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The Next Buy-Side Frontier: Derivatives Governance, Innovation and Risk

By Geoff Cole and Jackie Colella, Sapient Global Markets
Originally published on TABB Forum

While the majority of buy-side firms expect their derivatives volumes and trades to substantially rise over the next three years, many are not yet fully prepared for the changes to come. For asset managers looking to continually innovate, the revamping of governance models and approval processes specific to derivatives will be central to balancing the time-to-market pressures against operational risk.

A recent survey by Sapient Global Markets found that while the majority of buy-side firms expect their derivatives volumes and trades to substantially rise over the next three years, many are not yet fully prepared for the changes to come.

The issues investment managers face to effectively and efficiently implement a new derivative instrument type became clear: enabling the trading of a new instrument type to quickly support a portfolio manager request, while taking into account technology restraints and mitigating operational and reputational risks, requires significant due diligence and a robust yet flexible governance model to support the process.

The current state of governance models and practices

The investment management industry is struggling to determine the proper level of operational and legal due diligence necessary to create a level of comfort appropriate for firms to trade new derivative products while balancing investment managers’ desire to be the first to market with a new product offering that offers a unique exposure or risk management approach.

Many firms have governance committee(s) responsible for approving the operational aspects of new instruments; however, the process for implementing the changes varies widely from firm to firm. In most cases, different committees are responsible for approving derivative usage on a portfolio or fund level, but most committees only approve operational capability in terms of whether or not the instrument can be traded operationally. While the majority of firms review derivative usage bi-weekly or once a month, at many firms the committee convenes on an as-needed, ad-hoc basis to review any new issues that arise with a portfolio manager’s new instrument request.

Firms should consider implementing a dedicated, fully resourced derivatives team with appropriate product knowledge and capacity levels specific to the new instruments, markets and products to be launched. This team should support the lifecycle of onboarding a new derivative instrument type, including capabilities such as legal and client services. In addition, reviews should be conducted on a regular basis.

They should determine the level of efficiency in the current process for assessing “readiness to trade” a new instrument type. Incorporating a streamlined process to approve and implement a new derivative instrument is paramount to mitigating operational risk and reducing time to market for new products and investment strategies. In our experience, the governance structure is far from streamlined and challenges/backlogs exist in operations and technology, primarily due to:

  • Derivatives trading discussions (including new instrument types) usually occur at the portfolio manager/trading level; by the time operations is informed, the process is already behind.

  • The number of internal and external entities and departments required to support the implementation and enable trading for a new derivative instrument type reduces the ability of operations to respond in a timely manner.

  • Technology is adequate with multiple workarounds in place, but does not or will not scale well with increased volumes or complexity in the future. It often is the biggest inhibitor in the implementation of new derivatives.

Finding the right balance

Asset managers are searching for the right balance between enabling portfolio managers and investment teams to express their investment desires through any means possible (including usage of derivatives) and achieving the optimum level of operational control and reputational risk management.

The issues experienced by firms in facilitating the availability of a new derivative is magnified by the complexities of the lifecycle of derivative trading. The pre- and post-trade process for onboarding a new derivative at asset managers can include:

  • Portfolio managers, but also some product management teams, initiate the request to enable trading of a new derivative instrument type

  • In few cases, automated workflows and electronic voting for approval exist detailing the change controls necessary to efficiently onboard a complex instrument.

  • Counterparty information was the most critical information needed to trade a new derivative instrument along with projected volumes, underliers, currencies and markets.

  • Very few firms have a streamlined process in place for onboarding a new derivative instrument type; in most cases, many different departments are given a task with little or no accountability.

Legal Agreements

The due diligence needed to manage master umbrella agreements is cumbersome and requires qualified staffing with knowledge of the intricacies of derivatives documentation. Client sophistication must also be taken into consideration to best calibrate the level of handholding required through the documentation updates required to enable the trading of a new derivative instrument within a portfolio.

In discussions with asset managers around whether derivative trading in client accounts occurs under an umbrella master agreement, or their clients negotiate their own agreements, a small number said their clients negotiate their own agreements with counterparties. If an investment manager chooses to trade a new derivative not stipulated in the original client-negotiated agreement, it may take weeks or months to have all the paperwork completed, delaying capitalizing on that derivative trade.

Regulatory Implications & Constraints

The amplification of new regulatory requirements for trading and clearing of derivatives has created greater challenges with firms’ legal review and documentation processes, changing the legal review and documentation process in numerous ways:

  • Additional “touch points” requiring clients to sign off on each new requirement add weeks to months for documents to be returned.

  • Extra legal team resources are needed (in terms of experience and capacity) to review regulatory changes.

  • Most changes occur only in the documentation.

  • Because the regulatory environment may change such that if the firm already has authorization to trade, firms may “inform” rather than “request” approval from the client.

  • Regulatory mandates in Europe are especially challenging for derivatives.

Balancing Time to Market with Operational Risk

It can take anywhere from three weeks to one year to completely onboard a new derivative instrument type. Most are traded with manual workarounds without taking into account post-trade operational processing, including settlement, collateral management and even client reporting. In many cases, an instrument that is too complex for existing systems can delay implementation to over a year and sometimes lead to the decision not to make the instrument type available to portfolio managers at all. Such cases can create a negative client experience, significantly delay new product launches and cause significant frustration for front-office personnel.

While many firms complete a full end-to-end testing of any new derivative instrument, in some cases, this testing is completed for only one specific business area. If multiple order management systems exist, there may be increased operational and business risk in the trade lifecycle if another business unit subsequently attempts to trade the newly enabled derivative instrument.

Reliance on standard vendor packages for trading and risk management may provide out-of-the-box support for most instruments, but changes to interfaces and configuration may be more complex than anticipated or require close coordination with the software providers. The bulk of the testing effort is often directed at the accounting system, given its criticality for fund pricing and reporting. However, there are many other links in the chain that require significant analysis and testing in order to properly enable a new derivative instrument across the front-to-back investment infrastructure.

Essentially, each new instrument request becomes a joint business and technology project, requiring scope, funding and prioritization against all other IT projects, which can also prolong the period between the request to trade and the first execution.

Improving the governance model and practices

For asset managers looking to continually innovate, the revamping of governance models and approval processes will be central to balancing the time-to-market pressures against operational risk. This is also require investment in workflow tools for transparency and tracking, dedicated derivatives/new instrument due diligence teams and the active involvement of operations teams, to enable the necessary cultural change to support the usage of more complex product types.

These changes are often overlooked dimensions of a robust target operating model (TOM) initiative that can address the definition of roles, responsibilities and accountability, as well as identify opportunities for improvement and investment across a firm and integrate with the firm’s data and architecture.

As product innovation accelerates, fee and cost pressures persist and competition for assets increases, asset managers must tie all of the capabilities supporting derivatives – including legal, client service, collateral management, risk management, reporting and project management – together in the form of a nimble and responsive governance model to enable a true competitive advantage.

Improvements in governance models and practices must also take into consideration future industry, market and regulatory shifts. Specifically, asset managers should:

  • Determine if using Special Investment Vehicles (SIVs) across accounts is a viable option, based on client account structure.

  • Understand the potential challenges and develop strategic mitigation plans to ensure BCBS 269 compliance changes for cleared versus non-cleared derivatives.

  • Prepare for other regulatory change focused on increasing oversight of asset managers, such as the SEC’s proposal requiring funds to report on their use of complex derivatives products.

  • Assess the use of off-the-shelf (cleared) derivatives to model exposure to OTC derivatives, thereby employing the most cost-effective instruments to gain the same exposure.

  • Define a target operating model to ensure the ability to adapt to industry changes as well as unforeseen market and regulatory fluctuations across investment, operations and technology.

  • Provide all personnel with appropriate derivatives knowledge through education and training.

  • Dedicate appropriate resources to the management and supervision of derivatives-related initiatives.

Turning challenges into opportunities

As product innovation accelerates and competition for assets increases, derivatives usage will continue to grow in both volume and complexity.

While most firms recognize this, investment and operational improvement has typically been directed toward front-to-back trade flow improvements. Most have reactive governance structures, which is a major contributor to the time lag it takes to assess and approve a new derivative instrument that need to be refreshed. However, during our research it emerged that no investment manager was continuously improving its governance structures, suggesting it has not been recognized as a vital investment area.

Yet it is clear that derivatives are a valuable tool for product innovation and delivering outperformance in a risk-controlled manner. The opportunity exists to refresh or realign governance structures to better support organizational growth in accordance with derivatives usage plans. Adopting new practices for governance and operational risk management specific to derivatives can help asset managers reduce time to market and more quickly respond to portfolio managers’ needs.

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MIFID II: It’s Coming. Will You Be Ready?

By Jodi Burns and David Lawlor, Thomson Reuters
Originally published on TABB Forum

With less than 18 months until MiFID II takes effect in Europe, the industry needs to come to grips with its reporting and trading requirements if it is to be fully compliant by 2017. Here’s a road map of where to start.

In the specter of financial market reform, it would be easy to dismiss the recast Markets in Financial Instruments Directive (MiFID II) as an inconsequential afterthought, tying up loose ends that were omitted from the original MiFID rulebook, which was implemented in 2007, and the more recent European Market Infrastructure Regulation (EMIR).

But to do so would be to vastly underestimate the scale and scope of MiFID II and its accompanying regulation, MiFIR. Together, they will impact a wide range of institutions across asset classes, going much further than the G-20’s commitment on derivatives reform, which included central clearing, trade reporting and use of organized trading platforms. MiFID II adds position limits for commodity derivatives, for example, as well controls on algorithmic trading.

This is a regulatory project that is far more onerous than even the US Dodd-Frank Act, which has consumed the resources of market participants as they have progressed their compliance efforts over the past five years. On top of the wide scope, the timescale of these rules is an even greater challenge. MiFID II and MiFIR have been in force since mid-2014, although the rules won’t actually apply until January 3, 2017. That might sound a long way off, but in practice it leaves very little time for participants to get all of the necessary processes and resources in place to meet these requirements.

Adding to the complexity, the European Securities and Markets Authority (ESMA), which is responsible for drafting the technical standards, has consulted with the industry but is not expected to deliver its final standards to the European Commission for adoption until September 2015, once they have been reviewed by Commission lawyers. That brings a layer of uncertainty to the process, as the industry prepares for rules that could still change.

But whatever the size and type of your business, if you are active in European financial markets, you cannot afford to wait until you have final rules in hand to prepare for MiFID II. The complexity of these requirements means such an approach risks running out of time next year, and leaves open the possibility of noncompliance in 2017.

In this article, we focus on two key components of the proposed rules – transparency and organized trading. This doesn’t constitute an all-inclusive guide to compliance, but it should at least help make sense of complex legal texts, providing the beginnings of a road map on where to start.


MiFID II extends the transparency regime that was created for equity instruments in the original directive, adding reporting requirements for bonds and derivatives. Those requirements include both trade reporting, whereby trades must be reported publicly in close to real time, and transaction reporting, whereby trades must be reported to regulators no later than the close of the following working day.

The trade reporting obligation rests with the venue where the trade takes place, which could range from an independent regulated platform to a so-called “systematic internalizer” (SI) – typically a bank that has sufficient flow to match buy and sell orders internally. Derivatives trade data must be published within 15 minutes of execution, marking a step change for those platforms that have never had to report in the past.

With its pre-trade and post-trade reporting obligations, MiFID II will propel a slew of market data into the public domain that never existed before, including pre-trade prices and post-trade information. In the early days, data fragmentation is likely to be the biggest challenge and there will be a need for robust aggregation of reported data to build a meaningful picture for public consumption. How that aggregation will be delivered has yet to be determined.

While the burden of trade reporting is likely to rest predominantly with trading platforms and those banks that register as SIs under MiFID II, transaction reporting will have a much wider impact, requiring asset management firms to report their trades to regulators as well as their bank counterparts.

In this, the experience of EMIR may help guide asset managers, as those firms that use derivatives have had to report their activity to registered trade repositories since February 2014, fulfilling the onerous requirement for dual-side reporting, in which every trade must be reported by both counterparties.

But whatever the experience of EMIR, MiFIR transaction reporting is likely to be even tougher, with 81 information fields required to be filled out for every trade. That means firms will need real-time access to large amounts of market data and reference data, as well as “legal entity identifiers” – numerical codes used to identify those firms involved in the trade.

Submitting transaction reports to regulators will come at a significant cost to the industry, particularly for smaller firms that may not already have reporting infrastructure in place. At this stage, the priority for market participants is to determine exactly how they will be affected by the reporting obligations and then to assess what technology and resources will be needed to meet those obligations.

Regulated Platforms

When it comes to organized trading requirements, MiFID II fulfils the G-20 commitment that standardized OTC derivatives should be traded on regulated platforms where appropriate. In the US, the Dodd-Frank Act created swap execution facilities to meet that requirement, but MiFID II includes a wider range of platform types, including regulated markets, multilateral trading facilities (MTFs), organized trading facilities (OTFs) and SIs.

Not all products will need to be traded on these regulated platforms, but all market participants need to understand the MiFID trading rules and determine what their strategy will be. For large banks, the priority is to determine whether they wish to register as an SI, which will come with certain transparency and conduct obligations. If they decide not to do so, their internalized flow would need to fall below a certain threshold, which may mean directing more business towards MTFs and OTFs.

Smaller banks will be less likely to become SIs, but they will still need to determine how to conduct their trading business under MiFID II and what proportion of trades will be executed on MTFs and OTFs. To some extent, that will depend on what products are mandated to trade on organized platforms, which will be determined by ESMA in due course on the basis of the liquidity and whether it is already subject to the EMIR clearing obligation.

As an industry, we do not yet have all of the answers on MiFID II and we hope for greater clarity once ESMA’s technical standards have been published. But awareness and readiness still varies significantly from one firm to another, which is a cause for some concern. As 2017 draws ever closer, now is the time to start preparing.


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Trading Derivatives in Asia: If You Go Down to the Woods Today…

By Lewis Richardson, Fidessa
Originally published on TABB Forum

The Asian derivatives markets increasingly are the destination of choice for firms across the derivatives spectrum. But bear traps remain for the unwary. How can you choose the safest path through the woods of this asset class in Asia?

Derivatives markets in Asia are basking in global attention, with exchanges, clearing houses, brokers, international investors and vendors all piling in to local markets. Between August 2014 and August 2015, trading in SGX China A50 futures more than doubled. (Source: SGX).

Global exchanges are even going native to some degree, with ICE, for example, localizing its contract size and introducing domestic clearing in the Asian time zone. RMB and gold futures are on offer locally, as well as Mini Brent and Mini Gasoil futures. Seeing these global derivatives powerhouses reshape themselves for Asia demonstrates clearly the opportunities on offer here, and interest in trading in Asia is unlikely to wane any time soon.

European bond products are now being traded on ICE, and Eurex is planning to start clearing bonds in the Asian time zone in the next couple of years; opportunities abound for both local and international firms to expand their businesses and investments. As competition heats up between rival exchanges, even greater choice will become available. The key is taking advantage of this while avoiding the bear traps peculiar to the region.

Growth in the region is reflected in the annual growth of 27% in total F&O volume traded (Source: FOW).

The first challenge is regulatory. American and European institutions used to dealing with a single regulator will find plenty of new challenges to navigate in the treacherous terrain of Asian regulation. Regulators here can be even trickier than ESMA or the SEC. In Singapore, the MAS made some unprecedented demands of SGX after a systems outage. In Hong Kong, market participants have to answer long questionnaires about their use of technology and back-testing of algos. In Malaysia, equities and derivatives rules are completely un-harmonized – all securities activity must be completely onshore, yet derivatives are all remote.

The speed of regulatory change can also be frightening for those used to the lumbering processes in other regions. Asian regulators can – and do – move the goalposts in a single day, whereas in Europe it has taken seven years so far, with no end in sight. Being ready for Asia’s blistering pace is vital for success in this part of the world.

There’s plenty of innovation in derivatives, but regulators here have been taking a dim view of some more out-there solutions. Brokers and banks have been asked very directly to provide certainty around the security and storage of financial information – all regulators have rules on this, none of which are exactly the same, but all of which are relatively onerous.

Different clearing regimes require different approaches as well, so getting the middle and back office piece right is very important. While regional brokers localize their operation by allocating head count into the region, many larger firms outsource their middle office to places such as London – which means these companies are unlikely to be tooled up to meet nuanced Asian requirements. Technology developed for the big US and EU markets will need tweaking to meet Asian needs. The good news here is, a firm that has solved this conundrum for Asia has met the highest global regulatory hygiene requirements and so can legitimately claim the gold standard.

Once the regulators are satisfied, the nature of doing business in Asia continues to be challenging. Getting the balance right between direct market membership and trading through a local broker is important to ensure a cost-effective solution. Accessing global markets efficiently is important, as clients will be trading CME and ICE as much or more than local exchanges. Yet as the global exchanges begin to offer local trading and clearing, trading ICE can mean two different things.

This raises an interesting point. Clients now can choose which regimes to trade in, throwing up the question of regulatory arbitrage. There could be plenty of good reasons to choose one venue over another, and these reasons will differ from client to client. Having intimate global knowledge of each regime and its benefits and pitfalls will be a great selling point for firms willing to invest the time to understand this complex landscape. On top of this, offering a seamless and smooth end-user experience will be a very enticing proposition indeed.

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ISDA Reflects on 5-Years of Dodd-Frank, Proposes Fixes

Reflecting on the five-year anniversary of the Dodd-Frank Act, the International Swaps and Derivatives Association (ISDA) issued a briefing note on July 20, 2015, that tracks the progress made since the law’s historic enactment and outlines several outstanding issues that still need attention.

So, what changes have we seen?  Since the CFTC’s clearing mandate went into effect in 2013, a large portion of interest rate derivatives (IRD) and credit default swaps (CDS) are now centrally cleared, with trades executed on SEFs being reported to Swap Data Repositories (SDRs).  For IRD, 76.5% of average daily notional volume was centrally cleared in 2014 and for CDS that number totaled 74.7%, according to ISDA SwapsInfo data. Following made available to trade (MAT) rules  being implemented, in February 2014, more than 50 percent of IRD and 65 percent of CDS index average daily notional volume traded on swap execution facilities (SEFs). In addition, so far, 104 swap dealers have registered with the CFTC. 

While all of these are notable achievements, ISDA notes that are several areas of possible improvement for the implementation of Dodd-Frank:  

  • Cross-border harmonization: Fragmentation of liquidity across geographical lines results in an increase in costs and a more difficulty in unwinding large transactions. To alleviate some of the liquidity issues brought on by differences in U.S. and E.U. regulations, ISDA recommends allowing U.S. counterparties to apply overseas rules when trading outside domestic jurisdictions, if the laws are equivalent.

  • Clearing: Given the rise in importance for central counterparties, more needs to be done to ensure resiliency on issues such as transparency for margin methods, and minimum standards for stress tests.  The CFTC also requested further regulatory input on acceptable recovery tools for central counterparties and conditions for resolution for when problems occur.

  • Commercial end users: Legislative action is needed to make clear that end users who hedge through centralized treasury units (CTUs) in order to net and consolidate their hedging activities are eligible for the clearing exemption. Many CTUs classify as financial entities under Dodd-Frank, subjecting them to clearing requirements.

  • Reporting: Regulators need to identify and agree on what data best enables them to monitor trading conditions.  In addition to developing and then adopting standardized product transaction identifiers and reporting formats, ISDA recommends rescinding Dodd-Frank’s SDR indemnification requirements in order to enable more cross-border data distribution.

  • Capital: Like margin rules, capital rules should also be consistent so no participant is at a disadvantage to its competitors or counterparties in another country.  ISDA believes regulation should be “coherent and appropriate to the risk of a given activity” and that special attention should be given to the financing costs for borrowers and hedging costs for end users.

The agency also recommends further clarification for margin rules achieve consistency and reduce disputes, to targeted modifications of SEF rules to boost trading and expedite cross-border harmonization, provisions that will allow a SEF or a SEF user to petition for the removal of a MAT determination if liquidity conditions change, and mandating  final CFTC registration for swap dealers and major swaps participants to allow regulatory certainty.To read ISDA’s note in full, please click here.

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Swap Data Risk Rising – Q&A with DTCC’s Marisol Collazo

Marisol Collazo knows a thing or two about data quality.  As the CEO of DTCC’s Data Repository, she’s responsible for warehousing trade data and related information from over 5,000 clients representing about 100,000 accounts around the globe, in the Americas, Asia and Europe.  So, when she said she was worried about the potential systemic risks that could arise from the current manner in which data is reported to swap data repositories (SDRs), it got our attention.

We spoke with Collazo about the current state of swap data reporting, to get her views on what she notes is a lack of global harmonization on data reporting standards, which could create systemic risk.

DerivAlert: Could you tell us a bit about DTCC’s role in swap data reporting?

Marisol Collazo: DTCC has been aggregating and standardizing swaps data since long before it was ever required by Dodd-Frank.  We launched our Trade Information Warehouse for credit derivatives in 2003 and by the time of the financial crisis, we already had 99% of the world’s credit derivatives swaps trade data accounted for.  In fact, this data was used following the collapse of Lehman Brothers to quickly establish the firm’s exposure to the credit default swap market.  Original estimates were as high as $400 billion notional, but our Trade Information Warehouse records proved it was actually $5.2 billion, which helped to calm financial markets.

Now, post Dodd-Frank, our role is to collect swaps data for all asset classes prescribed by regulation for thousands of institutions worldwide. Essentially, we enable market participants to report trade information and provide this data to regulators and the public to create market transparency.

DA: What’s changed from when you were collecting data for the Trade Information Warehouse and now that you are collecting data as an SDR under Dodd-Frank?

MC: The biggest difference is that when we were collecting data for the Trade Information Warehouse, the trades were standardized and payment processing was facilitated from matched records, so there was absolute certainty that the data was accurate. Today, under Dodd-Frank, the required reporting fields and scope of products is broader and doesn’t necessarily tie into existing market structure. It’s a much more fragmented process due to regional differences and absence of standards. Unlike the Trade Information Warehouse, which is self-policing when it comes to accuracy, as money moves on matched records, in the new scenario we’re collecting data but don’t have the information to determine if it’s correct or otherwise. The only people who can be relied on to ensure the information is accurate are the contributing entities themselves. 

DA: Can you give us a scenario in which this lack of a system of checks-and-balances could become a problem?

MC: When we talk about data quality, we have to first start with a definition.  All data quality initiatives have two parts: 1) standards and validation, and 2) accuracy of content.  We have part one covered under Dodd-Frank as it relates to some fields.  There are standards that have emerged to support reporting, such as FpML, LEIs (Legal Entity Identifiers), ISDA product taxonomies, and trade IDs (also known as Unique Swap Identifiers), that allow the marketplace to quickly identify the data field and the value of the trade, and if it all checks out, we accept the record and move on.  But you also need the second part.  It is still possible today to provide a valid LEI, but have an incorrect counterparty name, or provide the right values and still give the wrong notional outstanding. There is no external information available to validate that data, which can only be confirmed by the counterparties to the trade.

DA: So, what’s the solution?

MC: Data quality needs to be everyone’s responsibility. Right now, the SEC places the responsibility for data accuracy predominately with the trade repository, which cannot possibly know if all of the data is accurate. So there’s an inherent problem in the current process.  Regulators need to support and promote global standards to enable market participants and trade repositories to establish stronger validation controls, which will allow data providers to implement standards and validations in their systems to support data quality.  Further, regulators should be conscious of the market structure that delivers data to the repository, and promote policies that will enable repositories to leverage this information.  Firms can then leverage market structure providers and reconcile data to the data repository to ensure accuracy.

We are focused on a foundational requirement that those submitting data and global regulators take responsibility for data quality, and develop a harmonized set of rules to standardize that process worldwide. 

To get this moving, we issued a proposal to CPMI IOSCO suggesting that we harmonize approximately 30 data fields across global trade repository providers, essentially creating a global data dictionary.  We believe it is important to focus on 30 core fields first, which address foundational data like the economics of the trade, the underlying entity, etc. We can then move on to dealing with jurisdictional data and other technicalities that have historically held up efforts to harmonize reporting.

DA: What’s been the response to your proposal?

MC: The industry is generally supportive of this approach.  ISDA and 11 trade associations have come out in support of data quality, suggesting a similar, simplified approach to data reporting as well.   However, the fact is that right now, this issue is still unresolved and – as a result – we are not meeting the G20 goals on trade repositories when it comes to global market transparency and the identification of systemic risk.

Increasingly, we’re starting to see that the practical sides of this issue are outweighing the political, however, and I’m optimistic that we’re going to start seeing progress soon.

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CFTC Commissioner J. Christopher Giancarlo Comments on Regulatory Framework for Swaps Trading

A veteran of Wall Street, Commissioner Chris Giancarlo of the Commodity Futures Trading Commission recently issued a statement regarding the ongoing debate over the future of reform following comments made by CFTC Chairman Timothy Massad on the future of swaps market regulation. Commissioner Giancarlo stated:

“I commend the CFTC for its recent announcement of first steps in improving its regulatory framework for swaps trade execution and SEF operability. I support these commonsense measures that address concerns raised in my January 2015 White Paper: namely, streamlining the process of correcting error trades, flexibly interpreting SEFs’ financial resources requirement and simplifying swap trade confirmations by SEFs.

He also highlighted his focus on working with fellow members of the CFTC towards realizing the regulatory objectives set forth in the Dodd-Frank Act.

Commissioner Giancarlo’s comments follow similar sentiments described in a speech by Chairman Massad last week and a recent profile in trade publication Institutional Investor. See his full remarks here

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CFTC Chairman Massad Extends No-Action Relief on SEF Data Reporting

In a speech to the DerivOps North America 2015 conference, Commodity Futures Trading Commission Chairman Timothy Massad spoke about the future of swaps market regulation. Comparing it to the regulation of futures on the 40th anniversary of his organization, he spoke about the need to balance transparency and reliability while not stifling future growth of the industry. He believes that progress has been made so far but that more work is needed.

He also extended the agency’s no-action relief for SEF confirmations and confirmation data reporting, which will alleviate the need to maintain copies of ISDA Master Agreements for all trades and to report confirmation data on uncleared swaps to swap data repositories until March 31, 2016.

The wide-ranging speech discussed a number of different areas. First among them was the need to revise the current set of regulations so they work for – not against -- industry players:

“Over the last ten months, one of our priorities has been to work on fine-tuning the new rules so that the new framework works effectively and efficiently for market participants. In particular, we have made a number of changes to address concerns of commercial end-users who depend on these markets to hedge commercial risk day in and day out, because it is vital that these markets continue to serve that essential purpose. This has included adjustments to reporting requirements and measures to facilitate access to these markets by end-users. We will continue to do this where appropriate. With reforms as significant as these, such a process is to be expected. We are also working on finishing the few remaining rules mandated by Dodd-Frank, such as margin for uncleared swaps and position limits.”

Massad spoke about the need to make sure clearinghouses themselves were run effectively in the event of a catastrophe:

“Oversight of clearinghouses has been another key priority. Under the new framework, clearinghouses play an even more critical role than before. So we have also been focused on making sure clearinghouses operate safely and have resiliency. We did a major overhaul of our clearinghouse supervisory framework over the last few years. Today we are focused on having strong examination, compliance and risk surveillance programs. And while our goal is to never get to a situation where recovery or resolution of a clearinghouse must be contemplated, we are working with fellow regulators, domestically and internationally, on the planning for such contingencies, in the event there is ever a problem that makes such actions necessary.”

In the context of extending no-action relief for SEF data reporting, Massad also highlighted past use of no-action letters for temporary relief as firms attempt to achieve compliance and regulatory objectives and areas of future use:

“This no-action letter also provides relief for SEFs regarding their obligation to report Confirmation Data on uncleared swaps to SDRs. SEFs have expressed concern that to comply with their reporting obligations for uncleared swaps, they might be required to obtain trade terms from the same ISDA Master Agreements or other underlying documentation that, as I have just discussed, are not otherwise available to them. In light of these concerns, this relief clarifies that SEFs need only report such Confirmation Data for uncleared swaps as they already have access to without undergoing this additional burden. I would note that SEFs must to continue to report all “Primary Economic Terms” data for uncleared swaps – as well as the Confirmation Data they do in fact have – as soon as technologically practicable. I would also note that the counterparties to the trade have ongoing reporting obligations for uncleared swaps.”

To see his full remarks, including greater description for the use of no-action letters for error trades and data, please click here.

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Collateral for Clearing – A Race to the Bottom?

By Miles Reucroft, Thomas Murray
Originally published on TABB Forum

With mandatory clearing approaching, a global collateral shortfall ranging anywhere from $500 billion to as much as $8 trillion is widely anticipated. And since CCPs are competitive entities, there is a fear that they will lower their collateral standards in order to facilitate client clearing and win new business. But we will not know how great the collateral shortfall is, or how far the race to the bottom has been run, until clearing participants start to default.

A race to the bottom in collateral terminology refers to the potential for a downward spiral to occur in the acceptable quality of collateral to be posted at central counterparty clearinghouses (CCPs). Individual eligibility criteria at each CCP, which are operating as competitive, for-profit entities, added to an anticipated collateral shortfall in the market is resulting in very real fears of a race to the bottom taking place.

How bad any race to the bottom becomes, if it even becomes a reality at all, depends on how big the collateral shortfall is. While the exact number is an unknown, with estimates widely ranging from around $500 billion to $8 trillion, there is, by and large, a consensus that there will be a collateral shortfall; that there exists insufficient quality collateral to satisfy the post-crises regulatory environment.

In the event of a collateral shortfall, how will market participants be able to margin their positions at CCPs? CCPs will be taking initial and variation margin to offset the risk of a potential default in a trade, acting as the do as a buyer to every seller and a seller to every buyer. If one party cannot make good on its position, the CCP will step in and complete the transaction, utilizing that clearing participant’s margin and default fund to do so.

If market participants cannot obtain eligible criteria to post as margin in order to clear, then what can they do? Clearing will soon be unavoidable, standing as it does as one of the central tenets of the G20 response to the post-2008 financial crises that swept through global financial markets.

CCPs are competitive entities and there is a possibility – a fear, even – that they will lower their collateral standards in order to facilitate client clearing, helping them to win new business.

Market participants have a number of collateral demands placed on them currently, and knowing where their assets are and what they can be used for is crucial from a competitive view point. If assets are ineligible, then market participants can undergo a collateral transformation process – changing ineligible collateral into eligible collateral.

“Something has to give,” says John van Verre, global head of custody at HSBC Securities Services. “Either collateral transformation will have to become very, very efficient, or the acceptable standards of collateral will have to drop.”

With transparency and safety being two of the buzzwords about the shift to mandatory clearing, it is counterintuitive to allow the acceptable standards of collateral to drop. Regulatory interference in this area at the CCPs and how they should be capitalized are two outstanding questions to be resolved as mandatory clearing approaches. While there are capitalization rules in existence, the structure and adequacy of the default waterfall – how collateral posted as margin will be used and to what to degree – remains a topic for discussion.

“Collateral management is one of the biggest challenges facing our clients,” continues van Verre. “They need to know where their assets are and how they can be utilized. With central clearing they must appoint a clearing broker who accesses a CCP – keeping track of assets is not a straightforward, two-way relationship. They must also work out how to most effectively use this collateral and if needs be, what they can most efficiently transform, bearing in mind that their assets are not just to be assigned to CCPs.”

The demands on collateral are, seemingly, ever increasing. Exchange-traded derivatives have been collateralized since time immemorial, but the shift to clearing and margining over the counter derivatives is where the bulk of the demand will now come from. Aside from cleared OTC transactions, there are also non-cleared OTC transactions that will need collateral posting against them as well. The non-cleared world will be a more expensive place than the cleared one, too.

Portfolio margining and compression at CCPs is one way of reducing the demand for collateral at CCPs. Compression is, in effect, very similar to netting, so while it clears up the balance sheet, it may not result in much reduction for collateral requirements.

Another collateral demand being faced by the market comes from the FSAP (the Financial Sector Assessment Programme) from the IMF (International Monetary Fund). One of the FSAP recommendations is the central clearing of repo transactions. If all repo transactions are to be run through CCPs, then you would, in a lot of cases as regards collateral transformation, be collateralizing the collateral – the demand for collateral would rise even further, making the shortfall greater. Central clearing of repo transactions is already underway; LCH.Clearnet runs a repo clearing arm, for example. But if it were to be extended to mandatory status, the collateral demands would be vast.

With this in mind, where is the supply of collateral coming from? There is an estimated $60 trillion of government debt in issue. This, clearly, is enough to cover any shortfall, a few times over. But the debt being in issuance and the debt being readily available for use as collateral are not the same thing.

A lot of government bonds have been purchased by central banks as part of the quantitative easing process. As an example, it is estimated that the Bank of Japan, operating in an economy that is just coming out of a 2014 recession, will own 40 percent of Japanese Government Bonds by the end of 2016. All quantitative easing is achieving, in some cases at least, is the monetization of debt, since central banks are buying up government bonds from banks in exchange for cash. The central banks are unlikely to lend out these purchases to participants in CCPs.

As you can see from the below chart, which represents the percentage of the industrialized world that is operating at or even below 0 percent Policy Rates, there is not a lot of new government debt in issuance:

da comm  4 8 a resized 600

How can market participants get hold of the government bonds from central banks? Well, they cannot. The vast majority of government bonds are held by parties that have no intention of lending them out. The collateral models that are operated by firms such as Euroclear and Clearstream will have to make the cost of lending them out very attractive. The knock-on effect of this is that the cost of borrowing would increase, making the cost of collateralizing OTC trades too expensive to make the trading activity viable.

The CCPs themselves are aware of this. A recently published paper from LCH.Clearnet, “Stress This House: A Framework for the Standardized Stress Testing of CCPs,” makes no mention of collateral. As soon as collateral is factored in, it makes the calculations impossibly complex and would have to rely upon the use of government debt. If equities are to be an acceptable form of collateral, then their inclusion in stress testing will weaken those CCPs that accept them.

So those central banks and pension funds that are holding government bonds are unlikely to be willing to put them up for use at CCPs, since there are no guarantees as to the safety of the clearing model.

While there are options available to market participants in regards of collateral transformation and compression, the most cost efficient way of posting collateral is to post what you have available at that time. As CCPs compete, it will be very tempting for them to start accepting lower-quality, more illiquid collateral – especially if the high-quality government debt is inaccessible.

If a CCP finds itself in a position where it has to liquidate a clearing participant’s collateral in order to make good a trade, then it will need highly liquid collateral in order to do so – government bonds fall under this category for countries such as the US and the UK. Until such a time of market stress, the requisite liquidity of the collateral remains unknown. We will not know how great the collateral shortfall is, or how far the race to the bottom has been run, until clearing participants start to default.

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Derivalert’s Top 10 News Stories of the Year: 2014

Just twelve months ago, as we turned the corner from 2013 to 2014, it looked like some of the derivatives reform upheaval was starting to subside – at least in the U.S.  Final SEF rules had been passed; swaps were being made-available-to-trade; we survived the government shut-down. By most accounts, things were transitioning in an orderly fashion in the U.S. and Europe looked like it was going to be the center of the action.

In fact, as we wrote in the January 15, 2014 edition of the DerivAlert newsletter: “It feels like déjà vu all over again as the headlines about European derivatives reform start to pile up on both sides of the Atlantic.  Just as we saw last year in the U.S., as each new rule implementation deadline draws closer, the fever pitch of industry concerns grows louder.”

We were partly right.  European derivatives reform did intensify over the course of 2014.  But so did the ongoing scrutiny of U.S. reforms, with the jury still out on what the final impact of the transition to SEF trading of derivatives will be on the industry.

But what were the absolute biggest stories of the year?  To find out, we dug into the analytics to find out which posts were the most viewed over the course of 2014. 

Here they are in descending order, as chosen by you, the DerivAlert reader, our top ten news stories of 2014:

10) Packaged Swaps Get SEF Go-Ahead

By Mike Kentz
Published May 3, 2014, IFR

Multi-legged swap transactions are set to make the move to swap execution facilities after the CFTC confirmed a set of phase-in dates. The decision finally removes a major industry bugbear, as the delayed migration of packages towards mandatory SEF trading was seen to be hampering volumes on the new regulated platforms. 

full article  (subscription)

9) Wall Street Gets Three-Month Delay on Interest-Rate Swap Mandate

By Silla Brush
Published February 10, 2014, Bloomberg

U.S. banks and other financial firms won a three-month delay for as much as half of the interest-rate swap market to meet a federal requirement to trade on platforms designed to increase competition and transparency.

full article  (free)

8) Thousands of Derivatives Users Not Ready for EMIR Reporting

By Fiona Maxwell
Published February 4, 2014, Risk

With just over a week left on the clock, regulators are said to be worried the market is not ready for the start of mandatory trade reporting under the European Market Infrastructure Regulation (Emir). According to some estimates, a little over 8% of the region's derivatives users have so far registered for the preliminary legal entity identifier (LEI) that will allow them to report their over-the-counter and listed trades.

full article  (subscription)

7) Time for a Change in Derivatives Trading

By Anish Puaar
Published April 21, 2014, Financial News

The clock has finally started ticking down to one of the most substantial changes ever seen in the European market for over-the-counter derivatives, a significant part of the global market worth €692 trillion at the end of June 2013, according to the Bank for International Settlements.

full article  (subscription)

6) SEF Execution of Package Trades to be Postponed

By Peter Madigan
Published November 6, 2014, Risk

CFTC chairman confirms no-action relief extension due to lack of market readiness.

The Commodity Futures Trading Commission (CFTC) is to postpone the migration of the most complex package transactions into swap execution facility (SEF) trading after recognizing that US swap market participants are not prepared to execute them on the trading venues.

full article  (subscription)

5) CFTC Said Ready to Push Interest-Rate Swaps to Trading Platforms

By Silla Brush
Published January 9, 2014, Bloomberg

The Commodity Futures Trading Commission is poised to push interest-rate and credit swaps onto trading platforms designed to make prices more transparent and competitive.

full article  (free)

4) Many Firms Will Not Meet EMIR Reporting Deadline, Says ISDA’s Pickel

By Tom Osborn
Published January 27, 2014, Risk

Many market participants will not be able to comply with new European derivatives reporting requirements when they take effect next month, and will have to rely on regulatory forbearance, according to Bob Pickel, chief executive of the International Swaps and Derivatives Association, who was speaking at a legal conference today in the Netherlands.

full article  (subscription)

3) SEF Trading Volumes Emerging from Summer Doldrums

By Ivy Schmerken
Published September 18, 2014, Wall Street & Technology

Despite the summer doldrums of SEF trading in interest rate swaps, activity in early September is showing signs of a rebound as traders conduct more of their business on the electronic venues. Tradeweb Markets announced Wednesday that average daily volume on its TW SEF for trading of interest rate swaps increased 20-fold to more than $20 billion in the first two weeks of September, over the first two weeks of trading on SEFs in October 2013.

full article  (free)

2) Make or Break Time for SEFs

By Mike Kentz
Published May 17, 2014, IFR

Two swap execution facilities have parted ways with their CEOs in the last two weeks in what market participants believe could trigger attrition across the 24 registered platforms. Consolidation has been predicted since the beginning of SEF discussions, but in a surprise turn it could be occurring just as volumes are set to receive a boost. 

full article  (free)

1) SEF Merger Talk Grows Stronger

By Mike Kentz
Published June 14, 2014, IFR

The saturated U.S. market for over-the-counter swap execution is on the cusp of the first wave of consolidation, just four months on from the first mandated execution of standardized derivatives on newly created swap execution facilities.

full article  (free)

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Assessing Regulation, Technology & Risk: Three Steps to Ensuring a Happy New Year

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?

Looking Back

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.”

Looking Forward

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.

Trading Technology

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.

Market Risk

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.

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