By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum
Despite record US equity prices and an improving economy, the underlying theme of 2014 was one of disappointment – in the levels of liquidity in most markets, in the spreads that market-makers were seeing, in the rising cost of being a market-maker, and in the ability of regulators worldwide to get their acts together. Here’s a preview of the issues that will shape 2015, including the Volcker Rule, mandatory clearing, automated trading and market risk, and three steps to ensure you have a happy New Year.
As we move from Thanksgiving to Christmas, it is traditional to reflect back on the year that is coming to a close, and to begin planning for the New Year. For the capital markets, reflecting on 2014 may result in mixed emotions; so does 2015 look to be any better?
Actually, taking the retrospective view, it would be easy to say that 2014 was a pretty good year, at least in US Equities, where prices spent most of the year rising (although the market has looked decidedly toppy in December). The economic indicators have been gradually improving all year, and the December jobs numbers gave everyone a warm feeling, if only for a moment. The Fed’s long period of aggressive easing finally seems to be paying off, even if everywhere else the world seems to be back on its heels. Corporate profits have been robust, except at the big banks, where mounting legal costs never seem to stop. Not bad, really.
But the functioning of the markets, as opposed to the economy as a whole, has been more of a mixed bag. Michael Lewis highlighted one aspect of the problems, and Carmen Segarra another; but the underlying theme of 2014 was one of disappointment – in the levels of liquidity in most markets, in the spreads that market-makers were seeing, in the rising cost of being a market-maker, and in the ability of regulators worldwide to get their acts, literally, together. As large banks ended the year with another round of impending investigations, more cutbacks in investment banking staff, and more exits from trading and clearing businesses, it would be easy for market participants to say, “Good riddance to 2014; I hope 2015 is better.”
But the groundwork for 2015 has already been laid, and thus some of the future should be apparent to the careful observer. So let’s look at some of that groundwork close up.
The two major regulatory stories of 2015 will be the implementation of many aspects of the Volcker Rule in the US and the start of mandatory clearing in Europe. Neither of these will be a surprise, of course, but there is a lot of uncertainty about how both events will work out. With Volcker, much of the discussion and trepidation relates to the market-making exemption; but the biggest changes may actually be in hedging. And the technology to support tagging of trades into specific exemptions and the monitoring for violations may be immature, if it exists at all. Without technology, trading under Volcker becomes a manual nightmare.
Clearing of derivatives trades is nothing new either, of course; but making it mandatory for a wide range of participants in Europe is new. The increased cost of margin is well documented, and has prompted some buy-side firms to move from swaps to futures, which has further prompted some FCMs to exit the swaps space; but the concentration of risk in the CCPs is only now coming to front-of-mind. Once that concentration is well understood, and the sources of CCP capital become clear, there will be a scramble to enhance the regulation of that sector, leading perhaps to more exits from the business … leading to even more concentration of risk … leading perhaps to even more regulation.
As spreads have fallen in every market, trading firms have predictably moved away from manual, expensive trading methods toward automated ones. Every month the percentage of computer-executed trades has been rising, so that by year-end half or less of the trading decisions in just about every market will be made by people. In fact, we even have the science-fiction scenario of buy-side bots trading with sell-side bots.
The biggest risk with automated trading is that most of the algorithms are mean-reversion formulas, meaning that the right price for anything is a function of the price of everything else. Experienced traders know that that kind of pricing works well when markets are essentially stable, but breaks down when large secular shifts occur. Looking at 2015, one such secular shift would be the end of the Fed’s many years of easing, and another would be a resumption of the financial crisis in Europe. Or perhaps both of them at the same time.
The people who run the dealer trading bots are well aware of this possibility, of course, and are prepared to shut them down if they see a secular shift. The problem will be that many of the people who could step into the breach and exercise human judgment were let go over the past few years, so we may run short of expertise just when we need it the most. The resulting trading volatility will be reflected in margin calls, which may exacerbate the same volatility, in a sort of feedback loop.
All this means that the risk in the markets will probably be higher in 2015 than it was this year. One simple measure might be in the potential mark-to-market for the largest category of swaps, fixed-float rate swaps. If we assume $420 trillion outstanding notional, 75% of it back-to-back, with an average tenor of six years, the mark-to-market of just the net exposure for a 100 basis-point rise in rates is $5.5 trillion. Given that such a rate rise would also serve to depress the market value of the very Treasuries used to generate the margin, we can see that there could be a tsunami lurking just under the surface of the markets.
What to Do?
So as this year draws to a close, and the New Year beckons, what’s a market participant to do?
1. Assess your trading and clearing partners – If the risk in the markets is as high as it appears, it behooves everyone to take a hard look at whom you trade with and where you clear. As trading moves more and more from principal to agency, customers will need to know where their liquidity will come from. If your traditional trading partners are feeling constrained by the capital and regulatory requirements, you need to find that out before you need them to stand up and they aren’t there.
The clearing assessment is at least as important. If CCPs are the single point of failure in the market, you need to know how much capital they have, how they can get more if they need it, and – most important – how they screen customers and clearing firms. The CCP space is a competitive business, and competition can lead to lax standards, so you need to be as rigorous with them as they should be with you.
2. Assess your trading technology – Whether you are a bank that will be dealing with Volcker in 2015 or a customer, you need to know how your technology will stack up to the new regulatory requirements. Systems take a notoriously long time to develop and test, so your tech providers should be well along on the upgrades you will need next year. Volunteering to be a beta tester for your vendors can give you early insight into how well they will perform when you need them. If they look iffy, you may need to plan a switch well before the rule changes hit.
3. Talk to your regulators – All the market regulators are feeling their way through these changes, along with everyone else. Some of them, like the OCC, have already begun pre-Volcker examinations, as much to learn what’s being done as to pass judgment. If you are embarked on some preparations that they will have to opine on, it is much better to find out early if they have a problem with your approach, as opposed to getting a bad report later. And you might just find that they are as anxious to learn from what you are doing as you are to learn from them.
The second half of December is always thought of as a slack period in the markets, as well as within market participants; but this December may just be the time to put in some extra work. If you do the things we’ve just described, you might just have a Happy New Year all of 2015, while others are playing catch-up.
In his speech at the SEFCON V Conference, CFTC Chairman Timothy Massad outlined the current and future state of affairs regarding swaps trading on regulated platforms. Massad conveyed a pro-markets sentiment in his remarks, continually emphasizing that regulations are not designed to quell the growth of swaps trading, rather they’re aimed at allowing the industry to flourish in a safe, efficient, technologically advanced manner.
After describing broad principles for regulation and noting that swap trading regulation was still in its infancy, he explained he does not want regulation to pose an undue burden on market participants:
“In regard to oversight, we want to make sure it is strong oversight because it promotes integrity and therefore confidence by participants. At the same time, we do not want that oversight to burden participants, particularly the users of these markets, unnecessarily. This is consistent with our general regulatory approach in futures.”
He went on to address specific marketplace concerns about package trades:
“…Packages have been an area of concern. Now, packages might more accurately be thought of as strategies involving multiple products, but whatever name you use, there is no doubt that different types of packages introduce significant complexities as we look to bring them into the SEF and DCM framework. And therefore, basically since the time of the first MAT determinations earlier this year, we have been working with market participants to figure out how to deal with packages in which one leg is a MAT swap. To enable that process, we issued no-action relief earlier this year. For some types of packages, the market has developed technical solutions, and the relief has expired. For others, however, more time is needed.
Consequently, at my direction, the CFTC staff this week have extended previously issued no-action relief so that we continue to work with market participants on phasing in trading for certain types of packages.”
Massad noted that there is a wide range of opinion regarding execution methods and market structure, and stated that “We look forward to listening to market participants on these and other issues that may arise.”
He also addressed cross-border issues, explaining that the CFTC is “committed to harmonizing our rules as much as possible” with its foreign counterparts in Europe and Asia so that firms are limited in their ability to shop for preferred regulatory framework.
To view Chairman Massad’s full remarks, please click here.
Greenwich Associates released a new research report on the U.S. derivatives trading marketplace: The SEF Landscape: Beyond the Numbers. The report discusses market activity and trading behavior, and highlights five key areas market participants should be focusing on in evaluating their approach to SEF trading: liquidity, distribution, unique functionality, pricing and service.
We found these areas to be essential to the understanding of the new electronic derivatives trading landscape, and recently hosted a webcast, “Understanding the SEF Landscape with Greenwich Associates,” which included an overview of the report with Kevin McPartland, Greenwich’s head of market structure and technology, and Michael Furman, managing director and head of U.S. rates sales at Tradeweb.
If you were unable to join us for the webcast, but wish to listen to a recording of it, a replay can be accessed here. In addition, please reach out to our sales team at email@example.com if you would like a copy of the Greenwich Associates SEF trading report.
By Jorgen Vuust Jensen, SimCorp
Originally published on TABB Forum
Seventy-nine percent of capital markets firms report that they still rely heavily on spreadsheets and manual processes when processing derivatives, and 84% cite the need to create workarounds to support derivatives in their current middle- and back-office operations.
An increasingly global emphasis on derivatives strategies by asset managers has made the need for straight-through-processing (STP) greater than ever before. In a highly competitive industry, a firm with investment management systems characterized by a high degree of automated workflows and processes is in a better position than competitors that still contend with manual processes and workarounds. However, a new SimCorp poll shows that a large number of firms are still at the mercy of their legacy systems, using manual processes when processing derivatives.
SimCorp recently conducted a survey of nearly 150 executives from capital market firms in North America to measure how important STP processing is and the current conditions that firms are working with. The poll revealed that 74% consider STP to be extremely important when it comes to derivatives processing. However, further poll results indicate that these needs are not being met by their current systems – 84% of respondents cited the need to create workarounds to support derivatives in their current middle- and back-office operations. Seventy-nine percent reported they still rely heavily on spreadsheets and manual processes when processing derivatives. Furthermore, 82% require at least two months to model and launch new derivatives products, and sometimes significantly longer, utilizing their current systems.
The findings of the survey demonstrate that firms are being exposed to major and unnecessary risk and as they continue to employ manual processes in a rapidly changing industry. As the study suggests, firms are conscious of new and improved solutions that will help them achieve a strong competitive advantage and improve the functions of their firm, but there is a major struggle to determine how they should move ahead with implementing these brand-new solutions.
The changes in the OTC derivative space increasingly drive the need for front-to-back STP, and it is imperative that operations teams consolidate STP throughout the derivatives lifecycle in order to increase efficiency, reduce processing time, and cease dependency on spreadsheets and manual “systems.” STP assimilation also helps firms to provide transparent audit streams and ensure proper reporting to management.
The challenges in the derivatives market – ranging from regulatory demands to rapidly changing market conditions – make the case for STP even stronger. Since individual derivatives trades can have a considerable effect on the portfolio, especially in terms of exposure to several market factors, it is extremely important to have updated technology in place to integrate the process, provide optimal data operability and ultimately increase portfolio performance.
Capital market firms are essentially aware of the significant benefits of STP but seem hesitant to implement the process. As new market requirements continue to emerge, it has become crucial for asset managers to evaluate and update their IT infrastructure to include automation – which in turn will shorten processing cycles and increase efficiency, thus securing a competitive market edge.
TABB Group is hosting an online survey of market participants’ activity on SEFs to gain insight from on their view of the new world order of electronic derivatives trading.
The survey will measure participants’ experiences with a variety of SEF-related issues, including MAT self-certification, swap trading activity, trading protocols, regulatory mandates and more.
Please note the survey is anonymous and will be available until August 4th. To participate in the SEF Barometer 2014 survey, please visit: https://www.surveymonkey.com/s/SEFBarometer14.
By Mayra Rodriguez Valladares, MRV Associates
Originally published on TABB Forum
Many challenges remain in implementing Dodd-Frank’s derivatives reforms, as swap dealers retool their technology to improve data collection, aggregation and reporting. But regulators, particularly the CFTC, have made strong progress.
A number of analysts, pundits, and financial journalists are observing the fourth anniversary of Dodd-Frank by pointing out that much of the law has not been implemented. That is correct. While a little more than half of the rules are now finalized, that does not necessarily mean that they have been implemented. Typically, financial and bank regulators give institutions a year or two to comply after a rule is finalized.
Source: ‘Dodd-Frank Progress Report, Davis Polk, July 18, 2014.
It is very important to remember that a toxic political environment in Washington, regulators with significant resource constraints, very strong and continued lobbying against every single part of Dodd-Frank, and lawsuits against regulators have been significant deterrents. In addition, financial regulators cannot deploy all of their staff to the challenging task of Dodd-Frank rule writing; they already have their existing regulatory, legal, and supervisory responsibilities. Even while writing rules, regulators have been doing so in an environment where the US economy has been mostly growing anemically, and they have to think of the potential impact of the rules on institutions, markets, and the economy at large.
Despite numerous challenges, some of the agencies have finished many of their assigned tasks. For example, the CFTC, which is responsible for regulating and supervising the disproportionately largest part of the financial derivatives markets, has done an incredible job in finishing almost 85% percent of its assigned rules.
Source: ‘Dodd-Frank Progress Report, Davis Polk, July 18, 2014, p.5.
The CFTC’s accomplishment is particularly impressive considering that is the smallest regulatory agency and has been a favorite target of Republicans who want to make sure that the agency has the smallest budget possible. Shockingly, the CFTC is still operating with a level of personnel and technology from decades before Dodd-Frank. This financial regulator is responsible not only for its existing mandate of regulating exchange traded products and derivatives exchanges, but also it now regulates over-the-counter (OTC) interest rate derivatives and index credit derivatives. In the US, these products represent about $200 trillion in notional amounts.
Also, CFTC professionals spend a good part of the day listening to comments and pleas from numerous market participants and lobbyists, as can be seen in their public website. (Actually, the CFTC is the only regulator that publishes its visits ahead of them taking place, as opposed to after they have already happened. Other regulators should learn from the CFTC’s transparency.)
In less than four years, the CFTC has finalized instrumental rules for derivatives reforms:
- Created legal definition for a swap
- Designated swap dealers
- Defined what is a US person
- Instituted swap transactions reporting
- Released core principles for derivatives clearing organizations (DCOs), which are the central clearing parties approved to clear derivatives in the US, and
- Has been conducting due diligence on and setting standards for the companies approved to be swap execution facilities (SEFs).
Yes, many challenges remain in implementing Dodd-Frank’s derivatives reforms, as swap dealers retool their technology to improve data collection, aggregation and reporting. Swap dealers, especially banks, also have to think continually of how to upgrade the skills of their existing middle- and back-office professionals, IT, auditors, and compliance professionals.
For its part, the CFTC will continue to be plagued by the roadblocks politicians place in its path. They ask it to do a better job and then tie its limbs by denying badly needed resources. Equally challenging for the CFTC will be to work with foreign regulators, especially in Europe. As long as rules and supervisory practices are different, the global derivatives market will be challenged by a potential lessening of liquidity. Importantly, if rules on both sides of the pond are not equally strong in the way that they are written, supervised, and enforced, then swap dealers will outsmart regulators through regulatory arbitrage.
The CFTC has new leadership. Given what I have seen by working both with swap dealers and training numerous CFTC professionals, I see Dodd-Frank’s derivatives reforms as a glass half-full. And I look forward to the next few years as it continues to fill up.
By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum
The OCC’s recently published Volcker Rule examiners’ manual offers a look at how regulators are going to approach the rule’s enforcement. It looks like we should expect a good deal of confusion, and possibly some contention.
After the final version of the Volcker Rule was published in December and banks began to prepare for the July 15, 2015, effective date, the only remaining question was how it would be enforced. That enforcement is up to the examiners of the various agencies. Recently, the Office of the Comptroller of the Currency (OCC) published a 26-page Volcker Rule examiners’ manual, which may be an inside peek into how the regulators are going to approach enforcement.
Here are some of the objectives it sets for examiners:
- Assess the bank’s progress toward identifying the [banks] that engage in activities subject to the regulations.
- Assess the bank’s progress toward identifying its proprietary trading.
- The bank must identify purchases and sales of financial instruments for specified short-term purposes.
- The bank must identify the trading desks (the smallest discrete unit of organization) responsible for the short-term trading identified above. Trading desks may span multiple legal entities or geographic locations.
- For each trading desk, the bank must determine on which permitted activities the desk will rely to conduct its proprietary trading.
- Assess the bank’s progress toward identifying its ownership interests in covered funds.
- Assess the bank’s progress toward identifying the covered funds that the bank sponsors or advises.
- Assess the bank’s progress toward identifying its ownership interests in and sponsorships of entities that rely on one of the regulations’ exclusions from the definition of covered fund.
- Assess the bank’s progress toward establishing a compliance program.
- Assess the bank’s plan for avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies.
Given the newness of the Volcker Rule, it is perhaps indicative that these objectives discuss a bank’s progress and plans, instead of its conformance. However, we should expect the instructions to move pretty quickly to assessing the bank’s conformance.
Within the document, there are some specific instructions that are both pertinent and perhaps informative of the general approach. For example (these are only a small fraction of what the manual requires):
- Under a section entitled, Assess the bank’s progress toward reporting metrics as and when required, we see:Some banks may combine previously delineated trading desks into a single trading desk.
- Multiple units with disparate strategies being combined into a single desk, however, could suggest a bank’s attempt to dilute the ability of the metrics to monitor proprietary trading. Relevant factors for identifying trading desks include whether the trading desk is managed and operated as an individual unit and whether the profit and loss of employees engaged in a particular activity is attributed at that level.
- Under Assess the bank’s ability to calculate the required metrics we see:
- This metric requires the bank to “tag” each trade as customer-facing or not. Inter-dealer trading typically does not count as customer-facing because a [bank] with trading assets and liabilities of $50 billion or more is not a customer unless the bank documents why it is appropriate to treat the counterparty as a customer. Trading conducted anonymously on an anonymous exchange or similar trading facility open to a broad range of market participants is customer-facing regardless of the counterparty.
- For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values.
- For comprehensive profit and loss (P&L) attribution, determine whether bank systems can segregate P&L into the required three categories:
- Determine whether the bank’s systems can report risk sensitivities on a sufficiently granular basis to account for a preponderance of the expected price variation in the trading desk’s holdings.
- Assess the bank’s progress toward using the metrics to monitor for impermissible proprietary trading.
- Determine whether the bank consistently applies, across its trading desks, methodologies for calculating sensitivities to a common factor shared by multiple trading desks (e.g., an equity price factor) so that these sensitivities can be compared across trading desks.
- Assess the bank’s policy for reviewing activities and positions whose metrics indicate a heightened risk of impermissible proprietary trading.
- Assess the bank’s progress toward identifying its market-making-related activities, market-maker inventory, and reasonably expected near-term demand (RENTD).
- Assess the bank’s progress toward developing a process for measuring and documenting RENTD for each market-making desk.
- Demonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks of or associated with financial instruments in which the trading desk makes a market, including through block trades.
- Assess the bank’s progress toward establishing and implementing an internal compliance program.
- Assess the bank’s progress toward developing procedures and controls to continuously review, monitor, and manage risk-mitigating hedging activity to ensure that the bank meets the requirements of the risk-mitigating hedging exemption. Note that under the regulations the risk-mitigating hedging activity cannot be designed to:
- reduce risks associated with – the bank’s assets or liabilities generally.
- general market movements or broad economic conditions.
- profit in the case of a general economic downturn.
- counterbalance revenue declines generally.
- arbitrage market imbalances unrelated to the risks resulting from the positions lawfully held by the bank.
- Assess the bank’s progress toward developing systems and processes to create and retain the hedging documentation for at least five years and in a manner that allows the bank to produce promptly those records to the OCC.
There is much more in the manual than we have listed here, of course. But these excerpts can give us some insights into how the regulators are approaching the VR. For example:
- The regulators are aware of the opportunity, and perhaps desire, to obfuscate compliance with the rules. Several places in the instructions warn examiners to make sure that efforts are “meaningful,” particularly around the metrics.
- In most of the more difficult areas of the metrics – for example, the inventory aging and turnover categories – the instructions appear to offer no additional help. On the question of how to apply inventory aging and turnover, the instructions simply say:
For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values. (For options, value means delta-adjusted notional value; for other interest rate derivatives, value means 10-year bond equivalent value).
There is nothing about what to do if a bank opened a position, or opened and closed the position on the same day, which would result in a turnover ratio of ∞. Either the regulators haven’t identified these problems yet or don’t yet have an answer.
- The instructions don’t give any guidance on how examiners are to determine that a bank stands ready to buy or sell those instruments that trade infrequently or are new to the market. Here, again, the regulators may not have identified the uncertainty, or may not have an answer.
Overall, the instructions mostly parrot the rule itself, without clarifying many of the complexities and uncertainties around enforcement. If this is an indication of the preparations examiners will get for their very difficult tasks, we should expect a good deal of confusion, and possibly some contention. Thus it behooves banks to start a dialog now with their assigned examiners about how they will apply these instructions and what the results will be.
By Mike O'Hara, The Realization Group
Originally published on TABB Forum
It is becoming much more expensive for firms to hedge their interest rate exposures using swaps, and existing swap futures may not be suitable for the buy side’s hedging needs. GMEX is betting its new constant maturity swap future product can fill the void.
The reforms instigated by the G20 in the wake of the global financial crisis have resulted in a number of structural changes to the world’s interest rate derivatives markets, changes that are now starting to have a significant impact on market participants. The G20’s stated objectives to reduce systemic risk and increase transparency across global financial markets were clear, in that all OTC derivatives contracts should be reported to trade repositories (TRs); all standardised contracts should be traded on electronic trading platforms where appropriate, and cleared through central counterparties (CCPs); and non-centrally cleared contracts should be subject to higher capital requirements.
It remains to be seen how successful these initiatives will be in the long term. However, it is clear that in the short term, at least, the increased capital and margin requirements have placed a greater strain on the financial resources of many firms active in this space. Likewise, operational changes are also making it more difficult for firms to accurately hedge their interest rate exposures. Buy-side firms in particular are facing a range of new challenges around duration hedging.
Increased Swap Costs
Historically, OTC interest rate swaps (IRSs) have been widely used by the buy side to hedge their interest exposures. However, in this new environment, it is becoming much more expensive for firms to continue duration hedging using swaps.
“One problem with bringing OTC instruments such as interest rate swaps into a CCP environment is that firms will no longer be able to rely on their ISDA Credit Support Annex agreements (Ed note: A CSA defines the terms under which collateral is posted or transferred between swap counterparties to mitigate credit risk),” says Andrew Chart, Senior Director, Origination and Structuring Prime Clearing Services, at Newedge Group.
“Whereas previously cash flows would not occur between the two counterparties until a position reached a pre-agreed level (e.g., $10 million), firms will now have to put up margin at a CCP and manage a daily cash flow as their positions are marked to market daily,” he continues. “Where do they find that collateral? This is a cash flow that they’ve never had to make before, which causes treasury and liquidity related challenges for firms if their cash is tied up on deposit, or they are fully invested in higher-yielding contracts.”
With standardised swaps subject to 5-day VaR and non-standardised swaps requiring 10-day VaR, costs in some cases are going up by an order of magnitude, a situation that Chart and his colleagues at Newedge refer to as “margin discrimination” when comparing to listed derivatives or similar products that attract a 2-day VaR treatment. “With Basel III provisions, OTC instruments are likely to weigh heavier from a capital requirements perspective,” says Chart. “Firms will have to make increased capital and liquidity provisions to show they can cover these transactions. They won’t be able to leverage up as easily as they could previously because of the new capital/position ratios that will force them to put more into their capital reserves to cover their trades and positions.”
The net result is that interest rate swaps are becoming prohibitively expensive to the buy side. More and more funds are now being directed by their investment committees to pull out of the swaps market and to find alternative hedging mechanisms. But this is easier said than done.
Challenges With Swap Futures
One of the problems facing the market is that there are very few viable alternatives to interest rate swaps for managing duration hedging, although a number of exchanges – including NYSE Euronext, CME and Eris Exchange – now offer various flavours of swap futures.
“From a buy-side perspective the products offered by those exchanges have a number of perceived disadvantages when compared with the swaps market, based on feedback market users have provided to us,” says Hirander Misra, CEO of Global Markets Exchange (GMEX) Group, which, subject to FCA approval, will operate a new multilateral trading facility in London. “Certain sections of the buy-side community are telling us that existing swap futures just aren’t suitable for them to manage their duration hedging, because they don’t provide a like-for-like hedge,” he explains.
“Of course, there’s no such thing as a perfect hedge, but with current quarterly rolling swap futures, you don’t get the granularity of duration hedging you get with IRSs. This makes managing the deltas extremely difficult because only certain points along the curve can be used. And as these swap futures expire every quarter, hedging longer-term exposures means that the contracts must be rolled each time they reach maturity. Every roll leads to more transactional costs, which add up and eat into the value of the portfolio, particularly when done multiple times over the life of a hedge,” continues Misra.
“Also, certain swap futures are or will be physically deliverable. So if a buy-side firm actually goes to delivery, they are faced again with the associated capital requirements and 5-day VaR of maintaining a swap position.” According to Misra, this is why, to date, no existing swap futures contracts have yet managed to build a critical mass of liquidity relative to the volumes seen in the OTC IRS market.
The Constant Maturity Approach
In order to address all of these challenges, GMEX recently announced the launch of its Constant Maturity Future (CMF). The CMF is a new breed of swap futures contract linked to GMEX’s proprietary IRSIA index, which is calculated in real time using tradable swap prices from the interbank market. By accurately tracking every point on the yield curve in this way, retaining its maturity throughout the lifetime of the trade and being traded on the rate, the duration hedging capability of the CMF is much more closely aligned with an IRS than other swap futures contracts that have set durations and expiry dates, according to GMEX’s Misra. This is the key for the buy-side, he says.
“The CMF gives you the closest approximation a futures contract can to the way in which the OTC interest rate swap market moves and is traded on a daily basis,” Misra claims. “Additionally, for example, if you want to hedge a 30-year Gilt issue that rolls down to maturity, given the CMF offers every annual maturity from 2 to 30 years, you can gain a very granular hedge by periodically rolling the appropriate number of 30-year CMF contracts down the curve to 29-year CMF contracts. Rather than rolling quarterly, this can become a simple middle-office, daily or periodic hedge tool. The advantage being that there is no quarterly brick wall by which point you have to roll,” adds Misra.
As a listed futures contract, the CMF comes with all the advantages that futures offer over swaps in terms of cheaper margin (2-day VaR as opposed to 5-day); electronic trading capability and accessibility; clearing through a central counterparty; and reporting via a central trade repository, Misra says. And with no quarterly roll and no deliverable element, the disadvantages typically associated with other swap futures are removed.
Diversity of Market Participants
In order to create liquidity in any market, a diverse group of participants – including both makers and takers – is required. “We’ve thoroughly researched the market, and it’s clear that anyone who hedges interest rates needs a product like this,” insists GMEX’s Misra.
“The buy-side [firms] need it for their duration hedging; the sell-side also have IRS exposures that they need to hedge more cheaply; all the banks are capital constrained and have fixed income exposures that they need to hedge; futures players like it because it’s a standardized IRS futures product that will see natural buy-side flow; electronic market-makers and proprietary traders like it because it gives them opportunities to arbitrage the CMF against other interest rate instruments; corporates with sophisticated treasury and hedging requirements and even insurance companies who currently run naked exposures because they’ve assessed the alternatives and deemed it cheaper to take one-off hits than run expensive hedges,” he adds.
The IRSIA CMF will be centrally cleared by Eurex Clearing (subject to final agreement at the time of writing). This arrangement will offer a range of advantages around collateral and margin offsets. For example, it will be possible to offset the margin for the IRSIA CMF against the margin for correlated assets such as Bund/Bobl/Schatz and Eurex-cleared OTC IRS. Such offsets and incentives will significantly lower barriers to entry for market participants given that existing Eurex clearing membership will apply.
“With the introduction of the new Basel III capital rules, the cost of clearing is now determining not only which instruments are used for hedging but where they are cleared,” says Philip Simons, Head of Sales and Relationship Management at Eurex Clearing. “Market participants will inevitably use the best tools available that manage the risk. This will include OTC IRS, traditional futures and options, as well as new instruments such as GMEX’s IRSIA CMF.”
According to Simons, the ability to clear all instruments at the same CCP with appropriate cross-margin benefits will be crucial. This will not only reduce the cost of funding but, more significantly, reduce the cost of capital, through a combination of maximising netting benefits for exposure at default, having an efficient default fund and minimising the funding costs.
“The higher the risks, the higher the costs of capital as reflected through higher initial margin and higher default fund contributions, which will inevitably be passed on to the end client,” says Simons. “Capital and operational efficiency will drive liquidity in the future.”
The IRSIA CMF will be traded on an electronic market, operating on a Central Limit Order Book via GMEX’s own proprietary matching technology. Request for Quote and the facility to report negotiated trades will also be available, according to GMEX.
GMEX says it will offer access to the market via its own trading screens as well as third party vendor products. Most firms may prefer to trade through screens such as those provided by ISVs such as Fidessa and Trading Technologies, many of which offer functionality for trading spreads or running other cross-instrument or cross-market strategies. For direct electronic access, GMEX provides a well-documented API, which is available in both FIX and Binary format.
Execution and prime service brokers such as Newedge will offer DMA and potentially sponsored access, as well as value-added services such as cross-product margining and linked margin financing of correlated portfolios.
Finally, trade reporting will be performed automatically via the REGIS-TR Trade Repository, resulting in true straight-through processing from pricing, execution and clearing through to reporting.
This article originally appeared on The Trading Mesh.
Imagine you had the last five years of derivatives market reform on DVR. If you could fast-forward past the requests for public comment, rule delays and angst, would you have guessed that we’d be where we are today?
Future-casting the outcome of financial markets reform is not for the faint of heart. But it is an art in which Kevin McPartland has had some success over the last several years. As a principal, overseeing market structure and technology for Greenwich Associates, McPartland is responsible for helping the world’s leading financial firms decode nascent trends and interpret emerging intelligence to make strategic decisions.
McPartland also holds the distinction of authoring the most-read blog post in DerivAlert history. His SEF 101: Deconstructing the Swap Execution Facility, written in 2010 when McPartland was a senior analyst at Tabb Group, was a seminal piece on the topic long before most market participants had ever heard of a swap execution facility (SEF). Now that we’ve all become familiar with SEFs, we thought it would be a good time to check back in with McPartland to see what he thinks the next few years of derivatives market reform would have in store for us.
DerivAlert: Given all of the events of the last five years -- derivatives reform, increased electronification of swap trading, Basel capital requirements, QE -- How do you see the trading in derivatives evolving over the next five years?
Kevin McPartland: It’s great that we’ve got a lot of the major rules in place. It’s good that we’re finally here, but it’s still very much early days. For clients that do not want to trade on SEFs, there are still plenty of ways to do that. Market participants need to feel incentivized to increase trading volume on SEFs, and the product sets that are required to trade electronically need to become larger in order to make the shift to SEFs real.
In terms of looking at who the winners and losers are in SEFs, the separation is starting to take shape, but it is still very early. It’s also important to look at the client make-up of different SEFs, which are very different. That has a big influence on volumes.
DA: What do you see coming down the pike for fixed income?
KM: The Treasury market is looking more and more like it is ripe for continued electronification. It is standardized and highly liquid. Nearly every financial firm is involved in Treasurys in some way shape or form. This is in contrast to the corporate bond market.
Our North American Fixed Income Study last year showed that 78% of clients we talked to were using electronic platforms to trade bonds. That means a big chunk of the market are already using electronic platforms in some way. But only 50% of notional volume is traded electronically, which outlines a huge opportunity for growth.
In credit, the story hasn’t really changed much. The structure of the market is such that there are so many issues that it’s hard for deep liquidity to grow in any one particular spot. For example, you have one IBM stock, but you could have upwards of 50 IBM bonds to choose from. That makes it tough to build deep liquidity in corporate bonds.
The real opportunity for electronic trading in credit is in bond selection. The major platforms are all innovating in this space and we expect that to be a growth area over the next several months. There’s still a long way to go, but a shift is starting to occur whereby investors are moving away from bond-specific thinking and toward a risk-based approach. Instead of saying ‘I want this IBM bond,’ they are saying ‘I’m looking for this type of credit exposure, what are my options?’
DA: What are your expectations for European derivatives reform?
KM: U.S. reforms have been complicated because the CFTC and SEC are jointly writing rules on Dodd-Frank. Europe has a dozen jurisdictions that need to write rules and get them accepted for all of their markets. The first thing we’ve seen is trade reporting, and by all accounts it’s been really messy.
As it stands now, the reporting requirement for both sides of a transaction largely defeats the purpose of the rule. In terms of the first clearing mandates, we’re expecting to see something maybe by the end of 2014/2015.
European reform is not a cut and paste of the U.S. The legal framework about how clearing works is very different in Europe, and the clearing rules are very different.
DA: What impact do you see the May 1st guidance on packaged trades having on SEFs?
KM: We’re still waiting for lots of liquidity providers to come into the market. It’s going to be a slow, organic process as some of the new products come online.
The CFTC’s guidance laid out a phased in approach for packaged transactions, starting with packages containing two or more MAT instruments and quickly expanding to include MAT swaps over US Treasuries. While the marketplace is certainly ready to handle the electronic execution of these packages, the operational infrastructure needed to risk-check and process these trades will struggle to be prepared by the deadline.
There was no shortage of big news from the derivatives market this year. In the month of October alone, the deadline for trading derivatives electronically on SEFs was met while the federal government implementing these regulations was shut down. Across the Atlantic, another group of regulators was lobbying for a delay in those rules, citing potential cross-border issues.
Meanwhile, CFTC Chairman Gary Gensler, who announced that he will step down at the end of the year, held firm to his agency’s game plan. And so, the new era of SEF-based OTC derivatives trading was born, as mandated by Dodd-Frank.
Amidst all of the upheaval of the past year – the passed rules and agency guidance, the extended deadlines, uncertainty around extraterritoriality and the gridlock in Washington – which stories grabbed the most attention among DerivAlert readers? To find out, we dug into the analytics to find out which posts were the most viewed over the course of 2013.
Here they are, chosen by you, the DerivAlert reader:
The Top Stories of 2013
(along with a few honorable mentions that we couldn’t resist including on the list):
10) EMIR Flaws Could See Futures Reporting Delayed Till 2015
By Tom Osborn
Published July 29, 2013, Risk
The European Securities and Markets Authority (Esma) has confirmed it is considering pushing back its trade reporting deadline for exchange-traded derivatives until as late as January 2015, in order to give firms more time to adapt the reporting framework to futures and options products.
full article (subscription)
9) Standardized OTC Swaps to Launch Within Weeks
By Peter Madigan
Published April 19, 2013, Risk
Within weeks, fixed-income market participants will be able to trade a new, exchange-traded version of the over-the-counter interest rate swap, with eight tenors, standard coupons and quarterly maturity dates like those used in the futures market. Some of those involved in the work see it as a way of defending the OTC market against the threat posed by swap futures.
full article (subscription)
8) Uh Oh: The Attempt to Regulate Swaps is Failing
By John Carney
Published April 6, 2013, CNBC
It's hardly surprising to hear that some of the largest derivatives brokerages are looking to set up futures exchanges. A huge portion of the traditional business these brokers did is in the process of migrating out of swaps and into futures.
full article (free)
7) US in Compromise on Derivatives Trade Rules
By Michael Mackenzie and Gregory Meyer
Published May 16, 2013, Financial Times
Commissioners on the US Commodity Futures Trading Commission voted 4 to 1 to pass long-awaited derivatives trading rules on Thursday that preserve voice-based transactions in conjunction with electronic platforms.
full article (subscription)
6) SEF Rules Hit Non-US Cross-Border Trading
By David Wigan
Published October 31, 2013, Euromoney
The requirement from October 2 for swap dealers and regular users of derivatives to transact swaps on Commodity Futures Trading Commission-mandated swap execution facilities (SEFs) was the last piece in the puzzle for US derivatives market regulation, after mandatory reporting and clearing came in earlier this year.
full article (free)
5) Swaps Clearing Rules Divide Market
By Philip Stafford
Published August 21, 2013, Financial Times
An obscure part of the Dodd-Frank Act has become the unwitting battleground among market infrastructure operators as they seek to meet rules tightening derivatives trading.
full article (subscription)
4) SEF Execution Agreement Requirement Angers Buy-Side
By Peter Madigan
Published September 24, 2013, Risk
Buy-side firms are refusing to sign participation agreements with some newly registered US swap execution facilities (Sefs), because of a controversial requirement that commits end-users to negotiate bilateral trade breakage agreements with any counterparty they transact with on the trading venues, Risk has learned.
full article (subscription)
3) Traders Take Their Swaps Deals to Futures ExchangesBy Matthew Philips
Published January 24, 2013, Bloomberg Businessweek
On Friday, Oct. 15, a rule designed to improve government oversight of the multitrillion-dollar market for derivatives took effect. The following Monday, many energy traders moved their swaps business to a futures exchange. After the U.S. Commodity Futures Trading Commission put two years into building its regulatory framework for swaps, a slice of the market simply sidestepped it.
full article (free)
2) CFTC to Shake Up Swaps Trading Market
By Michael Mackenzie, Gina Chon, and Philip Stafford
Published November 17, 2013, Financial Times
New guidance from the main US regulator of privately negotiated derivatives is set to test the business models of interdealer brokers, who have long played a crucial intermediary role between global banks.
full article (subscription)
1) High Drama at the CFTC: The Battle Over Swaps and Futures
By Matthew Philips
Published February 1, 2013, Bloomberg Businessweek
Hearings at the U.S. Commodity Futures Trading Commission aren’t exactly known for their riveting entertainment value. Nor for their mass-market appeal. Yet on Thursday, it was standing-room-only at the CFTC headquarters in Washington as the commission held a roundtable discussion about the recent migration of swaps trading into the futures market.
full article (free)
The Stories Made Us Stop and Say, ‘Whoa’
Three Wall Street Trade Associations Sue US Regulator
By Katy Burne
Published December 4, 2013, Wall Street Journal
Three Wall Street trade groups are suing a top U.S. regulator alleging procedural violations at the agency, in the latest effort by large banks to fight new rules that they contend will unfairly crimp their trading business.
full article (subscription)
Wetjen Said to Face Vote as Acting CFTC Head Replacing Gensler
By Silla Brush
Published December 13, 2013, Bloomberg
Commodity Futures Trading Commissioner Mark P. Wetjen is poised to be voted acting chairman of the top U.S. derivatives regulator within days, according to two people with knowledge of the process.
full article (free)
SEF MAT Submissions: Reality Check
By Radi Khasawneh
Published November 1, 2013, Tabb Forum
Implementing the Made Available to Trade rule will transform the swap market. But based on early SEF submissions to the CFTC, the industry needs clarity on which swaps will qualify.
full article (free)
Standardization Needed in SEF Reporting Conventions
By Michael Watt
Published October 25, 2013, Risk
One of the core principles behind swap execution facilities (Sefs) – the new breed of trading platforms that opened for business under the US Dodd-Frank Act on October 2 – was to create greater transparency in the swaps market. In the words of the Commodity Futures Trading Commission (CFTC), Sefs must "make public timely information on price, trading volume, and other trading data on swaps to the extent prescribed by the commission".
full article (subscription)
EMIR Reporting Questions Pile Up for Corporates
By Fiona Mawell
Published October 3, 2013, Risk
Amid fundamental questions about the timing and scope of Europe’s new derivatives reporting rules, corporates are weighing whether to delegate the work to their dealers. But some large companies are not keen – and many banks are sitting on the fence. Fiona Maxwell reports
full article (subscription)