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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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The Consolidated Audit Trail: Stitching Together the US Securities Markets

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

The complexity of our market structure and underlying technologies surpasses our current ability to monitor, analyze and reconstruct market events. If the US wants to maintain its predominate position as a global finance center, the SEC and the SROs need the ability to proactively review and analyze events that occur within the markets as whole.

Today’s market structure is not just complex and fragmented, it is dynamic, with trading activity shifting across multiple exchanges, asset classes and hyper-connected marketplaces. Though equities, OTC equities, options and futures all comprise market events, each is an independent market with its own ecosystem and regulatory infrastructure. But while each asset class is unique unto itself, they are inextricably linked. Unfortunately, the complexity of our market structure and the underlying technologies surpasses our current ability to monitor, analyze and reconstruct the events that shape our economic destiny. Recognizing these gaps, the SEC mandated the Self-Regulatory Organizations (SROs) to develop the CAT NMS Plan and propose the Consolidated Audit Trail, which would create a unified system to enable market reconstruction and analysis.

The need for the CAT is made somewhat self-evident by the markets’ inability to reconstruct some of the near-catastrophic events that have occurred in the past few years. The Flash Crash and the Madoff scandal, for example, seriously undermined invetsors’ confidence in the US markets. While the markets have been able to regain much of their swagger since, another such event with similar outcomes and indeterminate causes could be disastrous. The mere fact that neither the SEC or the SROs were able to reconstruct accurately the eventsthat led up to these disasters is unacceptable in today’s data-centric world. If the US wants to maintain its predominate position as the leading global economic center, the SEC and the SROs need the ability to proactively review and analyze events that ocur within the markets as whole.

The CAT will be the ”go to” system for regulators and exchanges to examine and analyze market activity in its totality. While it would not directly prevent future flash crashes from occurring, it would indirectly prevent these and other potentially disastrous events by enabling rapid reconstruction and analysis of market events, which in turn would protect the markets as a whole. The CAT initiative is the SEC’s main tool in its strategy to become more proactive and preventative and to take a more comprehensive and timely approach to market events.

Though initiated by the SEC, the CAT now is in the hands of the SROs. The SROs have downsized the bidding list and are in the process of selecting the CAT processor and finalizing the technical details. In July 2014, the SROs announced the final short-list of CAT bidders that included the following firms/consortiums:

  • AxiomSL & Computer Sciences Corporation (CSC)

  • CATPRO Consortium: HP, Booz Allen, Buckley Sandler, J. Streicher Analytics

  • EPAM Systems & Broadridge


  • SunGard Data Systems Inc. & Google

  • Thesys Technologies, LLC

There is no doubt that a program such as the CAT is what the industry needs. But the SEC does not have the budget or the political support in Congress to take on a project this large and/or complicated. As a result, the SEC put forward Rule 613, placing the CAT squarely in the laps of the SROs. By letting an industry consortium take over responsibility for the CAT, the SEC has been able to advance its needs for a sophisticated analytical tool without imposing a new bureaucracy on the markets that would require taxpayer dollars. However, the phrase “Too many cooks spoil the stew” comes to mind when summarizing the CAT process at present.

For their part, the SROs have been working with the broker-dealers, since they are the ones that are going to pay for the CAT. But each participant within the community has its own views concerning the CAT. It would appear that getting everyone in sync is surely as daunting as building the CAT itself. Consequently, the continually moving goalposts and additional requests for more information from vendors, along with the exemptive relief request filed in January 2015, mean the process still has a long way to go before it is finished.

Though the community at large is supportive of the initiative, there is a considerable amount of mistrust over the lack of transparency in the process. The biggest questions still unanswered include who exactly is going to foot the bill through the development phase, and how broker-dealers are going to pay for the CAT.Complying with OATS reporting system has been painful enough for the industry; market participants do not want to go bankrupt with the implementation of the CAT.

From TABB Group’s perspective, the CAT is a necessary tool for the 21st Century. The SROs and exchanges need timely access to a more robust and effective cross-market order and execution audit trail. However, the SROs need to tighten up the process and set definite targets against which they can deliver in a timely fashion.

In theory, this should not pose a problem; but in reality, the SROs are not a unified group, and as such, they bring their own challenges to the table – which in turn makes the task even more daunting. The current challenge with the CAT program is that nobody wants to take responsibility for this massive undertaking. Though the SROs did not initiate the CAT, if this project does not deliver what it promises, the SROs will be first in a long line of participants that will take the blame for its failure.

The CAT is the largest data undertaking ever proposed for the US securities market. Clearly, there is a lot at stake here. A lot of time and effort have gone into getting the market to approve and support this critical initiative. Now it’s in the hands of the 10 SROs to make sure that if Humpty Dumpty falls off that wall, we can accurately reconstruct what occurred and ensure it doesn’t happen again. 

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SDRs: The SEC Weighs in on Swaps Reporting – Part 2

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

All of the world’s swap regulators recognize that reporting is a mess. And while the SEC’s final rule on Swap Data Repositories does not mandate SDRs monitor reporting data quality, there are signs that such monitoring may be in the offing. But don’t bet on the SEC getting the rules right.

In my last article, I reviewed the SEC’s final and proposed rules on transaction reporting by market participants (“Missed Opportunity: The SEC Finally Weighs in on Swaps Reporting – Part 1”). In this article I will look at the final rule on SDRs, and make some observations on the effectiveness of current and future reporting regimes.The SEC’s final SDR rule is entitled “Security-Based Swap Data Repository Registration, Duties, and Core Principles” and runs some 468 pages. Don’t worry – you don’t have to read them all; just go to page 424 to find the beginning of the rule text. The bulk of the rule is in §232.13, which itself is divided into 12 subsections:

  • 240.13n-1 Registration of security-based swap data repository.

  • 240.13n-2 Withdrawal from registration; revocation and cancellation.

  • 240.13n-3 Registration of successor to registered security-based swap data repository.

  • 240.13n-4 Duties and core principles of security-based swap data repository.

  • 240.13n-5 Data collection and maintenance.

  • 240.13n-6 Automated systems.

  • 240.13n-7 Recordkeeping of security-based swap data repository.

  • 240.13n-8 Reports to be provided to the Commission.

  • 240.13n-9 Privacy requirements of security-based swap data repository.

  • 240.13n-10 Disclosure requirements of security-based swap data repository.

  • 240.13n-11 Chief compliance officer of security-based swap data repository; compliance reports and financial reports.

  • 240.13n-12 Exemption from requirements governing security-based swap data repositories for certain non-U.S. persons.

The Boring Stuff

As we can see from the list above, the first three sections of the rule pertain to registration as an SDR, or, as the SEC abbreviates it, SBSDR (except that the regulator very seldom abbreviates  it). Given that SDRs have been functioning in the US for more than a year, it would be astonishing if the SEC had significantly different registration requirements from the CFTC’s, and it doesn’t. So 13n-1 through 13n-3, 13n-6 through 13n-8, and 13n-11 are pretty much as expected.

Items of Interest

In light of the recognized problems with reporting accuracy, the following wording in 13n-4 bears examination:

(b) Duties. To be registered, and maintain registration, as a security-based swap data repository, a security-based swap data repository shall:

(7) At such time and in such manner as may be directed by the Commission, establish automated systems for monitoring, screening, and analyzing security-based swap data;

13n-5 has similar wording:

(i) Every security-based swap data repository shall establish, maintain, and enforce written policies and procedures reasonably designed for the reporting of complete and accurate transaction data to the security-based swap data repository and shall accept all transaction data that is reported in accordance with such policies and procedures.

So far, none of the regulators have mandated any responsibility on the part of the SDRs to monitor data quality, nor have they laid out any guidelines for doing so. However, there are signs that such monitoring may be in the offing, and this language lays that responsibility squarely on the SBSDR. How extensive the monitoring might be, how the regulators would verify that it was being done, and what the penalties would be for failing in this function aren’t covered here. And, since 13n-4 is the only place in the rule text where the term “monitoring” is used, it isn’t covered anywhere else in the rule or, as it turns out, in the preamble.

The Current State of Affairs

In January 2014, the CFTC issued a proposed rule called “Review of Swap Data Recordkeeping and Reporting Requirements.” The comment period ended May 27, 2014. I haven’t been able to find any comment letters on this proposal on the CFTC’s website, nor any final rule on this subject.

So how accurate is swaps reporting today? I took a look at a snapshot of the most liquid swaps category, rates, from the DTCC SDR site and posted it below. The questionable items are in red.

tabbf 2 25 resized 600

Just to help us read the table, the first item is a new, uncleared ZAR three-month forward rate agreement beginning 5/18 and ending 8/18. The notional amount appears to be ZAR 1,000,000,000, and the rate is 6.12%. With that as background, let’s look at some of the anomalies.

Item 4 is a new two-year USD basis swap beginning 9/21/2016. A basis swap is normally between two different floating rates, but the underlying assets in this transaction appear to be the same (USD-LIBOR-BBA). I’m not sure what a basis swap between the same rates would be, unless it is between two different term rates, like 1-year and 5-year. However, if that’s true, the report doesn’t tell us, so we are in the dark as to what this trade really is.

Item 7 is a new 8-year Euro-denominated fixed-fixed above the block threshold (that’s what the plus at the end of the notional means), which appears to have gone unreported for two weeks. There is a delay in reporting block trades, but it isn’t two weeks. One of the monitoring functions the regulators might implement would be any trade where the difference between the execution and reporting timestamps is greater than the rule allows.

Item 13 is a new 12-year Euro-denominated fixed-floating swap that appears to be above the block threshold of €110,000,000. What is interesting here is that the 12-year Euro rate at the time was about 0.4%, not 0.824%. If there is no other parameter on this trade, it looks to be significantly off the market, unless there was a large credit risk component.

Item 15 is … what, exactly? It’s a new trade in some exotic that went unreported for 5 days, with no price given, apparently. Since the notional looks like 5,000,000,000 Chilean pesos, or about US$8,000,000, perhaps we don’t need to worry too much about what it really is; but exotics of this size denominated in dollars should cause us to ask just what kind of swap was done, and how much risk it entails.

Summing Up

All of the world’s swap regulators recognize that reporting is a mess. For example, here’s an excerpt from ESMA’s annual report:

In order to improve the data quality from different perspectives, ESMA put in place a plan which includes 1) measures to be implemented by the TRs and 2) measures to be  implemented by the reporting entities. The first ones were/will be adopted and monitored by ESMA. The second ones are under the responsibility of NCAs. This plan was complemented by regulatory actions related to the on-going provision of guidance on reporting, as well as the elaboration of a proposal for the update of the technical standards on reporting, leveraging on the lessons learnt so far by ESMA and the NCAs.” (emphasis added)

However, it is hard to find any mention of such a plan in ESMA’s 2015 work programme.

We might have expected that the SEC, the latest to the swaps reporting party, would have taken pains to get it right and perhaps lead the way to a better world. Since some of its rulemaking is still in the proposal stage, we might still see the regulator get it right. But I wouldn’t bet on it.

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