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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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Missed Opportunity: The SEC Finally Weighs in on Swaps Reporting – Part 1

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

Global regulators have missed a golden opportunity to shed light on the opaque swaps market. The SEC, seeking to rectify this, recently issued two final swaps reporting rules and one proposed rule. But the final requirements remain muddy.

The all-important swaps reporting requirement has been badly mishandled by regulators worldwide, missing a golden opportunity to shed some light on this otherwise opaque market. In the US, one of the nagging problems has been that the SEC hadn’t put out its reporting rules, so there was no required reporting on one of the riskiest areas of the market – single-name CDSs.

Recently, though, the SEC took a major step in rectifying this, by issuing some proposed and final rules. So how well did they do? Let’s take a look.

First Things First

Actually, the SEC issued three rules – two final and one proposed – which means that we will have to patch them together to get as complete a picture as we can. The final reporting rule is: Regulation SBSR-Reporting and Dissemination of Security-Based Swap Information. There is also a proposed rule with an identical name, indicating that it will be combined with the final reporting rule at some point. I will cover both of them in this article. I will cover the SDR rule, Security-Based Swap Data Repository Registration, Duties, and Core Principles, in a later article.

Including their preambles, these three rules comprise more than 1,350 double-spaced pages. My practice has always been to go right to the rule text, since that is what everyone will be bound by, and then read any sections of the preambles that provide necessary clarifications. The rules themselves comprise 92 pages, a significantly more manageable reading assignment. I’ll cover only the unexpected or potentially troublesome aspects, but people should read all 92 pages.

In the SEC rulebook, the reporting rules are §§242.900-242.909. Specifically:

  • 242.900 Definitions

  • 242.901 Reporting obligations.

  • 242.902 Public dissemination of transaction reports.

  • 242.903 Coded information.

  • 242.904 Operating hours of registered security-based swap data repositories.

  • 242.905 Correction of errors in security-based swap information.

  • 242.906 Other duties of participants.

  • 242.907 Policies and procedures of registered security-based swap data repositories.

  • 242.908 Cross-border matters.

  • 242.909 Registration of security-based swap data repository as a securities information processor.


There are a few oddities among the definitions, each perhaps a warning about other oddities later on. One is:

“Trader ID means the [Unique Identification Code] UIC assigned to a natural person who executes one or more security-based swaps on behalf of a direct counterparty.”

So that seems to be leading to a requirement to identify the person who executed the trade. Unless, of course, the trade was executed by a computer. Do we use HAL’s UIC then?

There is also this:

Trading desk ID means the UIC assigned to the trading desk of a participant,” and, “Trading desk means, with respect to a counterparty, the smallest discrete unit of organization of the participant that purchases or sells security-based swaps for the account of the participant or an affiliate thereof.”

So will we be identifying both the desk and the trader who did every trade? That’s not required anywhere else, and certainly looks like overkill.

Who Reports?

Under the reporting obligations, we find another oddity:

(a) Assigning reporting duties. A security-based swap, including a security-based swap that results from the allocation, termination, novation, or assignment of another security-based swap, shall be reported as follows:

(1) [Reserved].

It looks like we are missing an important section. Sure enough, we find it in the proposed rule:

(1) Platform-executed security-based swaps that will be submitted to clearing. If a security-based swap is executed on a platform and will be submitted to clearing, the platform on which the transaction was executed shall report to a registered security-based swap data repository the information required.(emphasis added)

And one more item in the proposed rule:

(i) Clearing transactions. For a clearing transaction, the reporting side is the registered clearing agency.

I think that means that the SEF reports the original trade, and the DCO immediately reports the cleared trade.

What about life cycle events for cleared swaps? Here, the final rule says:

(i) Generally. A life cycle event, and any adjustment due to a life cycle event, that results in a change to information previously reported … shall be reported by the reporting side, except that the reporting side shall not report whether or not a security-based swap has been accepted for clearing.

(ii) [Reserved]

Back to the proposed rule:

(ii) Acceptance for clearing. A registered clearing agency shall report whether or not it has accepted a security-based swap for clearing.

So if the reporting side of the original trade is the SEF, and the DCO reports that it accepted the trade for clearing, does the DCO report the life cycle events of cleared swaps? That should be the case, but the rules are a bit confusing about that.

What Transactions Must Be Reported?

This is obviously a crucial question, and the final rule says:

(1) A security-based swap shall be subject to regulatory reporting and public dissemination if:

(i) There is a direct or indirect counterparty that is a U.S. person on either or both sides of the transaction; or

(ii) The security-based swap is accepted for clearing by a clearing agency having its principal place of business in the United States. (emphasis added)

And an indirect counterparty is defined as:

Indirect counterparty means a guarantor of a direct counterparty’s performance of any obligation under a security-based swap such that the direct counterparty on the other side can exercise rights of recourse against the indirect counterparty in connection with the security-based swap; for these purposes a direct counterparty has rights of recourse against a guarantor on the other side if the direct counterparty has a conditional or unconditional legally enforceable right, in whole or in part, to receive payments from, or otherwise collect from, the guarantor in connection with the security-based swap.

So a swap done between, for example, an EU dealer and a guaranteed EU subsidiary of a US corporation is reportable in the US, as well as by both parties in Europe. How fun! And who reports in the US? Back to §242.901.

In addition, the final rule requires reporting of all swaps in existence on the rule’s effective date (called backloading) and, although there is a phase-in for the rule as a whole, there doesn’t appear to be a phase-in period for backloading.

What Data Must Be Reported?

Here, in addition to the usual transaction material, the final rule requires:

(2) As applicable, the branch ID, broker ID, execution agent ID, trader ID, and trading desk ID of the direct counterparty on the reporting side;

Since only one side is reporting under the SEC rule, in dealer-to-dealer trades this appears to mean that the reporting dealer must supply all of this information, but not the non-reporting dealer. What that accomplishes, I’m not sure.

There’s one other data requirement in this section:

(5) To the extent not provided pursuant to paragraph (c) or other provisions of this paragraph (d), any additional data elements included in the agreement between the counterparties that are necessary for a person to determine the market value of the transaction;

Thus it appears that the reporting party must determine what data is necessary for an outside entity to price the transaction, and include that if it’s not already delineated.

Public Availability

This section requires immediate public availability of the usual information (i.e., no identification of the parties) with this exception:

(3) Any information regarding a security-based swap reported pursuant to § 242.901(i);

And 242.901(i), in the proposed rule, says:

(i) Clearing transactions. For a clearing transaction, the reporting side is the registered clearing agency that is a counterparty to the transaction.

Does this mean that cleared trades are reported but aren’t publicly available? If so, what is the logic for that? If not, what does it mean? Beats me.

Other Factors

There is a significant section in the final rule called § 240.901A, covering reports the Commission is expecting from the staff “regarding the establishment of block thresholds and reporting delays.” The Commission will use these reports to determine “(i) … what constitutes a large notional security-based swap transaction (block trade) for particular markets and contracts; and (ii) the appropriate time delay for reporting large notional security-based swap transactions (block trades) to the public.” One of the considerations the rule highlights is “potential relationships between observed reporting delays and the incidence and cost of hedging large trades in the security-based swap market, and whether these relationships differ for interdealer trades and dealer to customer trades.” So block sizes and block reporting delays haven’t been decided yet.

Finally, the final rule defers the compliance dates to the proposed rule, and although the rule itself doesn’t say, the preamble lists two phases:

Compliance Date 1 – Proposed Compliance Date 1 relates to the regulatory reporting of newly executed security-based swaps as well pre-enactment and transitional security-based swaps. On the date six months after the first registered SDR that accepts reports of security-based swaps in a particular asset class commences operations as a registered SDR, persons with a duty to report security-basedswaps under Regulation SBSR would be required to report all newly executed security-based swaps…Registered SDRs would not be required to publicly disseminate any transaction reports until Compliance Date 2.

Compliance Date 2 – Within nine months after the first registered SDR … commences operations … (i.e., three months after Compliance Date 1), each registered SDR in that asset class …would be required to comply with Rules 902 (regarding public dissemination), 904(d) (requiring dissemination of transaction reports held in queue during normal or special closing hours), and 905 (with respect to public dissemination of corrected transaction reports) for all security-based swaps in that asset class—except for “covered cross-border transactions.

So six months from sometime for reporting, and nine months for public disclosure.

Summing Up

Given the long delay between the CFTC’s reporting rules and these, we might expect that there would have been considerable communication between the agencies, and there might have been. It does appear that the CFTC is totally re-examining its reporting rules, and that might be a good thing. Meanwhile, as firms get ready to report SEC-regulated swaps, the situation still looks pretty muddy. It might get better, but I’m not very optimistic about that. 


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Derivatives in 2015 and Beyond – A Look into the Future with Kevin McPartland

Imagine you had the last five years of derivatives market reform on DVR.  If you could fast-forward past the requests for public comment, rule delays and angst, would you have guessed that we’d be where we are today? 

Future-casting the outcome of financial markets reform is not for the faint of heart.  But it is an art in which Kevin McPartland has had some success over the last several years.  As a principal, overseeing market structure and technology for Greenwich Associates, McPartland is responsible for helping the world’s leading financial firms decode nascent trends and interpret emerging intelligence to make strategic decisions. 

McPartland also holds the distinction of authoring the most-read blog post in DerivAlert history.  His SEF 101: Deconstructing the Swap Execution Facility, written in 2010 when McPartland was a senior analyst at Tabb Group, was a seminal piece on the topic long before most market participants had ever heard of a swap execution facility (SEF).  Now that we’ve all become familiar with SEFs, we thought it would be a good time to check back in with McPartland to see what he thinks the next few years of derivatives market reform would have in store for us.

DerivAlert: Given all of the events of the last five years -- derivatives reform, increased electronification of swap trading, Basel capital requirements, QE -- How do you see the trading in derivatives evolving over the next five years?

Kevin McPartland: It’s great that we’ve got a lot of the major rules in place.  It’s good that we’re finally here, but it’s still very much early days.  For clients that do not want to trade on SEFs, there are still plenty of ways to do that. Market participants need to feel incentivized to increase trading volume on SEFs, and the product sets that are required to trade electronically need to become larger in order to make the shift to SEFs real. 

In terms of looking at who the winners and losers are in SEFs, the separation is starting to take shape, but it is still very early.  It’s also important to look at the client make-up of different SEFs, which are very different.  That has a big influence on volumes. 

DA: What do you see coming down the pike for fixed income?

KM: The Treasury market is looking more and more like it is ripe for continued electronification.  It is standardized and highly liquid.  Nearly every financial firm is involved in Treasurys in some way shape or form.  This is in contrast to the corporate bond market. 

Our North American Fixed Income Study last year showed that 78% of clients we talked to were using electronic platforms to trade bonds.  That means a big chunk of the market are already using electronic platforms in some way.  But only 50% of notional volume is traded electronically, which outlines a huge opportunity for growth.

In credit, the story hasn’t really changed much.  The structure of the market is such that there are so many issues that it’s hard for deep liquidity to grow in any one particular spot.  For example, you have one IBM stock, but you could have upwards of 50 IBM bonds to choose from.  That makes it tough to build deep liquidity in corporate bonds.

The real opportunity for electronic trading in credit is in bond selection.  The major platforms are all innovating in this space and we expect that to be a growth area over the next several months.  There’s still a long way to go, but a shift is starting to occur whereby investors are moving away from bond-specific thinking and toward a risk-based approach.  Instead of saying ‘I want this IBM bond,’ they are saying ‘I’m looking for this type of credit exposure, what are my options?’

DA: What are your expectations for European derivatives reform?

KM: U.S. reforms have been complicated because the CFTC and SEC are jointly writing rules on Dodd-Frank.  Europe has a dozen jurisdictions that need to write rules and get them accepted for all of their markets.  The first thing we’ve seen is trade reporting, and by all accounts it’s been really messy. 

As it stands now, the reporting requirement for both sides of a transaction largely defeats the purpose of the rule.  In terms of the first clearing mandates, we’re expecting to see something maybe by the end of 2014/2015.

European reform is not a cut and paste of the U.S.  The legal framework about how clearing works is very different in Europe, and the clearing rules are very different. 

DA: What impact do you see the May 1st guidance on packaged trades having on SEFs?

KM: We’re still waiting for lots of liquidity providers to come into the market.  It’s going to be a slow, organic process as some of the new products come online.

The CFTC’s guidance laid out a phased in approach for packaged transactions, starting with packages containing two or more MAT instruments and quickly expanding to include MAT swaps over US Treasuries.  While the marketplace is certainly ready to handle the electronic execution of these packages, the operational infrastructure needed to risk-check and process these trades will struggle to be prepared by the deadline.

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Europe’s OTF to Follow the US’s SEF?

By Henner Bruner, Capco
Originally published on TABB Forum

It is still probably too early to derive meaningful conclusions from the impact of Swap Execution Facilities on trading behavior. However, European regulators and counterparties can learn from the US experience as they implement the European equivalent of SEFs, Organized Trading Facilities, as part of the Markets in Financial Instruments Regulation.

Although central clearing provides counterparty credit risk mitigation, SEF trading – because it will not become mandatory until the ‘made available to trade’ (MAT) rules are effective – is creating uncertainty and onboarding complexity rather than immediate economic benefits.

Why the uncertainty? Potential regulatory arbitrage between the Commodities and Futures Commission (CFTC) and the Securities and Exchange Commission (SEC) is one factor. Then there’s confusion about implementing the SEF trading rules. In addition, the actual start date for mandatory SEF trading varies on the one hand between the official deadline of 18 December 2013 and the market consensus estimate of Q1 2014.

Then there’s the complexity of these new rules where pre-trade credit checking involves feeding credit limits into the SEFs systems. This can easily amount to a high 5-digit number of credit limits a day (intra-day).

Add to this the operational implementation of the direct push, ping or hub approach. This is burdensome, as is the legal and operational documentation, which buy-side participants and futures commission merchants (FCM) may struggle to complete on time.

Meanwhile, in Europe there are many implications for regulators and counterparties concerning the implementation of the still-to-be-defined OTF, while dealing with the widely cited "Footnote 88." The note states that all multi-lateral trading in all swaps, as defined by the CFTC, must occur on SEFs.

And, since the US is months, maybe years, ahead in shaping the future derivatives trading space, there is the risk (or even fear) that US rules are being imposed on European counterparties.

To sum up, the role of US and non-US persons interacting with SEFs is not clear. This is bad news for European regulators who dread a negative operational impact on foreign trading platforms in which US banks participate. Non-SEF platforms already discriminate against non-US branches of US banks by excluding non-US accounts with liquidity pools. Therefore, firms might shy away from trading in the US or on SEFs, to avoid being subject to US regulatory requirements.

First lessons learned:

~ Regulatory differences (EU versus US) currently dampen the road to substituted compliance regarding pre-trade transparency rules. As a result, OTF guiding rules might be altered in the process of implementing MiFIR.

~ The CFTC should grant dealers and SEF operators outside their direct regulatory reach a no-action relief period until OTF rules have been finalized.

~ Avoid confusion among market participants: establish concise guiding rules for OTFs, allowing sufficient time for technical and operational implementation, and avoid regulatory arbitrage between MiFIR and linked regulations (e.g., EMIR).

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Litigators Must Love the CFTC

By David B. Weiss, Aite Group
Originally published on Aite Blog

The usual legal industry of lobbying, commenting, advising, etc. that the CFTC and SEC have created aside, it sure does seem like the CFTC is driving a fair amount of business for litigators these days:

Sure makes it interesting for the spectator. Of course, not all market operators have taken that route. Some have just asked to be let off the rules for a while. Bloomberg is noted far more for being “sticky” then litigious, but when it decided to step up to the plate, it did so in a big way, choosing Eugene Scalia (and former governor of New York, Mario Cuomo) to make its case. Scalia has a pretty good record when it comes to these regulatory lawsuits, so it was pretty bold of the CME to make light of Bloomberg’s lawsuit, given their own track record, detailed above, against the CFTC. How ironic that, hours later, the DTCC would sue the CFTC in direct response to the favor it believes was shown to the CME (and ICE) on SDRs.If the CFTC and SEC felt overwhelmed by their new regulatory tasks stemming from Dodd-Frank, then these latest two regulatory arbitrage opportunities created by the CFTC were not the right steps to take. Now they’re being sued on two fairly substantive grounds.

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Can the SEC Save Civilization?

By Steven Wunsch, Progress Wunsch Auction Associates, LLC
Originally published on 
Tabb Forum

The disintegration of our stock market into chaotic fragmentation is paradigmatic of the disintegration of Western society generally. And the cacophony of market structure voices – as evidenced in the debates on TabbFORUM, the SEC's comment period debates, and similar debates around the world – is not likely to produce solutions any more than Stalin's five-year plans solved the Soviet Union’s problems. But we've got to start somewhere. 

Now comes the news that the SEC wants more money and authority. After all the money spent creating the current chaos, the Commission says it needs much more, presumably to do much more of the same.

High-frequency trading, and the plethora of new rules, technology and staff the SEC proposes to deal with it – the Large Trader Rule; the Consolidated Audit Trail; the Market Access Rule; the Midas computer system; Limit-Up/Limit-Down; the Systems, Compliance and Integrity Rule, etc. – may be mysteries to the world at large, but not to readers of TabbFORUM. HFT is a feature of the SEC's National Market System that didn't exist before, and it is growing more complex and confusing as the SEC creates new rules and policies to control it. The more the SEC intervenes, the worse the problem seems to get.

There are other examples where government-imposed fairness and redistribution are producing chaos, areas that on the surface may seem more amenable to understanding by the public and therefore more amenable to being addressed by policy changes. The gender fluidity that began with feminism, for example, now finds some parents chemically blocking their children's puberty until they can make decisions on a rapidly proliferating array of gender selection options, which are no longer just male or female, or even straight or gay; rather, if a child is gay, whether to undergo surgical gender modification or not, and which orientation to adopt or present to the world, in public or private. [The New Yorker, “About a Boy: Transgender surgery at sixteen,” Margaret Talbot, March 18, 2013]

That simple women's equality would transform into gender chaos was not expected. But such results are always unexpected, because they are bound to spin out of the control of their initially well-intentioned founders as conflicting claims erupt over civil rights or redistributions of the economic pie. Because of the heated emotions in such battles, these are unlikely places in which to begin to reel government back in.

High-frequency trading and the National Market System, on the other hand, are good places to begin. While the HFT issue may be visible in detail only to market structure types like those who read TabbFORUM, readers and non-readers alike can recognize the unseemly grasp for more power and money by the SEC. As a result, reining in the SEC may be more possible than we imagine, if for no other reason than that there are no generally recognizable civil rights or redistribution issues involved.

Regardless of one's market sophistication, it is easy enough to see that the SEC's National Market System created HFT and all the ancillary problems associated with it – the Flash Crash, the Facebook IPO, the Knightmare on Wall Street. It is also clear that before NMS, the US stock market provided average investors unparalleled opportunities to participate in the growth of American businesses, and that it provided those businesses and the technologies they introduced unparalleled opportunities to get funded and to get started. It no longer provides these benefits with anything remotely resembling its previous power.

In an age of deficits as far as the eye can see, it would be very unwise to give more money to the SEC. But beyond the money, granting government the power to reorder naturally evolved structures that have endured for decades, centuries or millennia, as stock markets have, is unwise beyond belief.

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Jurisdiction Battles Threaten Swaps Reform

By Colby Jenkins
Originally published on 
Tabb Forum

The Securities and Exchange Commission faces ideological differences with the CFTC and international regulators in implementing Dodd-Frank reforms. But the SEC’s slow, deliberate approach to rulemaking affords the global swaps market a safer transition from opaque to transparent.

If the Dodd-Frank Act is the cure for an unstable market, the anticipation over its implementation may be as painful as the shot. After years of missed deadlines and underwhelming progress, regulators are at a crossroads. This is the situation Mary Jo White will be walking into as the chair of the US Securities and Exchange Commission.

This past January, Elisse Walter, as chairman of the SEC, pointed to the issue of extraterritoriality as the agency’s top priority for 2013. In her words, a definitive position on cross-border regulation is “a critical linchpin” in establishing remaining Dodd-Frank compliance rules domestically and abroad. Charged with the responsibility of regulating the global market of security-based swaps, the SEC has a tremendous uphill climb in front of it -- but at least the Commission is on the right path.

Extraterritoriality is not the only jurisdictional issue facing the swaps market. In the US, Dodd-Frank regulatory responsibilities are split bilaterally between the SEC and the CFTC. This means that many market participants will need to register with both agencies. Thus, it is not surprising that recent industry-wide surveys indicate that financial institutions are not prepared -- or even taking the appropriate precautions -- to meet the requirements of impending swaps market overhaul. After all, in the face of dual-jurisdiction requirements and potentially disparate sets of compliance rules, where does one start?     

Where the CFTC has gone the route of issuing guidance with regard to cross-border regulation application (releasing this past December a final exemptive order that would afford certain global participants temporary relief from compliance obligations while the CFTC finalizes its cross-border guidance), the SEC has chosen the route of formalized rulemaking. This process will include extensive analysis as to how extraterritorial Dodd-Frank applications might affect economic factors globally and, most important, systemically  affect the U.S. financial system -- focusing in particular on the tremendous capital and margin requirements expected of a trillion-dollar industry that has previously been largely unregulated.

This slow process of regulatory overhaul is not unique to the States. Aspirations for a centrally cleared, transparent OTC marketplace are shared globally. Foreign resistance to the extraterritorial reach of the Dodd-Frank Act stems from disparities in regulatory timelines and issues of overlapping, duplicative regulation that might lead to a fragmented global market if implementation is not carried out within a framework of global coordination.

This trepidation is in many ways underscored by the blunt approach the CFTC has taken in giving global participants until May 2013 to prepare for finalized guidance on cross-border applications. On the other hand, the SEC’s approach of formally proposing rules for analysis and discussion before any regulation is finalized will likely extend an already drawn out regulatory process.

As of February 1, the SEC lagged behind the CFTC in terms of overall Dodd-Frank rulemaking progress (see Exhibit 1). With regard to Title VII progress specifically, the CFTC had finalized 35 rules and missed deadlines on eight others, while the SEC had finalized 10 rules and missed 19 deadlines (see Exhibit 2).

Exhibit 1: Overall Dodd-Frank Rulemaking Progress

Source: Davis Polk

Exhibit 2: Title VII Progress

Source: Davis Polk

While at face value the CFTC is considerably ahead of the SEC in terms of rulemaking, the progress has come at a cost. “The lawsuits and the ad-hoc barrage of exemptions point to a flawed rulemaking process that prioritized getting the rules done fast over getting them done right,” lamented CFTC commissioner Scott O’Malia, speaking at the 2013 TABB Group fixed income event.

Going forward, the CFTC will be hard pressed to thoughtfully address critical issues regarding SEFs and margin/capital requirements before the May 1 deadline. Issues such as SEF execution method flexibility, the potential for a variety of SEF platforms rather than mirror DCMs, and finalizing margin and capital rules for uncleared products that are consistent with standards set by the BCBS and IOSCO are at the top of the list.

Meanwhile, the SEC, which has 19 remaining Title VII proposals to finalize, has no such time constraint. While the idea of continued regulatory ambiguity and lethargy is certainly unappealing, creating responsible, globally reaching rules requires time for analysis, public discussion/feedback, and further refinement. When the dust settles, the SEC’s formal, stepwise approach to rulemaking will, in all likelihood, afford the global security-based swaps market a slower and safer transition from opaque to transparent.

Until then, as regulatory agencies grapple with the difficult task of internationally and domestically coordinated rulemaking, it seems the devil is in the lack of details.


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Davis Polk Dodd-Frank Progress Report Reveals 93 Deadlines Met, 144 Missed to Date

Davis Polk has released their latest progress report on Dodd-Frank, summarizing regulatory activity to date. According to the executive summary of the report:

In October 2012

  • No New Deadlines. No new rulemaking requirements were due in October.
  • 6 Requirements Met. The Federal Reserve, FDIC and OCC released final rules on stress testing.  The SEC released its final rule on clearing agency standards.  The CFTC released a final rule that incorporates swaps into existing regulations.
  • 4 Requirements Proposed. The SEC released a proposed rule on capital, margin and segregation requirements for swap dealers and major swap participants.  The FHFA released a proposed rule on stress testing. 

To date:

  • As of November 1, 2012, a total of 237 Dodd-Frank rulemaking requirement deadlines have passes. Of these 237 deadlines, 144 (61%) have been missed and 93 (39%) have been met with finalizing rules.
  • In addition, 133 (33.4%) of the 398 total required rulemakings have been finalized, while 132 (33.2%) rulemaking requirements have not yet been proposed.
  • Major rulemaking activity this month included the Federal Reserve, FDIC and OCC final rules on stress testing. Additionally, the SEC proposed a rule on capital, margin and segregation requirements for swaps dealers and major swap participants.

For the complete PDF of the Davis Polk Dodd-Frank Progress Report, click here.

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