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2015 – A Year in Market Milestones: Tradeweb’s Billy Hult

By Billy Hult, Tradeweb Markets
Originally published on TABB Forum

2015 will go down in history as a milestone year for global financial markets. Meanwhile, the marketplace has continued to evolve in significant ways that have drastically impacted trade workflows and the business of trading fixed income and derivatives. At the center of the global government bond marketplace, here are the most significant events influencing trading over the course of 2015.

2015 will go down in history as a milestone year for global financial markets. Consider the list of monumental, one-of-a-kind market events, which reads like the résumé of an outrageous political candidate known for his liberal use of superlatives:

  • Record low yields in German 10-year Bunds

  • Largest one-day increase in Greek government bond yields on Tradeweb

  • Widest 10-year U.S. Treasury swap spreads in history

  • Highest yields in over 5 years for short-term U.S. Treasury notes

There’s no question about it: In the years following the financial crisis, the rates markets have become a macroeconomic seismograph, delivering an immediate feedback loop for global activity and uncertainty. Consider the performance of Eurozone debt, where yields for core and peripheral countries appeared in an un-choreographed dance. And in the U.S., the Federal Reserve’s long awaited decision to raise interest rates kept investors on baited breath all year long as yields gyrated on short term Treasury debt.

Meanwhile, the marketplace has continued to evolve in significant ways that have drastically impacted trade workflows and the business of trading fixed income and derivatives. The corporate bond landscape is in a new renaissance for electronic trading, introducing new protocols and functionality into the marketplace, and the dialog on algorithmic and high frequency trading in rates has reached new highs as market participants evaluate new and different ways of engaging liquidity.

Over the past 12 months, Tradeweb Markets has kept a watchful eye on all these moves in fixed income markets as a means of benchmarking the magnitude of different monetary and geopolitical events. At the center of the global government bond marketplace, here are the most significant events influencing trading over the course of 2015:

Negative Government Bond Yields Throughout Europe

In January 2015, nearly one quarter of all Eurozone government bonds were yielding below zero percent.

This meant investors were paying for the privilege of lending to central banks. There were a number of reasons for this phenomenon. For one, the European Central Bank (ECB) had cut interest rates to below zero and initiated bond repurchasing to prop up the economy. And despite the negative yields, asset managers continued to hold fixed income instruments in their portfolios, keeping the bond-buying spigot open throughout the dislocation.

On January 22, the ECB announced its intention to purchase government bonds yielding above the deposit facility rate of -0.20% as part of its easing program that launched on March 9 – leading to a 33% increase in European government bond trading volume in January v. December 2014. Yields continued to fall, however, and the percentage of Euro-based government bonds with a negative yield increased to 38.03% on April 14. A sell-off set in and Euro area government bond yields moved upwards again, and the percentage of negative-yielding instruments fell back to 22.21% by June 10. On the same day, the 10-year Bund mid-yield closed at 1%–its highest level since September 23, 2014.

The summer brought speculation that the ECB would ease monetary policy further, and Mario Draghi announced that the governing council was ready to do so on September 3. Yields for bonds with shorter tenures plunged to new record lows by December 2, a day before the ECB lowered its deposit rate to

-0.30%, a move expanding the universe of bonds eligible for purchase under the ECB QE scheme.

The chart below depicts the bid yield on the 2-year German note over the past 12 months and shows the trend in stark relief, with negative yields for the entire 12-months of 2015.

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Negative Swap Spreads

In the U.S., one of the more notable market dislocations of 2015 has been the inversion of the 10-year interest rate swap spread, which turned negative in September and has stayed there ever since.

The 10-year interest rate swap spread measures the cost for investors to exchange floating-rate cash flows for fixed-rate cash flows in the interest rate swaps market. It had been falling since July of 2015 in anticipation of an interest rate increase by the Federal Reserve, but also in response to surging supplies of corporate debt and persistently low yields on U.S. Treasury securities.

The benchmark spread is calculated by adding the bid yield of the 10-year U.S. Treasury note to equivalent U.S. dollar denominated interest rate swap spreads. As the chart below indicates, 10-year swap spreads first went negative on September 25, closing at -1.75 basis points. The spread continued to widen to a record low of -16.75 basis points on November 20. Since then, the spread has been on a tightening trend, but is still holding in negative territory at -5.5 basis points.

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U.S. Treasury Yields Start to Climb on Fed Rate Rise

Perhaps the biggest market data event of the year was also the most hotly anticipated – the U.S. Federal Reserve ending its seven-year run of keeping the Federal Funds Rate at zero percent, with a historic decision to raise rates for the first time since 2006 on December 16, 2015.

The results were immediate as trading volume increased 10% from November. The bid yield on the 2-year U.S. Treasury note reached its highest level in more than five years, rising above 1.0% for the first time since May 3, 2010. A similar, but less dramatic move unfolded in the 10-year U.S. Treasury note, which closed at 2.29% on the day of the Fed announcement, up 2.3 basis points from the previous day.

The following chart depicts the 12-month trend in the 2-year U.S. Treasury yield as it has slowly climbed from a low of 0.444% in January to 1.064% in December.

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Central Bank Policy Divergence Widens Further

However, the U.S. Federal Reserve was the only major central bank to tighten monetary policy in 2015.

The ECB, on the other hand, boosted quantitative easing and other central banks maintained their own expansionary measures.

This divergence was highlighted in December 2015 when the Federal Reserve became the first major central bank to raise interest rates since the financial crisis, despite a low inflation rate of 0.5% in November. In contrast, the ECB announced it would extend quantitative easing until March 2017 at the least, and also cut its deposit facility rate to -0.30%. This move came amid low Euro area inflation – 0.1% in November – but promising GDP growth rose steadily from 1.2% in Q1 2015 to 1.6% in Q3 2015. European government bonds generally traded significantly lower than their US counterparts, with 32.26% of the total issued amount yielding less than zero as of December 2.

Similarly, the Bank of England and the Bank of Japan maintained their asset purchasing programs in 2015, worth £375 billion and ¥80 trillion respectively, while Sweden’s Riksbank boosted its own plan by another 65 billion kronor (€6.9 billion) in October.

Political Uncertainty Tests Europe’s Peripheral Economies

A year of political uncertainty exposed a drop in public support for bailout commitments and strict deficit reduction targets in Greece, Portugal and Spain amid bond market volatility.

The threat of a Greek exit from the Eurozone, following the nation’s default on its rescue loan from the International Monetary Fund, increased as the newly-elected anti-austerity government sought to renegotiate the terms of its bailout. On June 29, at the height of speculation over how Greece would move forward, yields on the 10-year Greek government bond surged to their highest levels since 2012, when the nation’s debt was restructured. Yields on the Greek 10-year bond closed at 15.43% on June 29, after rising 462 basis points in a single day. It was the largest one-day yield move since electronic trading of Greek government bonds began on Tradeweb in 2001. The upward spike continued until its peak of 19.23% on July 8, when a bailout package was finally announced.

Meanwhile in Portugal, Socialist leader António Costa was appointed prime minister on November 25, ending six weeks of political uncertainty after October’s inconclusive election result. Yields on Portuguese 10-year bond rose to 2.85% on November 9, but finished the year at 2.52%, nearly a full percentage point above its lowest closing value of 1.54% on March 16.

Meanwhile in Spain, the December 20 election left the country without clear leadership as the incumbent Popular Party failed to secure a majority. The Spanish 10-year government bond finished 17 basis points higher over the year at 1.77% – comfortably between its lowest closing mid-yield of 1.08% on March 11 and the highest closing mid-yield of 2.37% on June 15.

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Regulation Sharpens Focus in Europe and Asia

2015 saw the European Securities and Markets Authority (ESMA) make considerable progress in writing the rules that will implement mandatory clearing and trading for OTC derivatives. On December 21, the regulatory technical standards (RTS) went live for the first instruments mandated to clear under the European Market Infrastructure Regulation (EMIR).

Additionally, ESMA further developed and consulted on rules to implement the Markets in Financial Instruments Directive II (MiFID II) and Markets in Financial Instruments Regulation (MiFIR). These rules include specific aspects of the new pre- and post-trade transparency for numerous asset classes, including OTC derivatives and ETFs, as well as a mandatory trading obligation for derivatives. And on September 28, ESMA delivered its final RTS to the European Commission, which are expected to be adopted during the first half of 2016.

However, the industry widely expects delays to the January 2017 implementation of these rules so that regulators gain ample time to build the necessary systems and infrastructure for surveillance and monitoring. Market participants and trading venues haven’t slowed down in the meantime, working together to interpret available rules and information in preparation for the transition to a new regulatory regime.

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Japan was the first country in Asia to introduce mandatory electronic trading for specified OTC instruments on September 1, 2015. The Financial Services Agency now requires institutions with derivatives positions greater than ¥6 trillion to execute 5-, 7- and 10-year yen swaps on regulated Electronic Trading Platforms (ETPs), which must then publish trade-related information.

The first transactions under the new regime were completed on the same day the rules came into force. And e-trading has grown rapidly, with more than ¥2 trillion traded across five different ETPs in September, led by Tradeweb accounting for ¥765 billion alone (ClarusFT data).

Elsewhere, authorities in Australia are developing proposals for their own electronic trading mandate, while legislators in Hong Kong and Singapore have been drawing up requirements for reporting and clearing. In Singapore, even though the country’s Monetary Authority previously stated that it does not intend to introduce an e-trading mandate for derivatives, it has nevertheless proposed putting in place the necessary legal framework for its potential implementation. We’ll continue to see greater implementation of new regulations in 2016 as clearing obligations come into effect and approval of new rules are expected before the third quarter.

Innovation Grows in Transaction Cost Analysis

As electronic trading has driven greater efficiency in the fixed income workflow, the availability of new information to interpret and manage trading activity continues to increase the focus on business performance. Compounded by upcoming regulatory reform in some regions and demand for improved compliance and monitoring tools, transaction cost analysis (TCA) for the bond markets is beginning to take hold.

In the equities markets, firms have had access to analytical solutions for TCA for years. However, the availability of such tools in the fixed income space has only just come to the forefront, as more robust trading information has become more readily available and tracked in electronic workflows.

With real critical mass in electronic trading of government bonds, firms like Tradeweb have begun to introduce new analytics that help institutions better understand their trading activity and support efforts to ensure best execution. Connecting the point of execution directly with systems to process and view TCA has introduced a new level of transparency into fixed income trading desks. Most importantly, this new information is helping organizations continue to become more intelligent and efficient in their counterparty selection and discovery of liquidity. And on the back-end, risk and compliance managers have a real view of trading activity, benchmarked against aggregate market data, like Tradeweb’s composite pricing and other post-trade reports.

However, there is new ground to cover as TCA offerings continue to expand beyond government bonds, European credit, covered bonds, supranationals, agencies and sovereigns. As new regulation increases the quality and availability of post-trade information around the globe, we’ll continue to see new applications for TCA to enhance best execution and overall trading operations.

Popularity in Fixed Income ETFs Climbs Higher

Exchange-traded funds (ETFs) have enjoyed consistent, fast-paced growth in assets since their launch more than two decades ago, exceeding $3 trillion in assets worldwide in May 2015. However, ETF liquidity and the way in which it trades has continued to evolve in different ways.

Now in its fourth year, the Tradeweb European-listed ETF marketplace represents one of the largest venues for ETF trading in Europe. European ETF volume surpassed €112 billion on Tradeweb in 2015, with nearly one third of the overall activity resulting from the growing use of fixed income ETFs in Q4. This represents an interesting trend in how market participants are leveraging request-for-quote and other protocols to gain best execution in an otherwise fragmented marketplace.

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Off-exchange trading continues to gain traction with the institutional fixed income community as they have begun accessing greater levels of liquidity through new trading protocols. And investors are quickly learning about the liquidity benefits of fixed income ETFs as they seek new ways of managing risk, especially in the corporate bond market.

Tradeweb is working with the industry to help support this crossover in trading of traditional equities products by fixed income investors, and partnered with BlackRock iShares and State Street to help develop new standards for analysis, evaluation, and calculations for converting yield, spread and duration with fixed income ETFs into identical terms for the underlying bonds.

Investors are also taking advantage of new post-trade reporting and access to dealer axes on venues like Tradeweb, introducing new data to inform better counterparty identification and improve access to liquidity. This has been so impactful, hit rates have shown to increase by five percent when sending a request-for-quote to axed dealers, and by ten percent when trading fixed income ETFs. And as market participants prepare to trade ETFs under MiFID II in Europe, we’ll continue to see even greater adoption of e-trading ahead of mandatory reporting coming into effect.

Derivatives Trading Outlook for 2016

2015 was a banner year for the electronification of derivatives markets, and some of the key issues and advances in swap trading seen to date may serve as indications for what’s next in the twelve months ahead. Market participants are leveraging new tools to source liquidity and optimize portfolios, while keeping a watchful eye on regulatory reforms in Europe and Asia. Average daily trading volumes on Tradeweb have increased to more than USD $30 billion on TW SEF. In addition, the platform has seen approximately 75% of D2C block trading, as of October 2015, according to ClarusFT.

The factors driving this growth include increased use of tools like buy-side compression, which helps improve line-item management at derivatives clearing organizations (DCOs), and the adoption of products like market-agreed coupon (MAC) swaps, that offer standardization to ease the process of rolling positions.

We expect innovation will continue in the U.S., Europe and Asia. Japan has already had a successful launch of electronic trading platforms (ETPs), and in the near future European market participants will focus their resources on the upcoming clearing mandate and the eventual trading and reporting reforms under MiFID II.

As swap trading continues to adapt to new regulatory requirements and we continue to see an increase in electronic trading, technological solutions are helping increase transparency, efficiency and compliance for all participants.

Record Corporate Bond Issuance Amid Rising E-trading

Bond sales by investment grade American corporations eclipsed the $1 trillion mark by September of last year, putting 2015 squarely on track for a record-setting pace of corporate bond issuance in the U.S. A similar trend has played out around the world, with the notional dollar value of global bond sales topping $2 trillion in December, not quite a record, but among the top four most active years for global bond deals in the last two decades.

The drivers of this trend are no mystery. Seven straight years of record-low interest rates have made the allure of cheap debt too hard to ignore for companies looking to raise funds and incremental improvements in the economy have given yield-starved investors the confidence they need to buy corporate debt.

Increasingly, the task of creating liquidity in the enormous market for corporate bonds is falling to electronic trading platforms. According to a December report from Greenwich Associates, the share of investment-grade bonds that trade electronically has doubled over the past two years and now makes up 20% of total market volume.3

Firms like Tradeweb are helping to drive this adoption with new methods of counterparty identification and streamlining trade workflows. For example, integrating its U.S. credit platform with its Treasuries marketplace, Tradeweb has deployed the industry’s first fully automated Treasury spotting tool. This significantly reduces a relatively manual and tedious process for hedging the interest rate risk of corporate bond trades, while reducing the likelihood of human error in the process. As we approach the brave new world of a rising rate environment, tools that improve the overall workflow and aid in the discovery of liquidity will gain even greater relevance in supporting greater efficiency in the marketplace.

Evolution and Progress of Algorithmic Trading in Fixed Income

Algorithmic trading firms now account for 60% of activity in electronic Treasury trading, up from 45% in 2012, according to TABB Group research appearing in The Wall Street Journal. That’s a staggering number when you consider that the market for U.S. Treasuries, arguably the most liquid market in the world, is currently valued at about $12.7 trillion.

The growing presence of algorithmic traders in the Treasury market has been met with a combination of enthusiasm and caution on Wall Street. Proponents of the tech-enabled approach to rapid-fire trading have consistently shown that the increased order flow they create has improved liquidity and makes pricing less volatile.

Regulators haven’t been as clear-cut in their support for the algorithmic evolution of Treasury trading, and have been hard at work since the “flash crash” in Treasuries on October 14, 2014. But this November, the Commodity Futures Trading Commission (CFTC) proposed new rules as part of its regulation on automated trading (Reg AT) that will allow regulators to inspect the source code algorithmic traders use to guide their trading activity without a subpoena – a new step forward in oversight of the market. Trading industry groups have voiced concern that the rule exposes algorithmic traders’ proprietary information to third party security risk and could potentially undermine competitive advantage.

Though buy- and sell-side demand, and liquidity within the institutional marketplace remains rooted in disclosed, request-for-quote trading, the debate over all forms of electronic trading in rates markets is bound to grow in the coming years.

Looking Ahead to 2016

While it’s impossible to predict the future, many of the issues that drove such significant market moves this year are still very much a factor for the year ahead. With stimulus still being pumped into European markets, a great deal of fixed income supply still owned by the U.S. Federal Reserve and continued concerns about market liquidity prevalent across all corners of the financial marketplace, it’s a safe bet that we haven’t seen the end of recent volatility.

This feeling of uncertainty is familiar, like when the industry first began working on reform under Dodd-Frank over five years ago: a commitment to preparation and improved operational performance. Whereas derivatives continue to provide market participants with effective risk management, access to efficient trading tools on SEFs will result in increased adoption of solutions like buy-side compression, and standardized instruments such as market-agreed coupon (MAC) swaps. When new products are made available to trade on SEFs, the scale of e-trading will increase.

Meanwhile, the global credit marketplace is warming up to new operational efficiencies afforded by electronic trading. We’re still in the early stages, but clients have begun to leverage a range of new technology to improve their ability to source liquidity, gain quality execution, and improve workflows at lower costs.

Similarly, trading in U.S. Treasuries will continue to hold its share of the spotlight, especially as the roles of market participants are changing and influencing liquidity. As the leading venue supporting Treasury trading in the institutional, wholesale and retail communities, we’re looking forward to leading the technical revolution by providing more efficient solutions, more liquid trading platforms, and more connections to more industry participants.

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Swap Execution Facilities: What’s Next?

By Ivy Schmerken, Flex Trade Systems
Originally published on TABB Forum

Despite the shift to electronic trading in the swaps market, the vision of a buy-side trader sitting in front of a screen with the ability to anonymously click on streaming prices from multiple SEFs could be several years away. But new liquidity providers could be catalysts for change in market structure.

This is part 2 of a series on SEF trading. View part 1: “SEF Trading: Challenges and Regulatory Hurdles

The U.S. ecosystem for swap execution facilities continues to evolve, but not as rapidly as regulators and lawmakers anticipated. Despite the shift to electronic trading, some observers question if swaps trading has reached a new equilibrium. The vision of a buy-side trader sitting in front of a screen with the ability to anonymously click on streaming prices from multiple SEFs could be several years away. However, new liquidity providers could be catalysts for change in market structure, suggested speakers at a recent webinar.

An Oct. 29 webinar, “Swap Execution Facilities: What’s Next?” hosted by Greenwich Associates, examined a range of issues impacting SEFs, including buy-side behavior, the entrance of non-bank liquidity providers and new trading protocols. Executives from firms including Citadel, Global Trading Systems and Javelin Capital Markets participated in the discussion.

Currently, swaps trading volume is concentrated with the top dealers. According to a Greenwich study on interest rate derivatives, more than 60% of dealer notional weighted market share of buy-side trading in interest rate derivatives was executed through the five top dealers. Only 24% went through 6-10 dealers and 13% was sent to 11-20 dealers.

“One of the main goals of Dodd-Frank was to diversify the liquidity landscape to reduce systemic risk, so if one market player was to malfunction, there would be plenty of players to pick this up,” said Kevin McPartland, head of market structure and technology at Greenwich during the webinar. The concentration levels began to increase in 2012 and this year are as high as they were before the financial crisis, noted McPartland.

Panelists cited the demand for non-traditional liquidity providers, predicting they will bring more liquidity and competition into the swaps market. But new entrants need to operate at the top of their game in order for the customers to reconsider their existing relationships.

In July 2014, Citadel, the market-making unit of the Chicago-based financial firm, began making markets on SEFs, according to an article in RiskNet. The trading powerhouse is said to be making a significant difference by providing firm quotes on SEF platforms, noted one webinar panelist. “The question is why more new liquidity providers haven’t come into the market and what is the impediment to them?” asked McPartland.

Mandatory clearing and the requirement that all swaps must trade on electronic venues was supposed to mean that firms no longer had to worry about with whom they traded. The idea was that people could focus on best price and trade through multiple dealers.

One impediment is that RFQ is too slow for high-speed trading firms that would like to enter the swaps market as liquidity providers. Computerized trading firms that are players in the equities and futures markets reportedly are eyeing the swaps market, but progress has stalled, according to Bloomberg News.

“The current electronic version of swaps trading, called request for quote, isn’t well-suited for computerized firms because it involves traders negotiating prices rather than computer programs deciding when to buy and sell,” the article says. Such firms trade in the futures exchanges, where computers match client orders based on central limit order books. These firms would prefer a more exchange-like market for swaps, according to Bloomberg.

Counting on Alternative Liquidity Providers

The value of new liquidity providers is the potential for greater diversification of liquidity, which benefits the buy-side firms as consumers of liquidity. Having a large number of liquidity providers is a way to facilitate innovation in market structure, said one panelist. New liquidity providers can differentiate themselves by providing firm prices and innovation. They also think about applying technology to the workflow, which is not what the existing market making firms are historically great at, added another panelist. One wholesale liquidity provider on interdealer-broker (IDB) platforms explained that the purpose was to provide better liquidity to the banks so that the banks, in turn, will use this liquidity to improve liquidity for their clients.

Non-traditional liquidity providers also tend to bring a technical capability to the equation. Most buy-side firms would rather trade faster, not slower, and have live prices, a panelist said. Alternative liquidity providers can facilitate market structure changes that require new pricing and faster technology, but they must also work together with large firms that bring capital and large franchises.

Buy-Side Behavior and Swap Execution Facilities

“Buy-side firms now have the technical capability to execute swap trades on SEFs, so why aren’t they changing their behavior?” asked McPartland. The SEFs operate central limit order books, but SEF operators have cited low demand for these venues.

People have adjusted to so many changes, such as implementing clearing and data reporting, there is no appetite to change workflows, suggested one panelist. Buy-siders are content taking prices, rather than making prices, he said.

In terms of trading protocols, the market is still dominated by request for quote trading on SEFs, and the clients are comfortable with it. RFQ is a good way to move a large order and remain anonymous, notes a technology source not participating in the webinar.

Most of the dealer-to-customer volume is happening on two SEFs, with disclosed RFQ with the dealers having the last look at prices, said one of the panelists. The interdealer volume has moved to SEFs but is bifurcated between five IDBs and Dealerweb (operated by Tradeweb) handling all the dealer-to dealer-volume and very little buy-side volume. Block trades are still created the old fashion way, by voice, and then subjected to breakage agreements and clearing, noted the panelist.

McPartland asked if there’s a need for more trading protocols to encourage new liquidity providers to step in. The introduction of firm prices is new to the swaps market, said one speaker. Traditionally, someone would get a price, but the dealer would have a last look and either accept or reject it. Other market makers are looking to replicate their experience in fixed income over to swap trading venues. One panelist said his firm is applying RFQ to live streaming prices, which is similar to clicking a price on a central limit order book.

Panelists concurred that customers want a better RFQ process, but they don’t necessarily want a so-called central limit order book, or CLOB. As far as needing more trading protocols, customers have a variety of competitive platforms to pick from. There isn’t a massive desire to change the way they trade, the source said.

While there’s been a lot of talk about CLOB trading and why it hasn’t taken off, one panelist said it takes a lot for buy-side clients to change their workflow. After going through the clearing mandate, buy-siders are not keen to change their workflow processes. In addition, impediments such as lack of average pricing and lack of anonymity with the interdealer SEFs continue to exist. Though many on the buy side say they want CLOB trading, it won’t happen until all the pieces are in place and the market is ready, suggested one panelist.

However, SEFs are gearing up for a changing ecosystem. More standardized swaps known as Market Agreed Coupon contracts, or MAC swaps, are expected to appeal to buy-side firms. MAC swaps, which emerged in 2013, have a range of pre-set terms, including start and end dates, coupons, currencies and maturities, similar to interest-rate futures.

“We have a MAC swap order book, outright rates in multiple currencies, and are connected to platforms such as UBS NEO,” explained Michael Koegler, Managing Director, Marketing & Strategy, at Javelin Capital Markets, LLC, speaking on the Greenwich Associates webinar.

Panelists predicted that the stage is set for more adoption of new innovations and styles of trading over the next few years. “If alternative liquidity providers enter the swap market to provide liquidity, they will get a good reception from the buy side,” said Koegler.

It remains to be seen whether MAC products are the tipping point that will push the buy side toward the era of standardized swap trading.

Up to the Buy-Side?

Now that the dust has settled with the clearing mandate, the onus is on the buy side to connect with different platforms or agency desks offering aggregators, panelists said. In the meantime, the industry could see some venues emerge as order books and others as RFQ venues, borrowing practices from each other.

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Regulation Is Transforming the OTC Market. Compliance Is a Journey, Not a Goal

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

Within the next 18 months, the impact of mandatory clearing and the margin on bilateral OTC trades will begin to reshape the global OTC market, driving changes in participants’ technology and businesses. Many firms might choose to scale back their short-term compliance investments until there is even greater regulatory clarity.

For many involved in regulatory compliance, the work has only just started. For CCPs, the scramble to achieve authorization under EMIR hit a crescendo in September 2013. Just five months later, the introduction of OTC trade reporting for EMIR brought a flurry of activity and much chaos. The pace of regulation hasn’t slowed since then, and neither have the intense demands to remodel internal processes. However, with some of the biggest and most impactful regulatory developments still to take place over the next 18 months, many firms might choose to scale back their short-term compliance investments until there is even greater regulatory clarity.

Trade Reporting

The onset of OTC and ETD trade reporting in Europe in February 2014 created a new industry of trade repositories (TRs) and other services designed to gather, reformat, transfer and reconcile the vast flow of data required by regulators. However, European trade reporting was significantly different from that in the U.S., leading to incompatible data across TRs. In particular, the U.S.’ decision to allow “single-sided” reporting, where one party can report for both entities on a trade, has proven to be much more efficient than the “double-sided” European approach. As a result, a review of EMIR is underway.

Other compliance streams over the next two years include:

  • Level 2 validation by TRs: a tighter requirement for European TRs to reject data that doesn’t meet a higher standard of accuracy than currently

  • Reporting of Security-Based Swaps to the SEC: parallel regulations to the CFTC, but for CDS and other trades within the remit of the SEC

  • EMIR phase 3 reporting: an outcome of the EMIR review

  • Securities Financing Transactions reporting: covers equity and repo trades, plus any collateral swaps

This article doesn’t cover trade reporting regulations outside the U.S. and Europe. One approach for firms to meet these regulations (and the BCBS 239 Risk Aggregation regulations) is to build an internal trade warehouse with the trade parameters and economic factors to satisfy the expanding range of regulatory needs.


Clearing is mandatory in the U.S. for specific transaction types, but doesn’t begin to take effect in Europe until late 2015. Even then, it will take until 2018 for full implementation of the phased timetable:

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While many firms have voluntarily begun clearing in advance of these timelines, the next wave of adoption will be the Category 2 firms in 2016. With the withdrawal of Nomura, RBS and BNY Mellon from the client clearing business, this might be the time that the survivors become profitable. Conversely, more providers may exit the market, which would result in difficulties for the Category 2 firms to obtain access to clearing.

Bilateral Margin

In September 2016, the OTC markets will be subject to the mandatory application of variation and initial margin to non-cleared trades. While the margin requirements are for trades executed after that date, the details aren’t final and may be amended to include backdated trades.

Variation margin (VM) applies from September 2016 to firms with an exposure of EUR3trn or above, and to all firms from 1st March 2017. There are 136,936 non-cleared agreements in use according to the 2015 ISDA Margin Survey, so the introduction of a mandated VM requirement won’t be technologically difficult for many firms. However, the need to make and receive the calls daily will be new to some buy side firms.

The legal challenge is far greater if all of those bilateral relationships need new credit support documents. While the industry looks for a way to simplify the process with standard documents and protocols, the search is laden with obstacles and complexities.

Exchanging two-way initial margin (IM), which requires firms to align their portfolio within five asset classes and apply either a simple schedule-based calculation (that could be costly in margin) or a complex value-at-risk (VaR) approach to all non-cleared trades, is the more challenging mandate.

The IM requirement is phased over a lengthy period until 2020, but will likely have the biggest economic impact (other than capital rules) to OTC businesses since their inception. Few firms apply a broad IM requirement into their collateral agreements presently, and the IM mandate will increase the cost of a complex OTC portfolio significantly. In response, some banks may withdraw their most complex trade structures from use, or even close whole business lines if the IM is too high and difficult to reduce.


While MiFID and its corresponding regulation MiFIR are primarily targeted at securities trading, they also include new requirements for trade reporting and open access rules between exchanges and CCPs.

The introduction of open access rules will allow a CCP to request access to an exchange to clear their trade flow and likewise for an exchange to request access to a CCP to send trades for clearing. The end goal is to allow the free choice of CCP-exchange combinations in the pursuit of horizontal competition, rather than the prevalent vertical alignment seen in today’s markets.

Detractors of open access say that the arrival of multiple CCPs clearing a single exchange venue will split liquidity, as has happened with swap execution facilities (SEFs) for cleared trades, and therefore will not be beneficial in the long run. Supporters say that the opportunity for participants to aggregate one asset class (such as STIR futures) on a single CCP will reduce net margin calls as well as technology and operation costs. The reality of the regulations is hard to predict. Lengthy timetables, opt-outs for small CCPs, and pushback due to liquidity concerns, operational capacity and cost reasons could limit the regulations’ impact.

Another goal of MiFID is to introduce a new class of trading platform, the Organized Trading Facility (OTF), intended to mirror the SEF model in the U.S. At some point, firms may be obligated to execute OTC trades on an OTF much like they are required to do on SEFs in the U.S.

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In the commodities markets, REMIT will introduce trade reporting requirements from late 2015 to early 2016. REMIT also addresses inside information, market manipulation, and market participant registration. It requires all participants in European commodities markets to be centrally registered, and will use the data reported to detect occurrences of inside information and market manipulation. Firms have little time to prepare, as the bulk of REMIT is to be complete by April 2016.


Two remaining regulatory streams focus on capital and risk management. The Fundamental Review of the Trading Book (FRTB) is a fresh look at the models and approaches used to calculate capital requirements. There is an extended period of modelling referred to as the Quantitative Impact Study (QIS) to test proposals for new rules, intended to be a step forward from the previous Basel II and Basel III approaches. BCBS 239 is a parallel and complementary approach to gathering key risk information within a bank. The key Bank for International Settlements (BIS) goals are to:

  • Enhance the infrastructure for reporting key information, particularly that used by the board and senior management to identify, monitor and manage risks

  • Improve the decision-making process throughout the banking organization

  • Enhance the management of information across legal entities while facilitating a comprehensive assessment of risk exposures at the global consolidated level

  • Reduce the probability and severity of losses resulting from risk management weaknesses

  • Improve the speed at which information is available and hence decisions can be made

  • Improve the organization’s quality of strategic planning, and ability to manage the risk of new products and services

The target date for completing the implementation of BCBS 239 is early 2016, so the firms affected will be heavily invested in their compliance efforts throughout the end of 2015.


It’s clear that the various regulatory streams will require financial institutions to upgrade their digital infrastructure to meet extensive reporting and risk management goals. A few key elements include:

  • A trade warehouse with the majority of trade parameters across all asset classes

  • A record of the risk metrics for every trade, and ways to calculate margin and risk factors across multiple trades in multiple asset classes

  • The infrastructure to distribute and report this data to many global venues

  • An approach to verifying the accuracy of the data delivered externally

Within the next 18 months, the impact of mandatory clearing and the margin requirements for bilateral OTC trades will begin to reshape the OTC market; by 2017, we may see a quite different market for OTC products. Don’t let up on the compliance program – we are only at the beginning of the regulatory journey.

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MiFID II and Best Execution for Derivatives

By Amir Khwaja, Clarus
Originally published on Clarus Financial Technology blog

Following on from my recent article on MiFID II and the Trading Obligation for Derivatives, I wanted to look into another key section in the ESMA Final Report; namely the requirements for Best Execution. There are two specific requirements, one for Trading venues and another for Investment Firms.

MiFID II Background

The Final Report deals with Draft Regulatory Technical Standards (RTS) of which there are 28 and describes the consultation feedback received, the rationale behind ESMA’s proposals and details each RTS. The report is now submitted to the European Commission, which has 3 months to decide (Dec 28, 2015) whether to endorse the technical standards.

Assuming that it does so, MiFID II will come into effect in Europe on Jan 3, 2017.

Best Execution and Total Cost Analysis (TCA)

There have been a number of good overview write-ups on Best Execution, two I would recommend are Michael Sparkes of ITG Analytics on Multi-Asset Best Execution and Simon Maisey of Tradeweb on TCA for Fixed Income.

I usually find that diving deep into the detail and coming back up is a good way to grasp the essence of a new regulation. So lets look at the relevant detail in the Final Report.

RTS 27 – Best Execution for Trading Venues

An investment firm has a fiduciary obligation to provide its clients with the best possible results when executing orders. The data required to assess best execution is essential for investment firms to monitor performance from venues and for the buy side to monitor the sell side.

This RTS sets out the data that must be made public for financial instruments subject to the trading obligation.

It applies to venues that can be selected by investment firms for execution of their client orders (e.g. RMs, MTFs, OTFs). As such it would seem to apply to All to All Venues and D2C Venues and exclude D2D only ones (assuming D2D continue to exist in the new market structure). Either-way a large chunk of Swaps trading will be included in the Best Execution requirements.

Frequency of Data Publication

Execution venues are required to publish data four times a year and no later than three months after the end of each quarter. So by 30 June for the period 1 January to 31 March.

This data is expected to be available free of charge in a machine readable format on their websites.

Articles 1 to 12, deal with the specifics of the data.

Article 4 – Price

We will start with the first interesting one, Article 4 on price. This requires price data for each financial instrument to be made available for each trading day with one format for intra-day information and one for daily information.

Intra-day requires the following:

MBE 1 1024x558 resized 600

Meaning that:

  • for 4 specific times of the day (9:30, 11:30, 13:30, 15:30) and

  • for each Size Range, 1 <= Size Specific to the Instrument (SSTI), 2 > SSTI and 3 > Large in Scale

  • for all trades executed within the first two minutes

  • the Simple Average Price

  • the Total Value executed

And if there are no transactions in the 2mins, then details on the first transaction are required as per the next set of column headings in the table, so price, time, size, etc.

Daily reporting requires:

MFBE 2 1024x161 resized 600

So for each trading day and instrument, the four rows above.

Lots of interesting price data indeed. Both point in time and daily averages.

Article 5 – Costs

Costs for execution fees, fees for submission/modification/cancelling or orders, fees for access to market data or terminals and any clearing or settlement fees.

As well as a description of the nature and level of rebates and discounts.

MFBE 6 1024x283 resized 600

Article 6 – Likelihood of Execution

For each instrument and trading day:

MFBE 3 1024x393 resized 600

Which will provide interesting comparative data on pre-trade vs post-trade and between venues.

Article 7 – Additional Information for Continuous Auction Order Book and Continuous Quote

MFBE 4 1024x285 resized 600

Which gives a sense of the oder book at 4 specific points in time for each trading day.

There is a second more detailed table, which I will skip as Order books are less relevant for D2C Swap trading, except to note that it contains the excellent sounding “Number of Fill or Kill Orders that failed”. For those interested, you can find this table on page 536 of the Final Report.

Article 8 – Additional Information for Request for Quote Venues

MFBE 5 1024x287 resized 600

Simple statistics on the time between acceptance and execution and the request and quotes.

That covers much of RTS 27 – Best Execution for Venues.


RTS 28 – Best Execution for Investment Firms

This requires investment firms to disclose annual information on the top five execution venues used for client orders in the prior year for each class of financial instrument, including whether the investment firm itself was one of the top five execution venues.

Classes of Financial Instrument

Those relevant to us today include:

  • Interest Rate Derivatives

    • Futures and options

    • Swaps, forwards and other interest rate derivatives

  • Credit Derivative

    • Futures and options

    • Swaps, forwards and other interest rate derivatives

  • Currency Derivatives

    • Futures and options

    • Swaps, forwards and other currency derivatives

Information on Top 5 and Quality of Execution

Requires the following table to be completed.

MFBE 8 1024x440 resized 600

Expressing volume as a percentage means that potentially market sensitive disclosures on the volume of business being conducted by an investment firm are avoided.

Passive orders means an order entered into an order book that provided liquidity, an Aggressive order means one that took liquidity and a Directed order means one where the execution venue was specified by the client prior to execution.

In addition there is a requirement to publish a summary of the analysis and conclusions the investment firm draws from its detailed monitoring of the quality of execution obtained, including an explanation of the relative importance given to price, costs, speed, likelihood of execution or other factors.

This information is required to be made public in machine readable format on the investment firms website.


That wasn’t so bad was it.

Time for a quick recap.

Trading venues will be required to make public each quarter,  daily information in prescribed formats, for each instrument subject to the trading obligation.

This information will allow Investment firms to fulfil their best execution obligation to clients.

Investment firms will also be required to make public annual information on the Top 5 venues used for each class of financial instrument.

Thats it.

All very sensible and simple.

I plan to cover further aspects of MiFID II, MIFIR and EMIR in future blogs.

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MiFID II and Swaps Transparency: What You Need to Know

By Amir Khwaja, Clarus Financial Technology
Originally published on TABB Forum

The swaps transparency changes driven by MiFID II are meant to establish a level playing field between trading venues so that price discovery of a particular financial instrument is not impaired by fragmentation on liquidity. What do the pre- and post-trade transparency requirements mean for market participants?

ESMA recently published its Final Report on Regulatory Technical Standards for MiFID II. A process that started in May 2014 with a Discussion Paper and then two Consultation Papers finally is nearing completion.

For this article I have read as many of the 402 pages as possible, to try to understand what MiFID II will mean, and while there is a lot of interesting information for Equities, Bonds, Structured Finance Products, Emission Allowances and Derivatives, I will limit my scope to Transparency for Interest Rate Swaps.


The Final Report deals with Draft Regulatory Technical Standards (RTS), of which there are 28, and describes the consultation feedback received and the rationale behind ESMA’s proposals, and details each RTS. The report is now submitted to the European Commission, which has three months to decide (Dec. 28, 2015) whether to endorse the technical standards.

Assuming that it does so, MiFID II will come into effect in Europe on Jan. 3, 2017.

RTS 2 – Transparency Requirements with Respect to Derivatives

RTS 2 has requirements on transparency to ensure that investors are informed as to the true level of actual and potential transactions, irrespective of whether the transactions take place on Regulated Markets (RMs), Multi-lateral Trading facilities (MTFs), Organized Trading Facilities (OTFs), or Systemic Internalizers (SIs), or outside these facilities.

This transparency is meant to establish a level playing field between trading venues so that price discovery of a particular financial instrument is not impaired by fragmentation on liquidity.

Meaning that there are both pre-trade and post-trade transparency requirements.

Post-Trade Transparency

Trading Venues and investment firms trading outside venues are required to make public each transaction in as close to real time as possible and in any case within a maximum 15 minutes of execution, which drops to 5 minutes after Jan. 1, 2020.

Meaning that most trades will be made public within a few minutes of execution and the data will include:

  • Execution date and time
  • Publication date and time
  • Venue
  • Instrument type code
  • Instrument identification code
  • Price
  • Notional
  • Transaction identification code
  • To be cleared or not

As well as Flags to signify details such as Cancel or Amend transaction or Non-Price Forming or Package transaction and many others.

Importantly a time deferral of 2 business days is available for transactions that either are:

  1. financial instruments for which there is not a liquid market, or
  2. large in scale compared to normal market size for the financial instrument, or
  3. above a size specific to that financial instrument trading on a venue, which would expose liquidity providers to undue risk.

We will come back to the definition and operation of each of these.

Pre-Trade Transparency

Trading Venues are also required to make public the range of bid and offer prices and depth of trading interest at those prices, in accordance with the type of trading system they operate. Interestingly, for RFQ markets this means making public all the quotes received in response to the RFQ and doing so at the same time. In addition, RFQ or Voice trading systems are also required to make public at least indicative bid and offer prices, where interest is above a specified threshold.

Which means lots of public pre-trade price information, including depth.

Importantly, this requirement is waived for the following:

  1. Derivatives that are not subject to a trading obligation (clearing and liquid market)
  2. Orders that are large in scale compared to normal market size
  3. Orders that held in an order management facility of a trading venue pending disclosure
  4. Actionable indications of interest in RFQ or Voice that are above a size specific to that financial instrument, which would expose liquidity providers to undue risk.

We now need to tackle the meaning of Liquid Market, Large in Scale and Size Specific to Instrument.

Liquid Market

The assessment for Liquid for Derivatives utilizes two criteria, specified for a Sub-Asset Class and Sub-Class:

  • Average Daily Notional Amount
  • Average Daily Number of Trades

The table extract showing single-currency interest rate swaps in the second row is as below:

1014aa resized 600

Showing that for each maturity (e.g., IRS 5Y), there needs to be an Average Daily Notional of at least EUR50 million and an Average Daily Number of Trades of at least 10.

ESMA will publish by July 3, 2016, its first assessment of which Financial Instruments are Liquid and will do so using data for the period July 1, 2015, to Dec. 31, 2015, and this assessment will apply from Jan. 3, 2017, to May 18, 2018, after which it will be periodic/yearly.

Meaning we will know by July 3, 2016, which are liquid (e.g., EUR IRS 5Y) and which are not (e.g., EUR IRS 13Y).

Large in Scale (LIS) and Size Specific to Instrument (SSTI)

For Pre-Trade and Post-Trade there are distinct thresholds for a Financial Instrument as to what is Large in Scale (LIS) or Size Specific to Instrument (SSTI), and these are lower for pre-trade given the greater sensitivity of this information. These are specified based on a trade or volume percentile.

The table extract for Liquid markets showing single-currency interest rate swaps in the second row is as below:

1014bb resized 600

Showing that for a liquid IRS (e.g., EUR 5Y) pre-trade LIS is 70% trade percentile and SSTI is 60%.

While for post-trade the LIS is 70% volume percentile and SSTI is 60% volume percentile; unless the volume percentile is greater than 97.5% trade percentile, in which case the trade percentiles of 90% and 80% are used (this addresses the bias caused by a very small number of transactions of very large size).

In exceptional circumstances where a liquid instrument does not have a sufficient number of trades (1,000 trades in the period), the threshold floor values would apply.

Again, the same yearly basis determination process will be used.

So we will know the threshold sizes by July 3, 2016, which will then apply from Jan. 3, 2017, to May 18, 2018.

And for Financial Instruments that are determined to not have a liquid market, the following thresholds apply:

1014cc resized 600

Well that completes the definitions and meanings.

Phew! I hope you are still with me.

An Example

Time for a few simple examples.

RFQ for a EUR IRS 5Y in 25m notional size

This will surely be a Liquid Market, meaning that pre-trade, the quotes provided to the RFQ will be made public in real time (as technologically possible) and all at the same time.

And post-trade details will be made public, including execution time-stamp, instrument code, price and size.

RFQ for a EUR IRS 13Y in 25m notional size

This will likely not be Liquid, meaning that no pre-trade quotes will be public and on trade execution only on T+2 business days will details be made public.

RFQ for a EUR IRS 5Y in 200m notional size

This will likely be Liquid and above the LIS or SSTI threshold for pre-trade but below the post-trade thresholds.

Meaning no pre-trade quotes are made public but on trade execution, details will be made public in real time.

RFQ for a EUR IRS 5Y in 500m notional size

This will likely be Liquid and above the LIS or SSTI threshold for pre-trade and post-trade thresholds.

Meaning no pre-trade quotes are made public but on trade execution, details will be made public on T+2 business days.

Final Thoughts

That’s it for MiFID II and transparency.

I am sure you will agree that the transparency changes are profound and significant.

The pre-trade rules in particular are more far-reaching than Dodd-Frank.

There is further detail on Derivatives that I have left out today for clarity’s sake.

And then there is a much wider scope – Futures, Derivatives in Other Asset Classes, Bonds, Equities …

I plan to cover further aspects of MiFID II in future blogs.

I look forward to a world of more data and more transparency.

Roll on Jan. 2017.

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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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