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.
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.”
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.
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.
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.
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 document, the 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.
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.
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.
By George Bollenbacher, Kinetix Trading Solutions
Originally published on Tabb Forum
The approval by the Commodity Futures Trading Commission and the Securities and Exchange Commission of the “Further Definition of Swaps” rule on July 10 has been heralded as the starting gun for many of the requirements under Title VII of the Dodd-Frank Act.
For sure, many of the effective dates of the rules that the CFTC has passed are set to 60 days after this rule appears in the Federal Register (an event everyone is watching for), but there are some important rules that haven’t been passed yet. So what will really start when the gun goes off?
What Has and Hasn’t Been Passed?
Here are the rules that have been passed by the CFTC and are awaiting the starting gun (in chronological order of passage):
- Reporting Pre-Enactment Swap Transactions
- Reporting Certain Post-Enactment Swap Transactions
- Prohibition on Price Manipulation
- Large Trader Reporting for Physical Commodity Swaps
- Process for Review of Swaps for Mandatory Clearing
- Swap Data Repositories: Registration Standards, Duties and Core Principles
- Derivatives Clearing Organization General Provisions and Core Principles
- Position Limits for Futures and Swaps
- Registration of Foreign Boards of Trade
- Real-Time Public Reporting of Swap Transaction Data
- Swap Data Recordkeeping and Reporting Requirements
- Registration of Swap Dealers and Major Swap Participants
- Business Conduct Standards for Swap Dealers and Major Swap Participants With Counterparties
- Internal Business Conduct Standards (too long a title to include here)
- Customer Clearing Documentation, Timing of Acceptance for Clearing, and Clearing Member Risk Management
- Further Definition of Various Parties (again, too long a title to include here)
- Swap Data Recordkeeping and Reporting Requirements: Pre-Enactment and Transition Swaps
- Core Principles and Other Requirements for Designated Contract Markets
- End-User Exception to the Clearing Requirement for Swaps
- Further Definition of “Swap,” (and a bunch of other categories)
Here is the list of the major rules that haven’t been passed as of July 23 (in chronological order of proposal):
- Core Principles and Other Requirements for Swap Execution Facilities
- Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants
- Capital Requirements of Swap Dealers and Major Swap Participants
- Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade
- Procedures to Establish Appropriate Minimum Block Sizes for Large Notional Off-Facility Swaps and Block Trades
- Swap Data Repositories: Interpretative Statement Regarding the Confidentiality and Indemnification Provisions of Section 21(d) of the Commodity Exchange Act
- Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act
- Clearing Exemption for Certain Swaps Entered Into by Cooperatives
Not everything begins with the starting gun but there is a lot to do and not much time to do it. You might want to record the London Olympics and play it back sometime after the Dodd-Frank starting gun goes off.
What Does It Mean For the Starting Gun?
Without reading all the rules listed above, what do we know about what will go into effect sometime in late September or early October?
Registration – Firms that qualify as SDs or MSPs will have to register by the start date. Qualification as SD means fitting into any of the categories below, with an aggregated (across affiliates) annual notional trading volume (the de minimis threshold) of $8 billion.
(i) Holds itself out as a dealer in swaps;
(ii) Makes a market in swaps;
(iii) Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
(iv) Engages in any activity causing it to be commonly known in the trade as a dealer or market maker in swaps.
Of particular interest is the third category because it doesn’t require that the entity perform most of the activities normally associated with dealing. There are some exceptions to the de minimis volume, such as inter-affiliate swaps, hedges for physical positions, swaps by floor traders and swaps included in a loan agreement. However, many large swap market participants – like hedge funds – could be swept up in the SD category. And that category has a host of requirements of its own. Among them…
Trade Reporting – One of the DFA requirements that will start with the gun is the reporting of trades (and follow-on valuations) to the SDRs. Trades done on SEFs or cleared at DCOs will be reported by those venues but most of those won’t be operational by the starting gun.
In other words, almost every trade done after the starting gun, but before the widespread use of SEFs and DCOs, will have to be reported by the dealer in dealer-to-customer trades and by one of the dealers in dealer-to-dealer trades. Since it doesn’t appear that the UPI and USI standards will be done by that time, reporting entities will need a reliable identification method for the products they trade.
External Business Conduct – Another requirement that will start with the gun is external business conduct, which primarily applies to SDs. In addition to some customer disclosure requirements, the rule also requires the SD to give the customer, before the trade is done, significant information about the swap and a mid-market price for the transaction. The dealer must also offer the customer a scenario analysis. These requirements only apply to off-SEF trades but, since SEF trading will probably not start with the gun, they effectively apply to all trades.
One significant point: the CFTC included deliverable FX forwards in the swap definition. The Treasury may exempt these forwards from the clearing and trading requirements but not from the reporting and business conduct requirements.
A special category of external business conduct requirements apply to trades done with special entities (SEs), which are governmental bodies and employee benefit plans. Many of these requirements can be satisfied by know your customer-type functions but potential SDs (and MSPs) will have to comply before the starting gun.
Internal Business Conduct – The last major requirement for SDs and MSPs is internal business conduct, which falls into two major categories. The first is record retention and covers the usual documents plus all verbal communications, not just on swaps, but on “related cash and forward” trades as well. For firms that routinely record trading conversations, this won’t be a big stretch but for those that stopped recording, it will be required at the gun.
The second category is listed under conflict of interest and covers both research and clearing. It says, in effect, that a trading unit can’t influence research output and that a clearing unit can’t influence trading (and vice versa). While that sounds innocuous, some of the language needs careful review, such as the prohibition of conversations about the content of research reports between the trading and research departments.
What Won’t Happen at the Starting Gun?
SEF Trading – Since no SEFs will be approved by late September or early October, no SEF trading, either mandatory or voluntary, will occur. In fact SEF trading will be a two-step process. First the SEF has to be approved and then it has to apply to make a contract available to trade. Once that is approved, mandatory trading will begin something like 60 days later. So the best guess as to when that will happen is sometime in the first quarter of 2013.
Mandatory Clearing – The same two-step process applies to clearing as to trading. However, the CFTC has already passed the DCO rules, while it hasn’t passed the SEF rules, so mandatory clearing will probably happen a little sooner than mandatory trading. Also, many of the more liquid swaps are already cleared, so there will be very little new process or technology required in those markets.
Uncleared Margin Rules – Various regulators have proposed rules covering the margin requirements for uncleared swaps and these regulators are attempting to coordinate their efforts. Meanwhile, we expect market participants to continue with their current practices. However, the margin rules could be adopted at any time, so everyone will have to keep an eye out for significant changes in this arena.
Block Trading – One of the most closely watched rules is the establishment of block thresholds above which trades can be done over-the-counter but must be cleared. It is possible that the SEF rule could be passed without the block threshold rule but that would require the CFTC to declare every trade a block, or none, which would be a problem either way. For automated trading systems, storing and checking the block threshold (which could change over time) will probably be new functionality.
Getting Ready for the Gun
Obviously, this all argues for prioritization of effort, especially since the gun goes off in about two months. Here are some of the highest priorities:
- Trade reporting – this encompasses not only the trade but daily valuations and lifecycle events;
- KYC functions – comparing current counterparty data with the requirements and preparing for the SE data requirements;
- Pre-trade disclosures – of swap characteristics, mid-market prices and any compensation arrangements the dealer has;
- Scenario analysis – preparation of SA for every trade and delivery to the customer where required;
- Voice recording – installation of equipment, where it doesn’t currently exist, for both swaps (remember to include FX forwards) and related cash;
- Firewalls – between the trading units and both research and clearing.
In accordance with the Dodd-Frank Act, the CFTC approved final regulations to establish a compliance schedule that will phase in the new clearing requirements. The schedule does not prohibit market participants from voluntarily complying with the clearing requirements prior to the deadline and it will be used at the Commission’s discretion.
Per the CFTC, the triggering event for the compliance schedule is the Commission’s issuance of a final clearing requirement determination.
Additional information about the compliance schedule as provided on the CFTC website:
“Phase 1/Category 1 Entities
- Category 1 Entities include swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, and active funds.
- The compliance schedule will phase in compliance with the clearing requirement for any swaps between Category 1 Entities or a Category 1 Entity and any other entity that desires to clear the transaction within the first 90 days after the Commission issues any clearing requirement.
- The compliance schedule provides these market participants with the least additional time to come into compliance based on, among other things, their level of activity, market experience, resources, and their status as registrants with the CFTC or SEC.
Phase 2/Category 2 Entities
- Category 2 Entities include commodity pools; private funds as defined in Section 202(a) of the Investment Advisors Act of 1940, other than active funds; or persons predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature as defined in Section 4(k) of the Bank Holding Company Act of 1956, provided that the entity is not a third-party subaccount. The Commission modified its proposal to remove employee benefit plans identified in paragraphs (3) and (32) of section 3 of the Employee Retirement Income and Security Act of 1974 from Category 2.
- The compliance schedule will phase in compliance for swaps between a Category 2 Entity and Category 1 Entity, another Category 2 Entity, or any other entity that desires to clear the transaction within 180 days after the Commission issues any clearing requirement.
- The compliance schedule provides these market participants 90 more days than Category 1 Entities because these market participants are not be required to be registered with the Commission and are likely to be less experienced and less frequent users of the swap markets than those in Category 1.
Phase 3/Category 3 Entities
- The compliance schedule will phase in compliance for all other swaps, including those involving third-party subaccounts, ERISA plans, and those not excepted from the clearing requirement within 270 days after the Commission issues a clearing requirement. In the final rule, the Commission has modified the definition of third-party subaccount to remove the execution authority requirement.
- The compliance schedule provides third-party subaccounts the most amount of additional time to bring their swaps into compliance as they are likely to require the most amount of time for documentation, coordination, and management.”
The compliance schedule will allot a compliance timeframe for each.
The DTCC testified last week before a Senate Committee that they are fully prepared to meet the September swap data reporting deadline as required by the Dodd-Frank Act.
At the hearing, Larry Thompson, DTCC Managing Director and General Counsel stated:
“DTCC will be ready on Day One to meet the new reporting requirements," Thompson said. “Over the past two years, DTCC has made substantial investments to design, develop and implement systems to support swap data reporting for all five OTC derivative asset classes. This infrastructure has been designed with maximum flexibility so that it can evolve over time to meet the changing needs of regulators and market participants. Regulators can leverage these resources in their efforts to enhance market transparency and ensure a safe and sound financial system."
The DTCC holds detailed trade information on more than 98 percent of all CDS transactions globally.
By Robert Pickel and George Handjinicolaou
Originally published on Tabb Forum
In many parts of the world, schools have come to the end of their terms, which makes it a nervous time for students: they are waiting for the report card to arrive.
We at ISDA empathize, as we too have been waiting for a report card. It came June 15 in the form of the Financial Stability Board's Third Progress Report on Implementation of OTC Market Reforms. The report measures progress toward the G20 commitments to reform OTC derivatives markets, agreed upon at the 2009 meeting in Pittsburgh.
So how did the OTC derivatives markets do?
Pretty well. As the report states:
Since the FSB’s previous progress report in October 2011, encouraging progress has been made in setting international standards, the advancement of national legislation and regulation by a number of jurisdictions and practical implementation of reforms to market infrastructures and activities.
One part of the report – the FSB’s discussion of exchange and electronic platform trading and market transparency – was especially encouraging. It elaborates on a recommendation to consider costs and benefits from their October 2010 report by explicitly adding that “Authorities need to take action to explore the benefits and costs of public price and volume transparency…. including the potential impacts on wider market efficiency, such as on concentration, competition and liquidity.”
We can’t say that the FSB has read our cost-benefit analysis of the Dodd-Frank requirements for SEF executionbut that sounds very familiar to the cost concerns that we raised in that study.
The biggest takeaway is that much remains to be completed by the end-2012 deadline to achieve the G20 commitments. The FSB leaves no doubt that they will be closely watching and driving for progress in the months ahead. As it states:
For the next progress report, the FSB intends to put additional focus on the readiness of infrastructures to provide central clearing, platform trading and reporting of OTC derivatives, the practical ability of industry to meet the requirements and the remaining steps for industry to take.
The report acknowledges that the largest markets in OTC derivatives – the EU, Japan and the U.S. – are the most advanced in their progress. It also recognizes that other jurisdictions are understandably waiting for those three regions to finalize their approaches before committing to a particular path of reform. It urges all jurisdictions “to aggressively push ahead to achieve full implementation of market changes by end-2012 to meet the G20 commitments in as many reform areas as possible.”
That’s the assignment for the public sector. But the FSB also has some assignments for the private sector, ones that we at ISDA are actively engaged in. Market participants are urged to address standardization, clearing, trading on organized platforms and reporting to trade repositories. Check, check, check and check – those are on ISDA’s agenda as well.
In short, the report card was delivered, but there will be no extended summer break for the OTC derivatives industry or all of us here at ISDA.