increasing.

6. Two-year Government Bond Yields Turn Negative (again)

The yield on two-year Japanese government debt turned negative for the first time ever on Nov. 28, continuing a trend also seen in some of Europe’s largest economies in a year of record low interest rates, heightened geopolitical risks and disappointing economic data. Two-year government bond mid-yields for Austria, Belgium, Denmark, Finland, France, Sweden and the Netherlands have been dipping below 0% intermittently since September, while German two-year bond mid-yields first closed in negative territory in August. According to the Bundesbank, the German Finance Agency sold €3.341 billion of a two-year note at a record low average yield of -0.07% in September, the first time German two-year debt was sold at a negative yield since 2012.

7. A Changing Municipal Bond Market

Municipal bonds experienced strong performance in 2014, following a year that saw major redemptions of nearly $50 billion as news spread of Puerto Rico’s debt issues and Detroit’s Chapter 9 bankruptcy. Though Puerto Rico’s bond rating was downgraded by Moody’s to B2 in July, after downgrades by all three ratings agencies to junk in February, the municipal bond market had some positive news when Detroit emerged from bankruptcy on December 11. This led to the longest rally in state and local government debt since 1992, according to Barclays, posting gains for 10 consecutive months. Based on data from Lipper, which tracks fund flows, muni bond funds have seen $18.2 billion in investments through October. Data compiled by the Wall Street Journal also shows that municipal bonds returned 8.32% through the beginning of November, higher than the Dow Jones Industrial Average (6.86%), investment grade corporate debt (6.68%) and U.S. Treasury debt (4.07%).

As the market prepares for 2015, reform of municipal bond trading is on the horizon. Under consideration is the provision to provide investors who purchase less than $100,000 in municipal bonds more information on what their securities firm paid for them under new mandates proposed by the Municipal Securities Board (MSRB). These would require brokers to disclose the prices they pay for bond issues on their trade confirmations, and are the latest effort by regulators to increase transparency in the $3.7 trillion municipal bond market.

8. Record Assets for ETFs/ETPs in Europe

Net new assets for European ETFs and exchange-traded products (ETPs) reached $61.8 billion in 2014, according to ETFGI, beating last year’s record. Total assets grew to $477.4 billion at the end of August, but have since dropped slightly to $472.1 billion. According to BlackRock’s Global ETP Landscape Report, ETPs in Europe enjoyed a successful year, as market penetration improved and ECB bond purchases boosted fixed income flows.

On the Tradeweb European-listed ETF marketplace, overall traded volume increased almost threefold in 2014, compared to the previous year. Trading activity in fixed income ETFs rose by three percentage points to 30%, while equity and commodity ETF trading saw a decrease of two and one percentage points, respectively. ”Buys” surpassed “sells” across all asset classes, reversing last year’s selling trend in fixed income and commodities ETFs.

9. Debate Heats Up on Corporate Bond Liquidity

New U.S. corporate debt issuance surpassed $1.5 trillion in 2014, while globally the number topped $4 trillion by the end of November with major bond issues from Medtronic, Apple, Alibaba and Volkswagen, among others. However, in order to meet capital requirements and regulations, Wall Street banks significantly reduced their corporate bond inventories during the year.

The debate about corporate bond liquidity continued to dominate headlines in 2014, and more market participants joined the conversation on the lack of corporate bond liquidity. Currently, only about 15% of U.S. corporate bond trades are executed electronically, while the rest are traded over the phone, according to TABB Group. The disparity led to the introduction of several new corporate bond trading platforms, including the Tradeweb investment grade corporate bond trading platform, which leverages new streaming price and RFQ protocols to support the 85% of the market that does not trade corporate bonds electronically.

The absence of corporate bond liquidity was also hotly debated in Europe. According to RBS, a European corporate bond issue trades once a day on average, compared with almost five times a day a decade ago. Electronic trading in cash credit products is estimated around 35% of the overall market volume. The portion of the market traded electronically is focused on the more liquid bonds and in trade sizes up to €10m, however, liquidity concerns center upon illiquid bonds and large block trades. On the Tradeweb European cash credit platform, the asset manager “hit-rate” – the percentage of price requests resulting in trades – has continued to grow steadily to 84%.

10. ECB Stress Tests and the Recapitalization of Eurozone Banks

Eurozone finance ministers adopted a new instrument under the European Stability Mechanism (ESM) in December, allowing for direct capitalization of troubled banks in the region. Previously, the ESM could only provide assistance to banks indirectly, via the government of the euro area member state where they are incorporated. The new direct recapitalization instrument removes the link between governments and banks, which is regarded as a potential destabilizing factor for some eurozone countries that could affect market sentiment.

Earlier in the year, the European Banking Authority’s (EBA) 2014 stress test results, released on Oct. 26, identified 25 banks with a capital shortfall of €25 billion. The stress test assessed the resilience of 123 banking groups across the EU against adverse economic developments, in order to understand systemic risk in the region, foster market discipline, and increase confidence in the banking sector. Of the 25 banks, 13 had to raise their levels of capital. Mid asset swap spreads for debt issued by Banca Carige and Monte dei Paschi di Siena, which were among these 13 banks, hit their widest levels for the year on Oct. 16 and Oct. 31, respectively.

11. European CDS Contracts under New ISDA Standard Financial and Investment Grade Indices Converge

Since October 6, European credit indices have been trading under a new standard for CDS contracts, the 2014 ISDA Credit Derivatives Definitions. The implementation of the new rules coincided with the trading of the new series (22) for iTraxx indices, which saw fifteen new sub-investment grade companies being added to the Crossover. Both series 21 and 22 of the index traded at their tightest level on December 5, at 197 and 310 basis points respectively, but retraced back to 252 and 379 basis points on December 16, as concerns over falling oil prices, the political uncertainty in Greece and the state of the Russian economy deepened.

Earlier in the year, the iTraxx Europe index, which comprises 125 equally-weighted European investment grade companies, and the iTraxx Senior Financials index, a benchmark linked to European senior financial debt, converged intermittently throughout September and the first half of October. 

Preview for 2015


  • Final Regulatory Technical Standards (RTS) on the clearing obligation for IRS under EMIR are expected to enter into force in Q2 2015.
  • Clearing obligation for IRS for Category 1 market participants is estimated to start in Q4 2015.
  • ESMA consultation on draft RTS on key MiFID II/MiFIR markets provisions – consultation closesMarch 2, 2015.
  • ESMA to deliver draft RTS on key MiFID II/MiFIR markets provisions to the European Commission by mid-2015.
  • Electronic trading of yen swaps in Japan is mandated from Sept. 1, 2015.

Central bank monetary policy

  • Divergence in central bank policy could gather pace.
  • The U.S. Federal Reserve likely to raise interest rates, in contrast with the ECB and BoE.
  • The ECB could implement additional stimulus measures, potentially including government bond purchases.

European ETF market

  • The European ETF/ETP industry should break through the $500 billion milestone in the first half of 2015 and fixed income ETFs will continue to grow in popularity.
  • Further harmonization in ETF infrastructure to address market fragmentation is on the way
  • Post-trade reporting initiatives will increase ahead of MiFiD II. 

Corporate credit market

  • The role of electronic trading will become increasingly important in the credit industry’s attempt to define new market structures.
  • Innovation will be key, and new tools will be developed aimed at improving the current dealer-to-client ecosystems.

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SEF Growing Pains

By Kim Hunter, Markit Magazine
Originally published on TABB Forum

US swap execution facilities remain a work in progress more than a year after their introduction, as regulators and industry continue to wrestle with the details of derivatives reform. Here's an overview of the state of the SEF competitive landscape.

A survey of the regulations of the US swaps market is necessarily a patchwork of competing regulatory gripes. Change came too fast (too slow). Volume is growing (progress is slow). It’s just like the old swaps market (if you discount the liquidity rout). Anonymity (not on my watch).

But there are two areas of agreement. First, regulation had unintended, often negative, consequences, the biggest of which is the much reported fracturing of liquidity between the US and London.

Second, the Commodity Futures Trading Commission (CFTC), under new chairman Timothy Massad, is attempting to figure out what works and what doesn’t and is willing to revisit areas that don’t. Matt Nevins, managing director and assistant general counsel at the Securities Industry and Financial Markets Association (SIFMA), said: “A good amount of the red tape has been cut through now and things are slowly improving. People like the ease and ability to go to a trading platform. It’s just taken some time to get there.”

Industry observers also understand that the CFTC had to create a set of rules out of six pages of the Dodd-Frank Act with no national or global precedent to build on. As much as they complain that the agency got the scope of its ambition and individual areas of rulemaking wrong, at least they have something in place. In the meantime, the long wait for European trading infrastructure rules to go live in 2017 is becoming a huge problem.

This leads to the area of most intense debate: liquidity. On-SEF trading has been slow to develop, but volumes have increased alongside volatility over the past couple of months, as the graph below shows. The proportion of the notional amount of US dollar interest rate swaps traded on-SEF was just over 50% for the four weeks to 14 November, according to International Swaps and Derivatives Association figures. For credit default index swaps, the picture is better still: around 70% of credit default swaps trading by volume was executed on-SEF in the four weeks to November 14th. The data shows that volume is dominated by SEF platforms controlled by ICAP, Tullett Prebon, BGC, Tradition and Bloomberg.

A recent TABB Group report also suggests a shift in protocol towards electronic request for quote (RFQ) and central limit order book (CLOB) trading. Figures from ICAP, owner of IGDL, one of the market’s few dually registered SEFs, show that around 40% of the SEF swaps trading is electronic, up from zero at the start of the year. Doug Friedman, general counsel at Tradeweb, also reported a significant increase in electronic trading on its TW SEF platform. “RFQ trading remains the most popular form of electronic execution for investors, as it provides them with the most flexibility in seeking swap liquidity. [However, while] 12 months ago, less than 10% of rates swaps traded electronically, that figure has already grown to more than 40% today,” he said.

The end users support the new regime, although they have difficulty with some of the detail. Supurna Vedbrat, BlackRock’s cohead of electronic trading and market structure, said that her firm trades all mandated products and, more broadly, “whatever the infrastructure is able to efficiently allow.” She added: “The impression that there is no trading on-SEF is not about willingness per se,” but that “SEFs’ ability to provide trading capabilities and liquidity is still underdeveloped for the way the market trades.”

Vedbrat cited the example of package trades that cross CFTC jurisdictions, i.e. transactions involving more than one swap or instrument, one leg of which is subject to the trade execution requirement. Her firm wants to be able to RFQ both legs as a single transaction to avoid taking basis risk or paying for bid-ask multiple times.

Tradeweb’s Friedman highlighted that many packages already can be priced and traded electronically, but the industry is working on the operational challenges and speed of pricing in some of the more bespoke packages.

A broad and, in many places, relatively shallow market such as the swaps market relies heavily on market making for liquidity. By creating an influx of market makers in the less risky, shorter maturity trades, open access to SEFs seems to have improved their liquidity and tightened spreads, according to Vanguard’s head of fixed income derivatives trading, Sam Priyadarshi. Conversely, he added: “Out beyond 10 years, where the smaller swap dealers are not willing to take on the risk, liquidity has deteriorated a little, though not a lot, and the bid-ask is wider.” Priyadarshi, like other end users, trades RFQ on a “handful” of SEFs that meet his firm’s requirements.

The predicted liquidity split between London and New York has also become manifest. “I liken [SEF liquidity] to a canary in a coal mine. It’s not dead yet, but it’s lying on its side,” said Dexter Senft, Morgan Stanley’s cohead of fixed income electronic markets. The fragmentation is “worrisome,” he said. Senft also fears for the market long term. He believes that the comparison between swaps and futures will inevitably arise once swaps have moved into more standardized products and CLOB trading has thus become viable. Senft has previously said that he expects 30% of the swap market volume to migrate to swap futures, but now expects that to take longer than the two years he originally predicted.

US banks, including Morgan Stanley, Bank of America, Citi, Goldman Sachs and J.P. Morgan, have de-guaranteed all or some of their London-based swaps business and boosted capitalization in the London subsidiary to enable dealing as a “non-US person” under CFTC rules. Nobody blames them, but as a senior SEF executive complained: “The exit of the US banks has shifted trading in euro, yen and sterling interest rate swaps to Europe. Given that interest rate swaps are 80% of the overall market, that’s effectively half the swap market gone at a stroke.”

It is ironic that the execution facilities the regulation was designed to create should be starved of volume at a time when they have the extra costs of ringing the changes the regulator has asked them to bear. As one SEF board member put it: “I can tell you it’s not very appetizing.” Another executive at a large SEF said: “Some of those with volume are not making a profit; the rest must be wondering how they can keep the lights on.” They’re hoping for change, he said, but he couldn’t see where it will come from.

Consolidation seems inevitable, although to what extent is not yet clear. One observer suggested that 15 or more SEFs may close, the only ones with a price tag being those with a “nice” bit of technology (a compression tool, for example) and then only at cents on the dollar.

Other than outright closure, other possible routes to consolidation may make SEFs more like exchanges, or involve the exchanges themselves. Tradeweb’s Friedman noted that designated contract markets would be able to steal a march on the competition if they are allowed to leverage the vertical nature of their expertise, i.e., their relationships with their clearing entities.

So far, the exchanges proper seem more interested in clearing than execution. CME’s $655 million counter bid for GFI following an initial bid by BGC Partners would seem to back that up. It would involve selling off the wholesale brokerage and clearing business to a management led consortium.

Get Ahead, Get a MAT

One change that does seem likely is to the mandatory listing made-available-to trade (MAT) process, and that is likely to make start-up SEFs’ positions worse, although it will please the CFTC’s other critics. The initial broad set of MAT applications was scaled back to the benchmarks before the first mandates in February, but not before the breadth of initial applications highlighted that it is in any struggling SEF’s interest to work on the infrastructure of a particular swap and capture volume while others catch scramble to offer it. SEFs at this year’s WMBA sponsored SEFCon confirmed that it is in their DNA to “list everything,” but neither the CFTC nor end users consider that outcome acceptable.

Vanguard’s principal and senior derivatives counsel, William Thum, told Markit: “We are very concerned that it is left to the good faith of the SEF to get the proposals correct.” Thum would prefer a more evolutionary path to SEF trading altogether, but is particularly concerned that imposed mandates, especially in the case of package trades and non-deliverable forwards (NDFs), both the cause of considerable controversy, should be applied with a “critical eye” to operational ability and overall liquidity. Vanguard and SIFMA worry in particular about front running if they are forced to request three quotes (as they are at present) in less-liquid contracts.

Yet another complex phase-in of package trades was announced in November, which effectively gives relief in the most problematic areas until February 2016. CFTC’s Massad gave a speech at SEFCon in November in which he said, in the context of NDFs, that the agency wants to think about the relationship between clearing mandates and trading. According to sources familiar with CFTC thinking, a non-public consultation has been launched.

CFTC commissioner Mark Wetjen told Markit that the issues raised often have more to do with mandating products for trading than with SEF trading per se. It is therefore “more than appropriate” that the CFTC should reconsider how they impose them, he said, adding: “Having the CFTC impose trading mandates rather than the SEF would probably lend itself to a more orderly and predictable process.”

Given Massad’s apparent sympathy for changing the MAT process, it seems possible that he would be prepared to issue interim relief in the meantime, or schedule in the introduction of any swap whose immediate mandatory trading is likely to have a negative effect on the market.

Competitive Edge

Competition between and within entities was part of what has been dubbed the “aspirational” nature of CFTC regulation. Former chairman Gary Gensler envisaged creating open market access to up to 100 or more SEFs, improving pricing and liquidity as he went. However, few think these extra-Congressional aims were laudable or have been achieved.

One competitive issue relates to the CME’s rule on trading invoice spreads, combined swap and futures positions, which states that the futures leg can be traded only on-exchange. “I don’t know as a technical matter yet whether it would violate any CFTC rule,” said Wetjen. “But it doesn’t feel right that you could hoard all the market activity for an invoice spread package, and it doesn’t seem consistent with some of the overarching policy goals of SEFs more generally.”

Neither has regulation broken the oligopoly of the big five interdealer-brokers, or slowed data terminal giant Bloomberg’s ascent to dominance. “The complexity of the new regime favors the present incumbents across all sections of the market,” explained Morgan Stanley’s Senft, while one SEF executive complained: “The new players are the same five plus Bloomberg. And how can you compete with Bloomberg when its $10 trading fee is below cost?” Bloomberg declined to be interviewed for this article.

The sheer effort it takes to get through the day in this complex new situation is a major reason for trading in a known way on a known entity. For end users, that largely means via RFQ. Vanguard, for instance, might describe its ideal platform as an all-to-all market with hybrid protocols, RFQ (including voice assisted) and request-for-stream as well as an active order book, but so far the firm has been conservative in trading RFQ only at a handful of platforms with the greatest liquidity, the greatest number of liquidity providers and the best infrastructure for efficient trading. “If there is more adoption of CLOBs by liquidity takers and liquidity providers, we will take advantage of that,” Vanguard’s Priyadarshi said.

BlackRock’s Vedbrat added that average price allocation is one area in which CLOBs have not caught up with the way asset managers trade. She thinks that the SEFs will develop solutions in the next few months. “Preferably at the CCPs,” she adds.

Tradeweb’s Friedman agrees. “CLOB trading will likely evolve over time, after the buy side demands greater trade velocity for certain standardized liquid swaps,” he said.

Business as usual for the dealer-to-dealer platform means on-SEF trading on a name give-up basis. However, a source close to the regulator said that anonymity is high on the CFTC’s agenda. Wetjen said that he and others at the CFTC have been asking market participants what, if anything, about the platforms with only dealer-to-dealer activity discourages customers from joining and actively trading. The answer? “Name give-up seems to be one issue. So-called dealer-to-dealer platforms that use or employ introducing brokers but keep them outside the SEF legal entity could be another,” he said.

Anonymity is one area in which no dealer-to-dealer SEF (i.e., an ICAP, Tradition, GFI or BGC) wants to go first. “The first one that goes anonymous is sending a signal that the buy side is becoming part of its platform. You’ll get wider spreads or even dealers withdrawing from that platform,” said one observer. The other side of the coin for dealer-to-dealer platforms is concern about bigger asset managers or hedge funds playing the markets. “If they’re able to enter the market anonymously, they could hit you three times instantaneously – through direct trading on block trades, via an anonymous order book and via Sef RFQ,” he said.

BlackRock’s Vedbrat suggested a compromise: fair and equal disclosure rights. “In a systematic way that would enable every participant to decide whether to give limited information to another participant,” she explained. For example, the SEF should default to non-disclosure and ask each participant to identify which participant they are willing to disclose. In all cases, execution takes place anonymously so there is no price differential.

Anonymity is just one of the questions on which the 24 temporarily registered SEFs need clarity to finalize their rule books as they head toward full registration. “We’re happy to create a straight-through anonymous market,” said one SEF executive. “But it stands in contrast to the permission to people to do disclosed RFQs. The CFTC needs to give clarity on what business models work.”

Another thorny issue is position limits, a statutory requirement that nevertheless needs revisiting for a market that, unlike physical commodities, has potentially infinite liquidity across multiple competing venues. It has been suggested that the CFTC conduct an in-depth study of trading across the whole market, on- and off-SEF, to put the rule into context.

Yet another is the “15 second” rule, the crossing delay that requires a customer order to be displayed for at least 15 seconds before it is filled. The delay at some venues is much lower than that and still problematic. “It’s one reason the interdealer-brokers have moved their brokers inside the SEF. Otherwise, prearranged trades submitted to the SEF would get ‘picked off’ in the majority of cases owing to the aggressive nature of those order book liquidity pools,” said one market participant.

More broadly still is the question whether you can have an affiliated broker-dealer when you’re running a SEF.

There also are questions about how platforms raise fees, including whether they can be capped based on trading in products traded off-SEF with the same company. CFTC rules appear to suggest that you can’t, given the requirement to treat all customers equally. But there are complaints that these rules have not been applied consistently.

One area that has given SEFs genuine relief is the recent no-action letter clarifying that a block trade can trade on-SEF, a position adopted to aid compliance with CFTC regulations covering pre-execution screening and prompt clearing. “The intention was about the delay, not where they’re traded. That’s one rule that should be changed,” said one market observer.

Back to the Future

Certainty will not come to the US swaps market until European market infrastructure rules come on stream in 2017. The nature of that certainty is a matter of interpretation. Morgan Stanley’s Senft told Markit: “Some people think the issue will be resolved in 2017 when Mifid II comes in and the two regimes become similar, that given a chance of frying pan or fire the large players will register in both jurisdictions. But that seems like a stretch to me, especially when people prefer one method of trading.”

Wetjen focused on the cross-border process itself. “[It’s] certainly not broken,” he said. But, referring to the equivalency determinations made so far, he added, it’s a matter of “building on work that’s already been done.”

Back on domestic soil, SEC rules will also go live and SEC registrations will be made, perhaps solving some inter-jurisdictional issues, perhaps creating domestic fragmentation. One market participant suggested that the SEC might be planning to make all players a SEF at the same time in a simple registration process, giving two years’ no action relief on the rules and then phasing them in gradually.

Pity the CFTC, which had to blaze that trail and is now faced with revisiting its own process as registrations become permanent. Wetjen confessed to still being “torn” on the appropriate time to make some of the changes he thinks might be necessary, but feels he has enough clarity on registration to think that adjustments should be made sooner rather than later. “We need to be pragmatic in what’s expected,” he said, without giving further detail.

One market participant, who stressed that he has every sympathy for the CFTC’s task and appreciation of its efforts, nonetheless said that it may have an ulterior motive for the changes: to give it powers that it doesn’t have under existing rules. “At the moment, since they don’t have the ability to mandate these things directly, they have to tie it to something else, like non-discriminatory access,” he said.

This same observer, despite thinking that the original CFTC rules overreached the regualtor’s mandate, would rather the rules were tougher than unclear. “Just don’t leave us in limbo,” he said.


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Derivatives Systems Then and Now

By Eunice Bet-Mansour, Actualize Consulting
Originally published on TABB Forum

Seismic changes have occurred in the world of derivatives since 2008, and derivatives systems best practices and integration requirements today are markedly more complex, with dual workflows for cleared and non-cleared trades and industry demands for real-time data and risk management. Vendors in the space continue to play catch up.

Seismic changes have occurred in the world of derivatives since 2008, beginning with the industry’s post-crisis response and followed by passage of Dodd-Frank in 2010 and the subsequent passage of EMIR – changes in valuations (OIS, Clearing), in collateral and margining (Standard Credit Support Annex, Standard Initial Margin Model, clearinghouse Initial Margin and Variation Margin), in stay protocols (Resolution Stay), and in workflows. Throughout, vendors in the derivatives space have played – and continue to play – catch up with industry and regulatory developments. To date, many vendors’ solutions are still evolving. It is worthwhile to take a step back and highlight some of the seismic shifts in derivatives systems’ best practice and integration requirements that have occurred with the change in the regulatory landscape and industry responses to the 2008 crisis and ensuing regulation.

In the “old” pre-2008 days, user requirements from large-scale derivatives systems were “relatively simple.” The focus was on booking, models rendering accurate pricing with Libor-based risk-neutral valuation (much-analyzed and well-understood analytics) and end-of-day risk parameter/metrics such as VaR, robust market data feeds, straight-through processing (STP) for all pricing, risk management, documentation, accounting and post trade life-cycle events management.

In the “new” post-2008 days, derivatives systems best practices and integration requirements are markedly more complex, with dual workflows for cleared and non-cleared trades and industry demands for real-time data and real-time risk. New STP best practices requirements for derivatives vendors include connectivity to trade repositories such as MarkitSERV/DTCC for regulatory reporting requirements for both cleared and non-cleared trades. Clients are also requiring derivatives vendors to provide connectivity to trade middleware such as MarkitWire for STP of cleared trades. Swap dealers and major swap participants require connectivity to Swap Execution Facilities (SEFs). Since vendors have been slow in providing these connections from their applications, most major derivatives users have developed their own solutions to connect third-party vendor applications to the various middleware, trade repositories and SEFs.

On the pricing front, OIS risk-neutral pricing is now the norm for both cleared and non-cleared trades. While vendors were initially slow and incremental in providing OIS pricing solutions in their applications, at this juncture OIS is a key new functionality of most third-party derivatives applications. OIS pricing, however, is multi-dimensional and complex, with a multitude of curve construction methodologies, and not all derivatives systems provide a comprehensive array of these methodologies.

Derivatives valuations, P/L and risk analytics are now further layered by CVA, DVA and FVA risk adjustments. While CVA was adopted by some major broker-dealers prior to 2008, CVA and DVA emerged at the forefront of industry best-practice response to the 2008 crisis and are now a regulatory requirement under Basel III for non-cleared derivatives. Derivatives users’ in-house quantitative analysts are at the forefront of OIS, CVA, DVA and FVA vendor model validations, and if validations fail, risk management and valuation best practices require connectivity of the vendor booking system to in-house models.

For cleared trades, best practices for third-party derivatives systems is to have connectivity to exchanges for retrieving end-of-day prices as well as to clearinghouses via clearing brokers to address both margining and CCP compression/netting. While variation margin (VM) is well-defined, initial margin (IM) and price accrued interest (PAI) calculations are not. Derivatives vendors have lagged behind the industry in developing these margining requirements. Most major derivatives users, therefore, have developed their own IM/PAI/VM calculators outside of their third-party derivatives vendor systems in order to meet the tight regulatory compliance timelines. Given these applications are outside the vendor system, STP requirements during implementation necessitate new connectivity between users’ vendor applications and the users’ proprietary IM/VM/PAI calculators.

For non-centrally-cleared trades, phased regulatory implementation of VM and Standard Initial Margin Model (SIMM) requirements loom on the horizon for various financial counterparties from December 2015 through 2019. Once again, as derivatives users are developing their own applications to address the regulatory requirements, derivatives vendors will likely lag behind the industry in providing these margining solutions for their clients. Here, too, STP requirements will necessitate new connectivity between the vendor applications and users’ proprietary SIMM/VM calculators for uncleared trades.

An important industry trend in OTC derivatives since 2008 is increased emphasis on risk reduction via notional compression. Major broker-dealers undertook bilateral and multilateral compression periodically prior to 2008. Post-crisis, however, portfolio compression for non-cleared trades has become an industry-wide exercise undertaken in regular monthly cycles. On the one hand, for non-cleared derivatives, while Dodd-Frank mandates the undertaking of bilateral and multilateral compression when appropriate, this initiative has been given further industry impetus due to high Basel III capital requirements. On the other hand, for cleared derivatives, this initiative is being pursued by clearinghouses as a means of risk and line item reduction.

As such, a critical addition to post-trade STP lifecycle event management is trade compression/netting for both non-cleared and cleared trades. Non-cleared derivatives trades counterparties now participate in monthly multilateral portfolio compression cycles through third-party compression infrastructure such as TriReduce of TriOptima. After every compression cycle, it is critical for these users, therefore, to ensure that their in-house derivatives systems reflect accurate trades, positions and risk. Third-party vendors have been slow to introduce connectivity between their applications and compression infrastructure providers such as TriReduce. To date, most derivatives users have been terminating/replacing trades after compression cycles either manually or via proprietary automated in-house solutions so as to ensure the accuracy of their positions, risk and P/L.

Cleared trade netting/compression is still evolving. While some clearinghouses such as CME Group have implemented end-of-day netting for a subset of products such as vanilla fixed-float interest rate swaps and vanilla credit default swaps, other clearinghouses are just beginning to develop netting infrastructure. It is critical that line item trades of counterparties to clearinghouses match the trades that are actually held by clearinghouses as well as those reported to trade repositories. Given that each clearinghouse implements a product-specific proprietary netting algorithm, third-party derivatives vendors will also have to develop the identical netting algorithms for their applications. Vendors have not yet begun to develop these algorithms, and most cleared trade derivatives users are looking to develop proprietary in-house solutions.

We have highlighted herein some new best practice and integration requirements from derivative systems. Although it has been six years since the 2008 financial crisis, new derivatives industry best practices and/or regulatory requirements are still evolving and emerging in both cleared and non-cleared spaces. As seen herein, the onus on derivatives systems now is much weightier than in the pre-crisis days.

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Meet the New Dodd-Frank. Same as the Old Dodd-Frank

By Colby Jenkins, TABB Group
Originally published on TABB Forum

When Congress killed the Swaps Push-Out Rule in December, it appeared as if Dodd-Frank were ready to crumble under conservative attack. In reality, not so much.

When the House narrowly passed the Consolidated and Further Continuing Appropriations Act of 2015 in early December, the media’s alarm bells started ringing. Dodd-Frank was under attack and the public needed to know. In reality, not so much.

Inserted within the $1.1 trillion must-pass government spending bill was a seemingly out-of-place Dodd-Frank amendment looking to roll back provisions aimed at migrating a small set of the “riskiest” derivatives activities outside of banks’ insured walls. This “Swaps Push-Out Rule” was the unfortunate legacy of a one-time Arkansas senator who sponsored the contentious amendment as part of a failed bid for reelection. After four years of lobbying from the Street, language had been inserted into Section 716 that significantly reduced the scope of the swaps push-out specifically to structured-finance swaps trading activity. The pressure was on the Senate two days later to make the choice: let Dodd-Frank take a hit, or face another government shutdown. Within days, the damage had been done and the Lincoln Amendment was a shadow of its original self.

The question is: What was at stake, and was it worth the fight?

The answers are pretty simple: Not much, and yes.

Looking at the original language, the scope of the push-out was pretty narrow to begin with. Interest rate swaps and currency swaps were largely, if not entirely, immune to the provision, as were cleared credit default swaps as well. This left solely equity-linked swaps, commodity swaps and uncleared credit default swaps subject to push-out mandates. Collectively, these securities make up less than $9 trillion in notional held across all U.S. banks. Small potatoes compared to the $300-plus trillion in outstanding notional for derivatives markets still remaining within the insurance walls of the banks.

From a public accountability perspective, Section 716 was never going to move the needle. Had the provisions have remained intact, there was little rationale as to how it would reduce systemic risk in the market. In fact, the push-out rule was almost unanimously opposed by regulatory heads when it was first drafted in 2010. Bernanke and Volcker both opposed the provisions from the get-go. Bernanke was even quoted opining that it would likely increase systemic risk.

The rollback certainly was a win for a small handful of banks that hold the vast majority of derivatives. For dealers that have experienced strain on their business models in the wake of the credit crisis, CDS trading remains a very profitable business, and it makes sense that they would fight to protect it. Should the push-out have gone through, the cost of pushing CDSs into non-affiliated divisions would have been tremendously costly and perhaps impossible to maintain for certain banks. This also would have led to increased complexity in the market, given that these new divisions would likely have been subject to less regulatory oversight.

Conversely, this amendment should be something of a win-win situation for both the big banks and folks with an axe to grind with Wall Street. Banks can keep nearly all their derivatives trading within their walls, yes; but the price of that will be more scrutiny than ever before.

Looking at the remaining Dodd-Frank rules to be finalized, there is a lot of land still to fight for in the New Year. Of the 90 rules related specifically to derivatives trading, nearly half missed their deadline as of December 2014 – by far the category with the most amount of work left to be done, according to Davis Polk. That leaves a lot of room for bigger problems than this to pop up, and even more room for improvement. 

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