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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 help@tradeweb.com 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: https://www.surveymonkey.com/s/SEFBarometer14

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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.

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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.

Clearing

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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Derivatives in 2015 and Beyond – A Look into the Future with Kevin McPartland

Imagine you had the last five years of derivatives market reform on DVR.  If you could fast-forward past the requests for public comment, rule delays and angst, would you have guessed that we’d be where we are today? 

Future-casting the outcome of financial markets reform is not for the faint of heart.  But it is an art in which Kevin McPartland has had some success over the last several years.  As a principal, overseeing market structure and technology for Greenwich Associates, McPartland is responsible for helping the world’s leading financial firms decode nascent trends and interpret emerging intelligence to make strategic decisions. 

McPartland also holds the distinction of authoring the most-read blog post in DerivAlert history.  His SEF 101: Deconstructing the Swap Execution Facility, written in 2010 when McPartland was a senior analyst at Tabb Group, was a seminal piece on the topic long before most market participants had ever heard of a swap execution facility (SEF).  Now that we’ve all become familiar with SEFs, we thought it would be a good time to check back in with McPartland to see what he thinks the next few years of derivatives market reform would have in store for us.

DerivAlert: Given all of the events of the last five years -- derivatives reform, increased electronification of swap trading, Basel capital requirements, QE -- How do you see the trading in derivatives evolving over the next five years?

Kevin McPartland: It’s great that we’ve got a lot of the major rules in place.  It’s good that we’re finally here, but it’s still very much early days.  For clients that do not want to trade on SEFs, there are still plenty of ways to do that. Market participants need to feel incentivized to increase trading volume on SEFs, and the product sets that are required to trade electronically need to become larger in order to make the shift to SEFs real. 

In terms of looking at who the winners and losers are in SEFs, the separation is starting to take shape, but it is still very early.  It’s also important to look at the client make-up of different SEFs, which are very different.  That has a big influence on volumes. 

DA: What do you see coming down the pike for fixed income?

KM: The Treasury market is looking more and more like it is ripe for continued electronification.  It is standardized and highly liquid.  Nearly every financial firm is involved in Treasurys in some way shape or form.  This is in contrast to the corporate bond market. 

Our North American Fixed Income Study last year showed that 78% of clients we talked to were using electronic platforms to trade bonds.  That means a big chunk of the market are already using electronic platforms in some way.  But only 50% of notional volume is traded electronically, which outlines a huge opportunity for growth.

In credit, the story hasn’t really changed much.  The structure of the market is such that there are so many issues that it’s hard for deep liquidity to grow in any one particular spot.  For example, you have one IBM stock, but you could have upwards of 50 IBM bonds to choose from.  That makes it tough to build deep liquidity in corporate bonds.

The real opportunity for electronic trading in credit is in bond selection.  The major platforms are all innovating in this space and we expect that to be a growth area over the next several months.  There’s still a long way to go, but a shift is starting to occur whereby investors are moving away from bond-specific thinking and toward a risk-based approach.  Instead of saying ‘I want this IBM bond,’ they are saying ‘I’m looking for this type of credit exposure, what are my options?’

DA: What are your expectations for European derivatives reform?

KM: U.S. reforms have been complicated because the CFTC and SEC are jointly writing rules on Dodd-Frank.  Europe has a dozen jurisdictions that need to write rules and get them accepted for all of their markets.  The first thing we’ve seen is trade reporting, and by all accounts it’s been really messy. 

As it stands now, the reporting requirement for both sides of a transaction largely defeats the purpose of the rule.  In terms of the first clearing mandates, we’re expecting to see something maybe by the end of 2014/2015.

European reform is not a cut and paste of the U.S.  The legal framework about how clearing works is very different in Europe, and the clearing rules are very different. 

DA: What impact do you see the May 1st guidance on packaged trades having on SEFs?

KM: We’re still waiting for lots of liquidity providers to come into the market.  It’s going to be a slow, organic process as some of the new products come online.

The CFTC’s guidance laid out a phased in approach for packaged transactions, starting with packages containing two or more MAT instruments and quickly expanding to include MAT swaps over US Treasuries.  While the marketplace is certainly ready to handle the electronic execution of these packages, the operational infrastructure needed to risk-check and process these trades will struggle to be prepared by the deadline.

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

There was no shortage of big news from the derivatives market this year.  In the month of October alone, the deadline for trading derivatives electronically on SEFs was met while the federal government implementing these regulations was shut down. Across the Atlantic, another group of regulators was lobbying for a delay in those rules, citing potential cross-border issues.  

Meanwhile, CFTC Chairman Gary Gensler, who announced that he will step down at the end of the year, held firm to his agency’s game plan.  And so, the new era of SEF-based OTC derivatives trading was born, as mandated by Dodd-Frank. 

Amidst all of the upheaval of the past year – the passed rules and agency guidance, the extended deadlines, uncertainty around extraterritoriality and the gridlock in Washington – which stories grabbed the most attention among DerivAlert readers?  To find out, we dug into the analytics to find out which posts were the most viewed over the course of 2013. 

Here they are, chosen by you, the DerivAlert reader:

The Top Stories of 2013 
(along with a few honorable mentions that we couldn’t resist including on the list):

10) EMIR Flaws Could See Futures Reporting Delayed Till 2015
By Tom Osborn
Published July 29, 2013, Risk

The European Securities and Markets Authority (Esma) has confirmed it is considering pushing back its trade reporting deadline for exchange-traded derivatives until as late as January 2015, in order to give firms more time to adapt the reporting framework to futures and options products.

full article  (subscription)

 9) Standardized OTC Swaps to Launch Within Weeks
By Peter Madigan
Published April 19, 2013, Risk

Within weeks, fixed-income market participants will be able to trade a new, exchange-traded version of the over-the-counter interest rate swap, with eight tenors, standard coupons and quarterly maturity dates like those used in the futures market. Some of those involved in the work see it as a way of defending the OTC market against the threat posed by swap futures.

full article  (subscription)

8) Uh Oh: The Attempt to Regulate Swaps is Failing
By John Carney
Published April 6, 2013, CNBC

It's hardly surprising to hear that some of the largest derivatives brokerages are looking to set up futures exchanges. A huge portion of the traditional business these brokers did is in the process of migrating out of swaps and into futures.

full article  (free)

7) US in Compromise on Derivatives Trade Rules
By Michael Mackenzie and Gregory Meyer
Published May 16, 2013, Financial Times

Commissioners on the US Commodity Futures Trading Commission voted 4 to 1 to pass long-awaited derivatives trading rules on Thursday that preserve voice-based transactions in conjunction with electronic platforms.

full article  (subscription)

6) SEF Rules Hit Non-US Cross-Border Trading
By David Wigan
Published October 31, 2013, Euromoney

The requirement from October 2 for swap dealers and regular users of derivatives to transact swaps on Commodity Futures Trading Commission-mandated swap execution facilities (SEFs) was the last piece in the puzzle for US derivatives market regulation, after mandatory reporting and clearing came in earlier this year.

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5) Swaps Clearing Rules Divide Market
By Philip Stafford
Published August 21, 2013, Financial Times

An obscure part of the Dodd-Frank Act has become the unwitting battleground among market infrastructure operators as they seek to meet rules tightening derivatives trading.

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4) SEF Execution Agreement Requirement Angers Buy-Side
By Peter Madigan
Published September 24, 2013, Risk

Buy-side firms are refusing to sign participation agreements with some newly registered US swap execution facilities (Sefs), because of a controversial requirement that commits end-users to negotiate bilateral trade breakage agreements with any counterparty they transact with on the trading venues, Risk has learned.

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3) Traders Take Their Swaps Deals to Futures ExchangesBy Matthew Philips
Published January 24, 2013, Bloomberg Businessweek

On Friday, Oct. 15, a rule designed to improve government oversight of the multitrillion-dollar market for derivatives took effect. The following Monday, many energy traders moved their swaps business to a futures exchange. After the U.S. Commodity Futures Trading Commission put two years into building its regulatory framework for swaps, a slice of the market simply sidestepped it.

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2) CFTC to Shake Up Swaps Trading Market
By Michael Mackenzie, Gina Chon, and Philip Stafford
Published November 17, 2013, Financial Times

New guidance from the main US regulator of privately negotiated derivatives is set to test the business models of interdealer brokers, who have long played a crucial intermediary role between global banks.

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1) High Drama at the CFTC: The Battle Over Swaps and Futures
By Matthew Philips
Published February 1, 2013, Bloomberg Businessweek

Hearings at the U.S. Commodity Futures Trading Commission aren’t exactly known for their riveting entertainment value. Nor for their mass-market appeal. Yet on Thursday, it was standing-room-only at the CFTC headquarters in Washington as the commission held a roundtable discussion about the recent migration of swaps trading into the futures market.

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Honorable Mentions:
The Stories Made Us Stop and Say, ‘Whoa’

Three Wall Street Trade Associations Sue US Regulator
By Katy Burne
Published December 4, 2013, Wall Street Journal

Three Wall Street trade groups are suing a top U.S. regulator alleging procedural violations at the agency, in the latest effort by large banks to fight new rules that they contend will unfairly crimp their trading business.

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Wetjen Said to Face Vote as Acting CFTC Head Replacing Gensler
By Silla Brush
Published December 13, 2013, Bloomberg

Commodity Futures Trading Commissioner Mark P. Wetjen is poised to be voted acting chairman of the top U.S. derivatives regulator within days, according to two people with knowledge of the process.

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SEF MAT Submissions: Reality Check
By Radi Khasawneh
Published November 1, 2013, Tabb Forum

Implementing the Made Available to Trade rule will transform the swap market. But based on early SEF submissions to the CFTC, the industry needs clarity on which swaps will qualify.

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Standardization Needed in SEF Reporting Conventions
By Michael Watt
Published October 25, 2013, Risk

One of the core principles behind swap execution facilities (Sefs) – the new breed of trading platforms that opened for business under the US Dodd-Frank Act on October 2 – was to create greater transparency in the swaps market. In the words of the Commodity Futures Trading Commission (CFTC), Sefs must "make public timely information on price, trading volume, and other trading data on swaps to the extent prescribed by the commission".

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EMIR Reporting Questions Pile Up for Corporates
By Fiona Mawell
Published October 3, 2013, Risk

Amid fundamental questions about the timing and scope of Europe’s new derivatives reporting rules, corporates are weighing whether to delegate the work to their dealers. But some large companies are not keen – and many banks are sitting on the fence. Fiona Maxwell reports

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Derivatives Reform Kicks Off Competitive Struggle

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

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

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

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

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

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

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

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

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

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

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

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

So what can we tell for sure about the outcome?

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

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

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

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

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What the CFTC Concept Release on Automated Trading Means for Derivatives

By Matt Simon, TABB Group
Originally published on TABB Forum

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

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

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

1. Finding Improvements to Existing Industry Practices

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

2.    Considerations for More Pre-Trade Risk Controls

Proposed solutions include:

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

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

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

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

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

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

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

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

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

4. Greater System Safeguards

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

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

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

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

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

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

5. Other protections

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

6. Questions, Questions, Questions

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

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