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CCPs: Risky Is as Risky Does – In Europe

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

On one hand, the European Commission is concerned that variation margin requirement for European pension funds in the event of an upward move in rates is so large that the repo market couldn’t handle it. On the other hand, it’s comfortable that the risk could be handled in the bilateral market. What’s the real risk?

Recently I wrote about the debate in the US over risk management programs at CCPs, and how “skin in the game” was not a very comforting approach (CCPs: Risky Is as Risky Does). A recent report by the European Commission on the use of CCPs by pension funds brings another aspect of this to light.

First, the report points out that:

Under EMIR, OTC derivatives that are standardised (i.e., that have met predefined eligibility criteria), including a high level of liquidity, will be subject to a mandatory central clearing obligation and must be cleared through central counterparties (CCPs).

Then it says:

Pension Scheme Arrangements (PSAs) in many Member States are active participants in the OTC derivatives markets. However, PSAs generally minimise their cash positions, instead holding higher yielding investments such as securities in order to ensure strong returns for their beneficiaries – retirees. The inability of CCPs to accept non-cash assets as collateral to meet [variation margin] VM calls means PSAs would need to generate cash on a short term basis either by borrowing cash or selling other assets in order to meet the CCP margin calls.

After observing that PSAs can post non-cash margin in the bilateral world, the report notes that a transition period was, “explicitly provided for under EMIR in order to provide further time for CCPs to develop technical solutions for the transfer of non-cash collateral to meet VM calls.” The solution envisioned was for PSAs to repo securities owned free and clear to generate the cash needed for VM.

On its face, this would be a workable solution, since there is an active market for repos in Europe, with several clearinghouses, such as LCH RepoClear, providing those services. If the derivatives were cleared at LCH, for example, it doesn’t seem to be too much of a stretch to imagine a linkage between RepoClear and SwapClear, where VM requirements would trigger a repo of securities held at LCH, and excess VM would trigger an unwind and return of the securities. Sounds like a good business model to me.

 However, the report points out an immediate concern:

The baseline study indicates that the aggregate VM call for a 100 basis point move would be €204–255 billion for EU PSAs. Of this, €98–123 billion (£82–103 billion) would relate to UK PSAs, and predominantly be linked to sterling assets, and €106–130 billion would relate to euro (and perhaps other currency) assets. Even if PSAs were the only active participants in these markets, the total VM requirement for such a move would exceed the apparent daily capacity of the UK gilt repo markets and would likely exceed the relevant parts of the EU Government bond repo market — i.e., primarily that in German Government bonds (bunds).

In other words, as I pointed out last July, the swaps markets are so large that a 100 bp move in short rates would create an enormous VM requirement. Given that risk, the report says:

The Commission therefore intends to propose an extension of the three-year period referred to in Article 89(1) of EMIR by two years through means of a Delegated Act. The Commission shall continue to monitor the situation with regards to technical solutions for PSAs to post non-cash assets to meet CCP VM calls in order to assess whether this period should be extended by a further one year.”

So, on the one hand, the VM requirement for European pension funds in the event of an upward move in rates is so large that the repo market couldn’t handle it. On the other hand, we’re all comfortable that the risk could be handled in the bilateral market. Really? Well, if all the PSAs are doing with swaps is hedging the risk of owning fixed rate debt, then we would expect them to be paying fixed and earning floating. Then, if rates rise, they will be receiving VM, not posting it. If, on the other hand, they own floating debt, why would they be hedging against a rate rise?

As it turns out, the management of this risk, as with all investment risks, doesn’t depend on whether the positions are carried in a CCP or not. It depends on whether the swaps positions are hedges and, if so, what risk they are hedging. If the PSAs are using swaps as a hedge, then the VM requirements would not be insurmountable, since the size of the positions would be commensurate with the size of the bond holdings. Thus the repo problem would solve itself. If they are not hedges, however, then someone should be asking what they are used for.

A good reporting system would help us assess this risk, but, as we all know, swaps reporting has been a disaster around the world. Thus we have very little chance of knowing how big the risk is, how well it has been managed, and when it will re-emerge. Instead, we’re focused on whether PSAs are required to clear their positions. Isn’t this another case of looking at second while the ball is going to first?

 

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Examining China’s Emerging OTC Derivatives Market

By Sol Steinberg, OTC Partners
Originally published on TABB Forum

China is building an OTC derivatives market without the shackles of legacy systems. It’s commitment to global financial reform will give one of the world’s largest economies a swaps market designed from the ground up for transparency, regulatory oversight and management of systemic risk.

When members of the G20 met in Pittsburgh in 2009 in the wake of the global financial crisis, they committed to reforms that ushered in a more calculated approach to systemic risk in the financial industry, and along with it, a new market structure for over-the-counter (OTC) derivatives. Anchored by the principles of mandatory reporting of OTC derivatives transactions, mandatory clearing through central counterparties (CCPs) and mandatory trading on exchanges or electronic trading platforms, the new market G20 planned for the OTC derivatives space stressed transparency, risk controls, and improved protections against market abuses.

In some of the world’s most established OTC derivatives markets, those changes are well under way. In the U.S. OTC derivatives market, trade reporting and central clearing are well established, and trade volumes on US Swap Execution Facilities (SEFs) is building. Europe has passed the European Market Infrastructure Regulation and implemented trade reporting. Legislative frameworks are being finalized and adopted for rolling out central clearing and trading on automated platforms. Elsewhere, in markets like Singapore and Australia, similar progress is being made, with reforms achieving milestones on the path to market transformation.

In line with this global commitment, Chinese regulators have proposed a similar regulatory regime. In China, where interest rate swaps, credit default swaps and many of the instruments that make up global OTC derivatives markets have not been traditional tools of finance, the commitment of the Chinese regulators to the post-financial crisis system of reforms means China is essentially building an OTC derivatives market without the shackles of legacy systems. China’s commitment to global financial reform will essentially give one of the world’s largest economies a swaps market designed from the ground up for transparency, regulatory oversight and management of systemic risk.

Central Clearing

Beginning in 2014 with mandatory clearing by the Shanghai Clearing House of new RMB interest rate swaps with tenors of no more than five years, China is building central clearing into the foundation of a its interest rate swaps market. Through Shanghai Clearing House, China was the fifth country in Asia to begin OTC clearing after Australia, Hong Kong, Singapore and Japan. On its inaugural data of operations, Shanghai Clearing House cleared 59 interest rate swaps between 15 financial institutions worth a total notion amount of 5 billion yuan, equivalent to $827 million.

On July 1, clearing of Chinese yuan interest rate swaps became mandatory onshore in China for dealers and clients. Thirty-five direct clearing members were admitted prior to launch, including nine foreign banks: Bank of East Asia (China), BNP Paribas China, Citibank China, Credit Suisse, Shanghai branch, DBS China, Deutsche Bank China, HSBC China, OCBC China and Standard Chartered Bank China.

Some notable foreign banks did not make the cut prior to the launch of mandatory trading of yuan interest rates swaps. Of the foreign firms that were not on board, some hesitated to join because of compliance rules and others were rejected by Shanghai Clearing House for various reasons. Authorized institutions, licensed corporations and other Chinese persons who are counterparty to a clearing-eligible transaction are required to clear through a CCP if both entities have a clearing threshold and are not exempted from clearing obligations.

Trade reporting and confidentiality

China has moved aggressively on other G20 goals as well. In China, only one trade repository should be designated for the purposes of the mandatory reporting obligation. The reporting obligation for Chinese persons will remain unchanged – i.e., their reportable transactions will have to be reported if their positions exceed a specified reporting threshold, which will be assessed based on the total amount of gross positions held. For licensed corporations, and local authorized institutions, the reporting obligation will apply if they are counterparty to the transaction or the transaction has a Chinese nexus. For foreign authorized institutions, the reporting obligation will not apply if its Chinese branch is neither involved as a counterparty to, nor as an originator or executor of, the reportable transaction, or its Chinese branch is the originator or executor of the transaction, but the reportable transaction does not have a Chinese nexus. A T+2 reporting schedule will provide market participants some leeway to ensure they can meet reporting obligations.

Reporting to global trade repositories will not suffice for the purposes of any mandatory reporting obligation under Chinese law. Chinese law prohibits the disclosure of state secrets, and there is some lack of clarity as to the definition of state secrets. In fact, there are already reports that some US firms located in China have stopped trading with each other in China because of concern that reporting their trades to US trade repositories, as would be required by two US firms, would be a violation of Chinese privacy law. Due to concern that the mandatory reporting obligation may compel market players to breach confidentiality obligations under overseas laws, Chinese regulators will try to build in a degree of flexibility into regime to avoid this.

Forthcoming: mandatory trading and oversight clarifications and adjustments

As of April 2014 three jurisdictions – China, Indonesia and the US – reported having regulations requiring organized platform trading. That said, mandatory trading will not be imposed in China at the outset, but will be phased in at a later date. Once mandatory trading on designated facilities is in place, fines will be imposed for breaches of mandatory trading obligations that will be comparable to those of other major jurisdictions around the world.

Legislation will seek to clarify when failures to comply with trading and clearing and reporting obligations should be penalized and when they may be excused. Chinese regulators should be able to take disciplinary action against parties that breach their obligation and regulators are also proposing a civil penalty regime whereby civil or administrative fines might be imposed for compliance breaches.

Margin and capital requirements will be proposed, and Chinese regulators intend to impose higher capital and margin requirements for non-cleared OTC derivatives transactions.

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CFTC Chairman Massad Addresses Cross-Border Issues, Extends Package Relief

In a speech to the Futures Industry of America, CFTC Chairman Timothy Massad discussed current and future regulation of derivatives. Ticking through a long list of agenda items that included a recap of regulatory activity to-date and deep-dive on cybersecurity, the Chairman’s most actionable comments centered on cross-border regulation and the upcoming extension of no-action relief to package transactions.

Noting that the CFTC and its staff have led all other G-20 nations in writing OTC derivatives rules, Massad acknowledged that it will be impossible to achieve full scale harmonization until all other jurisdiction have finalized their own laws.  He explained:

“So let’s remember that we are in a unique historical situation: the OTC derivatives industry grew up to be a global industry without any oversight or national regulation. Now, as the financial crisis exposed weaknesses in this global market we are seeking to regulate it through the actions of the various G-20 nations, each of which has its own legal traditions, regulatory philosophy, administrative process, and political dynamics. Although the G-20 nations have agreed on basic principles for regulating swaps, there will inevitably be differences in the specific rules as reforms are implemented, including in timing of implementation. This is something I regard as a glass half full, not half empty. We are making progress, but it will take time.

Indeed, the timing of implementation of reforms alone is a simple but critical issue in solving these cross-border issues. We wrote most of our rules faster than other jurisdictions and made many substituted compliance determinations last December. More will eventually follow. But you can’t make substituted compliance determinations until other jurisdictions have written their rules or passed their laws.”

Massad went on to note that he supports the recommendations of the CFTC staff that no-action relief on cross-border guidance, which is set to expire at the end of this year, be extended for the time being:

“We at the CFTC are also aware that the no-action relief that was granted with respect to the further cross border guidance we issued last November 14 will expire at the end of the year. This pertains to when a foreign swap dealer that engages in certain conduct in the United States is subject to U.S. transaction requirements. Earlier this year, the Commission asked for comment on that advisory. We are still considering those comments, as well as the relationship of this issue to other cross-border issues. Therefore, the staff is recommending that we extend this relief for the time being, and I support that recommendation so that we have the necessary time to consider these issues.”

Finally, Massad also announced that the CFTC would be extending no-action relief for SEF trading of package trades:

“I also wish to announce that CFTC Staff have recommended extending the no-action relief previously provided in order to phase-in the requirement to trade on SEFs swaps executed as part of certain package transactions—that is, transactions involving a swap that is required to be traded on a SEF and some other swap or other product. Over the last year, we have been phasing in the trading requirement as it pertains to swaps that are part of various types of packages. We recognize the market needs a bit more time on certain remaining packages, and I expect the staff will issue the letter shortly.”

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

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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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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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CFTC Certifies Tradeweb TW SEF MAT Determination

The CFTC announced today that it has certified Tradeweb Markets’ Made Available to Trade (MAT) determination.  This means that a number of U.S. dollar and Euro denominated benchmark credit default swaps (CDS) and interest rate swaps will be subject to the MAT provision.

As a result of the certification, transactions involving certain IRS contracts and CDS contracts will be subject to the trade execution requirement, effective February 26, 2014. This is in addition to the IRS contracts that will be subject to the trade execution requirement on February 15, 2014 and February 21, 2014, respectively.

A requirement of the OTC derivatives markets reforms adopted under Dodd-Frank is that all derivatives that have been MAT’d are required to trade on an exchange or a SEF or designated contract market (DCM).

Javelin was the first to MAT interest rate swaps, while Tradeweb Markets’ TW SEF was the first to MAT credit default swaps on October 29, 2013. Thus far, Javelin and trueEx have also secured MAT certification for certain interest rate swaps contracts.

To view the CFTC MAT announcement regarding the Tradeweb MAT certification, please click here.

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SEFs By the Numbers: Day One

By Will Rhode and Valerie Bogard, TABB Group
Originally published on TABB Forum

The launch of swap execution facilities on Oct. 2 was a success in that trading was largely uninterrupted and trade sizes remained in line with the OTC market. But many believe that overall swaps liquidity was negatively impacted, and the majority of buy-side firms did not trade on the first day. TABB Group breaks down the Day One numbers.

When Swap Execution Facilities (SEFs) went live on October 2, we polled the market to get a snapshot of activity as this long-anticipated date finally arrived. The launch was a success in that major disruptions and breakages were avoided despite the government shutdown and a last-minute rush to finalize documents and iron out technology glitches. Swaps trading activity was largely uninterrupted as SEFs went live, trade sizes remained in line with the over-the-counter (OTC) market, and a fair percentage of the market traded bilaterally, off-facility as blocks.

That said, a good portion of the market felt thatoverall swaps liquidity was negatively impacted by the introduction of SEFs, and the majority of buy-side firms did not trade on the first day, instead adopting a wait-and-see attitude at this initial phase of implementation. Many plan to become active on SEFs over the next three months (see below, TABB Group), as the temporary relief on pre-trade credit checks expires November 2 and both the Made Available to Trade Rule and mandatory trading requirement go into effect.

The bulk of SEF trades were conducted on dealer-to-customer (D2C) platforms, according to SEF data. Bloomberg and Tradeweb were the initial winners for market share, with 32 buy-side firms either onboarding, testing or live trading with them. Meanwhile, interest in swap futures as an alternative product to swaps has doubled over the past year, reaching 17% of respondents, as open interest in the contracts has steadily increased.

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Derivative Clearing Houses Shouldn't Be Too Big to Fail, Either

By Mayra Rodriguez, MRV Associates
Originally published on TABB Forum

With the regulatory push for central clearing of OTC derivatives, volumes and revenues have significantly increased at clearing houses. But this increases the danger that financial regulations have created the next 'Too Big to Fail' monster.

This is the fifth article in a nine-part series. It originally appeared on AmericanBanker.com. View the previous articles in the series and other thought leadership from Mayra Rodriguez Valladares here

Since the financial crisis, global regulators have been pushing to have as many over-the-counter derivative products as possible cleared with central counterparties, to improve transparency and minimize operational and credit risks.

As a result, volumes and revenues have significantly increased at these clearing houses. The regulators' intentions are good, but in my experience, any time business surges at any institution, risk managers and supervisors should be paying much more attention to the firm's increased operational risk.

CCPs, especially, have a lot of operational risk exposure – that is, potential problems arising due to people, processes, technology, and external threats – throughout the organization. A significant risk comes from the possibility of a member defaulting on the trades cleared by the CCP, and the potential insufficiency of the deadbeat's prefunded contribution to the default fund to cover this default. We do not want to end up in a situation where financial regulations give us the next 'Too Big to Fail' monster.

Fortunately, the Basel Committee recognizes this danger. In a recent consultative documentthe committee is signaling to banks that even if there are higher safeguards and default funds maintained by qualified central clearing parties, banks are not absolved from adequately calculating capital for those counterparties. Before Basel III, transactions with a QCCP did not require a capital allocation. These counterparties are also known as Derivative Clearing Organizations. Most of the exchanges, such as the Chicago Mercantile Exchange and Chicago Board of Trade, have one. There are a little more than a dozen of them in the U.S.

The new guidelines also encourage QCCPs to improve their default funds and their risk management. Together with recent guidelines on non-internal models to calculate derivative counterparties' risk, these recommendations are an important step in requiring banks, especially large international interconnected ones, to better identify, measure, control, and monitor their over-the-counter and exchange traded derivatives counterparties' credit quality. If bank regulators and market participants insist on higher standards for QCCPs, regulators could end up with an approach where capital charges for banks on exposures decline if QCCP default funds increase and safeguards around them are robust. QCCPs should be encouraged not only by regulators, but also by potential clients who want to minimize their capital charges.

In July 2012, the Basel committee had released interim rules on capital treatment for CCPs. To its credit, upon further study and cooperation with the Bank for International Settlements' Committee on Payment and Settlement Systems and the International Organization of Securities Commissions, the Basel committee admitted that it found that in some cases the interim rules were leading to instances of very little capital being held against exposures to some CCPs. In some cases, the capital levels were actually too high. Additionally, at times, the interim rules were also creating disincentives for QCCPs to maintain generous default funds.

In recognition of these findings, the new July 2013 guidelines focus on three areas related to transactions with QCCPs.

Two guidelines are for banks. First, the Basel committee proposes a new methodology to calculating a bank's capital for its trade exposures to a QCCP. Previously, the committee had recommended a mere 2% of the relevant risk-weighted assets. If the new guidelines were accepted, the risk weight applied to trade exposures would depend on the level of prefunded default resources available to the QCCP. If QCCP's want to attract banks as customers, they will have to really focus on their default resources; otherwise banks will have to allocate more in capital. With the new methodology, banks are likely to have to allocate 5% to 20% of RWAs depending on the QCCP's resources. While banks will not like the new guidelines, it should make them think more carefully about the amount and type of hedging or speculative derivatives transactions that they want to put on and will make them look for the QCCPs with the best safeguards.

Secondly, the new guidelines focus on new calculations for QCCP bank clearing members to use for prefunded default fund contributions. In my view and that of many financial derivatives markets reform advocates, the contributions required by the interim rules were not robust enough to absorb losses during market stress. The proposed method for QCCPs to calculate the default fund would better position the default funds to absorb losses, so that high credit quality members do not get hurt by a drawdown of the funds.

Thirdly, not only are banks required to improve their methodologies to calculate capital for transactions with QCCPs, but the guidelines also encourage QCCPs to have robust default funds. The Basel guidelines can be very useful if bank regulators use them to provide an incentive for, or at least not discourage, contributions to default funds to be prefunded, rather than commitments to pay after the fact. The creation of a default fund should not create new risk for the financial system in the form of hidden liabilities that surface when a trading partner falters. Rather, a default fund should serve to mutualize and distribute a risk that would otherwise fall on creditworthy members' trade exposure claims on the CCP.

Importantly, the proposed guidelines demonstrate the Basel Committee is aware that just insisting on additional capital is not enough. The Basel Committee is emphasizing that it wants improved risk management practices by banks and CCPs. For the QCCPs, there are established CPSS-IOSCO Principles for Financial Market Infrastructures so that they minimize their probability of disruptions or outright failures.

While the proposed guidelines can be very useful in improving banks capital against QCCPs, as I have written in these columns previously, it is imperative that banks disclose the inputs for their risk-weighted assets in calculating capital for positions with QCCPs.  Moreover the QCCPs will need to be more transparent about the level of their default funds and about how they are running simulations on how they would solve for multiple parties defaulting on trades simultaneously.  The more transparent banks and QCCPs are, the more likely it is that the transition of derivatives from OTC to clearing parties will provide safer financial derivatives markets and better capitalized banks.

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Is Clearing a Force for Good?

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

If central clearing delivers trust in the post-trade environment and the spread of market knowledge, then it is a force for good and should been seen as a new enabler for the development of emerging economies, more than aid or loans.

Most of us are focused on the large changes being made to the OTC derivatives markets in Europe and the US. However, when you look at the total system required to support market infrastructure from trading down to settlement, recreating that framework in a new country from scratch is an enormous undertaking -- I don’t mean just computers and software, but the legal framework, the settlement infrastructure, risk management and, importantly, the knowledge to bring it all together, much of which isn’t freely available and carries a high price by those that can provide it. If central clearing delivers trust in the post-trade environment and the spread of market knowledge, then I argue that it is a force for good, and should been seen as a new enabler for the development of emerging economies, more than aid or loans.

As countries develop, they have to engage with capital markets technology and import some or the entire capital markets framework into their economies to become competitive and attractive to outside investment. Developing a national capital market firstly relies upon law. This entails a well defined insolvency framework that recognises the rights of users of the capital markets to settle a bankruptcy in an orderly manner and preferably with netting of obligations within asset classes. Law enabling the delivery of securities as collateral must be in place, and of course there needs to be a corresponding securities lending market and a depository, to complete the foundations.

Once this is in place, the infrastructure for the effective movement of securities is needed. Most countries develop a depository to enable an equity or bond market, and if settlement delays are to be avoided, will want to provide a clearing function to enforce predictable settlement and de-risk the post-trade environment. Without clearing, the depository can only use fines to enforce good settlement behaviour, or block firms from participating in the markets at all.

The next step is development of traded products with central clearing. That needs technology for pricing and risk management, something that is harder to import or acquire than legal expertise. Vanilla products with observable prices such as interest rate futures, commodity futures or bond futures can be managed by reference to historical market data. Pricing, though, becomes more complex once options are introduced onto an exchange. Not only must the exchange be able to price options to calculate safe margin levels, but participants must have the ability to quote option prices, and become market makers to kick off the flow of trading activity.

Built on pricing technology is that of portfolio risk management and techniques such as Value at Risk (VaR) or the well used Standard Portfolio Analysis (SPAN). Pricing a single option is something you can do on-line; but pricing a whole portfolio of hundreds or thousands of trades and simulating the behaviour of markets to calculate margin levels is a higher order problem.

Computer hardware is cheap, so acquiring the processing power needed to carry out the calculations isn’t a barrier, but the intellectual problem of making sense of the data cascading out of the calculations is harder. The reality is that portfolio risk management relies upon a deep knowledge of statistics, plus the traded products themselves. Most people left behind statistics at high school, and the number of people who have the expertise to apply this knowledge in the context of central clearing is limited. Without this depth of knowledge and experience, the central clearing structure is unlikely to stand strong against the economic instability it is meant to protect against.

What good is all this for a developing nation? By introducing clearing for bond and equity markets, the margin and strict settlement requirements would (in theory) reduce credit risk in the secondary markets and attract more sources of capital, both on-shore and off-shore. Providing hedging products for risks such as interest and exchange rates would enable firms to transfer risk via a trusted counterparty (the CCP) and manage exposures proactively, rather than suffer from unpredictable and adverse rates making their business more costly and uncompetitive. By adding a CCP and bringing ‘trust’ into the capital markets, firms are enabled to grow and attract inward investment into an organised and safe market.

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E-Trading of OTC Derivatives: The Impossible Just Became Possible

By Rebecca Healey, TABB Group
Originally published on TABB Forum

The electronification of the over-the-counter derivatives market is happening much more quickly than anyone would have guessed. And it is driving a shift from the use of equity derivatives primarily for hedging to their use in the pursuit of alpha.

“OTC derivatives trading electronically? Never gonna happen.” A trader told me this only a couple of months ago. He may just want to eat his words.

In fact, the speed at which the supposedly sacred OTC derivatives markets will succumb to the vagaries of automated trading will happen at a far greater rate than most of the market suspects. New requirements for improved trade reporting will spearhead widespread uptake of automated workflows, transforming the equity derivatives market in the process.

EMIR Has Landed                                                      

EMIR technical standards on OTC derivatives regulation 648/2012 will require all counterparties to comply with operational risk management requirements – including timely confirmation, valuation, reconciliation, compression and dispute resolution – by mid-2013. The automation of workflows not only will enable firms to meet regulatory requirements, it will open up new opportunities to hedge risk, calculate margin and source liquidity, as increased use of data and technology will ensure the transition from a largely OTC bilateral market to electronic trading.

Meanwhile, as the need for trade certainty takes center stage, the introduction of the STP process will become the catalyst for the explosion of automated trading.

Turquoise, part of the LSE Group, announced this week that it will introduce trading in single-stock options, initially offering reporting of trades in single-stock options for 19 UK mining and energy listed companies. The introduction of trade reporting for UK options on June 10 will allow investors who already trade single-stock options and futures on other LSE-operated platforms to net their positions at LCH Clearnet.

From Hedging to Trading

Historically, European equity options have failed to reach the level of US interest; and interest from market participants remained centered on using options for hedging purposes rather than as a trade in its own right. However, the reasons for trading equity derivatives are already shifting as the cost of the insurance is becoming larger than the payout. Depleted margins and bank deleveraging due to Basel III are increasing the cost of hedging in the traditional sense. There is now little appetite for market makers to offer to warehouse risk for anyone other than the most lucrative clients. Increasing initial margin requirements plus onerous capital charges are removing the incentive to trade a large swath of non-clearable “exotic” derivatives. As a result, clients are being forced to standardize their product usage.

Investors are diversifying away from cash equity holdings at the same time as the derivatives product spectrum is becoming increasingly vanilla. This influx of new participants is transitioning the use of equity derivatives from a predominantly hedging function to a trading opportunity and altering the structural makeup of the market in the process.

Systemic Risk to Liquidity Risk

Similar to the changes in cash equities markets, traditional market makers will be forced to exit as automated trading gradually encroaches on their market share. Market participants will resort to greater levels of technology in order to transact their trades. Automated trade flows will lead to average trade sizes shrinking to avoid market impact, creating an increased feedback loop attracting further diversity of market participants and creating challenges for bilateral phone trading, hastening its demise.

While the move from a labor-intensive voice process to a centralized, transparent pricing module appears to be a slam dunk requirement for the buy side, the increased level of transparency will morph systemic risk into liquidity risk. The obligation to hold more collateral for OTC transactions will create additional pressure to hold liquid-only assets. As participants fight for dwindling liquidity in a reduced number of names, the liquidity premium will increase, and less actively traded instruments will become increasingly scarce.

Breaking down silos and resolving inefficient usage of collateral will now become a priority for firms obligated to hold more collateral for OTC transactions. Without an automated workflow process, efficient management of collateral will be impossible to manage. Without an optimal way to analyze the availability of collateral, there will be no way to ensure the ability to trade.

The ability to harness any available liquidity across the widest spectrum of instruments will require increased use of technology, irrespective of whether this is via a central limit order book, auction or RFQ process. The automation of the workflow process will make the step from partial to full automation merely a hair’s breadth away.

Technology is set to become the essential lifeline. As the evolution of OTC derivatives trading will transform the market from a predominantly voice-brokered industry to an electronic STP model, trading European derivatives successfully will become increasingly dependent on a combination of low-latency trading, global fund flows, data, trade analysis and, ultimately, economies of scale. The impossible has just become possible.

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