By Will Rhode, TABB GROUP
Originally published on TABB Forum
IFMA has come out in support of Bloomberg’s request to the CFTC to reduce the 5-day VaR calculation if initial margin for swaps to the same 1-day VaR requirement for futures. But shouldn’t it be left to each DCO to determine margin requirements based on how it chooses to compete in the marketplace?
The Asset Management Group (AMG) of the Securities Industry and Financial Markets Association (SIFMA) has written to the CFTC in support of Bloomberg’s letter requesting relief from the 5-day VaR calculation of initial margin for swaps vs. the 1-day VaR requirement on futures. In its letter it states:
AMG believes that the minimum liquidation time of 5 days for Non-commodity Swaps (a) is arbitrary and overly conservative, (b) is based on a fundamentally flawed assumption as to differences in liquidity between futures and swaps, (c) creates an artificial economic incentive for market participants to use futures rather than swaps and (d) is contrary to Congress’s goal of promoting trading of swaps on swap execution facilities (SEFs). We strongly believe that the minimum liquidation time for Non-commodity Swaps should be the same as for Futures and Commodity Swaps – i.e., 1 day – with DCOs using their reasonable and prudent judgment to set higher liquidation times for particular types or classes of transactions where warranted by their specific liquidity characteristics as evidenced by quantitative analyses derived from sources such as swap data repository data.
While we at TABB Group sympathize with the buy side’s struggle to deal with new clearing costs associated with swaps trading, and while we appreciate the illogic of an un-level playing field in margin treatment for what may be two economically equivalent products, we question the degree of intervention that the CFTC should take in determining DCO margin requirements. Should it be the CFTC that determines these things, or the DCOs themselves?
The AMG letter continues:
Rule 39.13(g) provides that DCOs shall employ models that will generate margin requirements adequate to cover the DCOs’ potential future exposure to a clearing customer’s position based on price movements between the last collection of variation margin and the time within which the DCO estimates that it would be able to liquidate a defaulting clearing member’s positions. Under the final rule, the models must assume, unless an exception is granted, that it will take at least one day to liquidate futures and options (“Futures”) and agricultural commodity, energy commodity and metal swaps (“Commodity Swaps”) and that it will take at least five days to liquidate all other swaps (“Non-commodity Swaps”). In the preamble to the final rules, the Commission explained that these “bright-line” minimum liquidation times would provide certainty to the market, ensure that margin requirements would be established for the “thousands of swaps that are going to be cleared” and prevent a potential “race to the bottom” by competing DCOs.
The question becomes: How literally should the industry interpret the “bright line” drawn by the CFTC? This appears to be more an attempt at guidance, rather than an outright prescription. More to the point, Dodd-Frank has mandated for competition in clearing, so shouldn’t it be left to each DCO to determine the margin requirement based on how it chooses to compete in the marketplace? Some DCOs will opt to become more conservative in their margin calculation as they seek to demonstrate their risk management expertise and stability. Others will emphasize their ability to offer savings through margin efficiencies and cross-product netting. The point is, it should be up to the DCO to determine how it wants to define its value proposition, not the CFTC.
To that end, we believe that the AMG misses the point when it says: “Surely, it could not have been Congress’ intent in adopting Title VII of the Dodd-Frank Act for the Commission to create a market structure that would move liquidity away from swaps and into futures.”
The intention of Congress and Dodd-Frank is quite clear: reduce systemic risk. This is true of the transparent trading mandate, central clearing and trade reporting. So it seems unnecessarily risky at this point to demand that the CFTC reduce swap margins just as clearinghouses are being intermediated into the derivatives market to improve financial market safety.
The AMG is right to point out that the appropriate liquidation time for derivatives will be affected by a number of factors, including the trading volume, open interest, and predictable relationships with highly liquid products. But we believe that should be left to the DCOs, which are the experts in such matters, to determine.
Today, the CFTC met to vote on final rules for swap execution facilities (SEFs). The Commission’s five members – three Democrats and two Republicans – voted in a public meeting on new platforms for swaps that will bring bilateral trading to an end, and transfer trades to centralized, transparent marketplaces. Critics say that the final rules are watered down, and as a result, a victory for Wall Street. Commissioners Jill Sommers and Scott O’Malia echoed those sentiments at the vote in their prepared statements.
Statements from each of the commissioner can be seen by clicking on their name: Scott O’Malia, Bart Chilton, Gary Gensler, Mark Wetjen, Jill Sommers
The Commission voted 4-1 in favor of the new rules.
More information on the final SEF rules can be found in the following Q&As and fact sheets:
By Will Rhode, TABB GROUP
Originally published on TABB Forum
The failure of many buy-side firms to meet the June 10 Category II OTC clearing deadline will lead to a compression in US swaps trading activity and a liquidity drain of approximately US$55 trillion in notional terms.
The June 10 date for Phase Two of the OTC clearing mandate is fast approaching, yet a large portion of buy-side firms are still not ready. TABB Group estimates that 500 buy-side firms will fall under the Category II mandate and that 75% of them, or 375 institutions, will fail to meet the deadline. When looking at Separately Managed Accounts (SMAs), the universe is much wider, with as many as 3,000 funds still needing to get Know-Your-Customer (KYC) documents in place before an intermediary will set them up for clearing. This failure to meet the deadline will lead to a compression in US swaps trading activity and a liquidity drain of approximately US$55 trillion in notional terms.
May 15 is the absolute cut-off date for selecting a Futures Commission Merchant (FCM). This will give a buy-side firm a week to complete legal documentation, two weeks for account opening and, if it is lucky, a day or two for testing.
Those commodity pools, hedge funds, and non-swap dealer banks that fall under the Category II definition but have yet to turn their attentions to clearing face a severe risk of being locked out of the swaps market after June 10. The same problem applies to those that should have complied with the Category 1 deadline of March 10 but managed to delay, as well as to those insurance companies that are reconsidering their Category III status. In practical terms, it takes three months to complete the process – from opening up a clearing relationship, to the final testing of trades (see Exhibit, below).
Source: Citigroup, TABB Group
Buy-side firms have to negotiate legal documents with FCMs, middleware providers, and Derivatives Clearing Organizations (DCOs), as well as with executing brokers. From an operations point of view, they have to establish connectivity to clearinghouses, set up Legal Entity Identifiers (LEIs), and upgrade their trade management and portfolio reconciliation systems. For those firms only now turning their attentions to the clearing challenge, some of the stickier negotiations around collateral haircuts and margin financing will have to be foregone in order to expedite the onboarding process.
Questions abound. Will there be a legal bottleneck as players rush to comply with regulation at the last minute? How will a clearing broker’s time and resources for onboarding be allocated? Will some market participants be temporarily locked out of the swaps market come June 10? Will they have to find alternative ways to meet their investment objectives? Will firms that have prepared for clearing face liquidity challenges as latecomers create drag in the system? What will that mean in terms of their ability to manage risk effectively? Will the new infrastructure be able to handle the sudden escalation in clearing volumes? How will buy side firms handle portfolio risk in the event of a major market disruption?
The one thing we do know: The period of procrastination is over.
By David B. Weiss, Aite Group
Originally published on Aite Blog
The usual legal industry of lobbying, commenting, advising, etc. that the CFTC and SEC have created aside, it sure does seem like the CFTC is driving a fair amount of business for litigators these days:
Sure makes it interesting for the spectator. Of course, not all market operators have taken that route. Some have just asked to be let off the rules for a while. Bloomberg is noted far more for being “sticky” then litigious, but when it decided to step up to the plate, it did so in a big way, choosing Eugene Scalia (and former governor of New York, Mario Cuomo) to make its case. Scalia has a pretty good record when it comes to these regulatory lawsuits, so it was pretty bold of the CME to make light of Bloomberg’s lawsuit, given their own track record, detailed above, against the CFTC. How ironic that, hours later, the DTCC would sue the CFTC in direct response to the favor it believes was shown to the CME (and ICE) on SDRs.If the CFTC and SEC felt overwhelmed by their new regulatory tasks stemming from Dodd-Frank, then these latest two regulatory arbitrage opportunities created by the CFTC were not the right steps to take. Now they’re being sued on two fairly substantive grounds.
Describing the revolution of breaking news doesn’t even require 140 characters; it can be summed up in just one word – Twitter. And in a shifting landscape of emerging technologies, tight deadlines, and new regulations, finding the right source for your financial news can keep you a step ahead.
That’s why Tradeweb assembled their list of the top ten Twitter feeds for news on derivatives reform, trading, and technology. Armed with this list, your timeline will become your own, customized financial news crawl.
To read the full list, click here.
By Will Rhode, TABB Group
Originally published on Tabb Forum
Already complex, swap portfolio management will become less forgiving with the implementation of the next clearing mandate in June. Buy-side firms need new technology that can help them streamline the process of trade terminations, compactions, fund rebalances and back-loading.
As the next clearing mandate hits June 10, buy-side firms are going to need new systems to help them manage their swaps portfolios. Today’s imperfect science of swap terminations, compactions and fund rebalancing will have to be perfected, since clearinghouses will only recognize precisely coded trades for netting purposes. If there is one mistake in any one of the 85 fields required by the CME Trade Register, for example, an offsetting swap designed to terminate a pre-existing position will count as an additional line item. Rather than eliminating the problem, this will create a new problem for traders.
Swaps portfolio management is already an operationally complex task, with the messaging of multiple Excel files containing multiple line items, the negotiation of trade prices, collective affirmation, and the delivery of the final trade packet – mostly manually managed. That said, while a bilateral dealer may today forgive a decimal error or an incorrectly labeled line item, a clearinghouse won’t. Without a system that can communicate with the clearinghouse in order to ensure all necessary fields and coding requirements are met prior to execution, the buy side will find it impossible to manage its swaps portfolios effectively through:
Terminations of existing bilateral swaps;
Compaction, which allows traders to replace multiple swaps with different coupons; and maturity dates with a single economic equivalent position;
Fund rebalances that transfer swap positions from one fund to another;
Or, when the specific risk of the bilateral swap must be retained, back-loading the swaps into the clearinghouse.
Even as the CFTC rules stipulate that certain swaps must clear, the portfolio logic of converting all swaps is increasing. The clearing mandate, escalating bank capital charges, a new margining regime for bilateral trades, and a desire to realize portfolio margining efficiencies all play a part in driving the industry toward clearing. Even though the Dodd-Frank clearing mandate does not require ‘grandfathering’ of pre-existing swaps into clearing, once any sizable volume of swaps are centrally cleared, it will make little sense to manage both old and new swaps with different operational and margin requirements in a single portfolio.
This is a heavy operational lift, however, since the world of bilateral trading has engendered a proliferation in line items. Now the process of rationalizing swap portfolios will need to begin, even as regulators raise the bar with a new real-time clearing requirement. Given the bottlenecks likely to occur as funds simultaneously look to comply with the clearing mandate, the need for new technology solutions that can help streamline the process of back-loading, fund rebalances, trade terminations and compactions is paramount.
By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.
Originally published on Tabb Forum
Earlier, I covered a report to the OTC Derivatives Regulatory Group (ODRG) meeting on resolving the international requirements for derivatives reform that the G20 passed in 2009. As it happens, the Financial Stability Board (FSB) published a report card on this same subject on April 15.
It shouldn’t surprise us that the cross-border aspect of derivatives reform is so much in the news today, since that is where the next big efforts will have to be made. Global market participants that are still heavily focused on Dodd-Frank are in danger of missing the bus, which is getting ready to leave the station.
The report card doesn’t start off on a positive note. It reads:
“While progress has been made in moving these markets towards centralised infrastructure, less than half of the FSB member jurisdictions currently have legislative and regulatory frameworks in place to implement the G20 commitments and there remains significant scope for increases in trade reporting, central clearing, and exchange and electronic platform trading in global OTC derivatives markets.”
Like a reproachful teacher, the FSB takes the jurisdictions to task for their slow progress:
“The FSB reiterates that, even though standards are still being finalized in a few areas, sufficient international guidance is overall available to jurisdictions to decide and implement policy frameworks for ensuring the G20 commitments are fully met in their jurisdictions, and that any necessary reforms to regulatory frameworks should be made without delay. This includes ensuring that there are no legal barriers to reporting all OTC derivatives contracts to trade repositories (TRs) and to the central clearing and organised platform trading of standardised OTC derivatives contracts... The FSB urges jurisdictions to clarify their respective approaches to cross-border activity, and to resolve any conflicts and inconsistencies as quickly as possible to provide certainty to stakeholders.”
Then the report gets into the details of the three major efforts: reporting, clearing, and centralized trading. Inreporting, the FSB points out one of the biggest problems to date: the lack of standardization in reporting data. “Only a small number of jurisdictions are placing obligations on market participants relating to non-centrally cleared transactions, such as trade confirmation timelines, portfolio reconciliation and compression, and trade valuation practices,” according to the report.
It also emphasizes another significant reporting issue, access to trade data by cross-border regulators. “Reporting a counterparty’s identity to TRs may be limited by domestic privacy laws, blocking statutes, confidentiality provisions and other domestic laws,” the FSB says. It also urges the jurisdictions to “continue to monitor the development of or changes in such laws and their proposed reporting requirements to ensure that any planned reforms adequately address barriers to reporting OTC derivatives transactions.”
With regard to clearing, the report says, “Jurisdictions must rapidly implement the G20 commitment to centrally clear all standardised products, in order to reduce systemic risk and to minimise risks of regulatory arbitrage between jurisdictions.” It points out three reasons why the clearing mandate hasn’t been completely adopted:
“Insufficient standardization. Some jurisdictions consider that currently there are not sufficiently standardized OTC derivatives products in their jurisdictions for central clearing to be viable.
“Availability of CCPs. Even where standardization is sufficient for central clearing to be viable, some jurisdictions report practical difficulties in implementation because no CCP is accessible by market participants located in their jurisdiction that offers clearing for the OTC derivatives products most actively traded in their markets.
“Use of incentives. Some jurisdictions have indicated that they expect that central clearing of standardized OTC derivatives will occur in their jurisdictions without mandatory obligations, due in part to the various incentives that market participants will face, including, for example, the requirements under the Basel III framework for banks and the margining requirements for non-centrally cleared trades.”
The FSB is skeptical of the reliance on incentives, and urges jurisdictions that do so to “recognise there is a risk that jurisdictions that have applied mandatory requirements may not regard their regime as equivalent. As international work increasingly focuses on implementation monitoring, the FSB will pay particular attention to the risk of regulatory arbitrage resulting from differences in jurisdictions’ implementation of central clearing reforms, across those jurisdictions imposing mandatory obligations and those that have not.”
Finally, on centralized trading, the report recognizes that this is perhaps the most difficult requirement, acknowledging that:
“Only a very small number of jurisdictions have requirements in force in this area. Many jurisdictions indicate that reform efforts are first being focused on implementing reporting and clearing requirements, or that further analysis is required of market liquidity before implementing trading requirements. However, this should not delay the enactment of legislation and regulation that would permit the implementation of trading requirements once they are determined to be appropriate for particular products.”
So the FSB gives the member jurisdictions a barely passing grade in derivatives reform, and, like a diligent teacher sending a note home, “The FSB Chairman has written to all member jurisdictions requesting confirmation that legislation and regulation for reporting to trade repositories are in place, as well as their committed timetables to complete all OTC derivatives reforms. He stressed that the need for prompt action on TRs should not in any way diminish the need for rapid completion of reforms in other areas, such as central clearing, capital and margining, and trading on exchanges or electronic platforms.”
Of course, as any teacher can attest, the parents have to take the warnings to heart or there will be no improvement in the classroom. The big question with this report card is: Will the jurisdictions care, or will they drop it in the trash on the way home?
By Alexander Tabb, TABB Group
Originally published on Tabb Forum
Everyone within the institutional capital markets knows that we exist in a hyper-sensitive, latency-dependent world in which time is no longer measured in minutes or seconds, but milliseconds and microseconds. So it is no real shock that the hack of the AP newswire Twitter feed Tuesday had such an immediate and discernible, but short-lived, impact.
At 1:07 pm (EST) unknown parties appeared to have gained unauthorized access the AP Newswire Twitter feed and tweeted to approximately 2 million followers that two explosions occurred in the White House and that President Barack Obama was injured. Subsequent to the tweet, the @AP Twitter account was suspended. But the damage had been done.
Immediately following the tweet, the markets reacted, with the S&P dropping approximately 11 points (~0.6%) and the Dow Jones Industrial Average dropping 144 points, or ~1%. Each rebounded within minutes, but millions of dollars were potentially gained or lost in the upheaval. During the disruption, S&P ETF volume increased dramatically, clearly indicating how sensitive the markets are to significant or potentially catastrophic events.
This gets to the real question: Was today’s hacking an attempt to manipulate markets, financial terrorism, or just an unforeseen side effect of an Internet hoax?
The case for market manipulation seems a bit weak. While it is true that the markets reacted with a rapidity that many will find scary, the AP Twitter account and the markets are too many steps removed from each other to ensure that hacking the account would in fact create this type of disruption. There likely are too many variables at play for a premeditated market manipulation event to make sense. However, the SEC and others will look at this closely, and if this was indeed an attempt at market manipulation, they will make every effort to uncover the truth behind it all.
As for financial terrorism, once again it is possible, but less probable. Though the Syrian Electronic Army claimed responsibility minutes after the hack, their motivation appears to be more geopolitical or cultural than financial. And again, the linkage between the AP Twitter feed and the markets is just too tenuous for me to believe that financial terrorism was the intended end goal. In addition, while the effect was significant, it was localized and short lived. Yes, individual investors and institutions were impacted; but the level of that impact has yet to be fully realized.
This leaves the third possibility – the perpetrators were looking to fulfill some as-yet-unknown goal, with the impact on the financial markets merely unintended. In the intelligence world that is called ‘blowback’; in the markets, oftentimes it is characterized as a ‘black swan’ event. Either way, an educated individual could assume that the events, while related, were not intended. Yes, the perpetrators were interested in creating havoc with their message; but the message’s impact on the markets could be looked at as an unforeseen consequence.
For me, the larger implications of the AP Twitter hack are driving my interest in the story. The fact that current events affect the markets is nothing new; as long as there have been exchanges, they have been impacted by outside events – from weather and war, to famine and the false reporting of an attack on the White House. What is new is the speed with which this now occurs. Back in 1849, the news traveled as fast as Paul Julius Reuter’s carrier pigeons; today, it moves as fast as a Tweet.
News analysis, webcrawlers, and the mining of unstructured information are just the logical conclusion of what started in 1849. Today, tweets and any other content added to the web are analyzed for their financial impact and digested in hours, minutes and, increasingly, milliseconds.
Tuesday’s micro-disruption, however, was not created by trading algorithms or smart order routers; they were just one part of a chain of events that was set off by the hijacking of AP’s Twitter account. The root of the problem lies not with automation, but with the more macro concepts of what constitutes a data feed and how a feed should be secured. This failure was one of security and procedure, not market structure.
Markets react to news – that is their purpose. Today’s events exposed a vulnerability not in the fast-paced, hyper-news sensitive market environment, but in what essentially is a news feed. Historically, news feeds were expensive infrastructures built by large market data complexes. Today, news feeds can be developed by people, organizations, and businesses by just signing up for a Twitter account. How do we secure that?
So what was the end-game of Tuesday’s attack? It is too early to tell. But I can already envision attorneys gathering in conference rooms throughout the city. And you can bet your bottom dollar that regulators (both financial and non-financial), government agencies and SROs will be pouring over the events, trying to understand exactly what happened. Certainly, a full review and analysis of how the events unfolded and what can be done to ensure that other sources of validated news are not compromised in the future is warranted. And I can only assume that news agencies and trusted sources of information such as the AP will move to a more restrictive regimen, controlling who has access to their accounts and where official tweets can originate (e.g., limiting outgoing tweets to a specific IP address or device), and avoiding “Password123” and other hackable credentials.
No matter how soothing a regulatory answer would be, though, at the end of the day, this event is all about how markets react to news, legitimate or not. And while it would be great to outlaw the dissemination of lies (oh, wait, it is outlawed), it may not always be possible to stop. And if you are trying to stop markets from reacting to news – be it real or fake – good luck, as news has financial impact, and the markets are the mechanism we use to price this impact.
That said, the faster we react to news, the faster we can either get it right or get it wrong. After all is said and done, if you live by speed, sometimes you die by speed. But if you’re careful and patient and have the right risk controls, hopefully you survive till tomorrow.
Weighing in at 200,000 words, the CFTC’s final rules governing the reporting of swaps data transactions isn’t the easiest collection of information to digest. But like it or not, the documents are must-reads for many swaps market participants because they contain dozens of reporting compliance dates that will be phased-in over the course of the year. Thankfully, now there’s an abridged version of the highlights.
Davis Polk’s Annette L. Nazareth and Gabriel D. Rosenberg were kind enough to do all of the heavy lifting and published the key dates in the March 2013 edition of Futures Industry magazine. They were also good enough to make the summary table available to the readers of DerivAlert.
The table breaks out reporting deadlines for three types of reporting:
- SDR Reporting – Under these requirements, swap counterparties must report a host of information about swaps to new swap data repositories that are registered with the CFTC.
- Real-Time Reporting – Under the real-time reporting requirements, key information about swaps must be publicly disseminated via swap data repositories.
- Historical Swap Reporting – Counterparties to historical swaps entered into before the compliance dates require reporting to swap data repositories are still required to report information to the repositories.
Following is the complete breakdown:
By Steven Wunsch, Progress Wunsch Auction Associates, LLC
Originally published on Tabb Forum
The disintegration of our stock market into chaotic fragmentation is paradigmatic of the disintegration of Western society generally. And the cacophony of market structure voices – as evidenced in the debates on TabbFORUM, the SEC's comment period debates, and similar debates around the world – is not likely to produce solutions any more than Stalin's five-year plans solved the Soviet Union’s problems. But we've got to start somewhere.
Now comes the news that the SEC wants more money and authority. After all the money spent creating the current chaos, the Commission says it needs much more, presumably to do much more of the same.
High-frequency trading, and the plethora of new rules, technology and staff the SEC proposes to deal with it – the Large Trader Rule; the Consolidated Audit Trail; the Market Access Rule; the Midas computer system; Limit-Up/Limit-Down; the Systems, Compliance and Integrity Rule, etc. – may be mysteries to the world at large, but not to readers of TabbFORUM. HFT is a feature of the SEC's National Market System that didn't exist before, and it is growing more complex and confusing as the SEC creates new rules and policies to control it. The more the SEC intervenes, the worse the problem seems to get.
There are other examples where government-imposed fairness and redistribution are producing chaos, areas that on the surface may seem more amenable to understanding by the public and therefore more amenable to being addressed by policy changes. The gender fluidity that began with feminism, for example, now finds some parents chemically blocking their children's puberty until they can make decisions on a rapidly proliferating array of gender selection options, which are no longer just male or female, or even straight or gay; rather, if a child is gay, whether to undergo surgical gender modification or not, and which orientation to adopt or present to the world, in public or private. [The New Yorker, “About a Boy: Transgender surgery at sixteen,” Margaret Talbot, March 18, 2013]
That simple women's equality would transform into gender chaos was not expected. But such results are always unexpected, because they are bound to spin out of the control of their initially well-intentioned founders as conflicting claims erupt over civil rights or redistributions of the economic pie. Because of the heated emotions in such battles, these are unlikely places in which to begin to reel government back in.
High-frequency trading and the National Market System, on the other hand, are good places to begin. While the HFT issue may be visible in detail only to market structure types like those who read TabbFORUM, readers and non-readers alike can recognize the unseemly grasp for more power and money by the SEC. As a result, reining in the SEC may be more possible than we imagine, if for no other reason than that there are no generally recognizable civil rights or redistribution issues involved.
Regardless of one's market sophistication, it is easy enough to see that the SEC's National Market System created HFT and all the ancillary problems associated with it – the Flash Crash, the Facebook IPO, the Knightmare on Wall Street. It is also clear that before NMS, the US stock market provided average investors unparalleled opportunities to participate in the growth of American businesses, and that it provided those businesses and the technologies they introduced unparalleled opportunities to get funded and to get started. It no longer provides these benefits with anything remotely resembling its previous power.
In an age of deficits as far as the eye can see, it would be very unwise to give more money to the SEC. But beyond the money, granting government the power to reorder naturally evolved structures that have endured for decades, centuries or millennia, as stock markets have, is unwise beyond belief.