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DerivAlert’s Top 10 News Stories of the Year: 2013

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)

Honorable Mentions:
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)

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Derivatives Reform Kicks Off Competitive Struggle

By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.
Originally published on TABB Forum

The real story in the derivatives market – one that is playing out mostly behind the scenes and that still is being written – is the competitive struggle that has been kicked off by regulatory reforms. Here are some of the drivers shaping the competitive landscape.

As the world’s regulators race to finalize the rules for derivatives reform, and the industry races to adapt to them, there is another drama playing out, mostly behind the scenes: the competitive struggle that has been kicked off by the reforms. This struggle is the real story in the derivatives market, one that is still being written. And it is the most interesting story of all.

In order to understand the competitive struggle, we have to understand the environmental changes, which may not be as obvious as the regulatory ones. Here are a few:

1. As the market moves from entirely bilateral to mostly cleared transactions, the pricing power of the banks and interdealer-brokers will erode. This is already becoming apparent in the narrowing of spreads, but there is a deeper implication. Lots of new pre-trade factors, such as the capital rules for banks and the choice of CCP, will impact pricing, so customers can no longer afford to simply accept a dealer’s price. They must demand the kind of technology that will allow them to shadow-price transactions, so as to ensure that they are getting a fair deal. This will be particularly important as daily pricing and variation margin make the mispricing of a trade immediately and painfully apparent.

2. Allowing clearinghouses, data repositories and exchanges to compete and to be run as profit-making businesses has opened up several new competitive possibilities. The fact, for example, that some data repositories are standalone entities and others are offshoots of another business, such as a clearinghouse, means that the same market function may represent completely different business models to different vendors. The fact that everyone agrees that there are too many CCPs and SEFs in the market leads everyone to expect consolidation. But consolidation can be a messy process, and the fact that this business is, at its core, all about risk makes this consolidation a potential risk nightmare.

3. We are already seeing the beginnings of the move away from a completely principal market to a partially agency market. That trend will certainly accelerate among the vanilla products, although it will be much slower among the bespoke products. In any case, the relationship between brokers and customers is very different than it is between dealers and customers, and both sides will have to learn how to communicate in a brokered market. Up to now, this culture change has been the focus of the dealer community, particularly among traders and salespeople; but customers will have to learn new ways of communicating as well.

4. The fragmented regulatory environment has done more than make it harder for everyone to get into compliance; it has opened up some short-lived marketing possibilities. As customers, in particular, wade through the documentation, reporting, and clearing undergrowth, and the generic solutions offered by the dealer lobbying groups have proven less than palatable, some enterprising dealers have been working on compliance with larger clients to gain a competitive advantage. Whether someone will do that for the larger universe of smaller customers, and thereby build a significant business, will be one of the most interesting questions.

Now let’s look at the new competitive landscape and see what shapes are emerging from the mist.

1. The most important competition will be over order flow. Whether we are talking about a SEF, a dealer, a CCP or even a data repository, the key to the future is capturing and holding onto order flow. Every competitor in every segment of the trade cycle is focused on this struggle. And there are some interesting and perhaps unexpected outcomes. One development is the use of certainty of clearing (CoC) as a competitive weapon. Everyone from SEFs to CCPs to FCMs is trying to be the party that provides CoC, so that they become the preferred access point to the market. There are other ways to compete for order flow, of course, so we should expect to see rebate competition among exchanges, and perhaps even the venerable research-leads-to-orders model that prevailed in equities years ago.

2. We should expect to see a blurring of the lines between the market functions as the competition heats up. We have already seen the combining of trading and clearing units at the big banks, but it is even more obvious to combine the FCM and broker function as markets move from principal to agency. We shouldn’t be surprised to see a SEF/CCP combination in the not-too-distant future, as both markets are overcrowded, and that combination would help capture order flow.

3. Although customers are expected to be the beneficiaries of all this competition, they will have to adapt to the new realities in order for that to be true. In the same way that buy-side research had to mature to replace sell-side research in equities, buy-side expertise in derivatives will have to mature to keep up with dealer expertise in the new world. One possibility, of course, is that the buy side will simply back away from swaps in favor of futures or simply unhedged positions; except for commodities, however, that trend hasn’t really developed yet.

So what can we tell for sure about the outcome?

1. The new derivatives world won’t look much like the old one, so market participants that are trying to hold onto the old ways for as long as possible, or even just comply with the new rules, will find themselves at the back of the pack, or even out of the race.

2. If controlling order flow will be the key, it will require new relationships between customers and just about everyone else in the market. If customers don’t want to have those relationships dictated to them, they will have to be active participants in the evolution of the new world.

3. There will be a significant consolidation among many of the vendors, and it could get messy; there will be business combinations among the vendors, perhaps in unexpected ways. Since many of the relationships in this market involve long-term risk, those combinations could come as an unwelcome surprise.

4. Understanding what is happening in the evolution of the market will require a combination of data analysis and business acumen. Either one by itself may give you a feeling of confidence, but only the two together will make you a winner. In the end, the key traits for success will be intelligence and agility, as they are in any competition.

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What the CFTC Concept Release on Automated Trading Means for Derivatives

By Matt Simon, TABB Group
Originally published on TABB Forum

The recent CFTC Concept Release on automated trading will have a significant impact on the technology offerings and the strategic direction derivatives market participants will pursue if new rules are created. TABB Group breaks down the document’s implications for the US derivatives markets.

The CFTC Concept Release on risk controls and system safeguards for automated trading environments, published Sept. 9, 2013, raises multiple issues pertinent to the outcome of the US derivatives markets. Specifically, it will have significant impact on technology offerings and the strategic direction market participants – including exchanges, broker-dealers, third-party vendors, and clearing agents – will take if new rules are created.

TABB Group has analyzed the document to assist our clients in responding to questions posed by the CFTC, and here we summarize our analysis of Section III, “Potential Pre-Trade Risk Controls, Post-Trade Reports, System Safeguards, and Other Protections.” We believe Section III is the most critical section of the Concept Release since it requests comments on potential industry solutions for improved handling of technology and automation issues. Section III also details efforts already made by market participants and, in certain sections, provides examples of solutions that appear in line with regulators’ expectations.

1. Finding Improvements to Existing Industry Practices

Current controls in place at exchanges and FCMs can include controls that oversee floor and ceiling prices, the use of kill switches and market pauses, and message controls such as throttle limits and weighted volume ratios (WVRs). The CFTC wants to know how many of these risk controls are being used, what can be standardized by the industry, and how new types of risk controls can be beneficial to the markets. In addition, the Commission is interested in how these rules can be best implemented, how consistent measures can be applied, and the benefits and costs associated with more regulatory mandated risk controls.

2.    Considerations for More Pre-Trade Risk Controls

Proposed solutions include:

a. “Execution Throttles” = Maximum message or execution rates and associated alerts that would help identify rogue algos and prevent entities from being faster than risk systems.

b. “Volatility Awareness Alerts” = Alerts for price changes over a set period of time that would help to identify rogue algos and identify situations where human interaction is required.

c. “Self-trade” & “Self-match” = Controls to prevent wash trades and/or potential illicit trading that would occur from buying and selling deviously for the same account.

d. “Price collars” = Price ranges to prevent orders from executing away from order entry expectations and erroneous executions during thinly traded market conditions.

e. “Maximum order size” = Added proposal for preventing major trading abnormalities, like fat finger errors, across multiple product types, clearing member firms, and customer types.

f. “Trading Pauses” = Time-outs for trading platforms, including requests to market centers and DCMs for rationale behind different approaches and when it is “safe” to re-open markets.

g. “Credit Risk Limits” = Attempt to limit trading system malfunctions and minimize clearing failures with checks at multiple entities or, similar to OTC markets, at a “hub” location.

3. New Post-Trade Reports and Other Post-Trade Measures

The CFTC is also accepting comments on whether to require real-time order and trade reports from all DCOs and to develop uniform cancellation and adjustment policies like minimum trade sizes and defined circumstances for cancellation.

4. Greater System Safeguards

Another objective of the regulators is to find ways to prevent market disruptions or manipulative behavior that could impact how markets operate. Perhaps this should be called the “Knight Section.” Potential new system safeguards include:

a. Controls Related to Order Placement = Proposals for order cancellation capabilities such as “auto-cancel on disconnect” and “kill switches” that would cancel all working orders. In addition, a concept proposed by the Principal Traders Group called “Repeated Automated Execution Throttle” would force human interaction for automated order repeat strategies.

b. Design, Testing, and Supervision of ATSs; Exchange Considerations = Proposal to make firms operating ATSs to undergo standardized procedures, or minimum standards, and to design systems in accordance with live markets. This would include testing standards and risk acknowledgements when system modifications are implemented. In this section, there is also greater pressure to understand algo development and crisis procedures.

c. Self-Certification and Notifications = Requires all firms operating ATSs and clearing firms to sign off on adherence to all CFTC requirements. It may also require sign-off by a C-level employee. However, the word “self” could be misleading, as certification if passed could be mandatory and under a formal regulatory authority. This would also include notifying other market centers when “risk events” occur, but it is not yet determined what exactly that means.

d. ATS or Algorithm Identification = Proposal to introduce a tagging system for messages generated by trading systems and algos in order to better understand what causes system outages, monitor results, and to learn from past mistakes.

e. Data Reasonability Checks = Concerns over how data is collected and more importantly used to trade on, including “market data reasonability checks” and social media mining.

5. Other protections

Additional areas being explored include registration of all ATSs to ensure risk controls are implemented, requiring market quality indicators for products with a consistent set of metrics, incentivizing market quality by introducing trade allocation formulas, identifying linked contracts on other exchanges, and standardizing order types that contain complex logic.

6. Questions, Questions, Questions

There are 124 questions raised within the Concept Release, many of which could surprise market participants. Evidently, the CFTC has a long ways to go in terms of keeping informed of industry developments. Certain CFTC Commissioners, including Bart Chilton, have been especially critical of this process; he has been quoted as saying, “If we continue at this pace, Rip Van Winkle could keep up with any possible action we might take.” With the release supposedly taking 2 years to compose, perhaps the question now is how long it will take to write laws for topics the industry struggles to find solutions to.

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Derivative Clearing Houses Shouldn't Be Too Big to Fail, Either

By Mayra Rodriguez, MRV Associates
Originally published on TABB Forum

With the regulatory push for central clearing of OTC derivatives, volumes and revenues have significantly increased at clearing houses. But this increases the danger that financial regulations have created the next 'Too Big to Fail' monster.

This is the fifth article in a nine-part series. It originally appeared on View the previous articles in the series and other thought leadership from Mayra Rodriguez Valladares here

Since the financial crisis, global regulators have been pushing to have as many over-the-counter derivative products as possible cleared with central counterparties, to improve transparency and minimize operational and credit risks.

As a result, volumes and revenues have significantly increased at these clearing houses. The regulators' intentions are good, but in my experience, any time business surges at any institution, risk managers and supervisors should be paying much more attention to the firm's increased operational risk.

CCPs, especially, have a lot of operational risk exposure – that is, potential problems arising due to people, processes, technology, and external threats – throughout the organization. A significant risk comes from the possibility of a member defaulting on the trades cleared by the CCP, and the potential insufficiency of the deadbeat's prefunded contribution to the default fund to cover this default. We do not want to end up in a situation where financial regulations give us the next 'Too Big to Fail' monster.

Fortunately, the Basel Committee recognizes this danger. In a recent consultative documentthe committee is signaling to banks that even if there are higher safeguards and default funds maintained by qualified central clearing parties, banks are not absolved from adequately calculating capital for those counterparties. Before Basel III, transactions with a QCCP did not require a capital allocation. These counterparties are also known as Derivative Clearing Organizations. Most of the exchanges, such as the Chicago Mercantile Exchange and Chicago Board of Trade, have one. There are a little more than a dozen of them in the U.S.

The new guidelines also encourage QCCPs to improve their default funds and their risk management. Together with recent guidelines on non-internal models to calculate derivative counterparties' risk, these recommendations are an important step in requiring banks, especially large international interconnected ones, to better identify, measure, control, and monitor their over-the-counter and exchange traded derivatives counterparties' credit quality. If bank regulators and market participants insist on higher standards for QCCPs, regulators could end up with an approach where capital charges for banks on exposures decline if QCCP default funds increase and safeguards around them are robust. QCCPs should be encouraged not only by regulators, but also by potential clients who want to minimize their capital charges.

In July 2012, the Basel committee had released interim rules on capital treatment for CCPs. To its credit, upon further study and cooperation with the Bank for International Settlements' Committee on Payment and Settlement Systems and the International Organization of Securities Commissions, the Basel committee admitted that it found that in some cases the interim rules were leading to instances of very little capital being held against exposures to some CCPs. In some cases, the capital levels were actually too high. Additionally, at times, the interim rules were also creating disincentives for QCCPs to maintain generous default funds.

In recognition of these findings, the new July 2013 guidelines focus on three areas related to transactions with QCCPs.

Two guidelines are for banks. First, the Basel committee proposes a new methodology to calculating a bank's capital for its trade exposures to a QCCP. Previously, the committee had recommended a mere 2% of the relevant risk-weighted assets. If the new guidelines were accepted, the risk weight applied to trade exposures would depend on the level of prefunded default resources available to the QCCP. If QCCP's want to attract banks as customers, they will have to really focus on their default resources; otherwise banks will have to allocate more in capital. With the new methodology, banks are likely to have to allocate 5% to 20% of RWAs depending on the QCCP's resources. While banks will not like the new guidelines, it should make them think more carefully about the amount and type of hedging or speculative derivatives transactions that they want to put on and will make them look for the QCCPs with the best safeguards.

Secondly, the new guidelines focus on new calculations for QCCP bank clearing members to use for prefunded default fund contributions. In my view and that of many financial derivatives markets reform advocates, the contributions required by the interim rules were not robust enough to absorb losses during market stress. The proposed method for QCCPs to calculate the default fund would better position the default funds to absorb losses, so that high credit quality members do not get hurt by a drawdown of the funds.

Thirdly, not only are banks required to improve their methodologies to calculate capital for transactions with QCCPs, but the guidelines also encourage QCCPs to have robust default funds. The Basel guidelines can be very useful if bank regulators use them to provide an incentive for, or at least not discourage, contributions to default funds to be prefunded, rather than commitments to pay after the fact. The creation of a default fund should not create new risk for the financial system in the form of hidden liabilities that surface when a trading partner falters. Rather, a default fund should serve to mutualize and distribute a risk that would otherwise fall on creditworthy members' trade exposure claims on the CCP.

Importantly, the proposed guidelines demonstrate the Basel Committee is aware that just insisting on additional capital is not enough. The Basel Committee is emphasizing that it wants improved risk management practices by banks and CCPs. For the QCCPs, there are established CPSS-IOSCO Principles for Financial Market Infrastructures so that they minimize their probability of disruptions or outright failures.

While the proposed guidelines can be very useful in improving banks capital against QCCPs, as I have written in these columns previously, it is imperative that banks disclose the inputs for their risk-weighted assets in calculating capital for positions with QCCPs.  Moreover the QCCPs will need to be more transparent about the level of their default funds and about how they are running simulations on how they would solve for multiple parties defaulting on trades simultaneously.  The more transparent banks and QCCPs are, the more likely it is that the transition of derivatives from OTC to clearing parties will provide safer financial derivatives markets and better capitalized banks.

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CFTC Proposes Rules for DCOs to Align with International Standards

The Commodity Futures Trading Commission has proposed final rules to implement enhanced risk management standards for systemically important derivatives clearing organizations.  These rules are significant because they bring the CFTC’s enforcement standards in line with international standards, ultimately enabling clearing organizations to be central counterparties for both US and international derivatives transactions.  Among the key focal points of the final rules are to:

  • Increase financial resources requirements for systemically important derivatives clearing organizations that are involved with more complex transactions

  • Prohibit the inclusion of assessments when clearing organizations calculate their available default resources

  • Enhance system safeguards for business continuity and disaster recovery at clearing organizations

Click here for a copy of the CFTC press release and here for the proposed rules.  A fact sheet can be found here.

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Basel's New Guidance on Derivatives' Counterparties Fixes Shortcomings

By Mayra Rodriguez, MRV Associates
Originally published on TABB Forum

Banks globally have significantly been underestimating important credit risk drivers about their derivatives counterparties. But not measuring counterparty risk in derivatives portfolios can quickly become a problem for all banks and the global economy.

This is the fourth article in a nine-part series. It originally appeared on View the previous articles in the series and other thought leadership from Mayra Rodriguez Valladareshere.

In 1973, when the Basel Accord was in its early gestation period, global derivatives markets were primarily comprised of exchange-traded commodity derivatives. Four decades later, the derivatives markets total about $632 trillion and are overwhelmingly over the counter.

The Basel Committee on Banking Supervision has had quite a challenge keeping up with bankers' incredible ability to create new derivatives products at a break-neck pace and to make recommendations on how banks should properly calculate for risks arising from derivatives transactions, especially those that are OTC.

A few weeks ago, the committee published a consultative paper on capitalizing derivatives' counterparty risk exposures. I view the recommendations as an important step in requiring banks to better measure and monitor their derivatives counterparties' credit quality. While the proposal, with its numerous, detailed formulae, is unlikely to be on anyone's summer beach reading list, it is very important for those wanting to understand how global systemically important banks should calculate for this subset of credit risk in their trillion dollar derivatives portfolios.

Before the financial crisis, participants clearly failed to focus adequately on the fact that their derivatives' counterparty credit quality might deteriorate or might even fail before their underlying asset does. If you ignore your counterparty's credit quality and only focus on the underlying reference asset, you are essentially assessing greater value to your derivatives' contracts than they are really worth. When the counterparty fails, especially if unexpectedly, you are stuck with positions worth less than you had thought, and importantly you run a significant risk of not having enough capital to sustain unexpected losses. Think of those banks that had any type of derivatives with Lehman Brothers or AIG in September 2008.

The Basel Committee has issued prior guidance on counterparty charges, but this guidance has had significant shortcomings. These shortcomings, which the new consultative paper proposes to address, include:

  • Existing framework does not differentiate between margined and unmargined transactions.
  • The supervisory credit conversion factors do not sufficiently capture the level of volatilities as observed over stress periods within the last five years.
  • The supervisory add-on factors do not sufficiently capture the level of volatilities as observed over the recent stress periods.
  • Recognition of hedging and netting benefits is too simplistic and does not reflect economically meaningful relationships between derivative positions.
  • The relationship between current exposure and potential future exposure (PFE) is misrepresented in the standardized method because only current exposure or PFE is capitalized.

The proposal has calculations that would address the above mentioned deficiencies, but also tries to balance risk sensitivity with not making the derivatives counterparty charges overly complex. Another positive is that the proposal minimizes discretion used by local regulators and banks while helping both national authorities and banks better understand banks' risk profiles relating to derivatives exposures. The proposal would apply to all five derivatives classes: interest rate (the largest volume globally), credit, foreign exchange, equity and commodities.

There are quite a number of allowable credit risk mitigants, such as collateral, insurance, credit derivatives, netting, offsets and guarantees, that influence credit conversion factors and enable banks to convert notional amounts into much lower on-balance-sheet equivalent credit exposures. However, I would argue that banks globally have significantly been underestimating important credit risk drivers about their derivatives counterparties. The new Basel proposal would compel banks to spend more time taking into account those key credit risk drivers.

Given that OTC derivatives account for the vast majority of all derivatives traded, how banks calculate counterparty charges in those transactions is where investor and supervisory focus should be. While there are risks in exchange-traded derivatives markets, there are a lot more credit, liquidity and operational risks, not to mention opacity, in the OTC markets.

Derivatives markets are changing due to Dodd-Frank in the U.S. and the European Market Infrastructure Regulation overseas, but the derivatives reforms in both of those regulatory frameworks are still evolving. As long as OTC markets continue to dwarf exchange-traded ones, bank observers need to pay close attention to whether banks have sufficient capital for their derivatives portfolios. Just because they are off-balance-sheet transactions does not mean that a bank's profit, not to mention its capital, cannot be eroded shockingly quickly when counterparty risk is measured inaccurately.

Given the interconnectedness of the top four banks (Bank of America, Citigroup, Goldman Sachs and JPMorgan Chase) that transact 90% of OTC derivatives in the U.S., not measuring counterparty risk in derivatives portfolios is not just a problem for a bank, but in times of stress, can quickly become a problem for all banks and the global economy.

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Derivatives Reform: A Day in the Life of the CFTC

By Mayra Rodriguez Valladares, MRV Associates
Originally published on TABB Forum

Reforming the global OTC derivatives market is one of the most critical aspects of reducing risk in the financial system, but harmonizing cross-border rules is proving a major challenge. As a key derivatives reform deadline approaches in the US, the pressure on the CFTC to delay and soften requirements on foreign entities has been intense.

“At some point in the future, someone will be calling the U.S. Treasury Secretary with bad news: A U.S. financial institution is failing under the weight of its overseas swaps business. And what else might he or she say? The public was on the losing end of the deal, in part, because the CFTC back in 2013 knowingly left offshore operations out of common-sense reform.”

–Chairman Gary Gensler’s Keynote Address on the Cross-border Application of Swaps Market Reform at Sandler O’Neill Conference, June 6, 2013

Reforming the $633 trillion global over-the-counter financial derivatives market is one of the most critical tools to end ‘Too Big to Fail.’ As a key July 12 derivatives reform deadline fast approaches in the US, the number of visitors and the amount of comment letters to the Commodity Futures Trading Commission from domestic and foreign financial institutions, lobbies, law firms, and corporations have risen dramatically.

Given that the monetary stakes are very high due to the cross-border implications of The Wall Street Reform and Consumer Protection Act’s (Dodd-Frank) Title VII, it is no surprise that CFTC Chairman Gary Gensler is having to compromise in light of strong opposition not only from banks, some US politicians, and European regulators, but also from most of his own commissioners. It is very likely that either the July 12 deadline will be extended at least six more months, or that foreign banks here in the US and US companies’ subsidiaries abroad may get lighter treatment in their OTC derivatives’ clearing and reporting requirements.

The US Derivatives Market

In the US alone, the $232 trillion notional OTC derivatives market represents billions in revenue for insured banks and savings and loans associations, especially disproportionately for the top four largest Significant Financial Institutions (SIFIs). Banks’ exchange traded derivatives represent only about 5% of their derivatives portfolios, with the overwhelming remainder being over-the-counter bilateral trades; 80% of OTC trades are interest rate swaps or options, which is why the CFTC focuses so much on trying to regulate these instruments.

Tabb 7 10 1

Note: $ millions
Source: OCC’s Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2013

An essential point that needs to be understood is that financial institutions may manage their derivatives portfolios in one location but often book their derivatives in multiple legal entities in the US and abroad. Bank of America, for example, has more than 2,000 subsidiaries, with 38% of them in foreign jurisdictions, especially the UK. Due to banks’ opacity, especially when it comes to financial derivatives, it is often very difficult to discover what type of parent guarantees exist for different subsidiaries. AIG, Citibank, and Lehman are recent examples of financial institutions where the US-headquartered parent was negatively impacted by those firms’ problems abroad. Lehman had 3,300 subsidiaries at the time that it declared bankruptcy, and its London subsidiary had more than 130,000 outstanding swaps contracts, many of them guaranteed by US-headquartered Lehman Brothers Holdings.

A US Person

In June 2012, the CFTC approved for public comment proposed interpretive guidance regarding the cross-border application of the swaps provisions of Dodd- Frank Title VII. The CFTC also proposed a one-year transition period phasing in requirements for foreign swap dealers and foreign branches of U.S. swap dealers; the transition ends this July 12.

Dodd-Frank requires that all foreign or U.S. firms transacting with U.S. persons are to comply with derivatives market reform. Chairman Gensler has proposed that the definition of “U.S. person” in the final guidance must include offshore hedge funds and collective investment vehicles that are majority-owned by U.S. persons or that have their principal place of business in the United States. Gensler has argued that Dodd-Frank requirements must cover swaps between non-U.S. swaps dealers and guaranteed affiliates of U.S. persons, as well as swaps between two guaranteed affiliates that are not swap dealers.

External Meetings

If you are not a fan of numerous meetings at work, then being a professional at the CFTC would be very challenging. In the first half of this year there have been hundreds of meetings with external visitors on various Dodd-Frank derivatives topics, of which the vast majoring have been about the cross-border implications of derivatives reform. Almost 90 different domestic and financial institutions, corporations, lobbies, and legal firms have paid about 125 visits to the CFTC to speak about cross-border issues, with a third of the visits occurring in June alone. It is important to remember that the visits to the CFTC are in addition to those paid to US congressional and state legislators, the bank agencies (the Federal Reserve, OCC, FDIC, and state bank regulators) and the SEC on this subject. Numerous other Dodd-Frank meetings under the heading ‘general’ have also taken place.

Given the meetings, presentations and reading of comments, it is actually impressive that the CFTC has completed 90% of the transparency and oversight rules for the swaps market. Yet much of what the CFTC has accomplished in spite of lobbying and working with limited financial resources will be significantly set back if, as looks likely, the July 12 deadline continues to be extended.

Other than financial sector reform groups, Better Markets and Americans for Financial Reform, all the other CFTC visitors who have come to meet about cross-border issues have been financial institutions (both buy- and sell-side institutions, as well as exchanges such as CME Group and LCH), financial lobbies, corporations (energy, automotive, industrial) or law firms. Most firms have come once or twice, but some have been very frequent visitors, such as the International Institute of Banks, which has visited the CFTC five times, and international law firm Clearly Gottlieb, which is by far the most frequent visitor, sometimes visiting twice in a day. How much is at stake is clear not only from the number and wide array of visitors, but also from the number of countries that they represent in addition to the United States, including Canada, France, Germany, Japan, Spain, Switzerland and the UK.

Banks’ Challenges                   

For the banks to transition from OTC to clearable derivatives is requiring a massive change in risk management culture, not to mention business strategy, and a significant overhaul of how data are collected, verified, and reported to comply with Dodd-Frank. Bank management have been very worried about the financial impact that transitioning derivatives portfolios will have on their profits, since they will have to learn to make money on volumes and not on the spread the way they do in the tailored OTC market.

Also, having derivatives go through a clearinghouse will mean that banks have to be able to post high-quality collateral at a time that multiple regulatory frameworks may make it challenging for banks to always have high-quality collateral at hand. This is particularly challenging for European banks and companies given the Eurozone’s fiscal woes. One need only look at the percent that UK, French, and German banks represent in their countries’ GDP to understand their incredible influence in the financial regulatory, and especially the derivatives, reform debate. This in part explains why European Commissioner for Internal Markets and Services Michael Barnier has intensified his critiques of the CFTC for essentially moving quicker than other regulators on attempting to reform the global derivatives market. In April, Barnier asked US Treasury Secretary Jack Lew for more implementation uniformity in derivatives rules between the US and Europe. In mid-June, Barnier took his message to a broad audience of business news readers.

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Source: Record of Meeting of the Federal Advisory Council and the Board of Governors May 17, 2013

Substituted Compliance

Pressure from domestic and financial lobbies has intensified even more since the beginning of June, with numerous financial institutions and companies asking for an extension from July 12 until January 12, 2014. Their argument is that until other countries all have uniform derivatives rules, the US should not unilaterally impose derivatives clearing requirements on US company branches offshore or foreign financial institutions here in the US. They also argue that compliance with transaction requirements for swaps could come under comparable and comprehensive rules abroad, where they exist – or what is known as “substituted compliance.” Substituted compliance means that if the CFTC believes that a foreign regulator’s derivatives rules are similar to the US’s, then the US would accept that regulator’s supervision. Under the proposed guidance, foreign branches – like JPMorgan’s U.K. branch – may comply with Dodd-Frank through substituted compliance. The final guidance, however, must ensure that the definition of a foreign branch is bona fide and that the swap is actually entered into by that branch. This is to ensure financial institutions do not attempt to sidestep full compliance with reform through substituted compliance, which may not be identical to Dodd-Frank.

Given that other regulators may not have written all their derivatives rules yet, and importantly, they may not all be conducting a risk-based supervision approach, ‘substituted compliance’ may mean no compliance at all. Unless we can find a way for foreign taxpayers to be substituted for us if a derivatives implosion comes back to haunt us, the CFTC and US bank regulators must monitor US branches abroad and foreign branches here. JP Morgan’s whale scandal, Citibank, AIG, Lehman, Bear Stearns, and Long Term Capital Management should have taught us by now that just because trades are booked offshore does not mean that the risk stays offshore.

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Is Clearing a Force for Good?

By Bill Hodgson, The OTC Space Limited
Originally published on TABB Forum

If central clearing delivers trust in the post-trade environment and the spread of market knowledge, then it is a force for good and should been seen as a new enabler for the development of emerging economies, more than aid or loans.

Most of us are focused on the large changes being made to the OTC derivatives markets in Europe and the US. However, when you look at the total system required to support market infrastructure from trading down to settlement, recreating that framework in a new country from scratch is an enormous undertaking -- I don’t mean just computers and software, but the legal framework, the settlement infrastructure, risk management and, importantly, the knowledge to bring it all together, much of which isn’t freely available and carries a high price by those that can provide it. If central clearing delivers trust in the post-trade environment and the spread of market knowledge, then I argue that it is a force for good, and should been seen as a new enabler for the development of emerging economies, more than aid or loans.

As countries develop, they have to engage with capital markets technology and import some or the entire capital markets framework into their economies to become competitive and attractive to outside investment. Developing a national capital market firstly relies upon law. This entails a well defined insolvency framework that recognises the rights of users of the capital markets to settle a bankruptcy in an orderly manner and preferably with netting of obligations within asset classes. Law enabling the delivery of securities as collateral must be in place, and of course there needs to be a corresponding securities lending market and a depository, to complete the foundations.

Once this is in place, the infrastructure for the effective movement of securities is needed. Most countries develop a depository to enable an equity or bond market, and if settlement delays are to be avoided, will want to provide a clearing function to enforce predictable settlement and de-risk the post-trade environment. Without clearing, the depository can only use fines to enforce good settlement behaviour, or block firms from participating in the markets at all.

The next step is development of traded products with central clearing. That needs technology for pricing and risk management, something that is harder to import or acquire than legal expertise. Vanilla products with observable prices such as interest rate futures, commodity futures or bond futures can be managed by reference to historical market data. Pricing, though, becomes more complex once options are introduced onto an exchange. Not only must the exchange be able to price options to calculate safe margin levels, but participants must have the ability to quote option prices, and become market makers to kick off the flow of trading activity.

Built on pricing technology is that of portfolio risk management and techniques such as Value at Risk (VaR) or the well used Standard Portfolio Analysis (SPAN). Pricing a single option is something you can do on-line; but pricing a whole portfolio of hundreds or thousands of trades and simulating the behaviour of markets to calculate margin levels is a higher order problem.

Computer hardware is cheap, so acquiring the processing power needed to carry out the calculations isn’t a barrier, but the intellectual problem of making sense of the data cascading out of the calculations is harder. The reality is that portfolio risk management relies upon a deep knowledge of statistics, plus the traded products themselves. Most people left behind statistics at high school, and the number of people who have the expertise to apply this knowledge in the context of central clearing is limited. Without this depth of knowledge and experience, the central clearing structure is unlikely to stand strong against the economic instability it is meant to protect against.

What good is all this for a developing nation? By introducing clearing for bond and equity markets, the margin and strict settlement requirements would (in theory) reduce credit risk in the secondary markets and attract more sources of capital, both on-shore and off-shore. Providing hedging products for risks such as interest and exchange rates would enable firms to transfer risk via a trusted counterparty (the CCP) and manage exposures proactively, rather than suffer from unpredictable and adverse rates making their business more costly and uncompetitive. By adding a CCP and bringing ‘trust’ into the capital markets, firms are enabled to grow and attract inward investment into an organised and safe market.

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Pole Position in the New Swaps Market

By Adam Sussman, TABB Group
Originally published on TABB Forum

Over the years, the value of pole position in NASCAR and Formula One races has been on the decline, as winning has more to do with having the right tools and equipment than where you start. The same can be said about the new swaps market.

Over the past month, the industry has been rightly focused on the complexities, barriers and importance for Category II firms to be ready to clear swaps. However, initial readiness by June 10 is hardly the finish line, and even those in leading positions now could easily fall into the back of the pack. The same holds true for the clearinghouses, trading venues and technology providers that are trying to sell the laundry list of services associated with the overhaul.

On the client side, even if a firm has completed the major steps to being able to clear, it does not mean it is capable of efficiently managing its swaps positions and the related movement of collateral. In other words, being ready to clear by June 10 is not the same as being ready to manage a cleared swaps portfolio.

Some clearing-ready clients will still choose to reduce their swaps activity over the next few months until they have a better understanding of the portfolio, collateral and operational nuances involved. Portfolio margining, collateral management, and safety of initial and variation margin are just three areas that go above and beyond the technical necessities to clear.

Precise and efficient communication with the clearinghouse will be a critical buy-side process that will become more important over time (see: “Swap Portfolios in Transit). As the buy side looks to terminate, compact and rebalance its swaps portfolio, a single mistake in coding or trade detail could mean that the clearinghouse fails to recognize the true intention of the trade and a sub-optimal margin requirement.

Clearing-ready clients may also scale back their swaps trading until they are ready to clear through multiple FCMs and multiple clearinghouses. TABB estimates that nearly 375 Category II funds will fail to meet the June 10 deadline; but even among those that are ready, how many will have multiple FCM relationships in place? And how many will be able to direct trades from any FCM to any clearinghouse? Reluctance to rely on a single FCM to handle all initial and variation margin may cause some firms to reduce their swap exposure, until they have multiple relationships in place.

Similarly, just because a clearinghouse, trading venue or technology provider seems to be best positioned for success right now, it is hardly a predictor of long-term success. Throughout the entire rulemaking process, we have learned that there is a first-mover disadvantage during this transformation.

The industry has consistently been wrong on the implementation date for the trading mandate. In 2011, in our SEF industry barometer, two-thirds of respondents believed the trading mandates would be in effect by Q1 2012 or earlier. It is also likely that the industry believes that the major changes will take place in the next year. I believe there is a much longer game at stake – that the changes we see this year will only be setting in motion a much greater series of changes.

The uncertainty surrounding the timing and the outcome of the swaps transformation has led to a tremendous amount of jockeying and innovation among the field of contenders. The vertical exchanges are hedging outcomes by focusing on the two core businesses – trading and clearing – but also by focusing on the markets where they are already a formidable presence: CME Group is focused on rates clearing and launched a deliverable swap future (DSF) on interest rates; ICE is clearing credit defaults swap with a plan to launch credit futures. The competition is multi-faceted, with competing contracts on one hand and competing clearinghouses on the other.

Over the past few months there has been an uptick in announcements. The types of announcements that have come out recently have focused on two areas: trading or plumbing. Trading is, of course, the glitzier announcement and the one that has garnered the most attention from the press. Whether it is the various efforts at standardizing interest rate swaps, the launch of credit default futures or the tweaking of existing products, there has been quite a bit of hype in this area, and we do not expect it to calm down anytime soon.

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The other type of announcement is on the plumbing necessary for the buy side to handle a cleared swap environment. On Friday, June 6, Tradeweb announced it has launched a service that allows customers to speed up approvals of swaps before they are executed and sent to the clearinghouse. Without this kind of functionality, a client could be waiting minutes or more to have the FCM/swap broker approve and send the trade along to a SEF for execution.

ICAP and its subsidiaries, TriOptima and Traiana, have also been busy on this front. In May, Traiana announced that an FCM successfully completed production testing of its CreditLink service, a way to manage pre-trade clearing and trading limits with DCMs or SEFs. This solution would also help bring certainty of clearing to the market. Then on Friday, TriOptima announced it will be using data reported to the DTCC’s trade repository to help in the reconciliation process. 

Earlier in the year, TrueEx announced it had developed an electronic communication tool to help the buy side manage its trade communication with clearinghouses and dealers. The tool is designed to help the buy side make sure that when it attempts to terminate, compact or rebalance a portfolio, the new trades being sent to the clearinghouse are sent with the correct information.

Lastly, Clarus Financial Technology announced the release of an application that allows market participants to view the tremendous amount, but little understood, data that is made available by the Depository Trust Clearing Corporation (DTCC) through its Swaps Data Repository (SDR).  

This type of functionality seems more than obvious. But that is the point. How can anyone know how this market is going to play out when the kind of functionality that is taken for granted in mature markets is barely developed for the new swaps world?

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The European FTT Is Finished

By Rebecca Healey, TABB Group
Originally published on TABB Forum

In a supposed victory for banks and trading organizations, the European Commission apparently will scale back the financial transaction tax significantly. But here are 5 reasons why the anti-FTT lobby should not relax just yet.

report from Reuters yesterday confirms weeks of suspicion that most of the politicians in Brussels were beginning to realize that the EU-11FTT was just too complex and draconian to implement in its current form. Yet understanding that the FTT will have a devastating impact on any economic recovery – it is not just a damaging tax on financial services that we can ill afford – is a vital argument that must not get lost in the political rhetoric.

The apparent revised proposals, according to Reuters, will be scaled back considerably; it is estimated that annual revenues could fall to as little as €3.5bn. The tax will fall to just 0.01% on shares and bonds, rather than the 0.1% initially proposed. In addition, the Jan. 1, 2014, start date will be delayed, with the tax on bonds held off until 2016; the planned levy on derivatives could be dropped altogether. 

As we discussed in our recent video, “FTT: The Cold, Hard Facts,” the announcement by Bayer and Siemens of the impact of the FTT on European companies, their day-to-day financial dealings and, most important, the impact on workers’ pensions would appear to have sent the right message to Brussels. Yet the current discussions remain in the corridors of political power: European politicians may have realized the folly of the initial proposals, but this will be a difficult message to sell to the general public. There will be no public support for this proposal from German Chancellor Angela Merkel’s coalition until after the election in September.

However, this is no landmark victory – the anti-FTT lobby should not relax just yet. We need to continue highlighting the folly of such a tax for the following reasons:

  1. These latest proposals, together with an announcement by France yesterday, indicate a shift toward allowing derivatives trading to continue unfettered. Initially, the tax was proposed as a way to make the financial sector bear some of the costs of the economic crisis and reduce systemic risk. The executive committee of the EC estimated that the FTT could lead to a 15 percent decline in the trade of shares and bonds and a 75 percent reduction in the volume of derivatives trading – widely regarded as the most risky form of financial speculation rather than a valued hedging tool. The latest proposals would appear to leave the “risky” element wide open and equities bearing the full brunt of the tax. There will be a backlash to this at some point.
  2. Current taxes are unaffected. Discrepancies among national governments remain and are unlikely to be resolved.France announced that it is interested in scaling back the tax on derivatives markets while controversially extending the levy to currency trades. Meanwhile, Italy remains committed to excluding bonds from the tax. The considerable administrative burden in adhering to European taxes still exists.
  3. Even a revised EU-11 FTT will not collect the funds it claims – it fundamentally goes against market behavior. If the tax is reduced and imposed purely on equities and bonds, the incentive remains for market participants to shift to alternatives, either in terms of asset class or geography.
  4. In addition, the countries involved would still have little say in how the funds are spent, and where. This is something that is of increasing concern to certain nation states. Germany, the Netherlands and the UK categorically do not want a European tax where revenues would flow into the EU's own budget.
  5. The latest announcements of youth unemployment in Italy reaching 40.5% -- the highest level in 36 years -- as well as record levels in Spain and Greece show that tackling youth unemployment is as essential as ever. But would we be better served by encouraging financial services firms to offer apprentice schemes rather than crushing banking institutions?
While shrinking economies and rising unemployment continue to challenge European governments, some nation states will continue to push for an FTT. Arguments that financial trading is under-taxed relative to the rest of the economy may be technically correct, but the idea that implementing the FTT is beneficial because banks derive excessive profit from trading shows how little some politicians understand capital markets today.
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