DerivAlert Commentary

Margin Compression in Interest Rate Derivatives: The Big Squeeze

Posted on Thu, May 12, 2016 @ 09:40 AM

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

The long-anticipated introduction of central clearing for over-the-counter interest rate swaps in parallel with the rollout of new capital, liquidity and leverage constraints for banks is bumping up the cost of hedging interest rate risk in Europe for brokers as well as their buy-side customers. What steps are required of buy-side firms to assess their hedging options?

Forewarned is forearmed; but sometimes it’s hard to use prior knowledge to your best advantage. 

Take, for example, the impact of post-crisis regulatory reforms on the cost of hedging interest rate risk in Europe. The long-anticipated introduction of central clearing for over-the-counter interest rate swaps in parallel with the rollout of new capital, liquidity and leverage constraints for banks is bumping up costs for brokers as well as their buy-side customers. In the U.S., which has already implemented G20-mandated central clearing and electronic trading of interest rate and credit default swaps, the new rules have given rise to a wave of innovation, in part due to the increased costs they impose. New instruments have been launched in Europe, too, including exchange-traded swap futures, which offer market participants the opportunity to offset their risks in ways that may prove cheaper or better suited to their needs than centrally cleared interest rate swaps. 

But while swap futures slowly gain momentum in the U.S., Europe stands nervously at the starting gate, ahead of a year of deadlines as the European Market Infrastructure Regulation’s (EMIR) clearing mandate finally comes into force. Some costs are already rising, but the overall cost/benefit analysis for continuing use of existing instruments, versus migration to swap futures et. al., is far from certain.

Will exchange-traded instruments provide a viable alternative as the prospect of cost hikes dampens the appeal of swaps? The buy side may need to keep its options for the foreseeable future, but it is worth examining some of those cost drivers for both the sell side and the buy side in order to further understand the motivation for using new approaches for hedging interest rate risks. 

Regulatory backdrop

Two of the biggest policy conclusions drawn from the collapse of major financial institutions in 2008 were that the opacity of the OTC derivatives markets and the size of bank balance sheets posed unsustainable systemic risks. Thus, the G20’s 2009 summit in Pittsburgh mandated central reporting, central clearing and electronic trading for standardized OTC derivatives – enacted under national and regional legislation, such as EMIR and the U.S. Dodd-Frank Act – and imposed higher capital charges and margin requirements for non-standardizable OTC instruments, based on guidelines drawn up by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). The BCBS was also tasked with tightening up the capital rules for banks, ostensibly to hike the cost of products and services in line with their inherent risks. Known as Basel III, and subject to “gold-plating” by local regulators, the new capital framework introduces a number of measures that increase the cost of clearing, structuring and execution services in the OTC derivatives market, as well as the cost of accessing collateral. Both Basel III and EMIR involve multi-year implementations, but they must also be placed in context of other legislation, notably MiFID II, with its implications for pre-trade transparency and best execution.

Explicitly, the aim of the G20 political leaders and the Financial Stability Board – the coordinating body for implementing post-crisis reforms – is to encourage banks to find cheaper and safer ways of providing the more high-risk services to clients, not least in the derivatives markets. This takes time and causes pain, as service providers and market participants alight on new innovations. But unintended consequences are also a fact of large-scale regulatory reforms, as recognized by regular revisions by the BCBS, and the European Union’s consultation on the collective impact of post-crisis legislation. Among several pertinent examples are capital charges on client collateral held by clearing members and the negative impact of Basel III’s leverage ratio on banks’ appetite for repo market business, which in turn hampers buy-side firms looking to transform assets into eligible collateral to post as margin at central counterparties (CCPs) in support of centrally cleared interest rate swaps.

Feeling the pressure

How does regulatory change translate into industry cost? Historically, buy-side clients posted collateral for interest rate swaps according to terms agreed bilaterally with a broker in a credit support annex (CSA). With the switch to central clearing of swaps, the buy-side firm needs one or more of its brokers to serve as a clearing member at multiple CCPs in order to post initial and variation margin on its behalf, according to collateral eligibility terms and schedules dictated by the CCP. Some broker-dealers in the European swaps market were already clearing members at some, but not all, European CCPs, for the purposes of clearing futures and other exchange-traded derivatives. But few, if any, had all the necessary connections to the growing range of CCPs needed to offer clients swaps clearing choice, and none already had the necessary risk and collateral management models and processes in place. 

Investing in the infrastructure needed to support a new, if complementary, service was already a challenge for banks under the shadow of Basel III. But the uncertainty of a return was multiplied by delays to EMIR’s timetable for launching central clearing, with a number of major banks deciding the risks and costs were no longer acceptable, quitting the market before it went live. As such, there is still a scramble for even large buy-side firms to sign up with clearing brokers ahead of the December deadline for mandatory clearing by non-clearing members. Moreover, the same mix of regulatory uncertainty and capital constraints means no major sell-side firm is currently supporting indirect clearing, designed by regulators for mid-tier and smaller users of interest rate swaps. This relative absence of competition has inevitable implications for pricing.

Laurent Louvrier, EMEA Head of Sell-Side and Hedge Funds, Risk Management Analytics, at MSCI, says Basel III may have an impact beyond the capital requirements imposed on execution and clearing services. “Generally, banks have to set aside more capital for certain activities, but the impact of this is combined with some very specific rules which exacerbate the impact, such as the capital treatment of collateral posted by clients for margin purposes, which is somewhat counter-intuitive and increases costs significantly,” he says. “Further, as a direct consequence of the new capital regime, some banks are retreating from specific areas of trading. Fewer offers in the market mean less competition, less liquidity and higher costs.”

New structures and processes must also be put in place for non-standardized derivatives that cannot be cleared centrally. From September, bilaterally cleared swaps will be subject to the BCBS-IOSCO risk mitigation framework, including consistent calculation methodologies for initial and variation margin and new controls for the exchange and secure holding of initial margin. As well as putting new models and processes in place, banks are factoring new costs into their pricing. “For bilateral trades, we’re starting to see pricing being impacted by XVAs, the valuation adjustment factors, due to regulatory capital requirements on the banks. Firms are no longer putting their heads in the sand and are taking a pragmatic approach, adjusting to the new environment ahead of the new rules,” says Liam Huxley, CEO of Cassini Systems, a provider of OTC cost and margin analytics.

Conflicting interests?

Nick Green, Global Head of eRates Product Management at Crédit Agricole CIB, sees a number of costs stemming from the regulation-driven shift in brokers’ counterparty risk distribution. Rather than many relatively small exposures spread across multiple buy-side clients in the bilaterally cleared world, brokers now face fewer, larger risks concentrated at a handful of CCPs in the centrally cleared environment.

“Clearing and collateral costs vary across CCPs and according to the size and nature of a clearing member’s aggregate position. If underlying client positions are highly skewed in a particular direction, the dealer can quickly find itself posting a lot more margin as it triggers bigger thresholds, which result in ever steeper collateral requirements. These increased collateral costs inevitably feed back into the price to the client,” he explains. 

Moreover, the proliferation of swap-clearing CCPs can also increase costs beyond mere connectivity. One variable arises if the client wishes to clear a swap at a different CCP than its dealer would choose, which is likely to be a common scenario as spreads offered by CCPs will reflect different risk implications for the buyer and the seller of the contract, informed in part by their existing positions. In the U.S. cleared swaps market, a market has developed in the spread between LCH.Clearnet’s SwapClear and CME Group for clearing the same swap tenors as participants seek to balance their exposures across the two and so minimize their clearing costs. 

“Clients can often get a better price by choosing to clear at the CCP that is favorable to the side of the trade they’re on. But they must also consider the overall collateral requirements: posting collateral in two CCPs is less cost-efficient than concentrating all your positions into one,” says Green. “These differences in price will become more of a factor as a wider range of CCPs become active in the swaps-clearing market.”

Cassini’s Huxley says buy-side firms need to assess these costs independently, including the embedded costs of the broker posting collateral to the CCP, which, as Green points out, will vary based on its overall position. “Buy-side firms must understand that the price offered by the broker will vary across clearing channels. And when you build in your own operational holding costs and collateral requirements bearing in mind the nature of your portfolio, the cheapest option offered by the broker might end up costing you more over the lifetime of the trade. But whichever choice you make, you’ll need to be able to demonstrate why you’ve done that, from a MiFID II best execution perspective,” says Huxley. 

Hunting elephants

Even after all these costs are factored in, we still haven’t mentioned the elephant in the room, according to Robert de Roeck, Head of Multi-asset Structuring at Standard Life Investments. For him, the critical challenge of the centrally cleared environment for interest rate swaps is mitigating the drag on performance caused by the need to post eligible collateral at CCPs. “The more of the fund one is required to hold in low-yielding eligible collateral, the greater the impact on fund performance,” says de Roeck, whose team oversees the firm’s liability-driven investment (LDI) funds.

According to de Roeck, delays and amendments to the European framework have already had “a material impact” on the ongoing development requirements for buy-side trading platforms. Access to interest rate swap markets is still considered fundamental to most LDI strategies, as the bespoke nature of OTC instruments enable managers to precisely hedge client’s long-term liabilities. (Pension funds have a temporary exemption from EMIR, but it is not clear how this will be replaced.)

“With bilaterally collateralized derivatives, the counterparty-negotiated CSA has historically allowed for the posting of assets already held within the fund, with the obvious benefits,” he explains. “Under central clearing, the assets that qualify as eligible collateral are very limited: cash or sovereign debt as initial margin, and only cash for variation margin.”

A typical pension fund liability hedging portfolio implemented on a bilaterally collateralized basis might easily require an additional 4% to 8% of the fund to be held in eligible collateral in order to meet the initial margin requirements under exchange clearing. This is before taking into account the eligible collateral requirements for variation margin. As a consequence of the more restrictive collateral posting constraints, asset managers also increasingly require access to a deep and liquid repo market in order to transform ineligible assets into eligible collateral. However, the impact of Basel III on the ability of banks to offer liquidity in repo markets is very much in question. “The ability to fully retain the fund’s exposure in funded return seeking assets and repo them out as required has, in my opinion, long since gone. Firms might end up holding 5% to 15% of the value of their funds in low-yielding eligible assets,” says de Roeck.

Exchange-traded instruments may well provide an alternative for certain funds but, he asserts, innovation will be required in order for such contacts to suit the idiosyncratic characteristics of LDI funds: “Historically, futures haven’t really cut it for LDI funds because they haven't offered the duration to meaningfully hedge pension and insurance liabilities. We are talking about durations of 20 years-plus, while the most liquid future in the sterling rates market is the 10-year gilt future.”

The swap spread effects being observed at the long end of the term structure are causing a rethink among providers and users of swaps, but de Roeck is also looking for other types of innovation, including new mechanisms for exchanging collateral assets in a repo market now hamstrung by capital regulations. “While Basel III makes repo too balance-sheet intensive for banks to participate at historic levels, there are still large pools of eligible collateral out there the owners of which are willing to lend out at a price. As such, peer-to-peer collateral transformation platforms might be the way forward, subject to agreement on the regulatory context,” he says.

Innovative alternatives 

Although anecdotal evidence suggests that cost pressures are beginning to make themselves felt, only the very largest buy-side firms are centrally clearing swaps in Europe, while even fewer have dipped their toes into the exchange-traded environment, despite the launch of numerous innovative contracts. This makes it hard to get a handle on future preferences. The slow growth of swap futures in the U.S. underlines the challenges of shifting liquidity in the derivatives market, but Cassini’s Huxley offers exchanges evidence for optimism, based on his platform’s analysis of the overall costs of new instruments versus cleared swaps. 

“It’s a multi-dimensional picture: the cost-benefit of swap future alternatives depends on how directional or balanced your portfolio is, as well as the exact nature of the trade. But if you’re running a directional portfolio, and hedging shorter duration, then you can find that putting on swap futures instead of swaps can give cost savings of up to 55+% over the lifetime of the trade,” he says.

Despite such potential savings, asset managers face a number of challenges in assessing and migrating to new instruments, says independent consultant David Bullen. “The investment consultants who are advising their pension fund clients on how to manage interest rate risk are not yet fully aware of these complexities. Pension fund trustees do not make major decisions without their investment consultants, but these advisors, not to mention actuaries, have not got the requisite tools to understand these new interest rate products at this stage,” he says. “The world simply hasn’t caught up with today’s market reality.”

The need to educate stakeholders and the difficulties of picking a winner from the current crop of swap future offerings add to the inertia resulting from ingrained processes and the weight of open interest. “There is clearly a market need for these new instruments, but the immediate challenge is the lack of liquidity, which is providing a disincentive for major firms to go into the market and test out these alternatives,” observes MSCI’s Louvrier. 

But the clock is ticking down on the EMIR deadline and the new costs of using OTC swaps will become more evident to asset managers of their clients. As such, many buy-side market participants will intensify their scrutiny of the new innovations, weighing up their fit with long-term requirements and operational realities. 

“For some firms, it will make sense to leverage existing collateral pools generated by their use of exchange-traded fixed-income, but that only makes sense if the available futures instruments meet their needs and can offer liquidity over the long term. Even the perfect product needs time to build momentum,” says Hirander Misra, CEO of GMEX. 

Bullen suggests that many on the buy side will have to cover all their bases, at least in the short term, securing access to OTC and exchange-traded interest rate derivatives. “To date, swap futures have mainly found favor at the shorter end of the market, with the reluctance of some exchanges to offer longer maturities, suggesting there will always be a place for OTC trades,” he observes. “The very precise hedging needs of a pension fund mandate typically favor OTC, but on the other hand we’ve seen over the last decade growing buy-side demand for instruments that can help them manage the roll risk.” Moreover, the widening cost differential between longer-dated OTC swaps and futures is now encouraging exchanges to offer 30-year contracts. 

Two years ago, Deloitte estimated the cost to the industry of reforms to OTC derivatives in Europe at €15.5 billion per annum, with the burden weighted toward the bilaterally cleared sector. Those figures are likely in need of upward revision, but reflect the scale of change faced by users of interest rate swaps, by far the biggest OTC market. This offers opportunity to investors, but new business will not simply fall into their laps. 

“The existing futures construct doesn’t automatically work as a replacement for OTC interest rate swaps, which is why we have come up with a futures paradigm that is more closely aligned to OTC instruments,” says Misra. “New products have to be aligned with existing processes and analytics. You need to be able to demonstrate the cost savings and hedging effectiveness over the life time of the instrument, but the more you can intertwine yourself into existing workflows, the better chance you have of succeeding.”

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Tags: Basel III, U.S., Buy-Side, IOSCO, G20, MiFID II, leverage ratio, EMIR, Derivatives, BCBS

The ‘Missing Link’ in Today’s Interest Rate Derivatives Markets

Posted on Thu, May 05, 2016 @ 09:00 AM

By David Bullen, Bullen Management Ltd; David Dixon, Independent
Originally published on Tabb Forum

Reduced market liquidity and structural market changes are driving up the cost of accessing traditional interest rate products for end users, pushing them to find alternatives. The evolving sub-asset class of IR swap futures sits neatly between the precision and flexibility of over-the-counter products and the liquidity and transparency of exchange-traded derivatives.

Interest rate (IR) markets have changed substantially since the financial crisis, both visibly and in their market structure. These differences challenge asset management firms attempting to operate on behalf of their clients, especially in liability-driven investing (LDI), where the rules and market are continuing to change around them. The risk management requirements of liability-driven investments challenge asset managers that turn to banks for solutions and liquidity in their desire to transfer risk on behalf of their clients.

New factors that have yet to impact fully, such as the greater flexibility surrounding pensions, prompting elevated transfer-out requests, increase the appetite for LDI fund flexibility. However, this desire for flexibility is at odds with reduced market liquidity and the structural changes that will make flexibility more costly. The reduced market liquidity is largely a result of a reduction in bank balance sheet levels deployed behind IR market-making functions in the bond, repo and swap sectors and the general profitability of investment bank franchises.

Many of the factors at work in European IR markets also affect the U.S., although the differing structures of the respective pension industries (401K vs. defined benefit/defined contribution) are generating different consequences. That said, the core need in the global market for IR liability hedging remains and will be viewed with much more focus on liquidity and flexibility considerations.

While the changes, current and planned, to the capital rules for banks have fundamentally changed the provision of IR market services, their full impact will only be felt in the future. Hence, there has been no massive shift away from over-the-counter (OTC) IR products yet, which some commentators mistakenly take to mean nothing has changed.

Regulations such as Basel III, especially the capital requirements within the leverage ratio rules, have significantly increased the amount of capital that banks are required to hold. This, coupled with the funding/liquidity requirements of the liquidity coverage ratio and net stable funding ratio rules, has severely restricted or indeed in some cases closed some banks’ business lines – for example, repo. Consequently, the cost of accessing these products for the end user is much higher. In addition, price competition for end users has been affected, as fewer prime brokerage and clearing services for OTC products are now available.

As a result of the leverage ratio, or the supplementary leverage ratio as it is known in the U.S., banks have withdrawn from, or re-priced, their balance-sheet intensive businesses. For firm evidence of this, one need look no further than the existence of the London Clearing House (LCH) to Chicago Mercantile Exchange (CME) “basis” in cleared IR swap pricing, whereby equivalent swaps are priced differently at the two institutions. This re-pricing phenomenon has prompted a range of new entrants to join the market: witness the arrival of non-traditional bank market-makers, hedge funds and other new market intermediaries, such as Citadel. These groups have demonstrated they are only too happy to step into new areas to provide market services and liquidity. Given some asset managers’ view that they expect and want to pay for leverage, it seems clear that market forces will encourage and reward these new entrants.

It remains to be seen whether these attractions will be strong enough to encourage asset managers themselves to act as market-makers to any meaningful or consistent extent. But the advent of a broader range of exchange-traded derivative (ETD) products, with their more “all-to-all” friendly trading protocol, will likely help bring about this outcome. The start of clearing of OTC products, with the ensuing removal of the credit risk element post-novation to the clearing house, also directly facilitates asset managers’ access to new sources of liquidity. They can become those sources themselves or indeed trade with other asset managers in the so called “all-to-all” model, the general clearing member’s involvement notwithstanding.

The repo market is a key area of change where there are already new entrants seeking to maintain liquidity, evidenced by the creation of collateral exchange efforts like DBV-X. The group’s CEO and founder, John Wilson, notes that Basel III has prompted dealers to withdraw capacity and widen spreads at a time when clients have growing collateral transformation needs. “Counterparty diversification will be essential for firms wanting continued access to deep liquidity and tight spreads,” he said. “However that will need to also encompass non-traditional counterparties like other buy-side firms and corporates.”

One prediction by an asset manager recently was of the “death of the reverse repo market,” given that it swells dealer balance sheets for little benefit whilst what capacity does exist is allocated according to the profitability of a client’s general derivative business rather than any fair market pricing logic. Collateral optimisation services on a principal basis are just too expensive due to the balance sheet costs of undertaking repo business, unless carried out as agent by custodians or via the new “agency” style services on collateral exchanges.

What of the drive to clear OTC derivatives mandated by the G20? As one asset manager commented, “Clearing is a red herring,” because it is the least significant consideration for funds, or should be. The more significant market development is Basel III and its additional capital requirements for dealers in line with the leverage of the position.

Red herring or not, the advent of mandatory clearing has not helped. It has started to create an uneven playing field that favors trading interest-rate risk in exchange-traded format – 1-day value at risk (VAR) margining (for exchange products), versus 5-day VAR (for OTC products). There are, in fact, slight variations of this with Europe being a 2-day net position for VAR and the U.S. being 1-day gross for ETD. Also, LCH charges 7-day VAR for client positions in OTC IR swaps. However, this still means margining for effectively the same risk profile is far cheaper for ETD versus OTC and should, over time, drive more business toward ETD formats, given best execution responsibilities under MiFID II.

OTC offers greater precision of asset-liability matching, while ETD offers better liquidity and transparency, suggesting both ETD and OTC interest rate risk formats will continue to co-exist. Current thinking suggests short-term IR markets and “imprecise” hedging products will be ETD format “owned,” whereas long-term IR markets, which provide a more precise hedging product, will remain OTC “owned.” However, this does leave the increased cost squarely in the end user’s corner.

The challenge for future liability driven investment (LDI) users of IR markets will be to decide how and where to link effectively both ETD and OTC IR markets in practical terms.

An ETD v OTC “link” is therefore needed. The evolving and new sub-asset class of IR swap futures is one tangible part of providing this link. Their form and attraction sit neatly between the precision and flexibility of OTC and the liquidity and transparency of ETD. The enthusiasm of providers to win in this race is apparent in the crowd that has gathered: there are currently five offerings from CME, ERIS, EUREX, GMEX and ICE. It generally takes one to two years to develop new sub-asset classes, such as swap futures, to the point at which they are widely available and liquid. Given the legendary difficulty of establishing exchange-traded contracts, there is some urgency here for one or two of these new products to be successful: 2018 is, after all, only seven future quarterly “rolls” away.

Mandated pension fund clearing in 2018 will drive pension funds and, in turn, asset managers to consider using this new and evolving asset class. Their fiduciary responsibilities for best execution and optimum collateral create a drag on their clients’ and pensioners’ monies, likely forcing them to trade this new asset class. Generating a credible market in these new products will also drive them to lobby liquidity providers, high-frequency trading firms, brokers, investment banks and innovative exchanges to provide products that address these needs.

Where does all this leave the traditional investment manager providing LDI services to, for example, pension funds? The incumbent providers might not be incentivized to make the investment necessary when they have such an established market position.

As one asset manager recently commented: “Successful LDI managers will need to excel at accurate hedging, liquidity provision and alpha; all whilst providing stable leverage at low cost, high levels of flexibility and clear best execution ability.” No mean feat in today’s IR market. The LDI toolkit, in order of importance, is effectively made up of four skill areas:

  1. Getting the hedge right
  2. Being liquid and flexible
  3. Generating alpha
  4. Minimizing drag costs (e.g. clearing costs)

The traditional means of interest rate de-risking a pension portfolio from moves in the interest-rate environment has been through the use of interest rate swaps. These OTC derivative instruments, rightly or wrongly, became one of the bogeymen of the last financial crisis and have attracted the attentions of regulators. This has in turn increased the cost base of OTC businesses across the board.

Investment consultants who advise pension schemes and other mandates on de-risking trades are yet to hear about or understand the full economics of new IR asset classes like swap futures. Currently, they are discounting these products as too innovative, insufficiently liquid or both. This situation is likely to change rapidly, largely due to the impact of capital requirements on the one hand and the push to clear derivative business on the other.

Asset management firms’ technology tends to change at a glacial pace versus that of market infrastructure and banks, so those asset managers that can position themselves correctly will have an opportunity to disrupt and enter the LDI market with a cheaper, more transparent and flexible product offering based on both ETD and OTC interest rate derivative products.

Current IR risk-transfer markets, following changes in capital rules and regulations, are unbalanced and provide insufficient liquidity to asset managers. Diligent best execution by asset managers will probably magnify this imbalance over time and be resolved only with the arrival of new entrants and new products.

To misquote Bill Clinton: “It’s the balance sheet, stupid.” It is the regulatory and mainly capital rule changes that have altered the provision of interest-rate risk transfer mechanisms available today. The current construct remains likely incomplete and certainly untested in terms of scale by the market’s users.

As such, ETD and OTC will need to co-exist. New instrument types, such as swap futures, while unproven, underdeveloped and new, are nonetheless an essential missing link in the IR markets of today.

Advanced new asset management operators offering LDI services that provide flexible and transparent products and services that see the world as one linked continuum of IR risk, both ETD and OTC, are likely to thrive. They will probably win pension fund de-risking mandates, which tend to be the most discerning selector of appropriate IR risk management products and, through necessity, pioneering users in interest-rate risk transfer mechanisms.

There is a pressing need for active, old and new market participants of all types to be willing to step in and provide the traditional risk-transfer function of markets, with a steady eye on their business models. Also, a new generation of LDI products, including some form of alpha generation, needs to be urgently designed and adopted, given real yields’ flirtation with negative territory.

In addition, for those asset managers that call the market structure moves correctly, there is a significant business opportunity to win new market share and an ability to avoid significant unnecessary costs.

‘The best way to call the market structure correctly is to take a view and influence outcomes by being proactive,” says Ricky Maloney, of the rates and LDI team at Old Mutual Global Investors. This is something relatively unknown in the asset management sector, because it has historically been the banks that have driven such market innovations and change.

Given what lies ahead, what should an asset manager do?

  • Spend time on market structure;
  • explore and understand new products like swap futures;
  • talk directly to product providers and innovators;
  • start to plan and budget for market infrastructure change;
  • seek information from bank and non-bank sources and
  • compare the pictures and data provided.

Crucially, asset managers need to hold views on market structure topics and express them vocally, as well as get into the business of sponsoring and founding new markets. Welcome to the world of “picking winners,” perhaps the other “missing” ingredient on the journey to the brave new world of interest rate risk-transfer markets.

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Tags: OTC, Derivatives, End-Users

National Archives Opens Financial Crisis Inquiry Commission Records

Posted on Tue, Mar 15, 2016 @ 10:11 AM

Exactly what caused the financial crisis?

In 2011, the Financial Crisis Inquiry Commission submitted a report that concluded “widespread failures in financial regulation and supervision” ended up hurting the strength and stability of U.S. financial markets.

Despite being released six months after it was passed, the Commission’s work reflects the thinking that led to the Dodd-Frank Wall Street Reform and Consumer Protection Act, which established post-financial crisis regulation such as the clearing requirement for over-the-counter derivatives and the  establishment of swap execution facilities.

We now have a chance to understand just what went into the Commission’s thinking.

Five years after the Committee finalized the report, the National Archives released background information that formed its thesis on the causes of financial crisis. The documents describe the mentality and actions of individuals like Former Federal Reserve Chairman Alan Greenspan and key financial executives in the years leading up to the crisis and while it was occurring.

A team of reporters from The Wall Street Journal provided commentary as they dug through this document release. Their insights can be accessed here

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Tags: Financial Crisis Inquiry Commission, regulation, SEFs, The Wall Street Journal, Alan Greenspan, Derivatives, Financial Crisis

2015 – A Year in Market Milestones: Tradeweb’s Billy Hult

Posted on Mon, Feb 01, 2016 @ 09:57 AM

By Billy Hult, Tradeweb Markets
Originally published on TABB Forum

2015 will go down in history as a milestone year for global financial markets. Meanwhile, the marketplace has continued to evolve in significant ways that have drastically impacted trade workflows and the business of trading fixed income and derivatives. At the center of the global government bond marketplace, here are the most significant events influencing trading over the course of 2015.

2015 will go down in history as a milestone year for global financial markets. Consider the list of monumental, one-of-a-kind market events, which reads like the résumé of an outrageous political candidate known for his liberal use of superlatives:

  • Record low yields in German 10-year Bunds

  • Largest one-day increase in Greek government bond yields on Tradeweb

  • Widest 10-year U.S. Treasury swap spreads in history

  • Highest yields in over 5 years for short-term U.S. Treasury notes

There’s no question about it: In the years following the financial crisis, the rates markets have become a macroeconomic seismograph, delivering an immediate feedback loop for global activity and uncertainty. Consider the performance of Eurozone debt, where yields for core and peripheral countries appeared in an un-choreographed dance. And in the U.S., the Federal Reserve’s long awaited decision to raise interest rates kept investors on baited breath all year long as yields gyrated on short term Treasury debt.

Meanwhile, the marketplace has continued to evolve in significant ways that have drastically impacted trade workflows and the business of trading fixed income and derivatives. The corporate bond landscape is in a new renaissance for electronic trading, introducing new protocols and functionality into the marketplace, and the dialog on algorithmic and high frequency trading in rates has reached new highs as market participants evaluate new and different ways of engaging liquidity.

Over the past 12 months, Tradeweb Markets has kept a watchful eye on all these moves in fixed income markets as a means of benchmarking the magnitude of different monetary and geopolitical events. At the center of the global government bond marketplace, here are the most significant events influencing trading over the course of 2015:

Negative Government Bond Yields Throughout Europe

In January 2015, nearly one quarter of all Eurozone government bonds were yielding below zero percent.

This meant investors were paying for the privilege of lending to central banks. There were a number of reasons for this phenomenon. For one, the European Central Bank (ECB) had cut interest rates to below zero and initiated bond repurchasing to prop up the economy. And despite the negative yields, asset managers continued to hold fixed income instruments in their portfolios, keeping the bond-buying spigot open throughout the dislocation.

On January 22, the ECB announced its intention to purchase government bonds yielding above the deposit facility rate of -0.20% as part of its easing program that launched on March 9 – leading to a 33% increase in European government bond trading volume in January v. December 2014. Yields continued to fall, however, and the percentage of Euro-based government bonds with a negative yield increased to 38.03% on April 14. A sell-off set in and Euro area government bond yields moved upwards again, and the percentage of negative-yielding instruments fell back to 22.21% by June 10. On the same day, the 10-year Bund mid-yield closed at 1%–its highest level since September 23, 2014.

The summer brought speculation that the ECB would ease monetary policy further, and Mario Draghi announced that the governing council was ready to do so on September 3. Yields for bonds with shorter tenures plunged to new record lows by December 2, a day before the ECB lowered its deposit rate to

-0.30%, a move expanding the universe of bonds eligible for purchase under the ECB QE scheme.

The chart below depicts the bid yield on the 2-year German note over the past 12 months and shows the trend in stark relief, with negative yields for the entire 12-months of 2015.

content hult1 resized 600

Negative Swap Spreads

In the U.S., one of the more notable market dislocations of 2015 has been the inversion of the 10-year interest rate swap spread, which turned negative in September and has stayed there ever since.

The 10-year interest rate swap spread measures the cost for investors to exchange floating-rate cash flows for fixed-rate cash flows in the interest rate swaps market. It had been falling since July of 2015 in anticipation of an interest rate increase by the Federal Reserve, but also in response to surging supplies of corporate debt and persistently low yields on U.S. Treasury securities.

The benchmark spread is calculated by adding the bid yield of the 10-year U.S. Treasury note to equivalent U.S. dollar denominated interest rate swap spreads. As the chart below indicates, 10-year swap spreads first went negative on September 25, closing at -1.75 basis points. The spread continued to widen to a record low of -16.75 basis points on November 20. Since then, the spread has been on a tightening trend, but is still holding in negative territory at -5.5 basis points.

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U.S. Treasury Yields Start to Climb on Fed Rate Rise

Perhaps the biggest market data event of the year was also the most hotly anticipated – the U.S. Federal Reserve ending its seven-year run of keeping the Federal Funds Rate at zero percent, with a historic decision to raise rates for the first time since 2006 on December 16, 2015.

The results were immediate as trading volume increased 10% from November. The bid yield on the 2-year U.S. Treasury note reached its highest level in more than five years, rising above 1.0% for the first time since May 3, 2010. A similar, but less dramatic move unfolded in the 10-year U.S. Treasury note, which closed at 2.29% on the day of the Fed announcement, up 2.3 basis points from the previous day.

The following chart depicts the 12-month trend in the 2-year U.S. Treasury yield as it has slowly climbed from a low of 0.444% in January to 1.064% in December.

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Central Bank Policy Divergence Widens Further

However, the U.S. Federal Reserve was the only major central bank to tighten monetary policy in 2015.

The ECB, on the other hand, boosted quantitative easing and other central banks maintained their own expansionary measures.

This divergence was highlighted in December 2015 when the Federal Reserve became the first major central bank to raise interest rates since the financial crisis, despite a low inflation rate of 0.5% in November. In contrast, the ECB announced it would extend quantitative easing until March 2017 at the least, and also cut its deposit facility rate to -0.30%. This move came amid low Euro area inflation – 0.1% in November – but promising GDP growth rose steadily from 1.2% in Q1 2015 to 1.6% in Q3 2015. European government bonds generally traded significantly lower than their US counterparts, with 32.26% of the total issued amount yielding less than zero as of December 2.

Similarly, the Bank of England and the Bank of Japan maintained their asset purchasing programs in 2015, worth £375 billion and ¥80 trillion respectively, while Sweden’s Riksbank boosted its own plan by another 65 billion kronor (€6.9 billion) in October.

Political Uncertainty Tests Europe’s Peripheral Economies

A year of political uncertainty exposed a drop in public support for bailout commitments and strict deficit reduction targets in Greece, Portugal and Spain amid bond market volatility.

The threat of a Greek exit from the Eurozone, following the nation’s default on its rescue loan from the International Monetary Fund, increased as the newly-elected anti-austerity government sought to renegotiate the terms of its bailout. On June 29, at the height of speculation over how Greece would move forward, yields on the 10-year Greek government bond surged to their highest levels since 2012, when the nation’s debt was restructured. Yields on the Greek 10-year bond closed at 15.43% on June 29, after rising 462 basis points in a single day. It was the largest one-day yield move since electronic trading of Greek government bonds began on Tradeweb in 2001. The upward spike continued until its peak of 19.23% on July 8, when a bailout package was finally announced.

Meanwhile in Portugal, Socialist leader António Costa was appointed prime minister on November 25, ending six weeks of political uncertainty after October’s inconclusive election result. Yields on Portuguese 10-year bond rose to 2.85% on November 9, but finished the year at 2.52%, nearly a full percentage point above its lowest closing value of 1.54% on March 16.

Meanwhile in Spain, the December 20 election left the country without clear leadership as the incumbent Popular Party failed to secure a majority. The Spanish 10-year government bond finished 17 basis points higher over the year at 1.77% – comfortably between its lowest closing mid-yield of 1.08% on March 11 and the highest closing mid-yield of 2.37% on June 15.

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Regulation Sharpens Focus in Europe and Asia

2015 saw the European Securities and Markets Authority (ESMA) make considerable progress in writing the rules that will implement mandatory clearing and trading for OTC derivatives. On December 21, the regulatory technical standards (RTS) went live for the first instruments mandated to clear under the European Market Infrastructure Regulation (EMIR).

Additionally, ESMA further developed and consulted on rules to implement the Markets in Financial Instruments Directive II (MiFID II) and Markets in Financial Instruments Regulation (MiFIR). These rules include specific aspects of the new pre- and post-trade transparency for numerous asset classes, including OTC derivatives and ETFs, as well as a mandatory trading obligation for derivatives. And on September 28, ESMA delivered its final RTS to the European Commission, which are expected to be adopted during the first half of 2016.

However, the industry widely expects delays to the January 2017 implementation of these rules so that regulators gain ample time to build the necessary systems and infrastructure for surveillance and monitoring. Market participants and trading venues haven’t slowed down in the meantime, working together to interpret available rules and information in preparation for the transition to a new regulatory regime.

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Japan was the first country in Asia to introduce mandatory electronic trading for specified OTC instruments on September 1, 2015. The Financial Services Agency now requires institutions with derivatives positions greater than ¥6 trillion to execute 5-, 7- and 10-year yen swaps on regulated Electronic Trading Platforms (ETPs), which must then publish trade-related information.

The first transactions under the new regime were completed on the same day the rules came into force. And e-trading has grown rapidly, with more than ¥2 trillion traded across five different ETPs in September, led by Tradeweb accounting for ¥765 billion alone (ClarusFT data).

Elsewhere, authorities in Australia are developing proposals for their own electronic trading mandate, while legislators in Hong Kong and Singapore have been drawing up requirements for reporting and clearing. In Singapore, even though the country’s Monetary Authority previously stated that it does not intend to introduce an e-trading mandate for derivatives, it has nevertheless proposed putting in place the necessary legal framework for its potential implementation. We’ll continue to see greater implementation of new regulations in 2016 as clearing obligations come into effect and approval of new rules are expected before the third quarter.

Innovation Grows in Transaction Cost Analysis

As electronic trading has driven greater efficiency in the fixed income workflow, the availability of new information to interpret and manage trading activity continues to increase the focus on business performance. Compounded by upcoming regulatory reform in some regions and demand for improved compliance and monitoring tools, transaction cost analysis (TCA) for the bond markets is beginning to take hold.

In the equities markets, firms have had access to analytical solutions for TCA for years. However, the availability of such tools in the fixed income space has only just come to the forefront, as more robust trading information has become more readily available and tracked in electronic workflows.

With real critical mass in electronic trading of government bonds, firms like Tradeweb have begun to introduce new analytics that help institutions better understand their trading activity and support efforts to ensure best execution. Connecting the point of execution directly with systems to process and view TCA has introduced a new level of transparency into fixed income trading desks. Most importantly, this new information is helping organizations continue to become more intelligent and efficient in their counterparty selection and discovery of liquidity. And on the back-end, risk and compliance managers have a real view of trading activity, benchmarked against aggregate market data, like Tradeweb’s composite pricing and other post-trade reports.

However, there is new ground to cover as TCA offerings continue to expand beyond government bonds, European credit, covered bonds, supranationals, agencies and sovereigns. As new regulation increases the quality and availability of post-trade information around the globe, we’ll continue to see new applications for TCA to enhance best execution and overall trading operations.

Popularity in Fixed Income ETFs Climbs Higher

Exchange-traded funds (ETFs) have enjoyed consistent, fast-paced growth in assets since their launch more than two decades ago, exceeding $3 trillion in assets worldwide in May 2015. However, ETF liquidity and the way in which it trades has continued to evolve in different ways.

Now in its fourth year, the Tradeweb European-listed ETF marketplace represents one of the largest venues for ETF trading in Europe. European ETF volume surpassed €112 billion on Tradeweb in 2015, with nearly one third of the overall activity resulting from the growing use of fixed income ETFs in Q4. This represents an interesting trend in how market participants are leveraging request-for-quote and other protocols to gain best execution in an otherwise fragmented marketplace.

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Off-exchange trading continues to gain traction with the institutional fixed income community as they have begun accessing greater levels of liquidity through new trading protocols. And investors are quickly learning about the liquidity benefits of fixed income ETFs as they seek new ways of managing risk, especially in the corporate bond market.

Tradeweb is working with the industry to help support this crossover in trading of traditional equities products by fixed income investors, and partnered with BlackRock iShares and State Street to help develop new standards for analysis, evaluation, and calculations for converting yield, spread and duration with fixed income ETFs into identical terms for the underlying bonds.

Investors are also taking advantage of new post-trade reporting and access to dealer axes on venues like Tradeweb, introducing new data to inform better counterparty identification and improve access to liquidity. This has been so impactful, hit rates have shown to increase by five percent when sending a request-for-quote to axed dealers, and by ten percent when trading fixed income ETFs. And as market participants prepare to trade ETFs under MiFID II in Europe, we’ll continue to see even greater adoption of e-trading ahead of mandatory reporting coming into effect.

Derivatives Trading Outlook for 2016

2015 was a banner year for the electronification of derivatives markets, and some of the key issues and advances in swap trading seen to date may serve as indications for what’s next in the twelve months ahead. Market participants are leveraging new tools to source liquidity and optimize portfolios, while keeping a watchful eye on regulatory reforms in Europe and Asia. Average daily trading volumes on Tradeweb have increased to more than USD $30 billion on TW SEF. In addition, the platform has seen approximately 75% of D2C block trading, as of October 2015, according to ClarusFT.

The factors driving this growth include increased use of tools like buy-side compression, which helps improve line-item management at derivatives clearing organizations (DCOs), and the adoption of products like market-agreed coupon (MAC) swaps, that offer standardization to ease the process of rolling positions.

We expect innovation will continue in the U.S., Europe and Asia. Japan has already had a successful launch of electronic trading platforms (ETPs), and in the near future European market participants will focus their resources on the upcoming clearing mandate and the eventual trading and reporting reforms under MiFID II.

As swap trading continues to adapt to new regulatory requirements and we continue to see an increase in electronic trading, technological solutions are helping increase transparency, efficiency and compliance for all participants.

Record Corporate Bond Issuance Amid Rising E-trading

Bond sales by investment grade American corporations eclipsed the $1 trillion mark by September of last year, putting 2015 squarely on track for a record-setting pace of corporate bond issuance in the U.S. A similar trend has played out around the world, with the notional dollar value of global bond sales topping $2 trillion in December, not quite a record, but among the top four most active years for global bond deals in the last two decades.

The drivers of this trend are no mystery. Seven straight years of record-low interest rates have made the allure of cheap debt too hard to ignore for companies looking to raise funds and incremental improvements in the economy have given yield-starved investors the confidence they need to buy corporate debt.

Increasingly, the task of creating liquidity in the enormous market for corporate bonds is falling to electronic trading platforms. According to a December report from Greenwich Associates, the share of investment-grade bonds that trade electronically has doubled over the past two years and now makes up 20% of total market volume.3

Firms like Tradeweb are helping to drive this adoption with new methods of counterparty identification and streamlining trade workflows. For example, integrating its U.S. credit platform with its Treasuries marketplace, Tradeweb has deployed the industry’s first fully automated Treasury spotting tool. This significantly reduces a relatively manual and tedious process for hedging the interest rate risk of corporate bond trades, while reducing the likelihood of human error in the process. As we approach the brave new world of a rising rate environment, tools that improve the overall workflow and aid in the discovery of liquidity will gain even greater relevance in supporting greater efficiency in the marketplace.

Evolution and Progress of Algorithmic Trading in Fixed Income

Algorithmic trading firms now account for 60% of activity in electronic Treasury trading, up from 45% in 2012, according to TABB Group research appearing in The Wall Street Journal. That’s a staggering number when you consider that the market for U.S. Treasuries, arguably the most liquid market in the world, is currently valued at about $12.7 trillion.

The growing presence of algorithmic traders in the Treasury market has been met with a combination of enthusiasm and caution on Wall Street. Proponents of the tech-enabled approach to rapid-fire trading have consistently shown that the increased order flow they create has improved liquidity and makes pricing less volatile.

Regulators haven’t been as clear-cut in their support for the algorithmic evolution of Treasury trading, and have been hard at work since the “flash crash” in Treasuries on October 14, 2014. But this November, the Commodity Futures Trading Commission (CFTC) proposed new rules as part of its regulation on automated trading (Reg AT) that will allow regulators to inspect the source code algorithmic traders use to guide their trading activity without a subpoena – a new step forward in oversight of the market. Trading industry groups have voiced concern that the rule exposes algorithmic traders’ proprietary information to third party security risk and could potentially undermine competitive advantage.

Though buy- and sell-side demand, and liquidity within the institutional marketplace remains rooted in disclosed, request-for-quote trading, the debate over all forms of electronic trading in rates markets is bound to grow in the coming years.

Looking Ahead to 2016

While it’s impossible to predict the future, many of the issues that drove such significant market moves this year are still very much a factor for the year ahead. With stimulus still being pumped into European markets, a great deal of fixed income supply still owned by the U.S. Federal Reserve and continued concerns about market liquidity prevalent across all corners of the financial marketplace, it’s a safe bet that we haven’t seen the end of recent volatility.

This feeling of uncertainty is familiar, like when the industry first began working on reform under Dodd-Frank over five years ago: a commitment to preparation and improved operational performance. Whereas derivatives continue to provide market participants with effective risk management, access to efficient trading tools on SEFs will result in increased adoption of solutions like buy-side compression, and standardized instruments such as market-agreed coupon (MAC) swaps. When new products are made available to trade on SEFs, the scale of e-trading will increase.

Meanwhile, the global credit marketplace is warming up to new operational efficiencies afforded by electronic trading. We’re still in the early stages, but clients have begun to leverage a range of new technology to improve their ability to source liquidity, gain quality execution, and improve workflows at lower costs.

Similarly, trading in U.S. Treasuries will continue to hold its share of the spotlight, especially as the roles of market participants are changing and influencing liquidity. As the leading venue supporting Treasury trading in the institutional, wholesale and retail communities, we’re looking forward to leading the technical revolution by providing more efficient solutions, more liquid trading platforms, and more connections to more industry participants.

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Tags: U.S., ETFs, treasuries, Greece, Spain, CFTC, SEFs, Federal Reserve, Swaps, ECB, Trading, Derivatives, Tradeweb, Japan, Portugal

Swap Execution Facilities: What’s Next?

Posted on Fri, Nov 20, 2015 @ 09:48 AM

By Ivy Schmerken, Flex Trade Systems
Originally published on TABB Forum

Despite the shift to electronic trading in the swaps market, the vision of a buy-side trader sitting in front of a screen with the ability to anonymously click on streaming prices from multiple SEFs could be several years away. But new liquidity providers could be catalysts for change in market structure.

This is part 2 of a series on SEF trading. View part 1: “SEF Trading: Challenges and Regulatory Hurdles

The U.S. ecosystem for swap execution facilities continues to evolve, but not as rapidly as regulators and lawmakers anticipated. Despite the shift to electronic trading, some observers question if swaps trading has reached a new equilibrium. The vision of a buy-side trader sitting in front of a screen with the ability to anonymously click on streaming prices from multiple SEFs could be several years away. However, new liquidity providers could be catalysts for change in market structure, suggested speakers at a recent webinar.

An Oct. 29 webinar, “Swap Execution Facilities: What’s Next?” hosted by Greenwich Associates, examined a range of issues impacting SEFs, including buy-side behavior, the entrance of non-bank liquidity providers and new trading protocols. Executives from firms including Citadel, Global Trading Systems and Javelin Capital Markets participated in the discussion.

Currently, swaps trading volume is concentrated with the top dealers. According to a Greenwich study on interest rate derivatives, more than 60% of dealer notional weighted market share of buy-side trading in interest rate derivatives was executed through the five top dealers. Only 24% went through 6-10 dealers and 13% was sent to 11-20 dealers.

“One of the main goals of Dodd-Frank was to diversify the liquidity landscape to reduce systemic risk, so if one market player was to malfunction, there would be plenty of players to pick this up,” said Kevin McPartland, head of market structure and technology at Greenwich during the webinar. The concentration levels began to increase in 2012 and this year are as high as they were before the financial crisis, noted McPartland.

Panelists cited the demand for non-traditional liquidity providers, predicting they will bring more liquidity and competition into the swaps market. But new entrants need to operate at the top of their game in order for the customers to reconsider their existing relationships.

In July 2014, Citadel, the market-making unit of the Chicago-based financial firm, began making markets on SEFs, according to an article in RiskNet. The trading powerhouse is said to be making a significant difference by providing firm quotes on SEF platforms, noted one webinar panelist. “The question is why more new liquidity providers haven’t come into the market and what is the impediment to them?” asked McPartland.

Mandatory clearing and the requirement that all swaps must trade on electronic venues was supposed to mean that firms no longer had to worry about with whom they traded. The idea was that people could focus on best price and trade through multiple dealers.

One impediment is that RFQ is too slow for high-speed trading firms that would like to enter the swaps market as liquidity providers. Computerized trading firms that are players in the equities and futures markets reportedly are eyeing the swaps market, but progress has stalled, according to Bloomberg News.

“The current electronic version of swaps trading, called request for quote, isn’t well-suited for computerized firms because it involves traders negotiating prices rather than computer programs deciding when to buy and sell,” the article says. Such firms trade in the futures exchanges, where computers match client orders based on central limit order books. These firms would prefer a more exchange-like market for swaps, according to Bloomberg.

Counting on Alternative Liquidity Providers

The value of new liquidity providers is the potential for greater diversification of liquidity, which benefits the buy-side firms as consumers of liquidity. Having a large number of liquidity providers is a way to facilitate innovation in market structure, said one panelist. New liquidity providers can differentiate themselves by providing firm prices and innovation. They also think about applying technology to the workflow, which is not what the existing market making firms are historically great at, added another panelist. One wholesale liquidity provider on interdealer-broker (IDB) platforms explained that the purpose was to provide better liquidity to the banks so that the banks, in turn, will use this liquidity to improve liquidity for their clients.

Non-traditional liquidity providers also tend to bring a technical capability to the equation. Most buy-side firms would rather trade faster, not slower, and have live prices, a panelist said. Alternative liquidity providers can facilitate market structure changes that require new pricing and faster technology, but they must also work together with large firms that bring capital and large franchises.

Buy-Side Behavior and Swap Execution Facilities

“Buy-side firms now have the technical capability to execute swap trades on SEFs, so why aren’t they changing their behavior?” asked McPartland. The SEFs operate central limit order books, but SEF operators have cited low demand for these venues.

People have adjusted to so many changes, such as implementing clearing and data reporting, there is no appetite to change workflows, suggested one panelist. Buy-siders are content taking prices, rather than making prices, he said.

In terms of trading protocols, the market is still dominated by request for quote trading on SEFs, and the clients are comfortable with it. RFQ is a good way to move a large order and remain anonymous, notes a technology source not participating in the webinar.

Most of the dealer-to-customer volume is happening on two SEFs, with disclosed RFQ with the dealers having the last look at prices, said one of the panelists. The interdealer volume has moved to SEFs but is bifurcated between five IDBs and Dealerweb (operated by Tradeweb) handling all the dealer-to dealer-volume and very little buy-side volume. Block trades are still created the old fashion way, by voice, and then subjected to breakage agreements and clearing, noted the panelist.

McPartland asked if there’s a need for more trading protocols to encourage new liquidity providers to step in. The introduction of firm prices is new to the swaps market, said one speaker. Traditionally, someone would get a price, but the dealer would have a last look and either accept or reject it. Other market makers are looking to replicate their experience in fixed income over to swap trading venues. One panelist said his firm is applying RFQ to live streaming prices, which is similar to clicking a price on a central limit order book.

Panelists concurred that customers want a better RFQ process, but they don’t necessarily want a so-called central limit order book, or CLOB. As far as needing more trading protocols, customers have a variety of competitive platforms to pick from. There isn’t a massive desire to change the way they trade, the source said.

While there’s been a lot of talk about CLOB trading and why it hasn’t taken off, one panelist said it takes a lot for buy-side clients to change their workflow. After going through the clearing mandate, buy-siders are not keen to change their workflow processes. In addition, impediments such as lack of average pricing and lack of anonymity with the interdealer SEFs continue to exist. Though many on the buy side say they want CLOB trading, it won’t happen until all the pieces are in place and the market is ready, suggested one panelist.

However, SEFs are gearing up for a changing ecosystem. More standardized swaps known as Market Agreed Coupon contracts, or MAC swaps, are expected to appeal to buy-side firms. MAC swaps, which emerged in 2013, have a range of pre-set terms, including start and end dates, coupons, currencies and maturities, similar to interest-rate futures.

“We have a MAC swap order book, outright rates in multiple currencies, and are connected to platforms such as UBS NEO,” explained Michael Koegler, Managing Director, Marketing & Strategy, at Javelin Capital Markets, LLC, speaking on the Greenwich Associates webinar.

Panelists predicted that the stage is set for more adoption of new innovations and styles of trading over the next few years. “If alternative liquidity providers enter the swap market to provide liquidity, they will get a good reception from the buy side,” said Koegler.

It remains to be seen whether MAC products are the tipping point that will push the buy side toward the era of standardized swap trading.

Up to the Buy-Side?

Now that the dust has settled with the clearing mandate, the onus is on the buy side to connect with different platforms or agency desks offering aggregators, panelists said. In the meantime, the industry could see some venues emerge as order books and others as RFQ venues, borrowing practices from each other.

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Tags: U.S., CLOBs, Dealers, Buy-Side, regulation, SEFs, Swaps, Derivatives, Tradeweb, RFQ, liquidity, Dealerweb

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

Posted on Fri, Nov 06, 2015 @ 09:57 AM

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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Tags: U.S., CCPs, OTC, regulation, ISDA, SEFs, Clearing, MiFID, OTF, SEC, EMIR, Derivatives, ETD, TRs

MiFID II and Best Execution for Derivatives

Posted on Thu, Oct 22, 2015 @ 09:03 AM

By Amir Khwaja, Clarus
Originally published on Clarus Financial Technology blog

Following on from my recent article on MiFID II and the Trading Obligation for Derivatives, I wanted to look into another key section in the ESMA Final Report; namely the requirements for Best Execution. There are two specific requirements, one for Trading venues and another for Investment Firms.

MiFID II Background

The Final Report deals with Draft Regulatory Technical Standards (RTS) of which there are 28 and describes the consultation feedback received, the rationale behind ESMA’s proposals and details each RTS. The report is now submitted to the European Commission, which has 3 months to decide (Dec 28, 2015) whether to endorse the technical standards.

Assuming that it does so, MiFID II will come into effect in Europe on Jan 3, 2017.

Best Execution and Total Cost Analysis (TCA)

There have been a number of good overview write-ups on Best Execution, two I would recommend are Michael Sparkes of ITG Analytics on Multi-Asset Best Execution and Simon Maisey of Tradeweb on TCA for Fixed Income.

I usually find that diving deep into the detail and coming back up is a good way to grasp the essence of a new regulation. So lets look at the relevant detail in the Final Report.

RTS 27 – Best Execution for Trading Venues

An investment firm has a fiduciary obligation to provide its clients with the best possible results when executing orders. The data required to assess best execution is essential for investment firms to monitor performance from venues and for the buy side to monitor the sell side.

This RTS sets out the data that must be made public for financial instruments subject to the trading obligation.

It applies to venues that can be selected by investment firms for execution of their client orders (e.g. RMs, MTFs, OTFs). As such it would seem to apply to All to All Venues and D2C Venues and exclude D2D only ones (assuming D2D continue to exist in the new market structure). Either-way a large chunk of Swaps trading will be included in the Best Execution requirements.

Frequency of Data Publication

Execution venues are required to publish data four times a year and no later than three months after the end of each quarter. So by 30 June for the period 1 January to 31 March.

This data is expected to be available free of charge in a machine readable format on their websites.

Articles 1 to 12, deal with the specifics of the data.

Article 4 – Price

We will start with the first interesting one, Article 4 on price. This requires price data for each financial instrument to be made available for each trading day with one format for intra-day information and one for daily information.

Intra-day requires the following:

MBE 1 1024x558 resized 600

Meaning that:

  • for 4 specific times of the day (9:30, 11:30, 13:30, 15:30) and

  • for each Size Range, 1 <= Size Specific to the Instrument (SSTI), 2 > SSTI and 3 > Large in Scale

  • for all trades executed within the first two minutes

  • the Simple Average Price

  • the Total Value executed

And if there are no transactions in the 2mins, then details on the first transaction are required as per the next set of column headings in the table, so price, time, size, etc.

Daily reporting requires:

MFBE 2 1024x161 resized 600

So for each trading day and instrument, the four rows above.

Lots of interesting price data indeed. Both point in time and daily averages.

Article 5 – Costs

Costs for execution fees, fees for submission/modification/cancelling or orders, fees for access to market data or terminals and any clearing or settlement fees.

As well as a description of the nature and level of rebates and discounts.

MFBE 6 1024x283 resized 600

Article 6 – Likelihood of Execution

For each instrument and trading day:

MFBE 3 1024x393 resized 600

Which will provide interesting comparative data on pre-trade vs post-trade and between venues.

Article 7 – Additional Information for Continuous Auction Order Book and Continuous Quote

MFBE 4 1024x285 resized 600

Which gives a sense of the oder book at 4 specific points in time for each trading day.

There is a second more detailed table, which I will skip as Order books are less relevant for D2C Swap trading, except to note that it contains the excellent sounding “Number of Fill or Kill Orders that failed”. For those interested, you can find this table on page 536 of the Final Report.

Article 8 – Additional Information for Request for Quote Venues

MFBE 5 1024x287 resized 600

Simple statistics on the time between acceptance and execution and the request and quotes.

That covers much of RTS 27 – Best Execution for Venues.


RTS 28 – Best Execution for Investment Firms

This requires investment firms to disclose annual information on the top five execution venues used for client orders in the prior year for each class of financial instrument, including whether the investment firm itself was one of the top five execution venues.

Classes of Financial Instrument

Those relevant to us today include:

  • Interest Rate Derivatives

    • Futures and options

    • Swaps, forwards and other interest rate derivatives

  • Credit Derivative

    • Futures and options

    • Swaps, forwards and other interest rate derivatives

  • Currency Derivatives

    • Futures and options

    • Swaps, forwards and other currency derivatives

Information on Top 5 and Quality of Execution

Requires the following table to be completed.

MFBE 8 1024x440 resized 600

Expressing volume as a percentage means that potentially market sensitive disclosures on the volume of business being conducted by an investment firm are avoided.

Passive orders means an order entered into an order book that provided liquidity, an Aggressive order means one that took liquidity and a Directed order means one where the execution venue was specified by the client prior to execution.

In addition there is a requirement to publish a summary of the analysis and conclusions the investment firm draws from its detailed monitoring of the quality of execution obtained, including an explanation of the relative importance given to price, costs, speed, likelihood of execution or other factors.

This information is required to be made public in machine readable format on the investment firms website.


That wasn’t so bad was it.

Time for a quick recap.

Trading venues will be required to make public each quarter,  daily information in prescribed formats, for each instrument subject to the trading obligation.

This information will allow Investment firms to fulfil their best execution obligation to clients.

Investment firms will also be required to make public annual information on the Top 5 venues used for each class of financial instrument.

Thats it.

All very sensible and simple.

I plan to cover further aspects of MiFID II, MIFIR and European Market Infrastructure Regulation (EMIR) is a European Union regulation designed to increase the stability of the OTC derivative markets throughout the EU states">EMIR in future blogs.

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Tags: ESMA, EC, TCA, regulation, MTFs, OTFs, D2C, Best Execution, Simon Maisey, MiFID II, Swaps, D2D, Trading, Derivatives, Tradeweb, RTS, RMs

MiFID II and Swaps Transparency: What You Need to Know

Posted on Wed, Oct 14, 2015 @ 10:14 AM

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

The swaps transparency changes driven by MiFID II are meant to establish a level playing field between trading venues so that price discovery of a particular financial instrument is not impaired by fragmentation on liquidity. What do the pre- and post-trade transparency requirements mean for market participants?

ESMA recently published its Final Report on Regulatory Technical Standards for MiFID II. A process that started in May 2014 with a Discussion Paper and then two Consultation Papers finally is nearing completion.

For this article I have read as many of the 402 pages as possible, to try to understand what MiFID II will mean, and while there is a lot of interesting information for Equities, Bonds, Structured Finance Products, Emission Allowances and Derivatives, I will limit my scope to Transparency for Interest Rate Swaps.


The Final Report deals with Draft Regulatory Technical Standards (RTS), of which there are 28, and describes the consultation feedback received and the rationale behind ESMA’s proposals, and details each RTS. The report is now submitted to the European Commission, which has three months to decide (Dec. 28, 2015) whether to endorse the technical standards.

Assuming that it does so, MiFID II will come into effect in Europe on Jan. 3, 2017.

RTS 2 – Transparency Requirements with Respect to Derivatives

RTS 2 has requirements on transparency to ensure that investors are informed as to the true level of actual and potential transactions, irrespective of whether the transactions take place on Regulated Markets (RMs), Multi-lateral Trading facilities (MTFs), Organized Trading Facilities (OTFs), or Systemic Internalizers (SIs), or outside these facilities.

This transparency is meant to establish a level playing field between trading venues so that price discovery of a particular financial instrument is not impaired by fragmentation on liquidity.

Meaning that there are both pre-trade and post-trade transparency requirements.

Post-Trade Transparency

Trading Venues and investment firms trading outside venues are required to make public each transaction in as close to real time as possible and in any case within a maximum 15 minutes of execution, which drops to 5 minutes after Jan. 1, 2020.

Meaning that most trades will be made public within a few minutes of execution and the data will include:

  • Execution date and time
  • Publication date and time
  • Venue
  • Instrument type code
  • Instrument identification code
  • Price
  • Notional
  • Transaction identification code
  • To be cleared or not

As well as Flags to signify details such as Cancel or Amend transaction or Non-Price Forming or Package transaction and many others.

Importantly a time deferral of 2 business days is available for transactions that either are:

  1. financial instruments for which there is not a liquid market, or
  2. large in scale compared to normal market size for the financial instrument, or
  3. above a size specific to that financial instrument trading on a venue, which would expose liquidity providers to undue risk.

We will come back to the definition and operation of each of these.

Pre-Trade Transparency

Trading Venues are also required to make public the range of bid and offer prices and depth of trading interest at those prices, in accordance with the type of trading system they operate. Interestingly, for RFQ markets this means making public all the quotes received in response to the RFQ and doing so at the same time. In addition, RFQ or Voice trading systems are also required to make public at least indicative bid and offer prices, where interest is above a specified threshold.

Which means lots of public pre-trade price information, including depth.

Importantly, this requirement is waived for the following:

  1. Derivatives that are not subject to a trading obligation (clearing and liquid market)
  2. Orders that are large in scale compared to normal market size
  3. Orders that held in an order management facility of a trading venue pending disclosure
  4. Actionable indications of interest in RFQ or Voice that are above a size specific to that financial instrument, which would expose liquidity providers to undue risk.

We now need to tackle the meaning of Liquid Market, Large in Scale and Size Specific to Instrument.

Liquid Market

The assessment for Liquid for Derivatives utilizes two criteria, specified for a Sub-Asset Class and Sub-Class:

  • Average Daily Notional Amount
  • Average Daily Number of Trades

The table extract showing single-currency interest rate swaps in the second row is as below:

1014aa resized 600

Showing that for each maturity (e.g., IRS 5Y), there needs to be an Average Daily Notional of at least EUR50 million and an Average Daily Number of Trades of at least 10.

ESMA will publish by July 3, 2016, its first assessment of which Financial Instruments are Liquid and will do so using data for the period July 1, 2015, to Dec. 31, 2015, and this assessment will apply from Jan. 3, 2017, to May 18, 2018, after which it will be periodic/yearly.

Meaning we will know by July 3, 2016, which are liquid (e.g., EUR IRS 5Y) and which are not (e.g., EUR IRS 13Y).

Large in Scale (LIS) and Size Specific to Instrument (SSTI)

For Pre-Trade and Post-Trade there are distinct thresholds for a Financial Instrument as to what is Large in Scale (LIS) or Size Specific to Instrument (SSTI), and these are lower for pre-trade given the greater sensitivity of this information. These are specified based on a trade or volume percentile.

The table extract for Liquid markets showing single-currency interest rate swaps in the second row is as below:

1014bb resized 600

Showing that for a liquid IRS (e.g., EUR 5Y) pre-trade LIS is 70% trade percentile and SSTI is 60%.

While for post-trade the LIS is 70% volume percentile and SSTI is 60% volume percentile; unless the volume percentile is greater than 97.5% trade percentile, in which case the trade percentiles of 90% and 80% are used (this addresses the bias caused by a very small number of transactions of very large size).

In exceptional circumstances where a liquid instrument does not have a sufficient number of trades (1,000 trades in the period), the threshold floor values would apply.

Again, the same yearly basis determination process will be used.

So we will know the threshold sizes by July 3, 2016, which will then apply from Jan. 3, 2017, to May 18, 2018.

And for Financial Instruments that are determined to not have a liquid market, the following thresholds apply:

1014cc resized 600

Well that completes the definitions and meanings.

Phew! I hope you are still with me.

An Example

Time for a few simple examples.

RFQ for a EUR IRS 5Y in 25m notional size

This will surely be a Liquid Market, meaning that pre-trade, the quotes provided to the RFQ will be made public in real time (as technologically possible) and all at the same time.

And post-trade details will be made public, including execution time-stamp, instrument code, price and size.

RFQ for a EUR IRS 13Y in 25m notional size

This will likely not be Liquid, meaning that no pre-trade quotes will be public and on trade execution only on T+2 business days will details be made public.

RFQ for a EUR IRS 5Y in 200m notional size

This will likely be Liquid and above the LIS or SSTI threshold for pre-trade but below the post-trade thresholds.

Meaning no pre-trade quotes are made public but on trade execution, details will be made public in real time.

RFQ for a EUR IRS 5Y in 500m notional size

This will likely be Liquid and above the LIS or SSTI threshold for pre-trade and post-trade thresholds.

Meaning no pre-trade quotes are made public but on trade execution, details will be made public on T+2 business days.

Final Thoughts

That’s it for MiFID II and transparency.

I am sure you will agree that the transparency changes are profound and significant.

The pre-trade rules in particular are more far-reaching than Dodd-Frank.

There is further detail on Derivatives that I have left out today for clarity’s sake.

And then there is a much wider scope – Futures, Derivatives in Other Asset Classes, Bonds, Equities …

I plan to cover further aspects of MiFID II in future blogs.

I look forward to a world of more data and more transparency.

Roll on Jan. 2017.

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Tags: ESMA, Transparency, regulation, MTFs, OTFs, SIs, MiFID, Derivatives, RFQ, RTS, liquidity, T+2, RMs

The Next Buy-Side Frontier: Derivatives Governance, Innovation and Risk

Posted on Fri, Oct 02, 2015 @ 10:02 AM

By Geoff Cole and Jackie Colella, Sapient Global Markets
Originally published on TABB Forum

While the majority of buy-side firms expect their derivatives volumes and trades to substantially rise over the next three years, many are not yet fully prepared for the changes to come. For asset managers looking to continually innovate, the revamping of governance models and approval processes specific to derivatives will be central to balancing the time-to-market pressures against operational risk.

A recent survey by Sapient Global Markets found that while the majority of buy-side firms expect their derivatives volumes and trades to substantially rise over the next three years, many are not yet fully prepared for the changes to come.

The issues investment managers face to effectively and efficiently implement a new derivative instrument type became clear: enabling the trading of a new instrument type to quickly support a portfolio manager request, while taking into account technology restraints and mitigating operational and reputational risks, requires significant due diligence and a robust yet flexible governance model to support the process.

The current state of governance models and practices

The investment management industry is struggling to determine the proper level of operational and legal due diligence necessary to create a level of comfort appropriate for firms to trade new derivative products while balancing investment managers’ desire to be the first to market with a new product offering that offers a unique exposure or risk management approach.

Many firms have governance committee(s) responsible for approving the operational aspects of new instruments; however, the process for implementing the changes varies widely from firm to firm. In most cases, different committees are responsible for approving derivative usage on a portfolio or fund level, but most committees only approve operational capability in terms of whether or not the instrument can be traded operationally. While the majority of firms review derivative usage bi-weekly or once a month, at many firms the committee convenes on an as-needed, ad-hoc basis to review any new issues that arise with a portfolio manager’s new instrument request.

Firms should consider implementing a dedicated, fully resourced derivatives team with appropriate product knowledge and capacity levels specific to the new instruments, markets and products to be launched. This team should support the lifecycle of onboarding a new derivative instrument type, including capabilities such as legal and client services. In addition, reviews should be conducted on a regular basis.

They should determine the level of efficiency in the current process for assessing “readiness to trade” a new instrument type. Incorporating a streamlined process to approve and implement a new derivative instrument is paramount to mitigating operational risk and reducing time to market for new products and investment strategies. In our experience, the governance structure is far from streamlined and challenges/backlogs exist in operations and technology, primarily due to:

  • Derivatives trading discussions (including new instrument types) usually occur at the portfolio manager/trading level; by the time operations is informed, the process is already behind.

  • The number of internal and external entities and departments required to support the implementation and enable trading for a new derivative instrument type reduces the ability of operations to respond in a timely manner.

  • Technology is adequate with multiple workarounds in place, but does not or will not scale well with increased volumes or complexity in the future. It often is the biggest inhibitor in the implementation of new derivatives.

Finding the right balance

Asset managers are searching for the right balance between enabling portfolio managers and investment teams to express their investment desires through any means possible (including usage of derivatives) and achieving the optimum level of operational control and reputational risk management.

The issues experienced by firms in facilitating the availability of a new derivative is magnified by the complexities of the lifecycle of derivative trading. The pre- and post-trade process for onboarding a new derivative at asset managers can include:

  • Portfolio managers, but also some product management teams, initiate the request to enable trading of a new derivative instrument type

  • In few cases, automated workflows and electronic voting for approval exist detailing the change controls necessary to efficiently onboard a complex instrument.

  • Counterparty information was the most critical information needed to trade a new derivative instrument along with projected volumes, underliers, currencies and markets.

  • Very few firms have a streamlined process in place for onboarding a new derivative instrument type; in most cases, many different departments are given a task with little or no accountability.

Legal Agreements

The due diligence needed to manage master umbrella agreements is cumbersome and requires qualified staffing with knowledge of the intricacies of derivatives documentation. Client sophistication must also be taken into consideration to best calibrate the level of handholding required through the documentation updates required to enable the trading of a new derivative instrument within a portfolio.

In discussions with asset managers around whether derivative trading in client accounts occurs under an umbrella master agreement, or their clients negotiate their own agreements, a small number said their clients negotiate their own agreements with counterparties. If an investment manager chooses to trade a new derivative not stipulated in the original client-negotiated agreement, it may take weeks or months to have all the paperwork completed, delaying capitalizing on that derivative trade.

Regulatory Implications & Constraints

The amplification of new regulatory requirements for trading and clearing of derivatives has created greater challenges with firms’ legal review and documentation processes, changing the legal review and documentation process in numerous ways:

  • Additional “touch points” requiring clients to sign off on each new requirement add weeks to months for documents to be returned.

  • Extra legal team resources are needed (in terms of experience and capacity) to review regulatory changes.

  • Most changes occur only in the documentation.

  • Because the regulatory environment may change such that if the firm already has authorization to trade, firms may “inform” rather than “request” approval from the client.

  • Regulatory mandates in Europe are especially challenging for derivatives.

Balancing Time to Market with Operational Risk

It can take anywhere from three weeks to one year to completely onboard a new derivative instrument type. Most are traded with manual workarounds without taking into account post-trade operational processing, including settlement, collateral management and even client reporting. In many cases, an instrument that is too complex for existing systems can delay implementation to over a year and sometimes lead to the decision not to make the instrument type available to portfolio managers at all. Such cases can create a negative client experience, significantly delay new product launches and cause significant frustration for front-office personnel.

While many firms complete a full end-to-end testing of any new derivative instrument, in some cases, this testing is completed for only one specific business area. If multiple order management systems exist, there may be increased operational and business risk in the trade lifecycle if another business unit subsequently attempts to trade the newly enabled derivative instrument.

Reliance on standard vendor packages for trading and risk management may provide out-of-the-box support for most instruments, but changes to interfaces and configuration may be more complex than anticipated or require close coordination with the software providers. The bulk of the testing effort is often directed at the accounting system, given its criticality for fund pricing and reporting. However, there are many other links in the chain that require significant analysis and testing in order to properly enable a new derivative instrument across the front-to-back investment infrastructure.

Essentially, each new instrument request becomes a joint business and technology project, requiring scope, funding and prioritization against all other IT projects, which can also prolong the period between the request to trade and the first execution.

Improving the governance model and practices

For asset managers looking to continually innovate, the revamping of governance models and approval processes will be central to balancing the time-to-market pressures against operational risk. This is also require investment in workflow tools for transparency and tracking, dedicated derivatives/new instrument due diligence teams and the active involvement of operations teams, to enable the necessary cultural change to support the usage of more complex product types.

These changes are often overlooked dimensions of a robust target operating model (TOM) initiative that can address the definition of roles, responsibilities and accountability, as well as identify opportunities for improvement and investment across a firm and integrate with the firm’s data and architecture.

As product innovation accelerates, fee and cost pressures persist and competition for assets increases, asset managers must tie all of the capabilities supporting derivatives – including legal, client service, collateral management, risk management, reporting and project management – together in the form of a nimble and responsive governance model to enable a true competitive advantage.

Improvements in governance models and practices must also take into consideration future industry, market and regulatory shifts. Specifically, asset managers should:

  • Determine if using Special Investment Vehicles (SIVs) across accounts is a viable option, based on client account structure.

  • Understand the potential challenges and develop strategic mitigation plans to ensure BCBS 269 compliance changes for cleared versus non-cleared derivatives.

  • Prepare for other regulatory change focused on increasing oversight of asset managers, such as the SEC’s proposal requiring funds to report on their use of complex derivatives products.

  • Assess the use of off-the-shelf (cleared) derivatives to model exposure to OTC derivatives, thereby employing the most cost-effective instruments to gain the same exposure.

  • Define a target operating model to ensure the ability to adapt to industry changes as well as unforeseen market and regulatory fluctuations across investment, operations and technology.

  • Provide all personnel with appropriate derivatives knowledge through education and training.

  • Dedicate appropriate resources to the management and supervision of derivatives-related initiatives.

Turning challenges into opportunities

As product innovation accelerates and competition for assets increases, derivatives usage will continue to grow in both volume and complexity.

While most firms recognize this, investment and operational improvement has typically been directed toward front-to-back trade flow improvements. Most have reactive governance structures, which is a major contributor to the time lag it takes to assess and approve a new derivative instrument that need to be refreshed. However, during our research it emerged that no investment manager was continuously improving its governance structures, suggesting it has not been recognized as a vital investment area.

Yet it is clear that derivatives are a valuable tool for product innovation and delivering outperformance in a risk-controlled manner. The opportunity exists to refresh or realign governance structures to better support organizational growth in accordance with derivatives usage plans. Adopting new practices for governance and operational risk management specific to derivatives can help asset managers reduce time to market and more quickly respond to portfolio managers’ needs.

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Tags: regulation, Asset Managers, counterparties, Trading, Derivatives

MIFID II: It’s Coming. Will You Be Ready?

Posted on Fri, Sep 25, 2015 @ 09:40 AM

By Jodi Burns and David Lawlor, Thomson Reuters
Originally published on TABB Forum

With less than 18 months until MiFID II takes effect in Europe, the industry needs to come to grips with its reporting and trading requirements if it is to be fully compliant by 2017. Here’s a road map of where to start.

In the specter of financial market reform, it would be easy to dismiss the recast Markets in Financial Instruments Directive (MiFID II) as an inconsequential afterthought, tying up loose ends that were omitted from the original MiFID rulebook, which was implemented in 2007, and the more recent European Market Infrastructure Regulation (EMIR).

But to do so would be to vastly underestimate the scale and scope of MiFID II and its accompanying regulation, MiFIR. Together, they will impact a wide range of institutions across asset classes, going much further than the G-20’s commitment on derivatives reform, which included central clearing, trade reporting and use of organized trading platforms. MiFID II adds position limits for commodity derivatives, for example, as well controls on algorithmic trading.

This is a regulatory project that is far more onerous than even the US Dodd-Frank Act, which has consumed the resources of market participants as they have progressed their compliance efforts over the past five years. On top of the wide scope, the timescale of these rules is an even greater challenge. MiFID II and MiFIR have been in force since mid-2014, although the rules won’t actually apply until January 3, 2017. That might sound a long way off, but in practice it leaves very little time for participants to get all of the necessary processes and resources in place to meet these requirements.

Adding to the complexity, the European Securities and Markets Authority (ESMA), which is responsible for drafting the technical standards, has consulted with the industry but is not expected to deliver its final standards to the European Commission for adoption until September 2015, once they have been reviewed by Commission lawyers. That brings a layer of uncertainty to the process, as the industry prepares for rules that could still change.

But whatever the size and type of your business, if you are active in European financial markets, you cannot afford to wait until you have final rules in hand to prepare for MiFID II. The complexity of these requirements means such an approach risks running out of time next year, and leaves open the possibility of noncompliance in 2017.

In this article, we focus on two key components of the proposed rules – transparency and organized trading. This doesn’t constitute an all-inclusive guide to compliance, but it should at least help make sense of complex legal texts, providing the beginnings of a road map on where to start.


MiFID II extends the transparency regime that was created for equity instruments in the original directive, adding reporting requirements for bonds and derivatives. Those requirements include both trade reporting, whereby trades must be reported publicly in close to real time, and transaction reporting, whereby trades must be reported to regulators no later than the close of the following working day.

The trade reporting obligation rests with the venue where the trade takes place, which could range from an independent regulated platform to a so-called “systematic internalizer” (SI) – typically a bank that has sufficient flow to match buy and sell orders internally. Derivatives trade data must be published within 15 minutes of execution, marking a step change for those platforms that have never had to report in the past.

With its pre-trade and post-trade reporting obligations, MiFID II will propel a slew of market data into the public domain that never existed before, including pre-trade prices and post-trade information. In the early days, data fragmentation is likely to be the biggest challenge and there will be a need for robust aggregation of reported data to build a meaningful picture for public consumption. How that aggregation will be delivered has yet to be determined.

While the burden of trade reporting is likely to rest predominantly with trading platforms and those banks that register as SIs under MiFID II, transaction reporting will have a much wider impact, requiring asset management firms to report their trades to regulators as well as their bank counterparts.

In this, the experience of EMIR may help guide asset managers, as those firms that use derivatives have had to report their activity to registered trade repositories since February 2014, fulfilling the onerous requirement for dual-side reporting, in which every trade must be reported by both counterparties.

But whatever the experience of EMIR, MiFIR transaction reporting is likely to be even tougher, with 81 information fields required to be filled out for every trade. That means firms will need real-time access to large amounts of market data and reference data, as well as “legal entity identifiers” – numerical codes used to identify those firms involved in the trade.

Submitting transaction reports to regulators will come at a significant cost to the industry, particularly for smaller firms that may not already have reporting infrastructure in place. At this stage, the priority for market participants is to determine exactly how they will be affected by the reporting obligations and then to assess what technology and resources will be needed to meet those obligations.

Regulated Platforms

When it comes to organized trading requirements, MiFID II fulfils the G-20 commitment that standardized OTC derivatives should be traded on regulated platforms where appropriate. In the US, the Dodd-Frank Act created swap execution facilities to meet that requirement, but MiFID II includes a wider range of platform types, including regulated markets, multilateral trading facilities (MTFs), organized trading facilities (OTFs) and SIs.

Not all products will need to be traded on these regulated platforms, but all market participants need to understand the MiFID trading rules and determine what their strategy will be. For large banks, the priority is to determine whether they wish to register as an SI, which will come with certain transparency and conduct obligations. If they decide not to do so, their internalized flow would need to fall below a certain threshold, which may mean directing more business towards MTFs and OTFs.

Smaller banks will be less likely to become SIs, but they will still need to determine how to conduct their trading business under MiFID II and what proportion of trades will be executed on MTFs and OTFs. To some extent, that will depend on what products are mandated to trade on organized platforms, which will be determined by ESMA in due course on the basis of the liquidity and whether it is already subject to the EMIR clearing obligation.

As an industry, we do not yet have all of the answers on MiFID II and we hope for greater clarity once ESMA’s technical standards have been published. But awareness and readiness still varies significantly from one firm to another, which is a cause for some concern. As 2017 draws ever closer, now is the time to start preparing.


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Tags: ESMA, regulation, MiFIR, MTFs, OTFs, G20, SI, MiFID II, bonds, EMIR, Trading, Derivatives

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

Posted on Tue, Sep 22, 2015 @ 10:38 AM

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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Tags: ESMA, Brokers, regulation, exchanges, clearing houses, SEC, Derivatives, Asia, ICE, Eurex, Institutional Investors

ISDA Reflects on 5-Years of Dodd-Frank, Proposes Fixes

Posted on Wed, Aug 12, 2015 @ 03:08 PM

Reflecting on the five-year anniversary of the Dodd-Frank Act, the International Swaps and Derivatives Association (ISDA) issued a briefing note on July 20, 2015, that tracks the progress made since the law’s historic enactment and outlines several outstanding issues that still need attention.

So, what changes have we seen?  Since the CFTC’s clearing mandate went into effect in 2013, a large portion of interest rate derivatives (IRD) and credit default swaps (CDS) are now centrally cleared, with trades executed on SEFs being reported to Swap Data Repositories (SDRs).  For IRD, 76.5% of average daily notional volume was centrally cleared in 2014 and for CDS that number totaled 74.7%, according to ISDA SwapsInfo data. Following made available to trade (MAT) rules  being implemented, in February 2014, more than 50 percent of IRD and 65 percent of CDS index average daily notional volume traded on swap execution facilities (SEFs). In addition, so far, 104 swap dealers have registered with the CFTC. 

While all of these are notable achievements, ISDA notes that are several areas of possible improvement for the implementation of Dodd-Frank:  

  • Cross-border harmonization: Fragmentation of liquidity across geographical lines results in an increase in costs and a more difficulty in unwinding large transactions. To alleviate some of the liquidity issues brought on by differences in U.S. and E.U. regulations, ISDA recommends allowing U.S. counterparties to apply overseas rules when trading outside domestic jurisdictions, if the laws are equivalent.

  • Clearing: Given the rise in importance for central counterparties, more needs to be done to ensure resiliency on issues such as transparency for margin methods, and minimum standards for stress tests.  The CFTC also requested further regulatory input on acceptable recovery tools for central counterparties and conditions for resolution for when problems occur.

  • Commercial end users: Legislative action is needed to make clear that end users who hedge through centralized treasury units (CTUs) in order to net and consolidate their hedging activities are eligible for the clearing exemption. Many CTUs classify as financial entities under Dodd-Frank, subjecting them to clearing requirements.

  • Reporting: Regulators need to identify and agree on what data best enables them to monitor trading conditions.  In addition to developing and then adopting standardized product transaction identifiers and reporting formats, ISDA recommends rescinding Dodd-Frank’s SDR indemnification requirements in order to enable more cross-border data distribution.

  • Capital: Like margin rules, capital rules should also be consistent so no participant is at a disadvantage to its competitors or counterparties in another country.  ISDA believes regulation should be “coherent and appropriate to the risk of a given activity” and that special attention should be given to the financing costs for borrowers and hedging costs for end users.

The agency also recommends further clarification for margin rules achieve consistency and reduce disputes, to targeted modifications of SEF rules to boost trading and expedite cross-border harmonization, provisions that will allow a SEF or a SEF user to petition for the removal of a MAT determination if liquidity conditions change, and mandating  final CFTC registration for swap dealers and major swaps participants to allow regulatory certainty.To read ISDA’s note in full, please click here.

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Tags: regulation, ISDA, SEFs, Derivatives, Margin

Swap Data Risk Rising – Q&A with DTCC’s Marisol Collazo

Posted on Mon, Jul 27, 2015 @ 02:12 PM

Marisol Collazo knows a thing or two about data quality.  As the CEO of DTCC’s Data Repository, she’s responsible for warehousing trade data and related information from over 5,000 clients representing about 100,000 accounts around the globe, in the Americas, Asia and Europe.  So, when she said she was worried about the potential systemic risks that could arise from the current manner in which data is reported to swap data repositories (SDRs), it got our attention.

We spoke with Collazo about the current state of swap data reporting, to get her views on what she notes is a lack of global harmonization on data reporting standards, which could create systemic risk.

DerivAlert: Could you tell us a bit about DTCC’s role in swap data reporting?

Marisol Collazo: DTCC has been aggregating and standardizing swaps data since long before it was ever required by Dodd-Frank.  We launched our Trade Information Warehouse for credit derivatives in 2003 and by the time of the financial crisis, we already had 99% of the world’s credit derivatives swaps trade data accounted for.  In fact, this data was used following the collapse of Lehman Brothers to quickly establish the firm’s exposure to the credit default swap market.  Original estimates were as high as $400 billion notional, but our Trade Information Warehouse records proved it was actually $5.2 billion, which helped to calm financial markets.

Now, post Dodd-Frank, our role is to collect swaps data for all asset classes prescribed by regulation for thousands of institutions worldwide. Essentially, we enable market participants to report trade information and provide this data to regulators and the public to create market transparency.

DA: What’s changed from when you were collecting data for the Trade Information Warehouse and now that you are collecting data as an SDR under Dodd-Frank?

MC: The biggest difference is that when we were collecting data for the Trade Information Warehouse, the trades were standardized and payment processing was facilitated from matched records, so there was absolute certainty that the data was accurate. Today, under Dodd-Frank, the required reporting fields and scope of products is broader and doesn’t necessarily tie into existing market structure. It’s a much more fragmented process due to regional differences and absence of standards. Unlike the Trade Information Warehouse, which is self-policing when it comes to accuracy, as money moves on matched records, in the new scenario we’re collecting data but don’t have the information to determine if it’s correct or otherwise. The only people who can be relied on to ensure the information is accurate are the contributing entities themselves. 

DA: Can you give us a scenario in which this lack of a system of checks-and-balances could become a problem?

MC: When we talk about data quality, we have to first start with a definition.  All data quality initiatives have two parts: 1) standards and validation, and 2) accuracy of content.  We have part one covered under Dodd-Frank as it relates to some fields.  There are standards that have emerged to support reporting, such as FpML, LEIs (Legal Entity Identifiers), ISDA product taxonomies, and trade IDs (also known as Unique Swap Identifiers), that allow the marketplace to quickly identify the data field and the value of the trade, and if it all checks out, we accept the record and move on.  But you also need the second part.  It is still possible today to provide a valid LEI, but have an incorrect counterparty name, or provide the right values and still give the wrong notional outstanding. There is no external information available to validate that data, which can only be confirmed by the counterparties to the trade.

DA: So, what’s the solution?

MC: Data quality needs to be everyone’s responsibility. Right now, the SEC places the responsibility for data accuracy predominately with the trade repository, which cannot possibly know if all of the data is accurate. So there’s an inherent problem in the current process.  Regulators need to support and promote global standards to enable market participants and trade repositories to establish stronger validation controls, which will allow data providers to implement standards and validations in their systems to support data quality.  Further, regulators should be conscious of the market structure that delivers data to the repository, and promote policies that will enable repositories to leverage this information.  Firms can then leverage market structure providers and reconcile data to the data repository to ensure accuracy.

We are focused on a foundational requirement that those submitting data and global regulators take responsibility for data quality, and develop a harmonized set of rules to standardize that process worldwide. 

To get this moving, we issued a proposal to CPMI IOSCO suggesting that we harmonize approximately 30 data fields across global trade repository providers, essentially creating a global data dictionary.  We believe it is important to focus on 30 core fields first, which address foundational data like the economics of the trade, the underlying entity, etc. We can then move on to dealing with jurisdictional data and other technicalities that have historically held up efforts to harmonize reporting.

DA: What’s been the response to your proposal?

MC: The industry is generally supportive of this approach.  ISDA and 11 trade associations have come out in support of data quality, suggesting a similar, simplified approach to data reporting as well.   However, the fact is that right now, this issue is still unresolved and – as a result – we are not meeting the G20 goals on trade repositories when it comes to global market transparency and the identification of systemic risk.

Increasingly, we’re starting to see that the practical sides of this issue are outweighing the political, however, and I’m optimistic that we’re going to start seeing progress soon.

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Tags: Dodd-Frank, regulation, Marisol Collazo, Data, Swaps, DTCC, Derivatives

CFTC Commissioner J. Christopher Giancarlo Comments on Regulatory Framework for Swaps Trading

Posted on Tue, Apr 28, 2015 @ 03:03 PM

A veteran of Wall Street, Commissioner Chris Giancarlo of the Commodity Futures Trading Commission recently issued a statement regarding the ongoing debate over the future of reform following comments made by CFTC Chairman Timothy Massad on the future of swaps market regulation. Commissioner Giancarlo stated:

“I commend the CFTC for its recent announcement of first steps in improving its regulatory framework for swaps trade execution and SEF operability. I support these commonsense measures that address concerns raised in my January 2015 White Paper: namely, streamlining the process of correcting error trades, flexibly interpreting SEFs’ financial resources requirement and simplifying swap trade confirmations by SEFs.

He also highlighted his focus on working with fellow members of the CFTC towards realizing the regulatory objectives set forth in the Dodd-Frank Act.

Commissioner Giancarlo’s comments follow similar sentiments described in a speech by Chairman Massad last week and a recent profile in trade publication Institutional Investor. See his full remarks here

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Tags: Timothy Massad, regulation, CFTC, SEFs, Derivatives, J. Christopher Giancarlo

CFTC Chairman Massad Extends No-Action Relief on SEF Data Reporting

Posted on Tue, Apr 28, 2015 @ 10:40 AM

In a speech to the DerivOps North America 2015 conference, Commodity Futures Trading Commission Chairman Timothy Massad spoke about the future of swaps market regulation. Comparing it to the regulation of futures on the 40th anniversary of his organization, he spoke about the need to balance transparency and reliability while not stifling future growth of the industry. He believes that progress has been made so far but that more work is needed.

He also extended the agency’s no-action relief for SEF confirmations and confirmation data reporting, which will alleviate the need to maintain copies of ISDA Master Agreements for all trades and to report confirmation data on uncleared swaps to swap data repositories until March 31, 2016.

The wide-ranging speech discussed a number of different areas. First among them was the need to revise the current set of regulations so they work for – not against -- industry players:

“Over the last ten months, one of our priorities has been to work on fine-tuning the new rules so that the new framework works effectively and efficiently for market participants. In particular, we have made a number of changes to address concerns of commercial end-users who depend on these markets to hedge commercial risk day in and day out, because it is vital that these markets continue to serve that essential purpose. This has included adjustments to reporting requirements and measures to facilitate access to these markets by end-users. We will continue to do this where appropriate. With reforms as significant as these, such a process is to be expected. We are also working on finishing the few remaining rules mandated by Dodd-Frank, such as margin for uncleared swaps and position limits.”

Massad spoke about the need to make sure clearinghouses themselves were run effectively in the event of a catastrophe:

“Oversight of clearinghouses has been another key priority. Under the new framework, clearinghouses play an even more critical role than before. So we have also been focused on making sure clearinghouses operate safely and have resiliency. We did a major overhaul of our clearinghouse supervisory framework over the last few years. Today we are focused on having strong examination, compliance and risk surveillance programs. And while our goal is to never get to a situation where recovery or resolution of a clearinghouse must be contemplated, we are working with fellow regulators, domestically and internationally, on the planning for such contingencies, in the event there is ever a problem that makes such actions necessary.”

In the context of extending no-action relief for SEF data reporting, Massad also highlighted past use of no-action letters for temporary relief as firms attempt to achieve compliance and regulatory objectives and areas of future use:

“This no-action letter also provides relief for SEFs regarding their obligation to report Confirmation Data on uncleared swaps to SDRs. SEFs have expressed concern that to comply with their reporting obligations for uncleared swaps, they might be required to obtain trade terms from the same ISDA Master Agreements or other underlying documentation that, as I have just discussed, are not otherwise available to them. In light of these concerns, this relief clarifies that SEFs need only report such Confirmation Data for uncleared swaps as they already have access to without undergoing this additional burden. I would note that SEFs must to continue to report all “Primary Economic Terms” data for uncleared swaps – as well as the Confirmation Data they do in fact have – as soon as technologically practicable. I would also note that the counterparties to the trade have ongoing reporting obligations for uncleared swaps.”

To see his full remarks, including greater description for the use of no-action letters for error trades and data, please click here.

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Tags: Timothy Massad, regulation, ISDA, No Action Relief, CFTC, SEFs, Swaps, Derivatives

Collateral for Clearing – A Race to the Bottom?

Posted on Wed, Apr 08, 2015 @ 09:44 AM

By Miles Reucroft, Thomas Murray
Originally published on TABB Forum

With mandatory clearing approaching, a global collateral shortfall ranging anywhere from $500 billion to as much as $8 trillion is widely anticipated. And since CCPs are competitive entities, there is a fear that they will lower their collateral standards in order to facilitate client clearing and win new business. But we will not know how great the collateral shortfall is, or how far the race to the bottom has been run, until clearing participants start to default.

A race to the bottom in collateral terminology refers to the potential for a downward spiral to occur in the acceptable quality of collateral to be posted at central counterparty clearinghouses (CCPs). Individual eligibility criteria at each CCP, which are operating as competitive, for-profit entities, added to an anticipated collateral shortfall in the market is resulting in very real fears of a race to the bottom taking place.

How bad any race to the bottom becomes, if it even becomes a reality at all, depends on how big the collateral shortfall is. While the exact number is an unknown, with estimates widely ranging from around $500 billion to $8 trillion, there is, by and large, a consensus that there will be a collateral shortfall; that there exists insufficient quality collateral to satisfy the post-crises regulatory environment.

In the event of a collateral shortfall, how will market participants be able to margin their positions at CCPs? CCPs will be taking initial and variation margin to offset the risk of a potential default in a trade, acting as the do as a buyer to every seller and a seller to every buyer. If one party cannot make good on its position, the CCP will step in and complete the transaction, utilizing that clearing participant’s margin and default fund to do so.

If market participants cannot obtain eligible criteria to post as margin in order to clear, then what can they do? Clearing will soon be unavoidable, standing as it does as one of the central tenets of the G20 response to the post-2008 financial crises that swept through global financial markets.

CCPs are competitive entities and there is a possibility – a fear, even – that they will lower their collateral standards in order to facilitate client clearing, helping them to win new business.

Market participants have a number of collateral demands placed on them currently, and knowing where their assets are and what they can be used for is crucial from a competitive view point. If assets are ineligible, then market participants can undergo a collateral transformation process – changing ineligible collateral into eligible collateral.

“Something has to give,” says John van Verre, global head of custody at HSBC Securities Services. “Either collateral transformation will have to become very, very efficient, or the acceptable standards of collateral will have to drop.”

With transparency and safety being two of the buzzwords about the shift to mandatory clearing, it is counterintuitive to allow the acceptable standards of collateral to drop. Regulatory interference in this area at the CCPs and how they should be capitalized are two outstanding questions to be resolved as mandatory clearing approaches. While there are capitalization rules in existence, the structure and adequacy of the default waterfall – how collateral posted as margin will be used and to what to degree – remains a topic for discussion.

“Collateral management is one of the biggest challenges facing our clients,” continues van Verre. “They need to know where their assets are and how they can be utilized. With central clearing they must appoint a clearing broker who accesses a CCP – keeping track of assets is not a straightforward, two-way relationship. They must also work out how to most effectively use this collateral and if needs be, what they can most efficiently transform, bearing in mind that their assets are not just to be assigned to CCPs.”

The demands on collateral are, seemingly, ever increasing. Exchange-traded derivatives have been collateralized since time immemorial, but the shift to clearing and margining over the counter derivatives is where the bulk of the demand will now come from. Aside from cleared OTC transactions, there are also non-cleared OTC transactions that will need collateral posting against them as well. The non-cleared world will be a more expensive place than the cleared one, too.

Portfolio margining and compression at CCPs is one way of reducing the demand for collateral at CCPs. Compression is, in effect, very similar to netting, so while it clears up the balance sheet, it may not result in much reduction for collateral requirements.

Another collateral demand being faced by the market comes from the FSAP (the Financial Sector Assessment Programme) from the IMF (International Monetary Fund). One of the FSAP recommendations is the central clearing of repo transactions. If all repo transactions are to be run through CCPs, then you would, in a lot of cases as regards collateral transformation, be collateralizing the collateral – the demand for collateral would rise even further, making the shortfall greater. Central clearing of repo transactions is already underway; LCH.Clearnet runs a repo clearing arm, for example. But if it were to be extended to mandatory status, the collateral demands would be vast.

With this in mind, where is the supply of collateral coming from? There is an estimated $60 trillion of government debt in issue. This, clearly, is enough to cover any shortfall, a few times over. But the debt being in issuance and the debt being readily available for use as collateral are not the same thing.

A lot of government bonds have been purchased by central banks as part of the quantitative easing process. As an example, it is estimated that the Bank of Japan, operating in an economy that is just coming out of a 2014 recession, will own 40 percent of Japanese Government Bonds by the end of 2016. All quantitative easing is achieving, in some cases at least, is the monetization of debt, since central banks are buying up government bonds from banks in exchange for cash. The central banks are unlikely to lend out these purchases to participants in CCPs.

As you can see from the below chart, which represents the percentage of the industrialized world that is operating at or even below 0 percent Policy Rates, there is not a lot of new government debt in issuance:

da comm  4 8 a resized 600

How can market participants get hold of the government bonds from central banks? Well, they cannot. The vast majority of government bonds are held by parties that have no intention of lending them out. The collateral models that are operated by firms such as Euroclear and Clearstream will have to make the cost of lending them out very attractive. The knock-on effect of this is that the cost of borrowing would increase, making the cost of collateralizing OTC trades too expensive to make the trading activity viable.

The CCPs themselves are aware of this. A recently published paper from LCH.Clearnet, “Stress This House: A Framework for the Standardized Stress Testing of CCPs,” makes no mention of collateral. As soon as collateral is factored in, it makes the calculations impossibly complex and would have to rely upon the use of government debt. If equities are to be an acceptable form of collateral, then their inclusion in stress testing will weaken those CCPs that accept them.

So those central banks and pension funds that are holding government bonds are unlikely to be willing to put them up for use at CCPs, since there are no guarantees as to the safety of the clearing model.

While there are options available to market participants in regards of collateral transformation and compression, the most cost efficient way of posting collateral is to post what you have available at that time. As CCPs compete, it will be very tempting for them to start accepting lower-quality, more illiquid collateral – especially if the high-quality government debt is inaccessible.

If a CCP finds itself in a position where it has to liquidate a clearing participant’s collateral in order to make good a trade, then it will need highly liquid collateral in order to do so – government bonds fall under this category for countries such as the US and the UK. Until such a time of market stress, the requisite liquidity of the collateral remains unknown. We will not know how great the collateral shortfall is, or how far the race to the bottom has been run, until clearing participants start to default.

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Tags: CCPs, OTC, Transparency, FSAP, Collateral, Mandatory Clearing, Derivatives, Capitalization, IMF

Derivalert’s Top 10 News Stories of the Year: 2014

Posted on Tue, Jan 06, 2015 @ 09:40 AM

Just twelve months ago, as we turned the corner from 2013 to 2014, it looked like some of the derivatives reform upheaval was starting to subside – at least in the U.S.  Final SEF rules had been passed; swaps were being made-available-to-trade; we survived the government shut-down. By most accounts, things were transitioning in an orderly fashion in the U.S. and Europe looked like it was going to be the center of the action.

In fact, as we wrote in the January 15, 2014 edition of the DerivAlert newsletter: “It feels like déjà vu all over again as the headlines about European derivatives reform start to pile up on both sides of the Atlantic.  Just as we saw last year in the U.S., as each new rule implementation deadline draws closer, the fever pitch of industry concerns grows louder.”

We were partly right.  European derivatives reform did intensify over the course of 2014.  But so did the ongoing scrutiny of U.S. reforms, with the jury still out on what the final impact of the transition to SEF trading of derivatives will be on the industry.

But what were the absolute biggest stories of the year?  To find out, we dug into the analytics to find out which posts were the most viewed over the course of 2014. 

Here they are in descending order, as chosen by you, the DerivAlert reader, our top ten news stories of 2014:

10) Packaged Swaps Get SEF Go-Ahead

By Mike Kentz
Published May 3, 2014, IFR

Multi-legged swap transactions are set to make the move to swap execution facilities after the CFTC confirmed a set of phase-in dates. The decision finally removes a major industry bugbear, as the delayed migration of packages towards mandatory SEF trading was seen to be hampering volumes on the new regulated platforms. 

full article  (subscription)

9) Wall Street Gets Three-Month Delay on Interest-Rate Swap Mandate

By Silla Brush
Published February 10, 2014, Bloomberg

U.S. banks and other financial firms won a three-month delay for as much as half of the interest-rate swap market to meet a federal requirement to trade on platforms designed to increase competition and transparency.

full article  (free)

8) Thousands of Derivatives Users Not Ready for EMIR Reporting

By Fiona Maxwell
Published February 4, 2014, Risk

With just over a week left on the clock, regulators are said to be worried the market is not ready for the start of mandatory trade reporting under the European Market Infrastructure Regulation (Emir). According to some estimates, a little over 8% of the region's derivatives users have so far registered for the preliminary legal entity identifier (LEI) that will allow them to report their over-the-counter and listed trades.

full article  (subscription)

7) Time for a Change in Derivatives Trading

By Anish Puaar
Published April 21, 2014, Financial News

The clock has finally started ticking down to one of the most substantial changes ever seen in the European market for over-the-counter derivatives, a significant part of the global market worth €692 trillion at the end of June 2013, according to the Bank for International Settlements.

full article  (subscription)

6) SEF Execution of Package Trades to be Postponed

By Peter Madigan
Published November 6, 2014, Risk

CFTC chairman confirms no-action relief extension due to lack of market readiness.

The Commodity Futures Trading Commission (CFTC) is to postpone the migration of the most complex package transactions into swap execution facility (SEF) trading after recognizing that US swap market participants are not prepared to execute them on the trading venues.

full article  (subscription)

5) CFTC Said Ready to Push Interest-Rate Swaps to Trading Platforms

By Silla Brush
Published January 9, 2014, Bloomberg

The Commodity Futures Trading Commission is poised to push interest-rate and credit swaps onto trading platforms designed to make prices more transparent and competitive.

full article  (free)

4) Many Firms Will Not Meet EMIR Reporting Deadline, Says ISDA’s Pickel

By Tom Osborn
Published January 27, 2014, Risk

Many market participants will not be able to comply with new European derivatives reporting requirements when they take effect next month, and will have to rely on regulatory forbearance, according to Bob Pickel, chief executive of the International Swaps and Derivatives Association, who was speaking at a legal conference today in the Netherlands.

full article  (subscription)

3) SEF Trading Volumes Emerging from Summer Doldrums

By Ivy Schmerken
Published September 18, 2014, Wall Street & Technology

Despite the summer doldrums of SEF trading in interest rate swaps, activity in early September is showing signs of a rebound as traders conduct more of their business on the electronic venues. Tradeweb Markets announced Wednesday that average daily volume on its TW SEF for trading of interest rate swaps increased 20-fold to more than $20 billion in the first two weeks of September, over the first two weeks of trading on SEFs in October 2013.

full article  (free)

2) Make or Break Time for SEFs

By Mike Kentz
Published May 17, 2014, IFR

Two swap execution facilities have parted ways with their CEOs in the last two weeks in what market participants believe could trigger attrition across the 24 registered platforms. Consolidation has been predicted since the beginning of SEF discussions, but in a surprise turn it could be occurring just as volumes are set to receive a boost. 

full article  (free)

1) SEF Merger Talk Grows Stronger

By Mike Kentz
Published June 14, 2014, IFR

The saturated U.S. market for over-the-counter swap execution is on the cusp of the first wave of consolidation, just four months on from the first mandated execution of standardized derivatives on newly created swap execution facilities.

full article  (free)

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Tags: regulation, Top News Stories, Derivatives, DerivAlert

Assessing Regulation, Technology & Risk: Three Steps to Ensuring a Happy New Year

Posted on Thu, Dec 18, 2014 @ 08:55 AM

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

Despite record US equity prices and an improving economy, the underlying theme of 2014 was one of disappointment – in the levels of liquidity in most markets, in the spreads that market-makers were seeing, in the rising cost of being a market-maker, and in the ability of regulators worldwide to get their acts together. Here’s a preview of the issues that will shape 2015, including the Volcker Rule, mandatory clearing, automated trading and market risk, and three steps to ensure you have a happy New Year.

As we move from Thanksgiving to Christmas, it is traditional to reflect back on the year that is coming to a close, and to begin planning for the New Year. For the capital markets, reflecting on 2014 may result in mixed emotions; so does 2015 look to be any better?

Looking Back

Actually, taking the retrospective view, it would be easy to say that 2014 was a pretty good year, at least in US Equities, where prices spent most of the year rising (although the market has looked decidedly toppy in December). The economic indicators have been gradually improving all year, and the December jobs numbers gave everyone a warm feeling, if only for a moment. The Fed’s long period of aggressive easing finally seems to be paying off, even if everywhere else the world seems to be back on its heels. Corporate profits have been robust, except at the big banks, where mounting legal costs never seem to stop. Not bad, really.

But the functioning of the markets, as opposed to the economy as a whole, has been more of a mixed bag. Michael Lewis highlighted one aspect of the problems, and Carmen Segarra another; but the underlying theme of 2014 was one of disappointment – in the levels of liquidity in most markets, in the spreads that market-makers were seeing, in the rising cost of being a market-maker, and in the ability of regulators worldwide to get their acts, literally, together. As large banks ended the year with another round of impending investigations, more cutbacks in investment banking staff, and more exits from trading and clearing businesses, it would be easy for market participants to say, “Good riddance to 2014; I hope 2015 is better.”

Looking Forward

But the groundwork for 2015 has already been laid, and thus some of the future should be apparent to the careful observer. So let’s look at some of that groundwork close up.


The two major regulatory stories of 2015 will be the implementation of many aspects of the Volcker Rule in the US and the start of mandatory clearing in Europe. Neither of these will be a surprise, of course, but there is a lot of uncertainty about how both events will work out. With Volcker, much of the discussion and trepidation relates to the market-making exemption; but the biggest changes may actually be in hedging. And the technology to support tagging of trades into specific exemptions and the monitoring for violations may be immature, if it exists at all. Without technology, trading under Volcker becomes a manual nightmare.

Clearing of derivatives trades is nothing new either, of course; but making it mandatory for a wide range of participants in Europe is new. The increased cost of margin is well documented, and has prompted some buy-side firms to move from swaps to futures, which has further prompted some FCMs to exit the swaps space; but the concentration of risk in the CCPs is only now coming to front-of-mind. Once that concentration is well understood, and the sources of CCP capital become clear, there will be a scramble to enhance the regulation of that sector, leading perhaps to more exits from the business … leading to even more concentration of risk … leading perhaps to even more regulation.

Trading Technology

As spreads have fallen in every market, trading firms have predictably moved away from manual, expensive trading methods toward automated ones. Every month the percentage of computer-executed trades has been rising, so that by year-end half or less of the trading decisions in just about every market will be made by people. In fact, we even have the science-fiction scenario of buy-side bots trading with sell-side bots.

The biggest risk with automated trading is that most of the algorithms are mean-reversion formulas, meaning that the right price for anything is a function of the price of everything else. Experienced traders know that that kind of pricing works well when markets are essentially stable, but breaks down when large secular shifts occur. Looking at 2015, one such secular shift would be the end of the Fed’s many years of easing, and another would be a resumption of the financial crisis in Europe. Or perhaps both of them at the same time.

The people who run the dealer trading bots are well aware of this possibility, of course, and are prepared to shut them down if they see a secular shift. The problem will be that many of the people who could step into the breach and exercise human judgment were let go over the past few years, so we may run short of expertise just when we need it the most. The resulting trading volatility will be reflected in margin calls, which may exacerbate the same volatility, in a sort of feedback loop.

Market Risk

All this means that the risk in the markets will probably be higher in 2015 than it was this year. One simple measure might be in the potential mark-to-market for the largest category of swaps, fixed-float rate swaps. If we assume $420 trillion outstanding notional, 75% of it back-to-back, with an average tenor of six years, the mark-to-market of just the net exposure for a 100 basis-point rise in rates is $5.5 trillion. Given that such a rate rise would also serve to depress the market value of the very Treasuries used to generate the margin, we can see that there could be a tsunami lurking just under the surface of the markets.

What to Do?

So as this year draws to a close, and the New Year beckons, what’s a market participant to do?

1. Assess your trading and clearing partners – If the risk in the markets is as high as it appears, it behooves everyone to take a hard look at whom you trade with and where you clear. As trading moves more and more from principal to agency, customers will need to know where their liquidity will come from. If your traditional trading partners are feeling constrained by the capital and regulatory requirements, you need to find that out before you need them to stand up and they aren’t there.

The clearing assessment is at least as important. If CCPs are the single point of failure in the market, you need to know how much capital they have, how they can get more if they need it, and – most important – how they screen customers and clearing firms. The CCP space is a competitive business, and competition can lead to lax standards, so you need to be as rigorous with them as they should be with you.

2. Assess your trading technology – Whether you are a bank that will be dealing with Volcker in 2015 or a customer, you need to know how your technology will stack up to the new regulatory requirements. Systems take a notoriously long time to develop and test, so your tech providers should be well along on the upgrades you will need next year. Volunteering to be a beta tester for your vendors can give you early insight into how well they will perform when you need them. If they look iffy, you may need to plan a switch well before the rule changes hit.

3. Talk to your regulators – All the market regulators are feeling their way through these changes, along with everyone else. Some of them, like the OCC, have already begun pre-Volcker examinations, as much to learn what’s being done as to pass judgment. If you are embarked on some preparations that they will have to opine on, it is much better to find out early if they have a problem with your approach, as opposed to getting a bad report later. And you might just find that they are as anxious to learn from what you are doing as you are to learn from them.

The second half of December is always thought of as a slack period in the markets, as well as within market participants; but this December may just be the time to put in some extra work. If you do the things we’ve just described, you might just have a Happy New Year all of 2015, while others are playing catch-up.

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Tags: regulation, Clearing, Risk, Technology, Volcker Rule, Trading, Derivatives

SEFCON V: CFTC Chairman Massad Discusses Regulations; Extends Package Relief

Posted on Tue, Nov 18, 2014 @ 08:59 AM

In his speech at the SEFCON V Conference, CFTC Chairman Timothy Massad outlined the current and future state of affairs regarding swaps trading on regulated platforms. Massad conveyed a pro-markets sentiment in his remarks, continually emphasizing that regulations are not designed to quell the growth of swaps trading, rather they’re aimed at allowing the industry to flourish in a safe, efficient, technologically advanced manner.

After describing broad principles for regulation and noting that swap trading regulation was still in its infancy, he explained he does not want regulation to pose an undue burden on market participants:

“In regard to oversight, we want to make sure it is strong oversight because it promotes integrity and therefore confidence by participants. At the same time, we do not want that oversight to burden participants, particularly the users of these markets, unnecessarily. This is consistent with our general regulatory approach in futures.”

He went on to address specific marketplace concerns about package trades:

“…Packages have been an area of concern. Now, packages might more accurately be thought of as strategies involving multiple products, but whatever name you use, there is no doubt that different types of packages introduce significant complexities as we look to bring them into the SEF and DCM framework. And therefore, basically since the time of the first MAT determinations earlier this year, we have been working with market participants to figure out how to deal with packages in which one leg is a MAT swap. To enable that process, we issued no-action relief earlier this year. For some types of packages, the market has developed technical solutions, and the relief has expired. For others, however, more time is needed.

Consequently, at my direction, the CFTC staff this week have extended previously issued no-action relief so that we continue to work with market participants on phasing in trading for certain types of packages.”

Massad noted that there is a wide range of opinion regarding execution methods and market structure, and stated that “We look forward to listening to market participants on these and other issues that may arise.”

He also addressed cross-border issues, explaining that the CFTC is “committed to harmonizing our rules as much as possible” with its foreign counterparts in Europe and Asia so that firms are limited in their ability to shop for preferred regulatory framework.

To view Chairman Massad’s full remarks, please click here

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Tags: Timothy Massad, regulation, CFTC, SEFCON V, Derivatives

The SEF Landscape – Understanding the Changing Marketplace

Posted on Tue, Oct 21, 2014 @ 02:23 PM

Greenwich Associates released a new research report on the U.S. derivatives trading marketplace: The SEF Landscape: Beyond the Numbers. The report discusses market activity and trading behavior, and highlights five key areas market participants should be focusing on in evaluating their approach to SEF trading: liquidity, distribution, unique functionality, pricing and service.

We found these areas to be essential to the understanding of the new electronic derivatives trading landscape, and recently hosted a webcast, “Understanding the SEF Landscape with Greenwich Associates,” which included an overview of the report with Kevin McPartland, Greenwich’s head of market structure and technology, and Michael Furman, managing director and head of U.S. rates sales at Tradeweb.

If you were unable to join us for the webcast, but wish to listen to a recording of it, a replay can be accessed here. In addition, please reach out to our sales team at if you would like a copy of the Greenwich Associates SEF trading report.

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Tags: swap execution facilities, SEFs, trades, Derivatives, Tradeweb

Derivatives Plagued by Manual Processing – the Case for Automation

Posted on Wed, Aug 13, 2014 @ 10:10 AM

By Jorgen Vuust Jensen, SimCorp
Originally published on TABB Forum

Seventy-nine percent of capital markets firms report that they still rely heavily on spreadsheets and manual processes when processing derivatives, and 84% cite the need to create workarounds to support derivatives in their current middle- and back-office operations.

An increasingly global emphasis on derivatives strategies by asset managers has made the need for straight-through-processing (STP) greater than ever before. In a highly competitive industry, a firm with investment management systems characterized by a high degree of automated workflows and processes is in a better position than competitors that still contend with manual processes and workarounds. However, a new SimCorp poll shows that a large number of firms are still at the mercy of their legacy systems, using manual processes when processing derivatives.  

SimCorp recently conducted a survey of nearly 150 executives from capital market firms in North America to measure how important STP processing is and the current conditions that firms are working with. The poll revealed that 74% consider STP to be extremely important when it comes to derivatives processing. However, further poll results indicate that these needs are not being met by their current systems – 84% of respondents cited the need to create workarounds to support derivatives in their current middle- and back-office operations. Seventy-nine percent reported they still rely heavily on spreadsheets and manual processes when processing derivatives. Furthermore, 82% require at least two months to model and launch new derivatives products, and sometimes significantly longer, utilizing their current systems.

The findings of the survey demonstrate that firms are being exposed to major and unnecessary risk and as they continue to employ manual processes in a rapidly changing industry. As the study suggests, firms are conscious of new and improved solutions that will help them achieve a strong competitive advantage and improve the functions of their firm, but there is a major struggle to determine how they should move ahead with implementing these brand-new solutions.  

The changes in the OTC derivative space increasingly drive the need for front-to-back STP, and it is imperative that operations teams consolidate STP throughout the derivatives lifecycle in order to increase efficiency, reduce processing time, and cease dependency on spreadsheets and manual “systems.” STP assimilation also helps firms to provide transparent audit streams and ensure proper reporting to management.

The challenges in the derivatives market – ranging from regulatory demands to rapidly changing market conditions – make the case for STP even stronger. Since individual derivatives trades can have a considerable effect on the portfolio, especially in terms of exposure to several market factors, it is extremely important to have updated technology in place to integrate the process, provide optimal data operability and ultimately increase portfolio performance.

Capital market firms are essentially aware of the significant benefits of STP but seem hesitant to implement the process. As new market requirements continue to emerge, it has become crucial for asset managers to evaluate and update their IT infrastructure to include automation – which in turn will shorten processing cycles and increase efficiency, thus securing a competitive market edge.

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Tags: OTC, capital markets, OTC Derivatives, STP, Derivatives, straight through processing

TABB Group SEF Barometer Survey: Industry Perspective on SEFs

Posted on Wed, Jul 23, 2014 @ 09:44 AM

TABB Group is hosting an online survey of market participants’ activity on SEFs to gain insight from on their view of the new world order of electronic derivatives trading.

The survey will measure participants’ experiences with a variety of SEF-related issues, including MAT self-certification, swap trading activity, trading protocols, regulatory mandates and more.

Please note the survey is anonymous and will be available until August 4th. To participate in the SEF Barometer 2014 survey, please visit:

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Tags: swap execution facilities, regulation, MAT self certification, SEFs, TABB Group, MAT, trades, survey, Derivatives

Dodd-Frank at 4: Derivatives Reform Is a Glass Half Full

Posted on Tue, Jul 22, 2014 @ 08:49 AM

By Mayra Rodriguez Valladares, MRV Associates
Originally published on TABB Forum

Many challenges remain in implementing Dodd-Frank’s derivatives reforms, as swap dealers retool their technology to improve data collection, aggregation and reporting. But regulators, particularly the CFTC, have made strong progress.

A number of analysts, pundits, and financial journalists are observing the fourth anniversary of Dodd-Frank by pointing out that much of the law has not been implemented. That is correct. While a little more than half of the rules are now finalized, that does not necessarily mean that they have been implemented. Typically, financial and bank regulators give institutions a year or two to comply after a rule is finalized.

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Source: ‘Dodd-Frank Progress Report, Davis Polk, July 18, 2014.

It is very important to remember that a toxic political environment in Washington, regulators with significant resource constraints, very strong and continued lobbying against every single part of Dodd-Frank, and lawsuits against regulators have been significant deterrents. In addition, financial regulators cannot deploy all of their staff to the challenging task of Dodd-Frank rule writing; they already have their existing regulatory, legal, and supervisory responsibilities. Even while writing rules, regulators have been doing so in an environment where the US economy has been mostly growing anemically, and they have to think of the potential impact of the rules on institutions, markets, and the economy at large.

Despite numerous challenges, some of the agencies have finished many of their assigned tasks. For example, the CFTC, which is responsible for regulating and supervising the disproportionately largest part of the financial derivatives markets, has done an incredible job in finishing almost 85% percent of its assigned rules.

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Source: ‘Dodd-Frank Progress Report, Davis Polk, July 18, 2014, p.5.

The CFTC’s accomplishment is particularly impressive considering that is the smallest regulatory agency and has been a favorite target of Republicans who want to make sure that the agency has the smallest budget possible. Shockingly, the CFTC is still operating with a level of personnel and technology from decades before Dodd-Frank. This financial regulator is responsible not only for its existing mandate of regulating exchange traded products and derivatives exchanges, but also it now regulates over-the-counter (OTC) interest rate derivatives and index credit derivatives. In the US, these products represent about $200 trillion in notional amounts.

Also, CFTC professionals spend a good part of the day listening to comments and pleas from numerous market participants and lobbyists, as can be seen in their public website. (Actually, the CFTC is the only regulator that publishes its visits ahead of them taking place, as opposed to after they have already happened. Other regulators should learn from the CFTC’s transparency.)

In less than four years, the CFTC has finalized instrumental rules for derivatives reforms:

  • Created legal definition for a swap
  • Designated swap dealers
  • Defined what is a US person
  • Instituted swap transactions reporting
  • Released core principles for derivatives clearing organizations (DCOs), which are the central clearing parties approved to clear derivatives in the US, and
  • Has been conducting due diligence on and setting standards for the companies approved to be swap execution facilities (SEFs).

Yes, many challenges remain in implementing Dodd-Frank’s derivatives reforms, as swap dealers retool their technology to improve data collection, aggregation and reporting. Swap dealers, especially banks, also have to think continually of how to upgrade the skills of their existing middle- and back-office professionals, IT, auditors, and compliance professionals.

For its part, the CFTC will continue to be plagued by the roadblocks politicians place in its path. They ask it to do a better job and then tie its limbs by denying badly needed resources. Equally challenging for the CFTC will be to work with foreign regulators, especially in Europe. As long as rules and supervisory practices are different, the global derivatives market will be challenged by a potential lessening of liquidity. Importantly, if rules on both sides of the pond are not equally strong in the way that they are written, supervised, and enforced, then swap dealers will outsmart regulators through regulatory arbitrage.

The CFTC has new leadership. Given what I have seen by working both with swap dealers and training numerous CFTC professionals, I see Dodd-Frank’s derivatives reforms as a glass half-full. And I look forward to the next few years as it continues to fill up.

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Tags: swap execution facilities, Swaps Dealers, Dodd-Frank, CFTC, SEFs, Swaps, Derivatives, regulators

An Inside Peek at Volcker Rule Enforcement

Posted on Thu, Jun 26, 2014 @ 09:03 AM

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

The OCC’s recently published Volcker Rule examiners’ manual offers a look at how regulators are going to approach the rule’s enforcement. It looks like we should expect a good deal of confusion, and possibly some contention.

After the final version of the Volcker Rule was published in December and banks began to prepare for the July 15, 2015, effective date, the only remaining question was how it would be enforced. That enforcement is up to the examiners of the various agencies. Recently, the Office of the Comptroller of the Currency (OCC) published a 26-page Volcker Rule examiners’ manual, which may be an inside peek into how the regulators are going to approach enforcement.

The Objectives

Here are some of the objectives it sets for examiners:

  • Assess the bank’s progress toward identifying the [banks] that engage in activities subject to the regulations.
  • Assess the bank’s progress toward identifying its proprietary trading. 
    • The bank must identify purchases and sales of financial instruments for specified short-term purposes.
    • The bank must identify the trading desks (the smallest discrete unit of organization) responsible for the short-term trading identified above. Trading desks may span multiple legal entities or geographic locations.
    • For each trading desk, the bank must determine on which permitted activities the desk will rely to conduct its proprietary trading.
  • Assess the bank’s progress toward identifying its ownership interests in covered funds.
  • Assess the bank’s progress toward identifying the covered funds that the bank sponsors or advises.
  • Assess the bank’s progress toward identifying its ownership interests in and sponsorships of entities that rely on one of the regulations’ exclusions from the definition of covered fund.
  • Assess the bank’s progress toward establishing a compliance program.
  • Assess the bank’s plan for avoiding material conflicts of interest and material exposures to high-risk assets and high-risk trading strategies.

Given the newness of the Volcker Rule, it is perhaps indicative that these objectives discuss a bank’s progress and plans, instead of its conformance. However, we should expect the instructions to move pretty quickly to assessing the bank’s conformance.

Specific Instructions

Within the document, there are some specific instructions that are both pertinent and perhaps informative of the general approach. For example (these are only a small fraction of what the manual requires):

  • Under a section entitled, Assess the bank’s progress toward reporting metrics as and when required, we see:Some banks may combine previously delineated trading desks into a single trading desk.
    • Multiple units with disparate strategies being combined into a single desk, however, could suggest a bank’s attempt to dilute the ability of the metrics to monitor proprietary trading. Relevant factors for identifying trading desks include whether the trading desk is managed and operated as an individual unit and whether the profit and loss of employees engaged in a particular activity is attributed at that level.
  • Under Assess the bank’s ability to calculate the required metrics we see:
    • This metric requires the bank to “tag” each trade as customer-facing or not. Inter-dealer trading typically does not count as customer-facing because a [bank] with trading assets and liabilities of $50 billion or more is not a customer unless the bank documents why it is appropriate to treat the counterparty as a customer. Trading conducted anonymously on an anonymous exchange or similar trading facility open to a broad range of market participants is customer-facing regardless of the counterparty.
    • For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values.
    • For comprehensive profit and loss (P&L) attribution, determine whether bank systems can segregate P&L into the required three categories:
    • Determine whether the bank’s systems can report risk sensitivities on a sufficiently granular basis to account for a preponderance of the expected price variation in the trading desk’s holdings.
  • Assess the bank’s progress toward using the metrics to monitor for impermissible proprietary trading.
    • Determine whether the bank consistently applies, across its trading desks, methodologies for calculating sensitivities to a common factor shared by multiple trading desks (e.g., an equity price factor) so that these sensitivities can be compared across trading desks.
  • Assess the bank’s policy for reviewing activities and positions whose metrics indicate a heightened risk of impermissible proprietary trading.
  • Assess the bank’s progress toward identifying its market-making-related activities, market-maker inventory, and reasonably expected near-term demand (RENTD).
    • Assess the bank’s progress toward developing a process for measuring and documenting RENTD for each market-making desk.
    • Demonstrable analysis of historical customer demand, current inventory of financial instruments, and market and other factors regarding the amount, types, and risks of or associated with financial instruments in which the trading desk makes a market, including through block trades.
  • Assess the bank’s progress toward establishing and implementing an internal compliance program.
  • Assess the bank’s progress toward developing procedures and controls to continuously review, monitor, and manage risk-mitigating hedging activity to ensure that the bank meets the requirements of the risk-mitigating hedging exemption. Note that under the regulations the risk-mitigating hedging activity cannot be designed to:
    • reduce risks associated with – the bank’s assets or liabilities generally.
    • general market movements or broad economic conditions.
    • profit in the case of a general economic downturn.
    • counterbalance revenue declines generally.
    • arbitrage market imbalances unrelated to the risks resulting from the positions lawfully held by the bank.
  • Assess the bank’s progress toward developing systems and processes to create and retain the hedging documentation for at least five years and in a manner that allows the bank to produce promptly those records to the OCC.

There is much more in the manual than we have listed here, of course. But these excerpts can give us some insights into how the regulators are approaching the VR. For example:

  • The regulators are aware of the opportunity, and perhaps desire, to obfuscate compliance with the rules. Several places in the instructions warn examiners to make sure that efforts are “meaningful,” particularly around the metrics.
  • In most of the more difficult areas of the metrics – for example, the inventory aging and turnover categories – the instructions appear to offer no additional help. On the question of how to apply inventory aging and turnover, the instructions simply say:
    For the inventory turnover ratio and inventory aging, determine whether the bank’s systems can compute delta-adjusted notional value and 10-year bond equivalent values. (For options, value means delta-adjusted notional value; for other interest rate derivatives, value means 10-year bond equivalent value).
    There is nothing about what to do if a bank opened a position, or opened and closed the position on the same day, which would result in a turnover ratio of ∞. Either the regulators haven’t identified these problems yet or don’t yet have an answer.
  • The instructions don’t give any guidance on how examiners are to determine that a bank stands ready to buy or sell those instruments that trade infrequently or are new to the market. Here, again, the regulators may not have identified the uncertainty, or may not have an answer.

Overall, the instructions mostly parrot the rule itself, without clarifying many of the complexities and uncertainties around enforcement. If this is an indication of the preparations examiners will get for their very difficult tasks, we should expect a good deal of confusion, and possibly some contention. Thus it behooves banks to start a dialog now with their assigned examiners about how they will apply these instructions and what the results will be.

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Tags: Volcker Rule, banks, OCC, Derivatives, regulators

Can Swap Futures Fill the Interest Rate Hedging Void?

Posted on Thu, May 08, 2014 @ 09:45 AM

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

It is becoming much more expensive for firms to hedge their interest rate exposures using swaps, and existing swap futures may not be suitable for the buy side’s hedging needs. GMEX is betting its new constant maturity swap future product can fill the void.

The reforms instigated by the G20 in the wake of the global financial crisis have resulted in a number of structural changes to the world’s interest rate derivatives markets, changes that are now starting to have a significant impact on market participants. The G20’s stated objectives to reduce systemic risk and increase transparency across global financial markets were clear, in that all OTC derivatives contracts should be reported to trade repositories (TRs); all standardised contracts should be traded on electronic trading platforms where appropriate, and cleared through central counterparties (CCPs); and non-centrally cleared contracts should be subject to higher capital requirements.

It remains to be seen how successful these initiatives will be in the long term. However, it is clear that in the short term, at least, the increased capital and margin requirements have placed a greater strain on the financial resources of many firms active in this space. Likewise, operational changes are also making it more difficult for firms to accurately hedge their interest rate exposures. Buy-side firms in particular are facing a range of new challenges around duration hedging.

Increased Swap Costs

Historically, OTC interest rate swaps (IRSs) have been widely used by the buy side to hedge their interest exposures. However, in this new environment, it is becoming much more expensive for firms to continue duration hedging using swaps.

“One problem with bringing OTC instruments such as interest rate swaps into a CCP environment is that firms will no longer be able to rely on their ISDA Credit Support Annex agreements (Ed note: A CSA defines the terms under which collateral is posted or transferred between swap counterparties to mitigate credit risk),” says Andrew Chart, Senior Director, Origination and Structuring Prime Clearing Services, at Newedge Group.

“Whereas previously cash flows would not occur between the two counterparties until a position reached a pre-agreed level (e.g., $10 million), firms will now have to put up margin at a CCP and manage a daily cash flow as their positions are marked to market daily,” he continues. “Where do they find that collateral? This is a cash flow that they’ve never had to make before, which causes treasury and liquidity related challenges for firms if their cash is tied up on deposit, or they are fully invested in higher-yielding contracts.”

With standardised swaps subject to 5-day VaR and non-standardised swaps requiring 10-day VaR, costs in some cases are going up by an order of magnitude, a situation that Chart and his colleagues at Newedge refer to as “margin discrimination” when comparing to listed derivatives or similar products that attract a 2-day VaR treatment. “With Basel III provisions, OTC instruments are likely to weigh heavier from a capital requirements perspective,” says Chart. “Firms will have to make increased capital and liquidity provisions to show they can cover these transactions. They won’t be able to leverage up as easily as they could previously because of the new capital/position ratios that will force them to put more into their capital reserves to cover their trades and positions.”

The net result is that interest rate swaps are becoming prohibitively expensive to the buy side. More and more funds are now being directed by their investment committees to pull out of the swaps market and to find alternative hedging mechanisms. But this is easier said than done.

Challenges With Swap Futures

One of the problems facing the market is that there are very few viable alternatives to interest rate swaps for managing duration hedging, although a number of exchanges – including NYSE Euronext, CME and Eris Exchange – now offer various flavours of swap futures.

“From a buy-side perspective the products offered by those exchanges have a number of perceived disadvantages when compared with the swaps market, based on feedback market users have provided to us,” says Hirander Misra, CEO of Global Markets Exchange (GMEX) Group, which, subject to FCA approval, will operate a new multilateral trading facility in London. “Certain sections of the buy-side community are telling us that existing swap futures just aren’t suitable for them to manage their duration hedging, because they don’t provide a like-for-like hedge,” he explains.

“Of course, there’s no such thing as a perfect hedge, but with current quarterly rolling swap futures, you don’t get the granularity of duration hedging you get with IRSs. This makes managing the deltas extremely difficult because only certain points along the curve can be used. And as these swap futures expire every quarter, hedging longer-term exposures means that the contracts must be rolled each time they reach maturity. Every roll leads to more transactional costs, which add up and eat into the value of the portfolio, particularly when done multiple times over the life of a hedge,” continues Misra.

“Also, certain swap futures are or will be physically deliverable. So if a buy-side firm actually goes to delivery, they are faced again with the associated capital requirements and 5-day VaR of maintaining a swap position.” According to Misra, this is why, to date, no existing swap futures contracts have yet managed to build a critical mass of liquidity relative to the volumes seen in the OTC IRS market.

The Constant Maturity Approach

In order to address all of these challenges, GMEX recently announced the launch of its Constant Maturity Future (CMF). The CMF is a new breed of swap futures contract linked to GMEX’s proprietary IRSIA index, which is calculated in real time using tradable swap prices from the interbank market. By accurately tracking every point on the yield curve in this way, retaining its maturity throughout the lifetime of the trade and being traded on the rate, the duration hedging capability of the CMF is much more closely aligned with an IRS than other swap futures contracts that have set durations and expiry dates, according to GMEX’s Misra. This is the key for the buy-side, he says.

“The CMF gives you the closest approximation a futures contract can to the way in which the OTC interest rate swap market moves and is traded on a daily basis,” Misra claims. “Additionally, for example, if you want to hedge a 30-year Gilt issue that rolls down to maturity, given the CMF offers every annual maturity from 2 to 30 years, you can gain a very granular hedge by periodically rolling the appropriate number of 30-year CMF contracts down the curve to 29-year CMF contracts. Rather than rolling quarterly, this can become a simple middle-office, daily or periodic hedge tool. The advantage being that there is no quarterly brick wall by which point you have to roll,” adds Misra.

As a listed futures contract, the CMF comes with all the advantages that futures offer over swaps in terms of cheaper margin (2-day VaR as opposed to 5-day); electronic trading capability and accessibility; clearing through a central counterparty; and reporting via a central trade repository, Misra says. And with no quarterly roll and no deliverable element, the disadvantages typically associated with other swap futures are removed.

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Diversity of Market Participants

In order to create liquidity in any market, a diverse group of participants – including both makers and takers – is required. “We’ve thoroughly researched the market, and it’s clear that anyone who hedges interest rates needs a product like this,” insists GMEX’s Misra.

“The buy-side [firms] need it for their duration hedging; the sell-side also have IRS exposures that they need to hedge more cheaply; all the banks are capital constrained and have fixed income exposures that they need to hedge; futures players like it because it’s a standardized IRS futures product that will see natural buy-side flow; electronic market-makers and proprietary traders like it because it gives them opportunities to arbitrage the CMF against other interest rate instruments; corporates with sophisticated treasury and hedging requirements and even insurance companies who currently run naked exposures because they’ve assessed the alternatives and deemed it cheaper to take one-off hits than run expensive hedges,” he adds.


The IRSIA CMF will be centrally cleared by Eurex Clearing (subject to final agreement at the time of writing). This arrangement will offer a range of advantages around collateral and margin offsets. For example, it will be possible to offset the margin for the IRSIA CMF against the margin for correlated assets such as Bund/Bobl/Schatz and Eurex-cleared OTC IRS. Such offsets and incentives will significantly lower barriers to entry for market participants given that existing Eurex clearing membership will apply.

“With the introduction of the new Basel III capital rules, the cost of clearing is now determining not only which instruments are used for hedging but where they are cleared,” says Philip Simons, Head of Sales and Relationship Management at Eurex Clearing. “Market participants will inevitably use the best tools available that manage the risk. This will include OTC IRS, traditional futures and options, as well as new instruments such as GMEX’s IRSIA CMF.”

According to Simons, the ability to clear all instruments at the same CCP with appropriate cross-margin benefits will be crucial. This will not only reduce the cost of funding but, more significantly, reduce the cost of capital, through a combination of maximising netting benefits for exposure at default, having an efficient default fund and minimising the funding costs.

“The higher the risks, the higher the costs of capital as reflected through higher initial margin and higher default fund contributions, which will inevitably be passed on to the end client,” says Simons. “Capital and operational efficiency will drive liquidity in the future.”

Operational Considerations

The IRSIA CMF will be traded on an electronic market, operating on a Central Limit Order Book via GMEX’s own proprietary matching technology. Request for Quote and the facility to report negotiated trades will also be available, according to GMEX.

GMEX says it will offer access to the market via its own trading screens as well as third party vendor products. Most firms may prefer to trade through screens such as those provided by ISVs such as Fidessa and Trading Technologies, many of which offer functionality for trading spreads or running other cross-instrument or cross-market strategies. For direct electronic access, GMEX provides a well-documented API, which is available in both FIX and Binary format.

Execution and prime service brokers such as Newedge will offer DMA and potentially sponsored access, as well as value-added services such as cross-product margining and linked margin financing of correlated portfolios.

Finally, trade reporting will be performed automatically via the REGIS-TR Trade Repository, resulting in true straight-through processing from pricing, execution and clearing through to reporting.

This article originally appeared on The Trading Mesh.

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Tags: CCPs, central counterparties, interest rates, OTC Derivatives, futures, Swaps, Derivatives

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

Posted on Mon, May 05, 2014 @ 09:49 AM

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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Tags: regulation, CFTC, SEFs, Kevin McPortland, Swaps, MAT, SEC, Derivatives, regulators