By George Bollenbacher, Kinetix Trading Solutions
Originally published on Tabb Forum
The approval by the Commodity Futures Trading Commission and the Securities and Exchange Commission of the “Further Definition of Swaps” rule on July 10 has been heralded as the starting gun for many of the requirements under Title VII of the Dodd-Frank Act.
For sure, many of the effective dates of the rules that the CFTC has passed are set to 60 days after this rule appears in the Federal Register (an event everyone is watching for), but there are some important rules that haven’t been passed yet. So what will really start when the gun goes off?
What Has and Hasn’t Been Passed?
Here are the rules that have been passed by the CFTC and are awaiting the starting gun (in chronological order of passage):
- Reporting Pre-Enactment Swap Transactions
- Reporting Certain Post-Enactment Swap Transactions
- Prohibition on Price Manipulation
- Large Trader Reporting for Physical Commodity Swaps
- Process for Review of Swaps for Mandatory Clearing
- Swap Data Repositories: Registration Standards, Duties and Core Principles
- Derivatives Clearing Organization General Provisions and Core Principles
- Position Limits for Futures and Swaps
- Registration of Foreign Boards of Trade
- Real-Time Public Reporting of Swap Transaction Data
- Swap Data Recordkeeping and Reporting Requirements
- Registration of Swap Dealers and Major Swap Participants
- Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties
- Internal Business Conduct Standards (too long a title to include here)
- Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing Member Risk Management
- Further Definition of Various Parties (again, too long a title to include here)
- Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps
- Core Principles and Other Requirements for Designated Contract Markets
- End-User Exception to the Clearing Requirement for Swaps
- Further Definition of “Swap,” (and a bunch of other categories)
Here is the list of the major rules that haven’t been passed as of July 23 (in chronological order of proposal):
- Core Principles and Other Requirements for Swap Execution Facilities
- Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants
- Capital Requirements of Swap Dealers and Major Swap Participants
- Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade
- Procedures to Establish Appropriate Minimum Block Sizes for Large Notional Off-Facility Swaps and Block Trades
- Swap Data Repositories: Interpretative Statement Regarding the Confidentiality and Indemnification Provisions of Section 21(d) of the Commodity Exchange Act
- Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act
- Clearing Exemption for Certain Swaps Entered Into by Cooperatives
Not everything begins with the starting gun but there is a lot to do and not much time to do it. You might want to record the London Olympics and play it back sometime after the Dodd-Frank starting gun goes off.
What Does It Mean For the Starting Gun?
Without reading all the rules listed above, what do we know about what will go into effect sometime in late September or early October?
Registration – Firms that qualify as SDs or MSPs will have to register by the start date. Qualification as SD means fitting into any of the categories below, with an aggregated (across affiliates) annual notional trading volume (the de minimis threshold) of $8 billion.
(i) Holds itself out as a dealer in swaps;
(ii) Makes a market in swaps;
(iii) Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
(iv) Engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps.
Of particular interest is the third category because it doesn’t require that the entity perform most of the activities normally associated with dealing. There are some exceptions to the de minimis volume, such as inter-affiliate swaps, hedges for physical positions, swaps by floor traders and swaps included in a loan agreement. However, many large swap market participants – like hedge funds – could be swept up in the SD category. And that category has a host of requirements of its own. Among them…
Trade Reporting – One of the DFA requirements that will start with the gun is the reporting of trades (and follow-on valuations) to the SDRs. Trades done on SEFs or cleared at DCOs will be reported by those venues but most of those won’t be operational by the starting gun.
In other words, almost every trade done after the starting gun, but before the widespread use of SEFs and DCOs, will have to be reported by the dealer in dealer-to-customer trades and by one of the dealers in dealer-to-dealer trades. Since it doesn’t appear that the UPI and USI standards will be done by that time, reporting entities will need a reliable identification method for the products they trade.
External Business Conduct – Another requirement that will start with the gun is external business conduct, which primarily applies to SDs. In addition to some customer disclosure requirements, the rule also requires the SD to give the customer, before the trade is done, significant information about the swap and a mid-market price for the transaction. The dealer must also offer the customer a scenario analysis. These requirements only apply to off-SEF trades but, since SEF trading will probably not start with the gun, they effectively apply to all trades.
One significant point: the CFTC included deliverable FX forwards in the swap definition. The Treasury may exempt these forwards from the clearing and trading requirements but not from the reporting and business conduct requirements.
A special category of external business conduct requirements apply to trades done with special entities (SEs), which are governmental bodies and employee benefit plans. Many of these requirements can be satisfied by know your customer-type functions but potential SDs (and MSPs) will have to comply before the starting gun.
Internal Business Conduct – The last major requirement for SDs and MSPs is internal business conduct, which falls into two major categories. The first is record retention and covers the usual documents plus all verbal communications, not just on swaps, but on “related cash and forward” trades as well. For firms that routinely record trading conversations, this won’t be a big stretch but for those that stopped recording, it will be required at the gun.
The second category is listed under conflict of interest and covers both research and clearing. It says, in effect, that a trading unit can’t influence research output and that a clearing unit can’t influence trading (and vice versa). While that sounds innocuous, some of the language needs careful review, such as the prohibition of conversations about the content of research reports between the trading and research departments.
What Won’t Happen at the Starting Gun?
SEF Trading – Since no SEFs will be approved by late September or early October, no SEF trading, either mandatory or voluntary, will occur. In fact SEF trading will be a two-step process. First the SEF has to be approved and then it has to apply to make a contract available to trade. Once that is approved, mandatory trading will begin something like 60 days later. So the best guess as to when that will happen is sometime in the first quarter of 2013.
Mandatory Clearing – The same two-step process applies to clearing as to trading. However, the CFTC has already passed the DCO rules, while it hasn’t passed the SEF rules, so mandatory clearing will probably happen a little sooner than mandatory trading. Also, many of the more liquid swaps are already cleared, so there will be very little new process or technology required in those markets.
Uncleared Margin Rules – Various regulators have proposed rules covering the margin requirements for uncleared swaps and these regulators are attempting to coordinate their efforts. Meanwhile, we expect market participants to continue with their current practices. However, the margin rules could be adopted at any time, so everyone will have to keep an eye out for significant changes in this arena.
Block Trading – One of the most closely watched rules is the establishment of block thresholds above which trades can be done over-the-counter but must be cleared. It is possible that the SEF rule could be passed without the block threshold rule but that would require the CFTC to declare every trade a block, or none, which would be a problem either way. For automated trading systems, storing and checking the block threshold (which could change over time) will probably be new functionality.
Getting Ready for the Gun
Obviously, this all argues for prioritization of effort, especially since the gun goes off in about two months. Here are some of the highest priorities:
- Trade reporting – this encompasses not only the trade but daily valuations and lifecycle events;
- KYC functions – comparing current counterparty data with the requirements and preparing for the SE data requirements;
- Pre-trade disclosures – of swap characteristics, mid-market prices and any compensation arrangements the dealer has;
- Scenario analysis – preparation of SA for every trade and delivery to the customer where required;
- Voice recording – installation of equipment, where it doesn’t currently exist, for both swaps (remember to include FX forwards) and related cash;
- Firewalls – between the trading units and both research and clearing.
In accordance with the Dodd-Frank Act, the CFTC approved final regulations to establish a compliance schedule that will phase in the new clearing requirements. The schedule does not prohibit market participants from voluntarily complying with the clearing requirements prior to the deadline and it will be used at the Commission’s discretion.
Per the CFTC, the triggering event for the compliance schedule is the Commission’s issuance of a final clearing requirement determination.
Additional information about the compliance schedule as provided on the CFTC website:
“Phase 1/Category 1 Entities
- Category 1 Entities include swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, and active funds.
- The compliance schedule will phase in compliance with the clearing requirement for any swaps between Category 1 Entities or a Category 1 Entity and any other entity that desires to clear the transaction within the first 90 days after the Commission issues any clearing requirement.
- The compliance schedule provides these market participants with the least additional time to come into compliance based on, among other things, their level of activity, market experience, resources, and their status as registrants with the CFTC or SEC.
Phase 2/Category 2 Entities
- Category 2 Entities include commodity pools; private funds as defined in Section 202(a) of the Investment Advisors Act of 1940, other than active funds; or persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature as defined in Section 4(k) of the Bank Holding Company Act of 1956, provided that the entity is not a third-party subaccount. The Commission modified its proposal to remove employee benefit plans identified in paragraphs (3) and (32) of section 3 of the Employee Retirement Income and Security Act of 1974 from Category 2.
- The compliance schedule will phase in compliance for swaps between a Category 2 Entity and Category 1 Entity, another Category 2 Entity, or any other entity that desires to clear the transaction within 180 days after the Commission issues any clearing requirement.
- The compliance schedule provides these market participants 90 more days than Category 1 Entities because these market participants are not be required to be registered with the Commission and are likely to be less experienced and less frequent users of the swap markets than those in Category 1.
Phase 3/Category 3 Entities
- The compliance schedule will phase in compliance for all other swaps, including those involving third-party subaccounts, ERISA plans, and those not excepted from the clearing requirement within 270 days after the Commission issues a clearing requirement. In the final rule, the Commission has modified the definition of third-party subaccount to remove the execution authority requirement.
- The compliance schedule provides third-party subaccounts the most amount of additional time to bring their swaps into compliance as they are likely to require the most amount of time for documentation, coordination, and management.”
The compliance schedule will allot a compliance timeframe for each.
The DTCC testified last week before a Senate Committee that they are fully prepared to meet the September swap data reporting deadline as required by the Dodd-Frank Act.
At the hearing, Larry Thompson, DTCC Managing Director and General Counsel stated:
“DTCC will be ready on Day One to meet the new reporting requirements," Thompson said. “Over the past two years, DTCC has made substantial investments to design, develop and implement systems to support swap data reporting for all five OTC derivative asset classes. This infrastructure has been designed with maximum flexibility so that it can evolve over time to meet the changing needs of regulators and market participants. Regulators can leverage these resources in their efforts to enhance market transparency and ensure a safe and sound financial system."
The DTCC holds detailed trade information on more than 98 percent of all CDS transactions globally.
By Robert Pickel and George Handjinicolaou
Originally published on Tabb Forum
In many parts of the world, schools have come to the end of their terms, which makes it a nervous time for students: they are waiting for the report card to arrive.
We at ISDA empathize, as we too have been waiting for a report card. It came June 15 in the form of the Financial Stability Board's Third Progress Report on Implementation of OTC Market Reforms. The report measures progress toward the G20 commitments to reform OTC derivatives markets, agreed upon at the 2009 meeting in Pittsburgh.
So how did the OTC derivatives markets do?
Pretty well. As the report states:
Since the FSB’s previous progress report in October 2011, encouraging progress has been made in setting international standards, the advancement of national legislation and regulation by a number of jurisdictions and practical implementation of reforms to market infrastructures and activities.
One part of the report – the FSB’s discussion of exchange and electronic platform trading and market transparency – was especially encouraging. It elaborates on a recommendation to consider costs and benefits from their October 2010 report by explicitly adding that “Authorities need to take action to explore the benefits and costs of public price and volume transparency…. including the potential impacts on wider market efficiency, such as on concentration, competition and liquidity.”
We can’t say that the FSB has read our cost-benefit analysis of the Dodd-Frank requirements for SEF executionbut that sounds very familiar to the cost concerns that we raised in that study.
The biggest takeaway is that much remains to be completed by the end-2012 deadline to achieve the G20 commitments. The FSB leaves no doubt that they will be closely watching and driving for progress in the months ahead. As it states:
For the next progress report, the FSB intends to put additional focus on the readiness of infrastructures to provide central clearing, platform trading and reporting of OTC derivatives, the practical ability of industry to meet the requirements and the remaining steps for industry to take.
The report acknowledges that the largest markets in OTC derivatives – the EU, Japan and the U.S. – are the most advanced in their progress. It also recognizes that other jurisdictions are understandably waiting for those three regions to finalize their approaches before committing to a particular path of reform. It urges all jurisdictions “to aggressively push ahead to achieve full implementation of market changes by end-2012 to meet the G20 commitments in as many reform areas as possible.”
That’s the assignment for the public sector. But the FSB also has some assignments for the private sector, ones that we at ISDA are actively engaged in. Market participants are urged to address standardization, clearing, trading on organized platforms and reporting to trade repositories. Check, check, check and check – those are on ISDA’s agenda as well.
In short, the report card was delivered, but there will be no extended summer break for the OTC derivatives industry or all of us here at ISDA.
Navigating the regulatory landscape in the age of Dodd-Frank can be tricky without a map. Luckily, the CFTC has put together a comprehensive section on their website that’s essentially a one-stop-CFTC-shop for all things Dodd-Frank.
Some of the key information contained on the page includes:
With new votes occurring almost weekly and the various deadlines for rule implementation creeping ever-closer, this page has become an invaluable resource for us to keep track of the play-by-play.
By Cubillas Ding
Originally published on Celent's Wealth and Capital Markets Blog
Reported through the Wall Street Journal yesterday, the Germans have issued a bond (a German treasury note known as Schatz) with a zero coupon. This is unprecedented in some ways. What it says is that investors are so desperate that they are willing to forfeit any yield for the privilege of parking their funds for two years in what they see as safe assets, as the escalating debt crisis in the euro zone continue to play out in contagious and unpredictable ways.
What’s driving demand? Between insurance companies and pension funds that offer products with ‘guaranteed returns’ or conservative fund portfolios that place an emphasis on value preservation; financial institutions hunting for sources of liquid, high quality collateral for regulatory purposes, repo and OTC derivative markets; and CCPs demanding more stringent margin requirements, one can expect this race to compete for a share of acceptable safe assets to grow.
Investors that have been burned over the past few years are saying capital preservation remains a paramount objective for them. For me, financial markets are so dislocated at the moment that perceived “safe havens” are elevated to “safe heavens” by investors in their flight to safety, whilst distressed entities/sovereigns are condemned to investment hell (so to speak).
However, such polarization between the two extremes of ‘elevated heavens’ and “investment hells” perhaps point to me that the market is running out of options for safe assets.
It also begs the question of whether this is an illusion that is too good to be true. At the moment, not even favored safe haven assets such as gold, investment grade government and corporate debt, and covered bonds are necessarily immune to the shaking that is rippling through the markets. In this instance of German treasuries, zero yields in theory means that it is completely ‘risk free’, for which there is no such thing, not in terms of absolute safety anyway. Germany may be the strongest economy in the Eurozone but contagion effects are difficult to predict.
There are a few points of caution here: First, the growing concentration of capital flows into these perceived safe assets is in itself a risk and (arguably) creates a bubble effect. Secondly, the polarization dynamic between the haves and have nots create large imbalances that will amplify structural volatility. Thirdly, current (and emerging) regulatory regimes like Basel 3, Solvency 2 and Dodd Frank/central clearing are almost, in tandem, sucking in and ‘consuming’ safe assets. It creates a backdrop for these effects to continue.
Is this an unintended consequence that we do not want or need in the longer term?
By Joséphine de Chazournes,
Originally published on Celent's Wealth and Capital Markets Blog
As the European and US authorities are trying to regulate pretty much everything in the financials industry in their “Prudential Regulation” stance to prevent our economies to implode, unregulated entities are thinking about getting a regulated status..
In the news today there is rumour that ICAP, one of the leading inter-dealer broker in the OTC derivatives space, is assessing whether they should buy the Plus Market, the UK exchange for fledgling companies that is planning to close after failing to secure a buyer. Now only four companies in the UK have a regulated market status: the London Stock Exchange, the London Metal Exchange (also for sale), ICE Futures Europe and Liffe, owned by NYSE Euronext.
It sounds like a safe bet, an insurance in case Dodd-Frank in the US and EMIR in Europe do not just ask for OTC derivatives trades to be cleared but also be traded on a regulated market. That’s a bit far out but you never know how crazy things can go! It’s probably going to be a matter of price for ICAP.
But for many fixed income players that are eyeing the “post-new-regulation” dealer-to-client market in Europe, and assessing how to best get into it, it has become compulsory to at least get an MTF licence, maybe an OTF licence when we will really know what they will be, and why not Regulated Market status, though costs of maintenance associated with the latter have to be valued carefully, not for the faint-hearted.
By Paul Rowady
Originally published on Tabb Forum
The public launch of DTCC’s over-the-counter rates trade repository is a subtle yet important step on the road toward greater transparency in the global OTC derivatives markets.
On the surface, this news may appear to be purely administrative since Trioptima has been publishing data for OTC derivatives rates trades since July 30, 2010. But for those of us who have been swimming in the details of this data – and I can assure you that we are a freakishly demented and small group – there are some key differences with this new information.
Without performing a full analysis of the new files, here’s what I notice: There is a nearly $100 trillion difference between the total notional of this first report from DTCC and the latest report from Trioptima on April 13. OTC rates notionals reached $578 trillion from in this 2 week span.
Knowing this data fairly well, I am confident that this is not explained by an uptick in activity (which I have been predicting is actually in a negative direction), but rather an expansion in the comprehensiveness of this dataset. And it is likely being driven by greater inclusion of non-dealer trades.
One thing is for sure: This new data will have an impact on our overall OTC derivatives market sizing estimates, which we will share as we gain more insights and of course in several upcoming reports.
Where we do have some improved clarity from this first DTCC report is where exposures are further illustrated through combined attributes such as product type and currency. This combination is new. In the prior framework, we could analyze counterparty and product type, or counterparty and maturity, or even product type and maturity. But product and currency is a new one.
With this new combination, we can drill further into where the concentrations of activity are – and perhaps more importantly, where the concentrations of activity are not. (For instance, I think the lack of activity in some product-currency structures may signal extinction in the new cleared paradigm.) The heatmap of trade counts (below) that we have developed shows that a majority – or, 77 percent as of April 27 – are “vanilla” swap trades. Moreover, 81 percent of these are concentrated in the top five currencies. Inversely, we can note that there are only 328 trades – or less than 0.01 percent – registered in Chinese renminbi.
We are just scratching the surface. The good news is that we have much more data to analyze. The bad news is…we have much more data to analyze. Over time, we will be able to show more of the short-term activity in any one product-currency-maturity-counterparty category.
In the meantime, keep an eye out for our upcoming report, “The Global Risk Transfer Market 2012,” which will be available in late May or early June. In that report we go into some detail about the meaning of this and similar data and the impact these moves are likely to have on the entire derivatives landscape.
By Will Rhode and Paul Rowady
Originally published on Tabb Forum
One hundred million dollars to $8 billion – sounds like a big leap. In reality it makes no difference.
News that the Commodity Futures Trading Commission and the Securities and Exchange Commission have jointly agreed to allow firms to trade anywhere up to $8 billion in swaps each year, up from a paltry $100 million, before labelling them a “swaps dealer” is supposed to offer relief to large energy firms that use derivatives to hedge.
But the dealer exemption merely means energy companies will likely become classified as end users. As we discussed in our report Initial Margin for OTC Derivatives: The Burden of Opportunity Costs, the end-user exemption is a mirage. As long as the dealer side of an over-the-counter trade with an exempted party is obligated to clear, then the dealer will be on the hook for both the counterparties’ margin requirements (since the CCP cannot only clear one side). To offset these costs, dealers will price initial margin into the trade, mostly likely in the spread and fees.
OTC derivatives market designations may change compliance requirements – reporting, and such – for swaps dealers vs. major swap participants vs. others. Clearly the more active players are the more systematically important. But the collateral requirements will impact all. TABB Group believes there will be no two-tier OTC derivatives market with cleared and uncleared, except in very rare circumstances.
Extraterritoriality is also a mirage. Extraterritoriality represents the extension of the rules in one domain to entities based in another domain. Dodd-Frank includes rules that extend to entities outside the U.S.
But TABB Group believes that rules that apply to OTC derivatives in the G20 will eventually converge and therefore major swap participants will ultimately need to comply with similar rules in all regions. The window of time for the potential for regulatory arbitrage is uncertain – not likely to be lengthy – and the operational aspects to exploit such opportunities is non-trivial. Major swap participants will need to comply with the spirit of the rules as well as the letter.
According to our report European Credit & Rates Dealers 2011: Capital Clearing and Central Limit Order Books, 73 percent of European dealers said they expected to steal a march on their U.S. counterparts as a result of Dodd-Frank’s extraterritoriality rules. Rest assured, U.S. authorities will take a dim view of that. For those who hope to exploit the discrepancy, don’t plan on a trip into the U.S. markets any time soon without a very unwelcome reception waiting on the other side of the border.
Some European dealers say they will not seek out regulatory arbitrage opportunities for fear of angering U.S. authorities and may force clients to clear even though they will not be obligated to do so.
In essence, the G20 central clearing mandate means there is no escaping the burden of collateral costs. It doesn’t matter if you are a large energy company, a pension fund or a European regional bank – one way or another you will end up footing the collateral bill for the simple reason that dealers have no intention of paying for it.
The CFTC voted 4-1 yesterday to adopt a regulation defining swap dealers as firms conducting swaps of derivatives with a notional value of $8 billion a year. The threshold will then fall to $3 billion after five years. Additionally, the CFTC voted 5-0 in favor of a separate rule that treats commodity options like all other swaps.
There is still some ambiguity around the definition since the CFTC added an explicit exemption for swaps that are used to hedge market risks. Trades that will do things like reducing exposure to interest-rate fluctuations will not count toward the threshold.
According to a Reuters article on the meeting:
“The CFTC gave itself wide latitude to change the threshold. The agency would collect two-and-a-half years of swaps data, then study that data, and then the CFTC would have nine months to determine whether to bring down the trigger from $8 billion in annual swap trades to $3 billion.”
Republican CFTC Commissioner Scott O'Malia voted against the final swap dealer rule because it includes "several unnecessary and astonishing contortions that may lead to potentially adverse inconsistencies and instabilities in the years that follow."
Following are the opening statements from the CFTC Commissioners and relevant documents from the meeting.
Opening Statement of Chairman Gary Gensler
Opening Statement of Commissioner Bart Chilton
Opening Statement of Commissioner Scott D. O’Malia
Statement of Dissent of Commissioner Scott D. O’Malia
Opening Statement of Commissioner Mark P. Wetjen
Opening Statement of Commissioner Jill E. Sommers
Fact Sheet: Final Rule: Final and Interim Final Rulemaking Regarding Commodity Options
Q&A: Final Rule: Final and Interim Final Rulemaking Regarding Commodity Options
— Approved 5 - 0
Fact Sheet: Final Rules Regarding Further Defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant”
Q&A: Final Rules Regarding Further Defining “Swap Dealer,” “Major Swap Participant” and “Eligible Contract Participant”
— Approved 4 - 1
The SEC also voted to approve swap dealer rules on Wednesday which were similar to the CFTC’s but contained a few key differences.
Since the SEC had more swap data to work with, they were able to closely tailor the thresholds to the different derivatives markets under their regulation.
According to Reuters:
“For single-name credit-default swaps, which make up the vast majority of the security-based swaps market, the $8 billion threshold will apply during the phase-in period and then taper down to $3 billion. For all other security-based swaps, such as equity swaps, a much smaller threshold will apply, with an initial phase-in level of $400 million that later goes down to $150 million.”
The SEC estimates that fewer than 50 clearinghouses, exchanges and other platforms will register as swap dealers with the agency, which only oversees security-based swaps under Dodd-Frank.
Following is a link to the SEC Fact Sheet: Defining Swaps-Related Terms