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Why Financial Market Infrastructures Matter

By Luis Carlos Nino, Thomas Murray
Originally published on TABB Forum

For now, the post-trade clearing and settlement infrastructure in Europe is humming along. But the unintended consequences of regulatory change could increase systemic risk rather than reduce it.

In the world of capital markets, the public spotlight has predominantly fallen on pre-trade and trade analysis. The media focuses its attention on the price of shares, the movement of currencies, the possibility of changes to interest rates and the fundamentals of markets, as well as corporate news.

These aspects matter for those making decisions to buy or sell securities and other instruments. In addition, these elements are visible and are perhaps more easily understood by the general public. In any case, it is important to note that public attention has not shifted to the financial market infrastructures (FMIs), because these have been working well, even during times of crisis. They are also less visible and somewhat less exciting to the press and public imagination.

In the mid-term, the post-trade sector will garner more of the spotlight, as it should. This is because, following the 2009 Pittsburgh G20 Summit, the tectonic plates of capital market infrastructures started to shift across the world. On the back of this summit, a series of complex and controversial new pieces of legislation were passed in the United States, the European Union (EU) and elsewhere.  As a result, the landscape of the financial industry has been changing dramatically and will continue to evolve over the coming years.

These changes to the financial environment are aimed at making financial markets less risky and more efficient. With the ostensible goal of minimizing risk and following the G-20 mandate, standardized over-the-counter (OTC) derivatives contracts have to clear through a central counterparty (CCP). In addition, CCPs in the EU must meet specific criteria to ensure they have robust risk management frameworks.

Similarly, and also with the same goal, EU regulators have set specific criteria that central securities depositories (CSDs) must meet. These criteria are aimed at standardizing key elements of settlement and safekeeping. In addition, EU lawmakers have established that both investors and issuers will be free to choose any infrastructure within the EU, as long as it meets EU requirements. This will open the field of competition, driving FMIs to be more efficient. Ultimately, this may benefit investors and issuers.

At least in theory.   

There are, in these regulatory changes, some side effects that must be analyzed and monitored.

First, having CCPs clear OTC derivatives substantially increases the degree of risk concentration in the market. This means CCPs will be more vulnerable and the repercussions to the market in the case of failure would be very serious and difficult to contain.

Secondly, by making CSDs compete with one another, there will be a consolidation process among them. Those CSDs that are expensive or have significant weaknesses in terms of asset servicing capabilities and asset safety, are likely to be absorbed by large groups that can generate economies of scale and are able to provide high quality services to both investors and issuers. Ultimately, this means more commercial concentration, as Europe will go from having more than 20 CSDs, to having just a handful.

All of these elements will be sufficient in diverting the media spotlight towards FMIs. But there is one more element that makes these regulatory changes even more important for investors and financial intermediaries.

Recently enacted EU regulations have imposed a high degree of legal liability on depository banks in terms of monitoring and advising their end clients of the different risks associated with the infrastructures they use. This implies that financial intermediaries should have a thorough understanding of FMIs and be in a position to monitor developments.

These potential changes are of international significance.

The result is that there will be more risk concentration at CSDs and CCPs. Admittedly, there will be opportunities for investors and issuers, if they feel they can benefit from engaging with a different CSD or CCP. For some financial intermediaries, there are new responsibilities to their end clients.

What do these elements have in common? They need to continuously monitor, over the next few years, the evolution of the post-trade space in Europe.

A final thought: As Europe’s infrastructures evolve, they will be doing so in the context of ongoing regulatory and commercial changes in the global financial system. This means a lot of moving parts. 

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Cleared for Launch: A New Era for OTC Derivatives

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

Buy-side users of OTC derivatives face many uncertainties as they prepare for mandatory central clearing in Europe, and they are turning to their dealers and clearing houses for help. But the widening range of instruments available offered by trading venues in response to the central clearing mandate is drawing in new market participants. Meanwhile, for CCPs, central clearing is an opportunity to generate new relationships and revenues, but it requires adjustments to existing services and operations as well as the development of new ones.

Buy-side users of OTC derivatives face many uncertainties as they prepare for mandatory central clearing in Europe, a requirement that finally comes into force next year, but which stems from the G20’s 2009 pledge to reduce systemic risk in the market. Initially, the European Market Infrastructure Regulation (EMIR) demands that major clearing brokers must centrally clear a select group of highly liquid interest rate derivatives. But eventually all counterparties must make arrangements to adopt central clearing if they want to carry on using any standardized OTC derivative. 

For asset managers – many of which fall into EMIR’s ‘Category 2’ basket of market participants that must start central clearing derivatives six months after clearing brokers migrate – interest rate swaps (IRSs) are a core risk management tool for bond portfolios, also used for hedging very specific client liabilities as part of liability-driven investment solutions. Ahead of EMIR’s deadlines, asset managers have been assessing the capabilities of clearing brokers, getting to grips with the collateral implications of margin calls by central counterparties (CCPs), selecting account structures to protect clients’ assets and liaising with end-clients such as pension funds to inform them of the cost and risk aspects of the new clearing requirements. 

On top of these complex and challenging tasks, asset managers – along with other users of OTC derivatives – must also come to terms with “frontloading,” a requirement unique to Europe’s approach to migrating from bilateral to central clearing. Because derivatives contracts expire over a variety of maturities, the migration process could lead to some instruments being centrally cleared and others bilaterally, thereby creating an uneven playing field for market participants. 

To ensure that the European market moves swiftly to a centrally cleared environment, EMIR includes the frontloading obligation, which requires bilateral trades entered into before central clearing is introduced to be centrally cleared once the new rules are in force. The rule has proved controversial and has been subject to a series of changes and clarifications over the past 12 months or so. In short, the frontloading period has shrunk, the range of exempt counterparties has increased, and a threshold has been introduced whereby only non-clearing member financial institutions with more than a certain level of derivatives notional outstanding must comply with the requirement. 

Nevertheless, there will be a seven-month period during which ‘Category 2’ asset managers know that any bilateral agreement to enter into an IRS is very likely to result in a central clearing obligation, if the contract has not expired by the time the EMIR clearing mandate comes into force.

Buy-side clearing challenges

For the vast majority of asset managers that have not previously centrally cleared OTC derivatives transactions, the initial response to the incoming EMIR clearing mandate has been to select a clearing broker and a CCP through which to clear. Some firms that already used exchange-traded derivatives turned initially to their futures clearing brokers, but the central clearing of OTC instruments is such new, unchartered territory that many asset managers have found themselves looking for brokers that could demonstrate capabilities and expertise across the OTC and exchange-traded space and across asset classes. 

The advice of clearing brokers is critical to another of the important decisions facing asset managers – that of selecting appropriate account structures. EMIR specifies that as well as existing omnibus account structures that hold the assets of multiple clients of a clearing member, CCPs must offer individually segregated accounts. These are designed to offer maximum protection to asset managers’ clients, such as pension funds whose assets are posted as collateral, thereby funding initial and variation margin payments in support of centrally cleared OTC derivatives transactions.  

From a frontloading perspective, one of the first tasks asset managers need to do is establish whether they trade sufficient volumes of OTC derivatives to be categorized as Category 2 or Category 3 market participants, the latter benefitting from a longer phase-in period. Although Category 2 and 3 firms have different clearing obligation timelines, the frontloading obligation only applies to Category 2 firms.

“To define yourself as Category 2 or 3, you need to calculate your OTC derivative positions – at an individual fund level and not at a group level – over a rolling three-month period to determine if you are over the EUR8 billion notional activity that would determine the fund being regarded as Category 2,” explains Lee McCormack, Clearing Business Development Manager at Nomura. “You also need to work out who you’re trading with, whether they’re going to be classified as 2 or 3, and whether the frontloading obligation applies.” 

Moreover, buy-side firms need to consider the operational and valuation implications of having OTC derivative transactions on their books that fall under the frontloading obligation. Trading a swap on the understanding that it will eventually go for central clearing may have an impact on credit support annexes (CSAs) and discount valuations, with implications for pricing too. 

For Luke Hickmore, Senior Investment Manager at Aberdeen Asset Management, uncertainty about clearing costs is the primary but not the only concern over frontloading. “There will be a period during which we’re holding the contract but we won’t know what the clearing costs are going to be at the end of that period. How that affects the value of your contract is going to be really important and needs addressing as soon as possible. Buy-side firms and their end-clients will have to look closely at the existing CSAs they have in place with their counterparties as well as the documentation provided by clearing houses. For us, it’s about taking a project management approach to getting over these complications,” he says.

The number of parties potentially involved and the complexity of the issues raised by frontloading means prompt action is required by asset managers, regardless of the scope for further slippage of regulators’ timelines. “Buy-side firms should be working with their clearing members now to get their trading limits and initial margin limits in place so that they have a lot more certainty that when they trade that product, they will be able to put it into clearing simply,” recommends McCormack.  

The earlier the issue is addressed, the better chance asset managers give themselves of working through all of the implications, from the front to the back office. “Buy-side firms need to be in a position to track, monitor and report transactions that will need to be frontloaded and ensure that those positions are then factored in as far as central clearing is concerned. It is not necessarily that difficult, but there is a great deal of operational work to adapt systems for adequate tracking and reporting, as well as the work required in terms of interfacing with CCPs in preparation for central clearing of IRS and other OTC derivatives,” says Hirander Misra, CEO of GMEX Group. 

From an operational perspective, Aberdeen’s Hickmore cites regulatory uncertainty as causing problems for the buy side at a time when resources are stretched by a need to deal with a wide range of reforms and rule changes in parallel. Europe’s central clearing rules have been consulted on, re-drafted and delayed on several occasions, and it is highly likely that asset managers will not now have to start clearing interest rate swaps until Q3 2016. That might give extra time to prepare, but the stop-start nature of implementation projects is far from ideal. 

“A lot of it has been done, but has now been put on ice. We saw our project stop at the end of last year when the time to clearing was getting longer. Since then, we’ve revisited the project to ensure our cost assumptions and concerns over operational complications are still valid. That’s not easy and it requires resources,” says Hickmore.  

Alternative approaches

As noted earlier, a key objective of the emerging post-crisis regulatory environment is to reduce systemic risk in the OTC derivatives market. In part, this means incentivizing market participants to choose the most highly regulated and operationally robust instruments. For example, the margin requirements for non-standardized OTC derivatives are based on a 10-day value at risk (VaR) treatment, while margins for plain vanilla, centrally cleared OTC derivatives are calculated on a five-day VaR basis, and listed derivatives attract a two-day VaR treatment, making the latter potentially the cheapest to fund over time, provided it offers the same level of protection. 

Aberdeen’s Hickmore views higher margin requirements for centrally cleared OTC derivatives compared with the historical cost of bilateral trades as a potential performance drag on his portfolio. “It’s not about transaction or usage charges; it’s about the long-term performance brake that placing collateral with a CCP for initial and variation margin can put on the portfolio. It’s hard to quantify, but asset managers are going to have to get on top of it,” he observes. 

The rising cost of swaps and other OTC derivatives instruments, not to mention the multiple uncertainties over future clearing costs, as exemplified by frontloading obligations, has sparked a number of innovations from venue operators that have caught the eye of buy-side firms. 

“The overall weight of the regulations and the costs of clearing trades centrally versus bilateral transactions mean that our clients are looking at exchange-traded alternatives with keen interest,” says McCormack.

In the US, swap futures listed by the CME Group and Eris Exchange have gained a foothold, while in Europe new exchange-based products are also being introduced ahead of EMIR’s central clearing mandate. One of these is GMEX’s Constant Maturity Future, the value of which is based on an underlying proprietary index to replicate the economic effect of traditional IRS, in an exchange-traded environment. 

“Buy-side users of OTC IRS are facing a capital shortfall as these instruments are forced into central clearing, and are looking for cheaper alternatives. With a Constant Maturity Future, you get the effect of an IRS, but a lower cost of margin and the cost of funding due to the two-day rather than five-day VaR treatment,” explains GMEX’s Misra. 

“The GMEX Constant Maturity Future closely mimics the underlying IRS market, the difference being it’s a two-day VAR product as opposed to a five-day VAR product, so it’s substantially cheaper on the cost of margin and the cost of funding,” continues Misra. “With an IRS-type framework but exchange-traded, that is good for the buy side because they can look at moving some of their positions to contracts like this. Equally, it also ensures that they can use their capital in a much more efficient manner.” 

Aberdeen is actively looking at use of exchange-traded alternatives to centrally cleared OTC derivatives and sees tools such as the GMEX Constant Maturity Future as having operational benefits. “For us, certainly in a credit world, it’s a good instrument, because it doesn’t have to be rolled all the time,” says Hickmore. “This means you can have a portfolio fully hedged off against your risks all the way across the yield curve on an ongoing basis. The on-exchange nature of such products also makes them operationally simpler.” 

But further innovation is required if asset managers are to find exchange-traded alternatives to all their hedging needs. “We’ll certainly be looking to do more exchange-traded derivatives, but many of our clients need more custom-built interest rate swaps, which will have to be centrally cleared,” says Hickmore.  

Developments in the exchange-traded market may not be sufficient just yet to replace the precision that tailored OTC derivatives can deliver to individual counterparts, but the widening range of instruments available offered by trading venues in response to the central clearing mandate is drawing in new market participants. Niche money managers that might have balked at the complexity of the OTC market are exploring the new competitive landscape with vigor says Nomura’s McCormack. 

“Smaller clients that have never had access to the OTC markets are seeing this as a great opportunity to get into trading different types of products,” he observes.  

Supporting roles

Despite new innovations such as swap futures, some buy-side market participants will continue to want to use familiar hedging instruments, at least until the new regulatory and competitive landscape takes a firmer shape. As such, they are looking to their clearing brokers to provide execution services, access to clearing and expertise, with the latter perhaps being the most important factor for buy-side firms that have never previously dealt directly with a CCP. 

“Both clearing brokers and clearing houses need to continue their efforts to raise awareness among buy-side firms of the implications of central clearing and the opportunities to maximize capital efficiencies – for example, by identifying and pursuing margin offsets across similar product sets,” says Misra. 

Clearing houses have had to embrace an entirely new role in interfacing directly with investment management firms, having previously dealt only with clearing members. According to Byron Baldwin, Senior Vice President, Eurex Clearing, they are already working closely with the buy side, notably by simulating currently unfamiliar processes in preparation for central clearing, such as posting margin, on a daily basis.  

“In our simulation program, we take trades from execution through to clearing and then generate the reports they would receive. It’s a matter of testing the pipes between the various platforms, testing the information flow, seeing the confirmation of trades, and understanding the margin calculation process. A lot of buy-side firms are sending us their portfolios to help them assess the margin implications of the positions within those,” he says.

For CCPs, central clearing is an opportunity to generate new relationships and revenues, but it requires a number of tweaks and adjustments to existing services and operations as well as the development of new ones. Eurex Clearing, for example, already accepts a wide range of asset types as collateral for margin payments and offers cross-margining across listed and OTC products. 

In 2014, Eurex introduced new services – Direct Collateral Transfer and Collateral Tagging – to help buy-side firms to tackle new challenges thrown up by central clearing of OTC derivatives, such as transit risk (i.e., the risk that collateral directed by an asset manager to an individual segregated account resides with a clearing member at the point of default and thus does not reach the CCP). “By introducing Direct Collateral Transfer, we eradicated transit risk. With Collateral Tagging, a big fund manager with 100-plus segregated accounts can achieve operational benefits by having just one fully segregated account with collateral tags on a per-fund basis,” explains Baldwin. 

Although the services required to handle the shift to central clearing are gradually falling into place, many challenges remain. Larger buy-side firms typically have a greater capacity to absorb the implications of regulatory change than their smaller counterparts. Their obligations under reforms such as EMIR are greater too, of course, but smaller firms must also comply, often needing more input from their sell-side counterparts to do so. 

“There is a level of clients which will have had lots of attention from their dealers and from their CCPs; but also there are a lot of smaller clients who have not had the time and attention,” notes McCormack. “It’s also important to get the message out to them, helping the clients understand their obligations and how they can prepare for them.”

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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.


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 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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