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You’re Not Ready for MAR? Are You MAD?

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

Although a lot of time and money have been spent on getting ready for MiFID II, there is another regulation out there that is actually more dangerous: the E.U.’s Market Abuse Regulation, or MAR. Along with its sibling, the Market Abuse Directive, or MAD, they pose a double threat to market participants worldwide.

Although a lot of ink has been spilled, and a lot of money spent, on getting ready for MiFID II, there is another regulation out there that is actually more dangerous: the E.U.’s Market Abuse Regulation, or MAR. Along with its sibling, the Market Abuse Directive, or MAD, they pose a double threat to market participants worldwide.

The first threat has to do with timing. Although MiFID II is currently scheduled to go into effect in January 2017, and there has been lots of discussion about a one-year delay, MAR/MAD is scheduled for July 2016, and there has been no indication of a delay in it. Thus, it behooves every market participant to understand these regulations, their applicability and how to comply.

The second threat has to do with applicability. MAR says that it applies to any instrument traded on an E.U. venue, any instrument where the underlying trades on an E.U. venue, or any benchmark based on instruments traded on an E.U. venue. Importantly, it purports to apply to any market participant who trades these or who executes orders in them, no matter where the trade was done.

What the Rules Say

MAR/MAD covers two main subjects: insider trading and market manipulation. Let’s look at insider trading first.

Insider trading is covered in Chapter 2 of MAR and Article 3 of MAD. They define insider trading as: “where a person possesses inside information and uses that information by acquiring or disposing of, for its own account or for the account of a third party, directly or indirectly, financial instruments to which that information relates. The use of inside information by cancelling or amending an order” is also culpable. That last sentence is very important because it is distinctly different from the SEC’s approach, contained in Rule 10b-5. Rule 10b-5 says that trading on what it calls material non-public information is culpable, although CFTC Rule 180 prohibits attempts to manipulate, and MAR/MAD says that even attempting to trade on it is a violation.

MAD says: “that insider dealing, recommending or inducing another person to engage in insider dealing … , constitute criminal offences at least in serious cases and when committed intentionally.” Article 4 of MAR says that the monitoring and reporting obligation applies to “investment firms,” but doesn’t mention third-country firms as defined in MiFID II. Finally, MAR/MAD makes it clear that brokers who execute orders for customers, but don’t trade as principal, are responsible for monitoring customer order flow for suspicious activity.

Market manipulation is covered in Article 12 of MAR and Article 5 of MAD. MAR defines manipulation as “entering into a transaction, placing an order to trade or any other behaviour which:

  • “gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of, a financial instrument, a related spot commodity contract or an auctioned product based on emission allowances; or

  • “secures, or is likely to secure, the price of one or several financial instruments, a related spot commodity contract or an auctioned product based on emission allowances at an abnormal or artificial level;

  • “unless … such transaction, order or behaviour ha[s] been carried out for legitimate reasons, and conform with an accepted market practice.”

That’s not all it has to say, however. It also lists “any other activity or behavior, … which employs a fictitious device or any other form of deception or contrivance,” and “providing false or misleading inputs in relation to a benchmark.”

MAD has much the same definition, so at least there is some consistency there. It does call out that, “Member States shall take the necessary measures to ensure that the attempt to commit any of the offences referred to in Article 3(2) to (5) and (7) and Article 5 is punishable as a criminal offence.” So the E.U. regulators are pretty clear that unsuccessful attempts to manipulate the markets are as bad as successful ones. This raises one question, however, since the logic of enforcement has relied on the concept of damage to other market participants: If attempts to manipulate are unsuccessful, one wonders how the regulators will demonstrate damage.


The first implication is that, as with MiFID and Dodd-Frank, global market participants are facing different, and possibly competing, regulations from different regulators. For example, U.S. persons transacting in E.U. instruments will be subject to MAR/MAD, while E.U. persons transacting in U.S. instruments will be subject to SEC or CFTC rules. This is particularly important with insider trading because a recent decision by the U.S. Second Circuit Court of Appeals eliminated insider trading culpability if the tippee (the trader) did not know that the tipper (the insider) was gaining financially from the information. Since no such ruling has been made in the E.U., it is reasonable to conclude that comparable surveillance practices in the U.S. and E.U. will not necessarily turn up comparable infractions, even for identical activities.

The second implication is that surveillance systems need specific patterns and metrics in order to issue alerts, and no such metrics are contained in any of the rules or the accompanying Regulatory Technical Standards (RTSs) issued by ESMA. The RTSs, which are about five times as long as MAR and MAD combined, spend a lot of time talking about allowed procedures such as buy-backs, stabilizations and market soundings, but no time addressing metrics. In fact, all the documents tend to define manipulative behaviors in terms of intent, as opposed to results. That will very likely lead to two possible outcomes: 1) excessive false positives, or 2) a lot of missed manipulations.

A third implication is that the reporting formats are different between the U.S. suspicious activity report (SAR) and the E.U. suspicious trade or order report (STOR). A field-by-field analysis shows a significant number of fields in the STOR that aren’t in a SAR. For example: the name and position of the reporting person, the relationship of the reporter to the subject, the reasons for the suspicion, and the acting capacity of the reporting entity with respect to the subject.


For U.S. market participants there are three major impacts of MAR/MAD: surveilling unexecuted orders, preparing STORs, and reconciling U.S. and E.U. approaches to insider trading.

Since Rule 10b-5 only applies to executed trades, complying with MAR/MAD will require introducing surveillance of unexecuted orders. To begin with, many trading systems either don’t keep unexecuted orders, or purge them after a short period. The same applies to dealer and multi-party networks. To the extent that those systems handle E.U. instruments and the parties are subject to MAR/MAD, order records will have to be retained and monitored.

Those systems that prepare and submit SARs in the U.S. will have to be updated to create and submit STORs. That will mean determining whether the systems even capture the extra data elements identified above, and then the STOR messages will have to be formatted and sent to the appropriate regulator.

Finally, any monitoring and reporting system will need different logic for reporting suspected insider trading in the U.S. and the E.U. Since reporting any suspicious behavior on the part of a client carries significant risk to the relationship, investment firms will be walking a tightrope in either domicile.

Hanging over all of these uncertainties is the biggest one – the fact that there are no metrics provided for determining when an activity is suspicious. As a result, firms will be left to grope their way down a dark corridor, trying to find a happy medium between over-reporting and missing an obvious event. Given the threat in MAR of being held criminally liable, it is no wonder that the prospect of implementing these rules by mid-July has left many firms not only unhappy, but downright angry.

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The Waiting Game: 5 Themes That Will Define Capital Markets in 2016

By Larry Tabb, TABB Group
Originally published on TABB Forum

Stuck between financial regulation and the next presidential election, 2016 will be a year of waiting – waiting on market structure reform, waiting on higher rates, waiting to see if disruptive fintech actually disrupts, and waiting on the next commander in chief. As the year plays out, the impact of these drivers will come into greater focus. Larry Tabb offers five themes that will define the capital markets in 2016.

2016 will be challenging for capital markets firms, but the challenges will not be insurmountable. Stuck between financial regulation and the next presidential election, 2016 will be a year of waiting – waiting on market structure reform, waiting on higher rates, waiting to see if disruptive fintech actually disrupts, and waiting on the next commander in chief. While few, if any, of these issues will be fully resolved in 2016, as the year plays out, the impact of these drivers will come into greater focus. Here are five themes that will define 2016.

1. The Election

It comes as no surprise that the majority of Americans believe our current election process is a mess. Virtually unlimited spending, the devolution of the Republican Party, and the rise of the anti-politician will make 2016 a year of political bombardment, as SuperPacs, political talk shows and late night comedians’ lampoons will make it impossible to ignore the US presidential election.

Through this rancor, I believe Hillary will wind up victorious – that is, unless a dark horse unexpectedly appears out of the shadows. While not particularly likable and viewed as untrustworthy by many, voter demographics, experience, name recognition, and the mess that is the Republican Party should enable Hillary to seize the mantle. Just look at the leading Republican candidates: Trump, Cruz, Rubio and Carson. Two are anti-politicians, one is less liked than Hillary, and the other is losing traction rather than gaining it. That said, even though the Republican Party is a mess, the election won’t be a landslide, with the victor winning by less than 5% of the popular vote. Who would have guessed that we would be pining for the days of Romney and McCain?

While a Republican would be better for the industry, Hillary shouldn’t be so bad. Given that Hillary is a Senator from New York, lives in Westchester, and has a history of working with the industry, and given the industry’s contributions to both her campaign and Clinton Global, it would be hard to see her take a drastic turn against Wall Street. That said, the good times of the ’90s and early ’00s are gone. It will be years before we see those days again.

Though she was tough on banks in her now infamous New York Times OpEd, this was more about political posturing and a call for campaign contributions. If elected, I believe she either will backtrack on many of these proposals or, more likely, have a very difficult time getting many of these planks through Congress, which will continue to be either Republican-controlled or -dominated.

The bottom line for the elections: The status quo will remain, with no sweeping victories, defeats and/or financial industry mandates. And we most certainly won’t be replacing the national anthem with Kumbaya any time soon.

2. FinReg – Still Dominating the Agenda

Regardless of who wins the election, gutting, or even rolling back, Dodd-Frank will be very challenging. And even if Dodd-Frank is gutted, getting the Basel Committee to reform Basel III/IV will be virtually impossible. While we may see some small changes to swaps trading regulation and some process changes (but not much) on extraterritorial regulation/substituted compliance, expecting the G20 derivatives rules for swaps to just go away or for the CFPB to pack it in would be like expecting the Mets, Jets and Islanders to all win 2016 world championships. Good luck with that.

Financial regulation will continue its push to make banks safer by boosting transparency, upping capital charges, increasing product standardization, ratcheting up stress tests, and generally limiting banks’ financial/capital markets activities. Basically, more of the same.

The focus in the US will be Basel III compliance, finalizing and adopting the SEC version of Title 7 swaps reform – which, by the way, is substantially different than the CFTC version – and what seems to be a never-ending stream of compliance challenges stemming from dark pool mischief, collusion, spoofing and market manipulation that the regulators will increasingly use to prosecute misbehavior (both real and perceived).

While the US will be drowning in compliance and regulatory issues, however, Europe will assume the regulatory focus. With EMIR’s implementation gaining steam and the MiFID II rules in final stages of approval, Europe, while two to three years behind the US in terms of financial reform, will be entering that critical phase of rule finalization, on-boarding, and conceptualizing the reality of new requirements’ impact.

While the world embraces financial regulation, the market’s No. 1 question will be about liquidity provision. As banks get weighed down by the anchor of financial regulation, two things can occur: First, banks find a way around the regulations by creating new and different products, or by developing a new governance structure that enables them to circumvent the most significant rules and capital charges; or second, they don’t.

If banks can’t get around finreg, which is the most likely scenario, bank liquidity will continue to drain from the market and risk will be transferred to investors, while the intermediary function is taken over by firms that are not as heavily regulated. While intermediary liquidity pools will decline, the newer and less-regulated firms that fill these gaps will have much better technology and connectivity. This will leave the market with thinner capital cushions and faster turnover rates.

Though banks will be safer, we expect greater market instability and volatility, especially given the rising rate environment. While we expect more high-yield funds to crater, the impact will fall on investors, not financial institutions. We don’t expect anything nearly as pernicious as the credit crisis, but an increasing number of volatile moments will plague the markets like a death by a thousand cuts.

3. Rates and Fixed Income Market Structure

The Federal Reserve has finally raised rates, albeit by only 25 basis points. In 2016, according to experts, rates will go up by 100 or so basis points. This most likely won’t create panic in the streets. We will, however, see some of the more precarious funds fail, not unlike Third Avenue. This also will be a test for the vast array of new credit trading platforms. While we don’t expect these new platforms to take over the market in 2016, we do expect a few to gain traction. This will be the boost that they need to refine their business models, hone their matching modes, push the buy- and sell-sides to at least test their platforms, and keep them in business.

While the rising rate environment will float some of these boats, however, it will be harder for the others to stay in business. We expect liquidity in these platforms to centralize around a few winners. Platforms that obtain client traction will generate a buzz, attracting more players and more liquidity, and the old saw “liquidity begets liquidity” will be the operative phrase for 2016.

On the rates side, we will continue to see technology-enabled market makers displace traditional market makers. More flow will be electronically traded, and the market increasingly will look more like equities than bonds.

As both rates and credit become more electronic (albeit in different ways), we will see the role of regulators change. Securities regulators historically have kept their distance from traditionally OTC markets. As more bonds (and currencies) trade on-screen, it will be easier for regulators to see how well brokers/dealers are treating their clients and how best execution rules can be applied to OTC markets. This will put an increased focus on broker/dealer behaviors and increase the number of enforcement actions. “Last look” will end, and by the end of the year, we will be one step closer to an agency-style market for fixed income products.

4. Equities Market Structure – Change Around the Edges

Equities market structure, unfortunately, will remain in the headlines. Fixing the ETP challenges demonstrated by the chaos of August 24 will be the first priority for the SEC, following the very interesting fact-filled but analysis-void paper it put out in December. Though not extensive, we should see changes to the opening process, the calculation of indices, and the tinkering of limit-up/limit-down thresholds for ETPs. While not radical, these changes will challenge some existing businesses and create opportunities for others.

Talking about shifting opportunities, IEX will eventually become an exchange. It needs to. If it doesn’t, it will be hard to keep its investors happy. While I don’t think that the SEC will force IEX to eliminate the speed bump, I am not sure regulators will greenlight the exchange as it currently stands; IEX may have to put its router on the same side of the speed bump as other brokers, or make other concessions to comply with Reg NMS/fair access rules.

If IEX is approved with either the speed bump and/or the router bypassing the speed bump, we will certainly see a few of the smaller exchanges change their structure to encompass similar, but not exactly the same, features as IEX. This will create a mess and leave routing firms stuck trying to decipher the location of real liquidity, its current price, how to negotiate each market given their peculiarities, and how to compensate for all of these new market structures in their routing strategies. While IEX advantages are supposedly tipped toward investors, what is to stop someone from subtly changing the model deleteriously?

Outside of the exchange brouhaha, regulators will continue to push transparency. We saw the SEC put out a proposal in November on ATS-N, and there are discussions around extending Rule 605/606 reports to cover institutional flows. Hand in hand with global regulators, equity transparency issues will continue to be front and center.

On the dark pool front, we will see regulators finally tie up the loose ends on outstanding dark pool settlements, but that won’t be the end of it. We will see a number of other dark pool investigations/settlements, as there are rumors of other enforcement actions circulating. The SEC also will finalize and implement ATS-N dark pool disclosure rules, which, of course, will create more compliance challenges and fines.

On the “kick it down the road” side, I am not optimistic that we will see much progress on the CAT. While regulators winnowed the field from six to three bidders in 2015, we still don’t have an SEC CAT czar, and it just seems as if the CAT has not been a major SEC priority.

With the delay of MiFID II, we see debate, confusion, and eventually some finality. Regulators will relent on strict separation of payment for research and trading commissions by allowing CSAs, but that won’t alleviate the challenges that European investors, brokers, and providers will have in ascertaining cost, quantifying value, and paying providers. The double volume caps will remain, but they will be very hard to enforce given the inability to collect data and to manage the reference price and large-in-scale exceptions, not to mention the lack of clean and consolidated data.

While MiFID will challenge the equity business, the European fixed income markets will be thrown into a tizzy as they come to grips with what transparency and accessibility really mean in the fixed income markets. This will be especially poignant given a US rate rise and the increasing pressure Basel III will place on European banks. This will certainly come back to bite Europe, especially if volatility picks up.

5. Fintech

While the talk around the industry will continue to revolve around regulation and enforcement, the excitement around fintech will increase. Though we are years away from a credible blockchain alternative, we will see factions develop in various target markets – including smart contracts, clearing/settlement, payments, securities lending, and back-office automation. While the smoke from blockchain initiatives will increase, however, we are still too early to see much fire. There will be deals, and proofs of concept, but wide-scale adoption is still years away.

Robo-advisors will continue to gain traction, but again, true disruption remains years away. Given it has taken almost 20 years for ETFs to hit the $2 trillion mark, we won’t see robos pressuring traditional managers in 2016. That is at least five to 10 years off, if at all.

That said, cloud, compliance, cyber security, and big data will continue to push ahead. While not the most sexy of topics, many of these technologies are battle-tested and can demonstrate realistic value propositions today.

Opportunities for the Fleet of Foot

In the macro, 2016 will be a challenging environment for banks, as regulation – including capital rules and the Volcker Rule – and enforcement actions will keep them on their heels. This will also impact hedge funds. Hedge funds had a pretty lousy 2015, and 2016 will remain challenging. Leverage will be hard to get and expensive. While the direction of rates will be more certain, it will be harder to take advantage of them without prime brokers’ balance sheets opening up. Long-only funds will continue to be pressured by ETFs, whose low cost structure will continue to prove problematic for traditional brokers.

As banks’ and brokers’ comp models remain under pressure, talent will continue to move toward firms without the heavy regulatory burden, oversight, and hurdles. This will push market making and HFT firms to begin courting traditional investors. While this won’t reach a flood in 2016, it will be the start of a long process as the industry shifts away from a banking model to the more traditional brokerage/investment banking model popular in the 80s and 90s.

One thing that can derail this process (and improve the industry outlook) is a way of better obtaining leverage, outside of the traditional bank/repo model. If we can develop/create leverage outside of the large banks/prime brokerage model, or novate financing risk through repo clearing or another mechanism, market making/dealer desks and other intermediaries will be able to be more active in the market without as much counterparty risk. This would be a significant help not only to banks, brokers, and hedge funds, but also to investors of all stripes, who would enjoy greater liquidity, better asset pricing and less execution risk. That said, we don’t expect this problem to be solved before the 2017 ball drops in Times Square either.

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Final U.S. Rules on Margin for Non-Cleared Swaps

By Amir Khwaja, Clarus Financial Technology
Originally published on TABB Forum

The United States published its final rules to establish the minimum margin requirements for swaps transacted by insured depository institutions that are not cleared by a clearing house. Clarus Financial Technology’s Amir Khwaja distills all 281 pages of requirements in little more than 1,000 words.

On Oct. 22, the United States published its Final Rules to establish the minimum margin requirements for swaps transacted by insured depository institutions that are not cleared by a clearing house.

The Joint Rules are the work of the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), the Federal Reserve Board (FRB), the Farm Credit Association (FCA) and the Federal Housing Finance Agency (FHFA) in consultation with the CFTC and SEC.

The press release and full documentation are available here.

Having waded my way through all 281 pages, at least three times, this is my summary and analysis.


The rules apply to Covered Swap Entities, which are registered with the CFTC or SEC and require the daily collecting and posting of risk-based variation and initial margin for non-cleared swaps.

They are consistent with the international framework proposed by BCBS and IOSCO for margin requirements for non-centrally cleared derivatives, published in September 2013.

Types of Counterparties

Four types of swap counterparties are defined:

  1. Swap entities

  2. Financial end-users with material swaps exposure (>$8 billion average daily notional exposure)

  3. Financial end-users without material exposure

  4. Non-financial end-users, Sovereigns and Multilateral Development Banks

Variation Margin

Covered Swap entities are required to collect or post daily variation margin with a swap entity or financial end-user (so in above list, only type 4 is exempt) in an amount that is at least equal to the increase or decrease in the value of the swap since the previous exchange of variation margin.

There is no threshold amount below which variation margin does not need to be collected or posted – except if the combined initial and variation margin is less than $500,000.

Initial Margin

Initial Margin may be calculated in one of two ways:

  1. Standardized margin schedule (given in the rule documentation)

  2. Internal margin model that satisfies specific criteria and has been approved by a prudential regulator

Initial margin must be collected and posted daily by a covered swap entity when its counterparty is a swap entity or a financial end-user with material exposure.

A maximum threshold of $50 million is allowed, below which it is not necessary to collect or post initial margin.


Eligible collateral for variation margin requirements between swap entities is limited to cash funds in U.S. dollars, another major currency or the currency of settlement for the swap. For financial end users, the same forms of collateral as permitted for initial margin are permissible.

Eligible collateral for initial margin includes cash, debt securities issued by the US Government or a US Government Agency, BIS, IMF, ECB, Multi-lateral development banks, GSEs, certain foreign government debt securities, certain corporate debt securities, certain listed equities, shares in certain pooled investment vehicles and gold.

Non-cash collateral is subject to haircuts as detailed in the rule documentation – e.g., 15% for gold.

A cross-currency haircut of 8% is specified for non-cash collateral denominated in a currency other than the currency of settlement.

Collateral to meet the initial margin requirements collected by a covered swap entity must be segregated and placed with a third-party custodian.

And collateral other than variation margin that it posts to a counterparty must also be segregated at one or more third-party custodians.


Foreign swaps of foreign covered swap entities are not subject to the margin requirements of the rule, while covered swap entities operating in a foreign jurisdiction and those organized as US branches or agencies of foreign banks may choose to abide by the requirements of the foreign jurisdiction if the agencies determine these are comparable to the final rule.


A covered swap entity is required to collect margin from its affiliates; however, it is not required to post initial margin to its affiliate (that is not also a covered swap entity), but must calculate the amount of initial margin that would be required to be posted and provide such documentation to the affiliate on a daily basis.

Each affiliate may be granted an initial margin threshold of $20 million.

Compliance Dates

The rules will apply to non-cleared swaps entered into on or after the applicable compliance date.

There are separate dates for variation and initial margin, with phased compliance.

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Netting Agreements

The rule permits the calculation of margin on an aggregate net basis across swaps executed with a counterparty under an Eligible Master Netting Agreement (EMNA). Either separate netting portfolios can be maintained for new swaps subject to compliance and old swaps not subject to compliance, or an entity can choose to include old pre-compliance swaps in the netting portfolio subject to the final rules.

Standard Initial Margin Models

The Standard Minimum Initial Margin is a simple method using looking tables of Asset Class and percentage of notional (e.g., 4% for IRS > 5Y) and then a calculation that gives some netting benefit, specified as 0.4 * Gross Margin + 0.6 * Net to Gross Ratio * Gross IM.

Very similar to the standard method for market risk capital.

This method will produce very high margin requirements for a portfolio of swaps, and as such it’s use is expected to very limited.

Meaning that approved internal models will definitely be the way to go.

Approved Initial Margin Models

The final rule specifies criteria for these models:

  • one-tailed 99% confidence level

  • 10-day close-out period (not scaled from 1d)

  • must include material non-linear risks

  • calibrated to a period of financial stress

  • the period to be at least 1 year and not more than 5 years

  • the data in the period to be equally weighted

  • a product must be assigned to one asset class (fx, ir, cr, cm, eq)

  • no risk offset is allowed between asset classes (so sum of each)

  • be approved by the entities prudential regulator

  • annual review of model and other governance similar to risk-based capital models

And that just about covers the main points.

Approximately 1,100 words.

Much better than reading 281 pages.

Of course, if you really need the full details, please click here.

Some Thoughts

A few jump out at me.

First, if both parties are swap entities, then they will both need to calculate margin requirements, and for initial margin the calculation is asymmetric, as the loss tail is not the same as the profit tail. Meaning for the same portfolio of trades between us, I will calculate how much to collect from my counterparty and it will calculate how much to collect from me, and the two will be different even with the exact same data and methodology.

Naturally, each party will also want to check the other’s calculations, using both its own internal model and perhaps also what it knows about the assumptions and data used by the other party’s model.

Common utility, I hear you say?

But that sounds too much like a clearing house.

A clearing house for non-cleared swaps, an oxymoron I think, though no doubt some will be launched.

But short of an actual and regulated clearing house, would a swap entity trust an external body to tell it the amount of margin to collect and post?

I doubt it. More likely, each swap entity will calculate what it needs to collect and post, both will be using approved internal models and will disclose details to their counterparty, so we are just left with the need to resolve disputes. Something that will have to be covered under the Master Agreement between the firms.

To calculate the initial margin, firms will most likely leverage their existing in-house or vendor supplied Value-at-Risk systems. Assuming that these are up to the task of handling the new demands.

Many more thoughts come to mind, including ISDA’s proposed Standard Initial Margin Model.

But that is one for another day.

Roll on Sept. 2016, March 2017 … Sept. 2020.

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Dangerous Border Crossings Under MiFID II

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

There are three parameters that govern the applicability – and thus the requirements – of various parts of MiFID II to market participants. But complicated criteria means crossing E.U. borders can be a dangerous process. George Bollenbacher provides some guidance on when and to whom MiFID II rules apply and highlights three trends that are likely to emerge as a result.

In a previous article, I addressed some of MiFID’s regulations on the provision of investment services to E.U. customers by firms outside the E.U., called “third-country firms” (“MiFID: Is ‘Third Country’ Synonymous With ‘Third World’?). While that issue is complicated enough in itself, it actually represents a small fraction of the cross-border concerns that are surfacing as people dig into the MiFID II requirements. So, unfortunately, we have to spend some more time in this area.

Understanding the Parameters and Combinations

There are actually three parameters that govern the applicability of various parts of MiFID II. The first is the regulatory venue of the investment firm providing the services. Second is the regulatory venue and status of the customer for the services. And finally there is the regulatory venue of the instrument(s) involved. When we start combining those parameters, we get a pretty wide variety of possibilities.

These parameters in turn affect the requirements contained in both MiFID and MiFIR, and, for good measure, MAR (the market abuse regulation). Among the more important requirements are: the trading obligation, the pre-trade transparency obligation, the post-trade transparency (or transaction reporting) obligation, the best execution obligation, and the obligation to monitor customer activity for market abuse. Some of these obligations appear to be triggered by where the customer is located, some by where the firm is based, some by the venue of the instrument, and some are just too confusing to call right now.

The Simple Combinations

Let’s look at the simplest of the combinations first. We will assume here that any non-E.U. firm has attained the appropriate third-country status, so that it can deal with EU customers. The first combination is a non-E.U. firm dealing with a non-E.U. customer in non-E.U. instruments. It seems pretty clear that none of the MiFID rules apply, except that we need to be careful with customers that are non-E.U. subsidiaries of E.U. entities, where the trade might have a significant impact on the parent or the E.U. itself.

The other simple combination is an E.U. firm, an E.U. customer, and an E.U. instrument, where all the E.U. provisions seem to apply. I think we can handle that one.

Some Complications

But things immediately start to get more complicated. For example, let’s look at an E.U. firm dealing with and E.U. customer in a non-E.U. instrument. Barclays executing a trade for Scottish Widows in U.S. Treasuries, for example. Simple enough, right? One would think that there’s no MiFID trading obligation, since the security doesn’t trade in the E.U. … unless somebody in the E.U starts an MTF for Treasuries. And, we hope, no reporting obligation.

But what about best execution? Since the customer is an E.U. person, albeit a professional, what best ex obligation does Barclays have? If Barclays is acting as a principal in this trade, which is highly likely, does the MiFID best ex requirement apply at all? And, while we might not think that market abuse would be applicable in Treasuries, our friends at Goldman would probably tell us otherwise, based on some recent revelations. So whose market abuse regulations apply: the E.U.’s or the US’s – or maybe both? Oh, I almost forgot, what is Barclays’ obligation regarding pre-trade transparency? If it did this trade as principal, must it expose the quote it showed the customer to the rest of the E.U. market, even though the trade was done in its New York office?

Just for fun, let’s reverse the parameters. A non-E.U. firm executing for a non-E.U. customer, in an E.U. instrument. UBS Securities LLC (with no presence in the E.U.) selling a German Bund for a U.S. hedge fund. If the bund is listed in the E.U., we assume that the trading obligation applies, as long as UBS can trade on that venue. Except, it isn’t UBS the Swiss bank we’re talking about, it’s UBS Securities LLC, the U.S. securities firm. Let’s assume that LLC isn’t a member of any of the E.U. venues where the bond trades, so it would have to use a broker such as its Swiss affiliate to execute. Now we need to know whether the trade with the hedge fund was done as principal, with LLC doing a matching trade with its Swiss affiliate. Or was it done as agent, with LLC passing the order through to the E.U. broker? If so, was it done omnibus, where the executing broker (the Swiss bank) only knows LLC as the selling party, even though the actual seller was the hedge fund? Or was it done on a disclosed basis?

Let’s say it was done as agent, under the omnibus arrangement. Clearly the trading obligation applies ... or does it? The selling party, the hedge fund, isn’t bound by any MiFID rules, and its agent, LLC, isn’t either, since it isn’t an “investment firm” as defined by MiFID. Never mind, we’ll do the trade on a venue. But the executing broker, which must then file the report, doesn’t know who the actual seller is, so part of its reporting requirement can’t be satisfied. And do any of the parties owe the hedge fund a best ex report? Oh, and the monitoring for market abuse – who does that? If the original seller is a U.S. person, and the broker that knows its identity isn’t subject to MiFID, can anyone be held to the monitoring obligation?

But wait, it turns out that LLC bought the bonds from the hedge fund as principal, so it is the one selling them on the venue. The trade with the hedge fund is totally outside of MiFID and MAR, and totally within the purview of the SEC, except the SEC doesn’t regulate trades in E.U. securities. LLC’s trade on the venue is the one now under MiFID. So it doesn’t take much imagination to see non-E.U. customers gravitating to principal trades with U.S. broker-dealers in E.U. instruments – let somebody else worry about MiFID.

And just to complicate it a bit more, let’s say that LLC sold the bunds as principal to its E.U. affiliate, raising the question of whether inter-affiliate trades are covered. I’ve asked ESMA about this, but haven’t heard back yet.

Sorting It All Out

So now, I don’t know about you, but I’m pretty confused. With all these moving parts we need some organized way of looking at this. Let’s try the matrix below, where the columns labeled Trading, Reporting, Best Ex, Pre Trade and Market abuse indicate whether the MiFID requirements apply. Hopefully, the domicile columns are self-explanatory.

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There are a few “?”s in the matrix, and I’m perfectly prepared to admit that I’m not 100% sure about some of the other answers, so if any of you have something to add on this, please chime in.

Some Possible Developments

Meanwhile, what can we predict about how this will all shake out?

  1. The best execution requirement, which has everybody up in arms, will probably lead to a rise in limit orders, as long as everyone agrees that this part of Article 27 of MiFID II means what it says: “Where there is a specific instruction from the client the investment firm shall execute the order following the specific instruction.” The open question is whether a limit order in a principal trade that is away from the market (too high on the bid or too low on the offered) is still exempt from the best ex obligation.

  2. For non-E.U. customers that want to avoid some of the MiFID requirements, such as intrusive trade reporting, and for non-E.U. dealers that serve them, there will probably develop a “grey market” of principal trades in E.U. instruments by two non-E.U. parties, where MiFID doesn’t apply, and where the non-E.U. dealer then lays off the position with an E.U. affiliate. The desire of some E.U. customers to avoid some E.U. regulations may also lead to a raft of customer requests for service under Article 42 of MiFIR. In any event, one of the major impacts will be to drive some trades in E.U. instruments outside of the E.U.

  3. As with every other part of MiFID, technology will be the key. OMSs will have to store domicile information about both the customer and the instrument, and will have to apply the appropriate rules, since traders and/or salespeople won’t be able to make those determinations on the fly. Who’s working on that – are you?

The hordes of migrants moving across the European continent have reminded us recently that crossing E.U. borders can be a dangerous process. By the middle of next year the world’s financial markets may be proving the very same thing.

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Regulation Is Transforming the OTC Market. Compliance Is a Journey, Not a Goal

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

Within the next 18 months, the impact of mandatory clearing and the margin on bilateral OTC trades will begin to reshape the global OTC market, driving changes in participants’ technology and businesses. Many firms might choose to scale back their short-term compliance investments until there is even greater regulatory clarity.

For many involved in regulatory compliance, the work has only just started. For CCPs, the scramble to achieve authorization under EMIR hit a crescendo in September 2013. Just five months later, the introduction of OTC trade reporting for EMIR brought a flurry of activity and much chaos. The pace of regulation hasn’t slowed since then, and neither have the intense demands to remodel internal processes. However, with some of the biggest and most impactful regulatory developments still to take place over the next 18 months, many firms might choose to scale back their short-term compliance investments until there is even greater regulatory clarity.

Trade Reporting

The onset of OTC and ETD trade reporting in Europe in February 2014 created a new industry of trade repositories (TRs) and other services designed to gather, reformat, transfer and reconcile the vast flow of data required by regulators. However, European trade reporting was significantly different from that in the U.S., leading to incompatible data across TRs. In particular, the U.S.’ decision to allow “single-sided” reporting, where one party can report for both entities on a trade, has proven to be much more efficient than the “double-sided” European approach. As a result, a review of EMIR is underway.

Other compliance streams over the next two years include:

  • Level 2 validation by TRs: a tighter requirement for European TRs to reject data that doesn’t meet a higher standard of accuracy than currently

  • Reporting of Security-Based Swaps to the SEC: parallel regulations to the CFTC, but for CDS and other trades within the remit of the SEC

  • EMIR phase 3 reporting: an outcome of the EMIR review

  • Securities Financing Transactions reporting: covers equity and repo trades, plus any collateral swaps

This article doesn’t cover trade reporting regulations outside the U.S. and Europe. One approach for firms to meet these regulations (and the BCBS 239 Risk Aggregation regulations) is to build an internal trade warehouse with the trade parameters and economic factors to satisfy the expanding range of regulatory needs.


Clearing is mandatory in the U.S. for specific transaction types, but doesn’t begin to take effect in Europe until late 2015. Even then, it will take until 2018 for full implementation of the phased timetable:

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While many firms have voluntarily begun clearing in advance of these timelines, the next wave of adoption will be the Category 2 firms in 2016. With the withdrawal of Nomura, RBS and BNY Mellon from the client clearing business, this might be the time that the survivors become profitable. Conversely, more providers may exit the market, which would result in difficulties for the Category 2 firms to obtain access to clearing.

Bilateral Margin

In September 2016, the OTC markets will be subject to the mandatory application of variation and initial margin to non-cleared trades. While the margin requirements are for trades executed after that date, the details aren’t final and may be amended to include backdated trades.

Variation margin (VM) applies from September 2016 to firms with an exposure of EUR3trn or above, and to all firms from 1st March 2017. There are 136,936 non-cleared agreements in use according to the 2015 ISDA Margin Survey, so the introduction of a mandated VM requirement won’t be technologically difficult for many firms. However, the need to make and receive the calls daily will be new to some buy side firms.

The legal challenge is far greater if all of those bilateral relationships need new credit support documents. While the industry looks for a way to simplify the process with standard documents and protocols, the search is laden with obstacles and complexities.

Exchanging two-way initial margin (IM), which requires firms to align their portfolio within five asset classes and apply either a simple schedule-based calculation (that could be costly in margin) or a complex value-at-risk (VaR) approach to all non-cleared trades, is the more challenging mandate.

The IM requirement is phased over a lengthy period until 2020, but will likely have the biggest economic impact (other than capital rules) to OTC businesses since their inception. Few firms apply a broad IM requirement into their collateral agreements presently, and the IM mandate will increase the cost of a complex OTC portfolio significantly. In response, some banks may withdraw their most complex trade structures from use, or even close whole business lines if the IM is too high and difficult to reduce.


While MiFID and its corresponding regulation MiFIR are primarily targeted at securities trading, they also include new requirements for trade reporting and open access rules between exchanges and CCPs.

The introduction of open access rules will allow a CCP to request access to an exchange to clear their trade flow and likewise for an exchange to request access to a CCP to send trades for clearing. The end goal is to allow the free choice of CCP-exchange combinations in the pursuit of horizontal competition, rather than the prevalent vertical alignment seen in today’s markets.

Detractors of open access say that the arrival of multiple CCPs clearing a single exchange venue will split liquidity, as has happened with swap execution facilities (SEFs) for cleared trades, and therefore will not be beneficial in the long run. Supporters say that the opportunity for participants to aggregate one asset class (such as STIR futures) on a single CCP will reduce net margin calls as well as technology and operation costs. The reality of the regulations is hard to predict. Lengthy timetables, opt-outs for small CCPs, and pushback due to liquidity concerns, operational capacity and cost reasons could limit the regulations’ impact.

Another goal of MiFID is to introduce a new class of trading platform, the Organized Trading Facility (OTF), intended to mirror the SEF model in the U.S. At some point, firms may be obligated to execute OTC trades on an OTF much like they are required to do on SEFs in the U.S.

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In the commodities markets, REMIT will introduce trade reporting requirements from late 2015 to early 2016. REMIT also addresses inside information, market manipulation, and market participant registration. It requires all participants in European commodities markets to be centrally registered, and will use the data reported to detect occurrences of inside information and market manipulation. Firms have little time to prepare, as the bulk of REMIT is to be complete by April 2016.


Two remaining regulatory streams focus on capital and risk management. The Fundamental Review of the Trading Book (FRTB) is a fresh look at the models and approaches used to calculate capital requirements. There is an extended period of modelling referred to as the Quantitative Impact Study (QIS) to test proposals for new rules, intended to be a step forward from the previous Basel II and Basel III approaches. BCBS 239 is a parallel and complementary approach to gathering key risk information within a bank. The key Bank for International Settlements (BIS) goals are to:

  • Enhance the infrastructure for reporting key information, particularly that used by the board and senior management to identify, monitor and manage risks

  • Improve the decision-making process throughout the banking organization

  • Enhance the management of information across legal entities while facilitating a comprehensive assessment of risk exposures at the global consolidated level

  • Reduce the probability and severity of losses resulting from risk management weaknesses

  • Improve the speed at which information is available and hence decisions can be made

  • Improve the organization’s quality of strategic planning, and ability to manage the risk of new products and services

The target date for completing the implementation of BCBS 239 is early 2016, so the firms affected will be heavily invested in their compliance efforts throughout the end of 2015.


It’s clear that the various regulatory streams will require financial institutions to upgrade their digital infrastructure to meet extensive reporting and risk management goals. A few key elements include:

  • A trade warehouse with the majority of trade parameters across all asset classes

  • A record of the risk metrics for every trade, and ways to calculate margin and risk factors across multiple trades in multiple asset classes

  • The infrastructure to distribute and report this data to many global venues

  • An approach to verifying the accuracy of the data delivered externally

Within the next 18 months, the impact of mandatory clearing and the margin requirements for bilateral OTC trades will begin to reshape the OTC market; by 2017, we may see a quite different market for OTC products. Don’t let up on the compliance program – we are only at the beginning of the regulatory journey.

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Trading Derivatives in Asia: If You Go Down to the Woods Today…

By Lewis Richardson, Fidessa
Originally published on TABB Forum

The Asian derivatives markets increasingly are the destination of choice for firms across the derivatives spectrum. But bear traps remain for the unwary. How can you choose the safest path through the woods of this asset class in Asia?

Derivatives markets in Asia are basking in global attention, with exchanges, clearing houses, brokers, international investors and vendors all piling in to local markets. Between August 2014 and August 2015, trading in SGX China A50 futures more than doubled. (Source: SGX).

Global exchanges are even going native to some degree, with ICE, for example, localizing its contract size and introducing domestic clearing in the Asian time zone. RMB and gold futures are on offer locally, as well as Mini Brent and Mini Gasoil futures. Seeing these global derivatives powerhouses reshape themselves for Asia demonstrates clearly the opportunities on offer here, and interest in trading in Asia is unlikely to wane any time soon.

European bond products are now being traded on ICE, and Eurex is planning to start clearing bonds in the Asian time zone in the next couple of years; opportunities abound for both local and international firms to expand their businesses and investments. As competition heats up between rival exchanges, even greater choice will become available. The key is taking advantage of this while avoiding the bear traps peculiar to the region.

Growth in the region is reflected in the annual growth of 27% in total F&O volume traded (Source: FOW).

The first challenge is regulatory. American and European institutions used to dealing with a single regulator will find plenty of new challenges to navigate in the treacherous terrain of Asian regulation. Regulators here can be even trickier than ESMA or the SEC. In Singapore, the MAS made some unprecedented demands of SGX after a systems outage. In Hong Kong, market participants have to answer long questionnaires about their use of technology and back-testing of algos. In Malaysia, equities and derivatives rules are completely un-harmonized – all securities activity must be completely onshore, yet derivatives are all remote.

The speed of regulatory change can also be frightening for those used to the lumbering processes in other regions. Asian regulators can – and do – move the goalposts in a single day, whereas in Europe it has taken seven years so far, with no end in sight. Being ready for Asia’s blistering pace is vital for success in this part of the world.

There’s plenty of innovation in derivatives, but regulators here have been taking a dim view of some more out-there solutions. Brokers and banks have been asked very directly to provide certainty around the security and storage of financial information – all regulators have rules on this, none of which are exactly the same, but all of which are relatively onerous.

Different clearing regimes require different approaches as well, so getting the middle and back office piece right is very important. While regional brokers localize their operation by allocating head count into the region, many larger firms outsource their middle office to places such as London – which means these companies are unlikely to be tooled up to meet nuanced Asian requirements. Technology developed for the big US and EU markets will need tweaking to meet Asian needs. The good news here is, a firm that has solved this conundrum for Asia has met the highest global regulatory hygiene requirements and so can legitimately claim the gold standard.

Once the regulators are satisfied, the nature of doing business in Asia continues to be challenging. Getting the balance right between direct market membership and trading through a local broker is important to ensure a cost-effective solution. Accessing global markets efficiently is important, as clients will be trading CME and ICE as much or more than local exchanges. Yet as the global exchanges begin to offer local trading and clearing, trading ICE can mean two different things.

This raises an interesting point. Clients now can choose which regimes to trade in, throwing up the question of regulatory arbitrage. There could be plenty of good reasons to choose one venue over another, and these reasons will differ from client to client. Having intimate global knowledge of each regime and its benefits and pitfalls will be a great selling point for firms willing to invest the time to understand this complex landscape. On top of this, offering a seamless and smooth end-user experience will be a very enticing proposition indeed.

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Data Analytics Hold Key to Saving the Sell Side

By Matthew Hodgson, Mosaic Smart Data
Originally published on TABB Forum

Regulation is rapidly increasing transparency across financial markets, enhancing audit requirements and ensuring effective market surveillance. However, the mounting cost of compliance continues to squeeze sell-side banks, which have been facing declining FICC revenues and higher capital costs. With the introduction of MiFID II set for January 2017, technology – and particularly data analytics – could hold the key to developing competitive advantage in this new regulatory reality.

Since the financial crisis in 2008, regulation has played a key role in transforming the structure of capital markets and the manner of counterparty interaction. The requirements imposed have enabled regulatory bodies, such as the FCA, FINRA and SEC, to introduce more effective monitoring and superior levels of transparency across foreign exchange (FX), fixed income, equities and commodity markets.

Driven by regulatory change, trading activity has migrated away from opaque voice based markets toward a model based on transparency and risk mitigation on electronic venues, with market participants increasingly required to report and clear trades through CCPs. 

The playing field for sell-side sales and trading teams is shifting permanently from relationship-driven to electronic message-based banking.

While the structural benefits of reform to the financial ecosystem are wholly apparent, however, the cost of compliance for individual firms has increased significantly, with sell-side banks bearing the lion’s share of the burden. As a result, the ability of these institutions to hold trading inventory and operate as liquidity providers has been increasingly constrained by regulatory capital requirements and mounting pressures on fixed costs.

According to the Economist, FICC revenues have fallen by 48% among the world’s largest banks over the four-year period between 2009 and 2013, and the downward trajectory is expected to continue. This has much to do with the desire from the Central Bank community to keep long-term interest rates low through quantitative easing, thus depressing trading activity, but also the weight of regulation. Current industry research indicates that these sell-side institutions will continue to experience fixed income balance sheet declines of between 10%-15% over the next 2 years and as much as 15%-25% out of flow rates.

Facing the Challenge

  • Banks’ FICC revenues have already declined by 48%
  • Cost-to-income ratio (CIR) remains above 70%
  • Fixed income balance sheets set to decline by further 10%-15%

These challenges have arisen as a result of two prominent factors:

  1. A sharp rise in regulatory oversight, with banks now having to post increased regulatory capital to cover potential losses; and
  2. Tighter spreads associated with electronic trading having a detrimental impact on revenue. While this provides enormous benefits for the wider market, this decline in margins has resulted in banks having to turn over their balance sheets at a faster rate, as the cost of warehousing risk has becomes increasingly prohibitive.

Adding to the current concerns, the implementation of MiFID II will further reshape the regulatory landscape, posing new challenges for banks, specifically by changing the way in which bonds, derivatives and ETFs are traded on electronic platforms. While full details are yet to be finalized, proof of best execution is a regulatory certainty, and the new rules will force players to adjust their market models toward a hybrid-agency model. This will be especially relevant for banks that cannot afford the capital costs of maintaining inventory. Clearly, many of the lessons learned from the equity markets will now be applicable to the FICC markets, with specific emphasis on being able to measure execution performance in both a principal and agency environment.

Marching Out of Step

Despite the growth, adoption rates in electronic trading, a key component of financial technology, remains inconsistent, with significant discrepancies between FX, equities and fixed income, as well as across geographical lines. The fixed income market, for example, has transitioned at a slower pace by comparison, with 57% of volume executed electronically in Europe and only 12% in the US in 2014, according to Greenwich Associates. However, sell-side fixed income volume executed electronically continues to increase, as data from Celent demonstrates:

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Observing the US IRS market, which has been directly impacted by Dodd-Frank, in the chart below, it is apparent that the migration to electronic venues can be relatively immediate. In the dealer-to-client market, SEF (electronic) market share rose from ~10% in January 2014 to the current ~60% (March 2015), with further electonification anticipated. The implication for European markets with the upcoming MiFID II implementation in January 2017 is apparent.

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Old Heads. Young Minds

Although a cliché, every cloud has a silver lining, and this could well be the case for FICC markets. The financial crisis and subsequent regulation proved to be extremely important in ushering in the current wave of creativity and fintech innovation, causing banks and other financial institutions to rethink their strategies. Many are coming to the realization that they need to partner with emerging innovators. As such, finance and technology has become synonymous, and data analytics, in particular, is moving to the forefront of efforts to provide new solutions to ongoing market challenges, such as trade reporting, risk management and audit requirements. Moreover, a profound and atomic understanding of client activity and behavior will define winners and losers in the coming years.

With technology front and center in today’s financial marketplace, the debate remains as to how to effectively identify and deploy new technology, leading to the perennial question of: Should we build in-house or purchase from a specialist vendor?

Building in-house solutions has its benefits, but it takes significant time and resources. With budgets and margins under real pressure, many firms are unable to meet this challenge by deploying internal teams to address the overwhelming tidal wave of change. By opting for the latter, banks have been able to cut their time to market by years, quickly and efficiently adhering to new market rules and meeting best practice legislation.

Another significant advantage for banks in outsourcing technology to third-party providers is to keep pace and engage with the rapidly evolving fintech landscape. As a result, they are now looking to technology vendors to bridge the gap and ensure sales and trading teams have access to the best and most competitive tools.

By tapping into fintech clusters such as London and New York, banks are capitalizing on the highly focused and outcome-based delivery of these companies. As a consequence, it is not surprising that global investment in financial technology ventures has more than tripled, from less than US$930 million in 2008, to more than US$2.97 billion in 2013.

Smart Data Is the New Currency

Within the fintech sector, the field of data analytics has quickly become the new opportunity in financial markets. This comes at a time when banks are beginning to recognize the competitive advantage that can be gained from partnering with specialist technology vendors.

However, challenges persist. While electronic trading has generated a torrent of transaction data, the industry currently lacks the necessary processing tools for effective aggregation, standardization and analysis. This has become crucially important to sell-side firms at a time when strategy differentiation by market, client type or geographical region is becoming common practice as a means to achieve unique competitive advantage.

Furthermore, market fragmentation, as a result of the proliferation of electronic venues, has effectively fractured liquidity and trading volumes in some markets, rendering the standardization of trade data more challenging.

Only by gaining control of an abundance of available data and deriving actionable intelligence will banks be able to focus on identifying new opportunities and generate the highest returns in the markets they choose to compete in and be able to navigate the new regulations and operational challenges ahead.

The pace of change in the field of data analytics is rapid. As technology vendors continue to work toward providing easy-to-use tools that can be quickly integrated into existing systems, it is the ability to harness predictive analytics based on historical patterns that remains at the cutting edge. For a FICC-trading bank, this could provide answers to questions such as: Which clients am I anticipating seeing in the market today? Or, What products do I think clients will likely be trading?

The business advantages that can be harnessed by predictive analytics are significant and will act as a differentiating factor in performance. In a recent Harvard Business School article, leading academic and analytics guru Thomas Davenport argued that we are now entering the era of Analytics 3.0, where its predecessors were Business Intelligence (1.0) and Big Data (2.0). Gartner has been predicted that by 2017, firms with predictive analytics in place will be 20% more profitable than those without.

As the FICC trading ecosystem continues to evolve, sell-side institutions must focus on how to apply technology at the intersection of trading, regulatory compliance and operational efficiency to maintain and grow market share within a profitable client universe. The entrepreneurship and financial creativity of yesteryear, which is being restricted by regulatory codes of conduct led by global government agencies, can only be replaced by the granularity of understanding that intelligent data analytics delivers.

In what has become a challenging environment for all, the real question is how quickly the industry can adapt.


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The Evolution of the Markets: It’s Not Just About Regulation

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

Much has been written about the impact of regulation on the fixed income and derivatives markets, but market forces also are transforming the space. How are the fixed income and derivatives markets evolving, what is driving the changes, and how can the buy side cope?

Ever since the passage of the Dodd-Frank Act and EMIR, and with the looming implementation of MiFIR/MiFID, there has been a lot of press coverage of the impact various regulations have had on the performance and adequacy of markets, particularly the fixed income and derivatives markets. To mention a few recent items: an op-ed by Michael S. Piwowar and J. Christopher Giancarlo, of the SEC and CFTC, respectively, entitled “Banking Regulators Heighten Financial Market Risk”; an opinion pieceby BlackRock, entitled “Addressing Market Liquidity”; and a joint regulatory report on the Treasury market spike of Oct. 15, 2014. With all these voices, and others, raised about the state of the markets, perhaps we need to take a clear, and hopefully unbiased, look at how the fixed income and derivatives markets are evolving, what the causes are, and how the buy side, in particular, can cope.

In order to get the picture, let’s separate the influences into regulatory and market, the latter referring to the market for services as opposed to the financial markets.

Regulatory Influences

The first thing we need to look at is specific regulatory changes and their impacts, starting with the lowest impacts and working our way up.

Reporting – Here, aside from the obvious discontinuity between the US and Europe, the bulk of the effort will be borne by the dealers. European buy-siders do need to make sure someone is reporting for them, and, since they remain responsible for the reporting quality, that the reports are accurate. The accuracy requirement may be the bigger of the two, since the quality of reporting has been very bad worldwide, and the EU regulators are making noises about cracking down on bad reporting. European buy-siders who delegate their reporting to their trading counterparties may need to winnow down their trading stable to those firms that can be trusted to report for them properly.

Trading Venues – In this area we face acronym overload, with SEFs, DCMs, MTFs, OTFs, and SIs. The US has had the first experience with mandatory exchange trading of OTC derivatives (is that term now an oxymoron?), so it’s worth looking at the US experience. The first thing we see is that exchange trading is anything but mandatory, even where it’s mandatory. SEF trading as a percentage of overall MAT trading is about 50%, largely because it is laughably easy to trade non-MAT versions of MAT swaps, as well as using the exclusions for block and end-user trades. The second observation of note is the bifurcation of the SEF markets into dealer-to-customer (D2C) and dealer-to-dealer (D2D) specialties, in much the same way the old OTC market worked. Plus ca change? In all, the much-heralded era of exchange trading of swaps is a long way from reality.

Clearing – In many ways, this regulatory change has the biggest direct impact on the buy side. One major result is the concentration of risk. Where a large buy-sider could spread its risk across many counterparties, it now must accept one or two CCPs as counterparties. Everyone, at this point, is aware of the worldwide concerns with the potential failure of a CCP. There is, however, a second, perhaps more unsettling, impact of required clearing: opacity. Most buy-siders interact with a CCP through a FCM, which means that CCPs have no idea who their ultimate credit risk is. Since both CCPs and FCMs are in a competitive business, and since one way to compete is on risk, the ultimate impact of mandatory clearing on the market may be that everyone is carrying a loaded pistol in a dark room.

Capital and Liquidity – Finally, the capital and liquidity requirements being implemented under Basel III have rewritten the rules for almost every aspect of the capital markets. The rapid comprehension within banks of the meaning of “denominator creep” has already prompted them to scale back many of their capital markets services, from trading to clearing. Although much of the public’s attention has been focused on Dodd-Frank, the deepest and longest-lasting regulatory impact will probably be from Basel III.

Market Forces

While the regulatory forces above have been gestating, another set of influences has been at work – changes in the markets themselves. Let’s look at those now.

Costs and Spreads – Long before the great recession and any resulting legislation, the natural forces of increased competition and efficiency were at work. These two inevitable trends are universal, impacting every market, even those as disparate as energy and mobile technology. In the capital markets, the trends are evidenced by the use of technology across every part of the trading cycle, and by the pricing pressures that competition brings. In other words, automated trading, narrow spreads, fragmented markets, and some reductions in the liquidity of non-standard products.

Low Volatility and Trading Volume – This phenomenon is not a natural force, but a result of the seemingly unending quantitative easing of the various central banks as a result of the great recession. As these central banks inject money through the mechanism of purchasing bonds, they artificially drain the markets of tradable securities and keep price volatility artificially low. This artificial situation may have masked a serious problem, namely …

Attrition of Market-Making – Both of the previous forces have the entirely predictable impact of reducing the incentives to make markets, so it shouldn’t surprise us that the bond and derivatives markets are moving inexorably away from a principal to an agency structure. This is not a complete change, of course, and increased volatilities and volumes may return principal trading to its former levels; but that process won’t be simple or painless. Buy-siders will have to go through some unpleasant market experiences before the trading banks come back in force, if they ever do.

Evolution at Work

So where are all these forces taking us, especially from the buy-side view?

Total Cost of Ownership – Everyone is becoming aware that trading decisions are being heavily influenced by a series of things that happen after the trade is done. If I have to clear this trade, which is the most efficient CCP? Will the choice of CCP affect my price? Whom can I trust to report for me? When I want to get out of this position, will there be enough market liquidity to accommodate me? Which clearing agent will be the best choice over the long run?

Embracing the Agency Model – Years ago the equity markets were entirely agency, and the fixed income markets were entirely principal. Now the world, while not exactly turned on its head, looks decidedly different. Fixed income buy-siders are having to understand how a bond or swap trade gets done on an agency basis, whether one must become a member of a venue or use a broker in order to trade, and who bears the cost of a trade that can’t be cleared. As clearing agents fall by the wayside, trading agents rise out of the mist.

Manufacturing Liquidity – As Basel III forces banks to re-examine their market-making commitment, other firms, such as the principal trading firms (PTFs) identified in the joint regulatory report, have stepped to the fore. In fact, the report indicates that, during the Oct. 15, 2014, Treasury spike, the PTFs stayed in the market while the primary dealers stepped back, if only momentarily. We will probably see liquidity come from other sources than the dealer banks, including possibly unguaranteed affiliates, as we have been seeing in the swaps market. To be sure, manufacturing anything has its costs, and we should expect to see the costs of trading rise somewhat as the need for liquidity intensifies.

Closing Out Positions – In the swaps market particularly, the cost of maintaining back-to-back positions has been recognized as prohibitive. Dealers have already begun their efforts to close out positions as soon as they lay them off, and we should expect this practice to accelerate. This will have two main impacts:

  1. Because standardized contracts are much easier to compress, we should see a pronounced price advantage to buy-siders for using them. For those who have non-standard hedging needs, this will introduce basis risk; but that is something that the futures market has dealt with for decades, so the buy side should be able to manage it.
  2. As dealers exit swaps positions ASAP after executing the customer’s order, this will leave CCPs with a portfolio of positions with only the buy side and non-traditional players. Whether anybody in that business knows how to deal with that kind of swaps market, which, after all, has been the futures model for years, remains to be seen.

Evolution has always been a messy business, of course. Some species become extinct, others unexpectedly rise to dominance, and the whole process has been called survival of the fittest. I guess there’s no reason why the financial markets should be any different.


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4 Big Questions Dogging Financial Market Reform

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

The prognosis for financial regulation in the US appears very poor at the moment. Here are four important questions about structural reform that need to be answered to get regulation back on track. Otherwise, we may just have to wait for the next financial disaster to prompt lasting change.

The recent series of papers on reforming the financial regulatory structure published by the Volcker Alliance makes interesting reading. You may or may not agree with the conclusions; but I, for one, can’t help but think that there are some important questions about structural reform lurking just under the surface that either were not asked or were subsumed in these papers. So let’s get them out on the table and see where they lead us.

No. 1: Should a central bank be the primary banking regulator?

The Volcker Alliance documents recommend that the primary banking regulator should be the Fed. But we need to look closely at the functions of a central bank, and a banking regulator, to see if that combination really works.

To begin with, a central bank must be, by definition, a bank. That sounds obvious, but it has one or two subtle implications. The first is that, in the modern world, 99.99% of money is actually a bank’s promise to pay. And every commercial bank’s promises to pay are offset by the central bank’s promise to pay. So all of these institutions are tied together in a web. Whether the entanglements of that web make it harder for a central bank to act as a truly independent banking regulator is open to debate, but we probably need a healthy public discussion of that topic, for a start.

Then we have to recognize that most central banks are also lenders of last resort – generally to the banks in their system. Here, it is important to understand that the last resort function only happens in a crisis, but the potential is there all the time. If the regulator is doing its job well, the last resort function usually remains just a concept; but events that aren’t within the purview of the regulator, such as the actions of another country’s regulator, can bring on a crisis in a hurry. If that happens, is it better to have the banking regulator separate from the lender of last resort? Another topic for discussion.

Finally, central banks have a set of functions that require them to be active in the markets, such as controlling interest rates and currency values. These functions especially require them to deal as principal (and sometimes as agent) in these markets, often trading with the banks in their system. Thus, we could easily see instances where the central bank as monetary authority is dealing with a bank in one way, and the banking regulator is dealing with the same bank in another way. Whether the needs of the central bank as market operator might trump the needs of the central bank as regulator is another subject for discussion.

There are countries, of course, where the only regulator of the banking system is the central bank, but those countries may not have the same political or economic framework the US has. In any event, if we are going to restructure financial regulation in the US, we need to answer this question first.

No. 2: How should we define market regulation and depository regulation?

A variation of this question has often been discussed, in the form of combining the two market regulators in the US. Since we’re the only country with separate regulators for securities and commodities, the Volcker Alliance recommendations are to combine the SEC and CFTC, to nobody’s surprise. Have one banking regulator, and one market regulator, so the logic goes.

But there is another, perhaps more relevant question: Should we instead place the depository functions of both banks and brokers under depository regulation, and the market functions of those same institutions under a market regulator? Should we have one regulator charged with protecting, in effect, both checking and trading deposits, and another regulator requiring all market participants, large and small, including clearinghouses, to act professionally and prudently?

The idea that one depository regulator would oversee both a bank and a brokerage firm may sound strange, but it is more palatable if we define regulation along functional as opposed to organizational lines. The recent experience with such requirements as Volcker Rule examinations has shown us that the expertise necessary for depository regulation doesn’t usually translate well into regulation of principal trading functions, and vice versa. To the extent that deposits are insured, as they are in both banking and brokerage, the regulation of deposit takers is essentially the same across both industries. And the surveillance of market participants, whether they are trading for their own account or for others, is homogeneous enough to be handled by one regulator across all market participants.

There are, of course, lots of discussion points here. This would require two regulators for all entities that both take deposits and trade in markets, but most financial institutions have more than one regulator anyway. This structure would preclude what we currently see in Volcker Rule exams, the folly of having five sets of examiners, the Fed, the OCC, the FDIC, the SEC, and the CFTC, all trying to come up to speed on what is essentially the same subject. If asked, most financial institutions would probably prefer to have one regulator knowledgeable in their depository functions and one knowledgeable in their market functions, as opposed to several regulators trying to handle both functions.

No. 3: How important is international symmetry in regulation?

There has been discussion about international asymmetry in financial regulation for as long as I can remember, perhaps as far back as Walter Bagehot (you can look him up). Even then, the crux of the matter was regulatory arbitrage. Long ago, it was about moving physical money and assets into venues where regulation was more lax or out of date. Today it’s about moving transactions or funds electronically between venues for the same purpose.

As it turns out, there are other reasons to move transactions between venues, such as tax and counterparty location, so every intra-company, cross-border trade isn’t a regulatory arbitrage. On the other hand, cases like AIGFP, where trades done in London by a French-chartered company resulted in a $150+ billion Fed bailout of a US insurance company, show that regulatory arbitrage can have some very significant impacts, in particular the kind of “blow-back” danger we saw in AIGFP. In the ongoing regulatory conversations about the implementation of the Pittsburgh G-20 agreement, there have been some sharp words exchanged about regulatory practices that led to blow-backs.

Thus, it is a good idea to prioritize the regulatory asymmetries that would promote the kind of arbitrage that could result in blow-back, while placing less importance on asymmetries that would keep the problems contained in the venue where they began. The area of most interest today is the recognition and regulation of derivative clearinghouses. Since the implementation of the G-20 agreement is generally recognized to have greatly concentrated the risk in the derivatives market, perhaps the most important international symmetry concerns CCPs. The main Volcker report only mentions clearinghouses once, in passing, and the national case studies not at all. Given the amount of attention being paid to the international regulation of CCPs, that’s an important omission that makes the report look a bit out of date.

No. 4: Finally, is this all just a waste of time?

The Volcker Alliance report laments – and everyone is probably aware of – the many unsuccessful attempts to streamline financial regulation in the US. If most impartial observers recognize that US financial regulation is decidedly sub-optimal, and that the structure is at least partly to blame, we need a clear understanding of why that structure persists.

Perhaps we can start the explanation with this quote from the report, which is itself a quote from the Financial Times: “Former Senator Chris Dodd echoed that sentiment in a speech last year. ‘I would’ve established a single prudential regulator and gotten rid of the rest,’ he said. But, he added, ‘I got about three votes at the time.’” That leads to the immediate question of why such an obvious improvement would be so unpopular in the halls of Congress.

That may sound like a naïve question, but it’s really not. If the members of Congress have enough intelligence to understand the benefits of such a change, then the only explanation I can see is that the financial industry has so much influence over Congress that it can stop this kind of reform in its tracks. Assuming that this isn’t a case of blackmail, then it can only be a case of money, perhaps suitcases of money.

If that logic is correct, and I’m anxious for it to be proven wrong, then the prognosis for financial regulation in the US is very poor. If financial institutions can – pardon the expression – bank on a fragmented regulatory structure to give them the freedom they want, then we just have to wait patiently for the next financial disaster. In that case, the Volcker Alliance documents might make interesting history someday, but not public policy today. 

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The CAT Conundrum: A Cost-Benefit Analysis

By Shagun Bali and Alexander Tabb, TABB Group
Originally published on TABB Forum

The Consolidate Audit Trail is one of those unique initiatives that the capital markets community agrees is important. The details, however, are reason for concern. Who will pay for the CAT and how remains the No. 1 question. But implementation timelines, data challenges, and how to incorporate options market data all remain critical challenges.

This is the second in a three-part series about the Consolidated Audit Trail (CAT). The first note, “The Consolidated Audit Trail: Stitching Together the US Securities Markets,”examined the process to date, how the industry arrived at this point, and where the CAT needs to go to be successful.

The Consolidate Audit Trail is one of those unique initiatives that the capital markets community agrees is important. When completed, it will be the single largest repository of financial services data in the world. The CAT will house more than 30 petabytes of data, connect to approximately 2,000 separate data providers, and enable regulators to reconstruct market activity at any point in time.

According to TABB Group interviews with 100 financial institutions from the buy and sell sides, the majority of the industry agrees that the CAT is necessary; everyone recognizes the benefits. But what concerns market participants are the details.

When questioned about the importance of the CAT, more than three-quarters of respondents said they viewed the CAT as an important” orcritically important” element that contributes directly to the health and well-being of the US markets (see Exhibit 1, below).

Exhibit 1: Market Perceptions Regarding the Importance of the CAT 

However, the uncertainty in the process – which includes funding, implementation timelines, data challenges, and new participants from the options markets – has the community concerned. Cost and funding of the CAT is surely giving the community sleepless nights. First, the direct and indirect costs associated with the CAT are a concern for the broker-dealers, as they recognize that all funding avenues lead directly to their doorstep. In addition, they are deeply concerned over the fact that not only do they have to pay for the development and upkeep of the CAT, they also will need to cover the costs of FINRA’s Order Audit Trail System (OATS) and the SEC’s Electronic Blue Sheet (EBS) requests for at least five years after the CAT is started.

Yes, the CAT is necessary. But the big question among many on the sell side remains, “Can the industry afford it?” The broker-dealers need from the SROs a solution that will lighten their burden of investment and that will reassure them that the industry can indeed afford it.

In addition, elements related to data – gathering, storing, and data usage and governance – need heightened attention. To win the wholehearted support of the industry, the SROs need to put out clear strategies that address these challenges. The B/Ds understand the requirements, but ultimately are still uncomfortable with the idea of supplying this type of data with so many ambiguities left unanswered. The SROs need to address these issues head on and need to develop a solution that takes the concerns seriously – especially when it comes to data security and governance.

Furthermore, both TABB Group and the community recognize that the real wild card in the CAT process is the options market. Previously under-appreciated, adding options to the CAT mix greatly increases the complexity of the endeavor. A naiveté has been replaced with a clear understanding that incorporating the options markets into the CAT is no small feat and that whomever is tasked with this undertaking needs to understand all of the implications involved.

The same can be said of the need to solve the data storage and government questions, as well as the security and control issues associated with the program. Unfortunately, the CAT is a unique project, one whose size and scale are unmatched within the institutional capital markets. This means that the SROs do not have the luxury of learning from other people’s mistakes. They have to figure this all out in advance, with everyone looking over their shoulders and trying to influence the outcome.

Getting this right is critical for the success of the project. Market confidence is so fragile that authorities cannot afford to make mistakes in such harsh market conditions, when volumes are low and each participant is struggling with its bottom line numbers. Success is only possible if the SROs prioritize these key elements of the CAT and select a bidder that can deliver against all of the challenges. The entire onus and responsibility of the CAT’s success lies on the SROs’ ability to work out the problems and choose a solution that is in the best interest of the markets, and not their own.

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