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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:

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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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SEFCON V: CFTC Chairman Massad Discusses Regulations; Extends Package Relief

In his speech at the SEFCON V Conference, CFTC Chairman Timothy Massad outlined the current and future state of affairs regarding swaps trading on regulated platforms. Massad conveyed a pro-markets sentiment in his remarks, continually emphasizing that regulations are not designed to quell the growth of swaps trading, rather they’re aimed at allowing the industry to flourish in a safe, efficient, technologically advanced manner.

After describing broad principles for regulation and noting that swap trading regulation was still in its infancy, he explained he does not want regulation to pose an undue burden on market participants:

“In regard to oversight, we want to make sure it is strong oversight because it promotes integrity and therefore confidence by participants. At the same time, we do not want that oversight to burden participants, particularly the users of these markets, unnecessarily. This is consistent with our general regulatory approach in futures.”

He went on to address specific marketplace concerns about package trades:

“…Packages have been an area of concern. Now, packages might more accurately be thought of as strategies involving multiple products, but whatever name you use, there is no doubt that different types of packages introduce significant complexities as we look to bring them into the SEF and DCM framework. And therefore, basically since the time of the first MAT determinations earlier this year, we have been working with market participants to figure out how to deal with packages in which one leg is a MAT swap. To enable that process, we issued no-action relief earlier this year. For some types of packages, the market has developed technical solutions, and the relief has expired. For others, however, more time is needed.

Consequently, at my direction, the CFTC staff this week have extended previously issued no-action relief so that we continue to work with market participants on phasing in trading for certain types of packages.”

Massad noted that there is a wide range of opinion regarding execution methods and market structure, and stated that “We look forward to listening to market participants on these and other issues that may arise.”

He also addressed cross-border issues, explaining that the CFTC is “committed to harmonizing our rules as much as possible” with its foreign counterparts in Europe and Asia so that firms are limited in their ability to shop for preferred regulatory framework.

To view Chairman Massad’s full remarks, please click here

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The SEF Landscape – Understanding the Changing Marketplace

Greenwich Associates released a new research report on the U.S. derivatives trading marketplace: The SEF Landscape: Beyond the Numbers. The report discusses market activity and trading behavior, and highlights five key areas market participants should be focusing on in evaluating their approach to SEF trading: liquidity, distribution, unique functionality, pricing and service.

We found these areas to be essential to the understanding of the new electronic derivatives trading landscape, and recently hosted a webcast, “Understanding the SEF Landscape with Greenwich Associates,” which included an overview of the report with Kevin McPartland, Greenwich’s head of market structure and technology, and Michael Furman, managing director and head of U.S. rates sales at Tradeweb.

If you were unable to join us for the webcast, but wish to listen to a recording of it, a replay can be accessed here. In addition, please reach out to our sales team at if you would like a copy of the Greenwich Associates SEF trading report.

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Derivatives Plagued by Manual Processing – the Case for Automation

By Jorgen Vuust Jensen, SimCorp
Originally published on TABB Forum

Seventy-nine percent of capital markets firms report that they still rely heavily on spreadsheets and manual processes when processing derivatives, and 84% cite the need to create workarounds to support derivatives in their current middle- and back-office operations.

An increasingly global emphasis on derivatives strategies by asset managers has made the need for straight-through-processing (STP) greater than ever before. In a highly competitive industry, a firm with investment management systems characterized by a high degree of automated workflows and processes is in a better position than competitors that still contend with manual processes and workarounds. However, a new SimCorp poll shows that a large number of firms are still at the mercy of their legacy systems, using manual processes when processing derivatives.  

SimCorp recently conducted a survey of nearly 150 executives from capital market firms in North America to measure how important STP processing is and the current conditions that firms are working with. The poll revealed that 74% consider STP to be extremely important when it comes to derivatives processing. However, further poll results indicate that these needs are not being met by their current systems – 84% of respondents cited the need to create workarounds to support derivatives in their current middle- and back-office operations. Seventy-nine percent reported they still rely heavily on spreadsheets and manual processes when processing derivatives. Furthermore, 82% require at least two months to model and launch new derivatives products, and sometimes significantly longer, utilizing their current systems.

The findings of the survey demonstrate that firms are being exposed to major and unnecessary risk and as they continue to employ manual processes in a rapidly changing industry. As the study suggests, firms are conscious of new and improved solutions that will help them achieve a strong competitive advantage and improve the functions of their firm, but there is a major struggle to determine how they should move ahead with implementing these brand-new solutions.  

The changes in the OTC derivative space increasingly drive the need for front-to-back STP, and it is imperative that operations teams consolidate STP throughout the derivatives lifecycle in order to increase efficiency, reduce processing time, and cease dependency on spreadsheets and manual “systems.” STP assimilation also helps firms to provide transparent audit streams and ensure proper reporting to management.

The challenges in the derivatives market – ranging from regulatory demands to rapidly changing market conditions – make the case for STP even stronger. Since individual derivatives trades can have a considerable effect on the portfolio, especially in terms of exposure to several market factors, it is extremely important to have updated technology in place to integrate the process, provide optimal data operability and ultimately increase portfolio performance.

Capital market firms are essentially aware of the significant benefits of STP but seem hesitant to implement the process. As new market requirements continue to emerge, it has become crucial for asset managers to evaluate and update their IT infrastructure to include automation – which in turn will shorten processing cycles and increase efficiency, thus securing a competitive market edge.

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TABB Group SEF Barometer Survey: Industry Perspective on SEFs

TABB Group is hosting an online survey of market participants’ activity on SEFs to gain insight from on their view of the new world order of electronic derivatives trading.

The survey will measure participants’ experiences with a variety of SEF-related issues, including MAT self-certification, swap trading activity, trading protocols, regulatory mandates and more.

Please note the survey is anonymous and will be available until August 4th. To participate in the SEF Barometer 2014 survey, please visit:

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Dodd-Frank at 4: Derivatives Reform Is a Glass Half Full

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

Many challenges remain in implementing Dodd-Frank’s derivatives reforms, as swap dealers retool their technology to improve data collection, aggregation and reporting. But regulators, particularly the CFTC, have made strong progress.

A number of analysts, pundits, and financial journalists are observing the fourth anniversary of Dodd-Frank by pointing out that much of the law has not been implemented. That is correct. While a little more than half of the rules are now finalized, that does not necessarily mean that they have been implemented. Typically, financial and bank regulators give institutions a year or two to comply after a rule is finalized.

tabb 7 22 14 1

Source: ‘Dodd-Frank Progress Report, Davis Polk, July 18, 2014.

It is very important to remember that a toxic political environment in Washington, regulators with significant resource constraints, very strong and continued lobbying against every single part of Dodd-Frank, and lawsuits against regulators have been significant deterrents. In addition, financial regulators cannot deploy all of their staff to the challenging task of Dodd-Frank rule writing; they already have their existing regulatory, legal, and supervisory responsibilities. Even while writing rules, regulators have been doing so in an environment where the US economy has been mostly growing anemically, and they have to think of the potential impact of the rules on institutions, markets, and the economy at large.

Despite numerous challenges, some of the agencies have finished many of their assigned tasks. For example, the CFTC, which is responsible for regulating and supervising the disproportionately largest part of the financial derivatives markets, has done an incredible job in finishing almost 85% percent of its assigned rules.

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Source: ‘Dodd-Frank Progress Report, Davis Polk, July 18, 2014, p.5.

The CFTC’s accomplishment is particularly impressive considering that is the smallest regulatory agency and has been a favorite target of Republicans who want to make sure that the agency has the smallest budget possible. Shockingly, the CFTC is still operating with a level of personnel and technology from decades before Dodd-Frank. This financial regulator is responsible not only for its existing mandate of regulating exchange traded products and derivatives exchanges, but also it now regulates over-the-counter (OTC) interest rate derivatives and index credit derivatives. In the US, these products represent about $200 trillion in notional amounts.

Also, CFTC professionals spend a good part of the day listening to comments and pleas from numerous market participants and lobbyists, as can be seen in their public website. (Actually, the CFTC is the only regulator that publishes its visits ahead of them taking place, as opposed to after they have already happened. Other regulators should learn from the CFTC’s transparency.)

In less than four years, the CFTC has finalized instrumental rules for derivatives reforms:

  • Created legal definition for a swap
  • Designated swap dealers
  • Defined what is a US person
  • Instituted swap transactions reporting
  • Released core principles for derivatives clearing organizations (DCOs), which are the central clearing parties approved to clear derivatives in the US, and
  • Has been conducting due diligence on and setting standards for the companies approved to be swap execution facilities (SEFs).

Yes, many challenges remain in implementing Dodd-Frank’s derivatives reforms, as swap dealers retool their technology to improve data collection, aggregation and reporting. Swap dealers, especially banks, also have to think continually of how to upgrade the skills of their existing middle- and back-office professionals, IT, auditors, and compliance professionals.

For its part, the CFTC will continue to be plagued by the roadblocks politicians place in its path. They ask it to do a better job and then tie its limbs by denying badly needed resources. Equally challenging for the CFTC will be to work with foreign regulators, especially in Europe. As long as rules and supervisory practices are different, the global derivatives market will be challenged by a potential lessening of liquidity. Importantly, if rules on both sides of the pond are not equally strong in the way that they are written, supervised, and enforced, then swap dealers will outsmart regulators through regulatory arbitrage.

The CFTC has new leadership. Given what I have seen by working both with swap dealers and training numerous CFTC professionals, I see Dodd-Frank’s derivatives reforms as a glass half-full. And I look forward to the next few years as it continues to fill up.

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An Inside Peek at Volcker Rule Enforcement

By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum

The OCC’s recently published Volcker Rule examiners’ manual offers a look at how regulators are going to approach the rule’s enforcement. It looks like we should expect a good deal of confusion, and possibly some contention.

After the final version of the Volcker Rule was published in December and banks began to prepare for the July 15, 2015, effective date, the only remaining question was how it would be enforced. That enforcement is up to the examiners of the various agencies. Recently, the Office of the Comptroller of the Currency (OCC) published a 26-page Volcker Rule examiners’ manual, which may be an inside peek into how the regulators are going to approach enforcement.

The Objectives

Here are some of the objectives it sets for examiners:

  • Assess the bank’s progress toward identifying the [banks] that engage in activities subject to the regulations.
  • Assess the bank’s progress toward identifying its proprietary trading. 
    • The bank must identify purchases and sales of financial instruments for specified short-term purposes.
    • The bank must identify the trading desks (the smallest discrete unit of organization) responsible for the short-term trading identified above. Trading desks may span multiple legal entities or geographic locations.
    • For each trading desk, the bank must determine on which permitted activities the desk will rely to conduct its proprietary trading.
  • Assess the bank’s progress toward identifying its ownership interests in covered funds.
  • Assess the bank’s progress toward identifying the covered funds that the bank sponsors or advises.
  • Assess the bank’s progress toward identifying its ownership interests in and sponsorships of entities that rely on one of the regulations’ exclusions from the definition of covered fund.
  • Assess the bank’s progress toward establishing a compliance program.
  • Assess the bank’s plan for avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies.

Given the newness of the Volcker Rule, it is perhaps indicative that these objectives discuss a bank’s progress and plans, instead of its conformance. However, we should expect the instructions to move pretty quickly to assessing the bank’s conformance.

Specific Instructions

Within the document, there are some specific instructions that are both pertinent and perhaps informative of the general approach. For example (these are only a small fraction of what the manual requires):

  • Under a section entitled, Assess the bank’s progress toward reporting metrics as and when required, we see:Some banks may combine previously delineated trading desks into a single trading desk.
    • Multiple units with disparate strategies being combined into a single desk, however, could suggest a bank’s attempt to dilute the ability of the metrics to monitor proprietary trading. Relevant factors for identifying trading desks include whether the trading desk is managed and operated as an individual unit and whether the profit and loss of employees engaged in a particular activity is attributed at that level.
  • Under Assess the bank’s ability to calculate the required metrics we see:
    • This metric requires the bank to “tag” each trade as customer-facing or not. Inter-dealer trading typically does not count as customer-facing because a [bank] with trading assets and liabilities of $50 billion or more is not a customer unless the bank documents why it is appropriate to treat the counterparty as a customer. Trading conducted anonymously on an anonymous exchange or similar trading facility open to a broad range of market participants is customer-facing regardless of the counterparty.
    • For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values.
    • For comprehensive profit and loss (P&L) attribution, determine whether bank systems can segregate P&L into the required three categories:
    • Determine whether the bank’s systems can report risk sensitivities on a sufficiently granular basis to account for a preponderance of the expected price variation in the trading desk’s holdings.
  • Assess the bank’s progress toward using the metrics to monitor for impermissible proprietary trading.
    • Determine whether the bank consistently applies, across its trading desks, methodologies for calculating sensitivities to a common factor shared by multiple trading desks (e.g., an equity price factor) so that these sensitivities can be compared across trading desks.
  • Assess the bank’s policy for reviewing activities and positions whose metrics indicate a heightened risk of impermissible proprietary trading.
  • Assess the bank’s progress toward identifying its market-making-related activities, market-maker inventory, and reasonably expected near-term demand (RENTD).
    • Assess the bank’s progress toward developing a process for measuring and documenting RENTD for each market-making desk.
    • Demonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks of or associated with financial instruments in which the trading desk makes a market, including through block trades.
  • Assess the bank’s progress toward establishing and implementing an internal compliance program.
  • Assess the bank’s progress toward developing procedures and controls to continuously review, monitor, and manage risk-mitigating hedging activity to ensure that the bank meets the requirements of the risk-mitigating hedging exemption. Note that under the regulations the risk-mitigating hedging activity cannot be designed to:
    • reduce risks associated with – the bank’s assets or liabilities generally.
    • general market movements or broad economic conditions.
    • profit in the case of a general economic downturn.
    • counterbalance revenue declines generally.
    • arbitrage market imbalances unrelated to the risks resulting from the positions lawfully held by the bank.
  • Assess the bank’s progress toward developing systems and processes to create and retain the hedging documentation for at least five years and in a manner that allows the bank to produce promptly those records to the OCC.

There is much more in the manual than we have listed here, of course. But these excerpts can give us some insights into how the regulators are approaching the VR. For example:

  • The regulators are aware of the opportunity, and perhaps desire, to obfuscate compliance with the rules. Several places in the instructions warn examiners to make sure that efforts are “meaningful,” particularly around the metrics.
  • In most of the more difficult areas of the metrics – for example, the inventory aging and turnover categories – the instructions appear to offer no additional help. On the question of how to apply inventory aging and turnover, the instructions simply say:
    For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values. (For options, value means delta-adjusted notional value; for other interest rate derivatives, value means 10-year bond equivalent value).
    There is nothing about what to do if a bank opened a position, or opened and closed the position on the same day, which would result in a turnover ratio of ∞. Either the regulators haven’t identified these problems yet or don’t yet have an answer.
  • The instructions don’t give any guidance on how examiners are to determine that a bank stands ready to buy or sell those instruments that trade infrequently or are new to the market. Here, again, the regulators may not have identified the uncertainty, or may not have an answer.

Overall, the instructions mostly parrot the rule itself, without clarifying many of the complexities and uncertainties around enforcement. If this is an indication of the preparations examiners will get for their very difficult tasks, we should expect a good deal of confusion, and possibly some contention. Thus it behooves banks to start a dialog now with their assigned examiners about how they will apply these instructions and what the results will be.

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Can Swap Futures Fill the Interest Rate Hedging Void?

By Mike O'Hara, The Realization Group
Originally published on TABB Forum

It is becoming much more expensive for firms to hedge their interest rate exposures using swaps, and existing swap futures may not be suitable for the buy side’s hedging needs. GMEX is betting its new constant maturity swap future product can fill the void.

The reforms instigated by the G20 in the wake of the global financial crisis have resulted in a number of structural changes to the world’s interest rate derivatives markets, changes that are now starting to have a significant impact on market participants. The G20’s stated objectives to reduce systemic risk and increase transparency across global financial markets were clear, in that all OTC derivatives contracts should be reported to trade repositories (TRs); all standardised contracts should be traded on electronic trading platforms where appropriate, and cleared through central counterparties (CCPs); and non-centrally cleared contracts should be subject to higher capital requirements.

It remains to be seen how successful these initiatives will be in the long term. However, it is clear that in the short term, at least, the increased capital and margin requirements have placed a greater strain on the financial resources of many firms active in this space. Likewise, operational changes are also making it more difficult for firms to accurately hedge their interest rate exposures. Buy-side firms in particular are facing a range of new challenges around duration hedging.

Increased Swap Costs

Historically, OTC interest rate swaps (IRSs) have been widely used by the buy side to hedge their interest exposures. However, in this new environment, it is becoming much more expensive for firms to continue duration hedging using swaps.

“One problem with bringing OTC instruments such as interest rate swaps into a CCP environment is that firms will no longer be able to rely on their ISDA Credit Support Annex agreements (Ed note: A CSA defines the terms under which collateral is posted or transferred between swap counterparties to mitigate credit risk),” says Andrew Chart, Senior Director, Origination and Structuring Prime Clearing Services, at Newedge Group.

“Whereas previously cash flows would not occur between the two counterparties until a position reached a pre-agreed level (e.g., $10 million), firms will now have to put up margin at a CCP and manage a daily cash flow as their positions are marked to market daily,” he continues. “Where do they find that collateral? This is a cash flow that they’ve never had to make before, which causes treasury and liquidity related challenges for firms if their cash is tied up on deposit, or they are fully invested in higher-yielding contracts.”

With standardised swaps subject to 5-day VaR and non-standardised swaps requiring 10-day VaR, costs in some cases are going up by an order of magnitude, a situation that Chart and his colleagues at Newedge refer to as “margin discrimination” when comparing to listed derivatives or similar products that attract a 2-day VaR treatment. “With Basel III provisions, OTC instruments are likely to weigh heavier from a capital requirements perspective,” says Chart. “Firms will have to make increased capital and liquidity provisions to show they can cover these transactions. They won’t be able to leverage up as easily as they could previously because of the new capital/position ratios that will force them to put more into their capital reserves to cover their trades and positions.”

The net result is that interest rate swaps are becoming prohibitively expensive to the buy side. More and more funds are now being directed by their investment committees to pull out of the swaps market and to find alternative hedging mechanisms. But this is easier said than done.

Challenges With Swap Futures

One of the problems facing the market is that there are very few viable alternatives to interest rate swaps for managing duration hedging, although a number of exchanges – including NYSE Euronext, CME and Eris Exchange – now offer various flavours of swap futures.

“From a buy-side perspective the products offered by those exchanges have a number of perceived disadvantages when compared with the swaps market, based on feedback market users have provided to us,” says Hirander Misra, CEO of Global Markets Exchange (GMEX) Group, which, subject to FCA approval, will operate a new multilateral trading facility in London. “Certain sections of the buy-side community are telling us that existing swap futures just aren’t suitable for them to manage their duration hedging, because they don’t provide a like-for-like hedge,” he explains.

“Of course, there’s no such thing as a perfect hedge, but with current quarterly rolling swap futures, you don’t get the granularity of duration hedging you get with IRSs. This makes managing the deltas extremely difficult because only certain points along the curve can be used. And as these swap futures expire every quarter, hedging longer-term exposures means that the contracts must be rolled each time they reach maturity. Every roll leads to more transactional costs, which add up and eat into the value of the portfolio, particularly when done multiple times over the life of a hedge,” continues Misra.

“Also, certain swap futures are or will be physically deliverable. So if a buy-side firm actually goes to delivery, they are faced again with the associated capital requirements and 5-day VaR of maintaining a swap position.” According to Misra, this is why, to date, no existing swap futures contracts have yet managed to build a critical mass of liquidity relative to the volumes seen in the OTC IRS market.

The Constant Maturity Approach

In order to address all of these challenges, GMEX recently announced the launch of its Constant Maturity Future (CMF). The CMF is a new breed of swap futures contract linked to GMEX’s proprietary IRSIA index, which is calculated in real time using tradable swap prices from the interbank market. By accurately tracking every point on the yield curve in this way, retaining its maturity throughout the lifetime of the trade and being traded on the rate, the duration hedging capability of the CMF is much more closely aligned with an IRS than other swap futures contracts that have set durations and expiry dates, according to GMEX’s Misra. This is the key for the buy-side, he says.

“The CMF gives you the closest approximation a futures contract can to the way in which the OTC interest rate swap market moves and is traded on a daily basis,” Misra claims. “Additionally, for example, if you want to hedge a 30-year Gilt issue that rolls down to maturity, given the CMF offers every annual maturity from 2 to 30 years, you can gain a very granular hedge by periodically rolling the appropriate number of 30-year CMF contracts down the curve to 29-year CMF contracts. Rather than rolling quarterly, this can become a simple middle-office, daily or periodic hedge tool. The advantage being that there is no quarterly brick wall by which point you have to roll,” adds Misra.

As a listed futures contract, the CMF comes with all the advantages that futures offer over swaps in terms of cheaper margin (2-day VaR as opposed to 5-day); electronic trading capability and accessibility; clearing through a central counterparty; and reporting via a central trade repository, Misra says. And with no quarterly roll and no deliverable element, the disadvantages typically associated with other swap futures are removed.

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Diversity of Market Participants

In order to create liquidity in any market, a diverse group of participants – including both makers and takers – is required. “We’ve thoroughly researched the market, and it’s clear that anyone who hedges interest rates needs a product like this,” insists GMEX’s Misra.

“The buy-side [firms] need it for their duration hedging; the sell-side also have IRS exposures that they need to hedge more cheaply; all the banks are capital constrained and have fixed income exposures that they need to hedge; futures players like it because it’s a standardized IRS futures product that will see natural buy-side flow; electronic market-makers and proprietary traders like it because it gives them opportunities to arbitrage the CMF against other interest rate instruments; corporates with sophisticated treasury and hedging requirements and even insurance companies who currently run naked exposures because they’ve assessed the alternatives and deemed it cheaper to take one-off hits than run expensive hedges,” he adds.


The IRSIA CMF will be centrally cleared by Eurex Clearing (subject to final agreement at the time of writing). This arrangement will offer a range of advantages around collateral and margin offsets. For example, it will be possible to offset the margin for the IRSIA CMF against the margin for correlated assets such as Bund/Bobl/Schatz and Eurex-cleared OTC IRS. Such offsets and incentives will significantly lower barriers to entry for market participants given that existing Eurex clearing membership will apply.

“With the introduction of the new Basel III capital rules, the cost of clearing is now determining not only which instruments are used for hedging but where they are cleared,” says Philip Simons, Head of Sales and Relationship Management at Eurex Clearing. “Market participants will inevitably use the best tools available that manage the risk. This will include OTC IRS, traditional futures and options, as well as new instruments such as GMEX’s IRSIA CMF.”

According to Simons, the ability to clear all instruments at the same CCP with appropriate cross-margin benefits will be crucial. This will not only reduce the cost of funding but, more significantly, reduce the cost of capital, through a combination of maximising netting benefits for exposure at default, having an efficient default fund and minimising the funding costs.

“The higher the risks, the higher the costs of capital as reflected through higher initial margin and higher default fund contributions, which will inevitably be passed on to the end client,” says Simons. “Capital and operational efficiency will drive liquidity in the future.”

Operational Considerations

The IRSIA CMF will be traded on an electronic market, operating on a Central Limit Order Book via GMEX’s own proprietary matching technology. Request for Quote and the facility to report negotiated trades will also be available, according to GMEX.

GMEX says it will offer access to the market via its own trading screens as well as third party vendor products. Most firms may prefer to trade through screens such as those provided by ISVs such as Fidessa and Trading Technologies, many of which offer functionality for trading spreads or running other cross-instrument or cross-market strategies. For direct electronic access, GMEX provides a well-documented API, which is available in both FIX and Binary format.

Execution and prime service brokers such as Newedge will offer DMA and potentially sponsored access, as well as value-added services such as cross-product margining and linked margin financing of correlated portfolios.

Finally, trade reporting will be performed automatically via the REGIS-TR Trade Repository, resulting in true straight-through processing from pricing, execution and clearing through to reporting.

This article originally appeared on The Trading Mesh.

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