DerivAlert Commentary

It’s Not About What’s Fair

Wed, 19 Jun 2013 13:07:00 GMT

By Larry Tabb, TABB Group
Originally published on TABB Forum

The free market is about taking risks to harvest opportunities, and our capital markets are about investment, reward and competition – not fairness.

Last week, the Wall Street Journal featured TABB Group research in a front page story about low-latency economic data and machine-readable news (“Traders Pay for an Early Peek at Key Data,” June 12, 2013). The angle of the story was how certain firms buy access to data ahead of the general public, albeit by seconds and sub-second intervals. The article focused on the University of Michigan Consumer Sentiment Index, the Chicago Business Barometer, and the Institute for Supply Management (ISM) Monthly Manufacturer’s Index – all examples of privately sourced data.

Then, like clockwork, legislators started calling to inquire what can be done to address this apparently obvious market inefficiency. Isn’t it unfair that some traders can buy advanced access from data providers to this information? Aren’t individual investors at a disadvantage? Isn’t this something that Congress should fix?

I (maybe all of us as a society?) must have some Pavlovian response to the word “fair.” Maybe it was growing up with three brothers and being told constantly to share. Maybe it was ingrained in my psyche when I was in nursery school. Who knows? But when I hear the word “fair,” all these images pop up into my head about playing nicely, doing the right thing, letting others go first …

But are those feelings right? Are they correct in terms of capitalism and market structure?

Let’s look at the issue of payment for preferential access to information and the question of fairness. It really boils down to two sides of the same coin:

First, is it fair that traders/firms with deeper pockets get access to potentially market moving information before other investors?
Second, should the SEC, or the “Government,” dictate how private (or, for that matter, public) entities monetize their efforts?

This is clearly a discussion about the balance between fairness and business models. So where do we stand?

I don’t want to wrap myself in the Conservative Agenda (personally, I generally lean more left of center), but for this argument, I’m squarely right of center. Our markets – and, for that matter, our economic system – are about investment, reward and competition, not fairness. Is it fair that the computer killed the typewriter? Is it fair that the smartphone killed the traditional handset? Is it fair that Apple was almost dead and a visionary brought it back from the brink? No, no, and no. Were some people hurt by these developments? Of course. Where are Smith Corona (making thermal labels), Motorola (bought by Google for its patents), and Dell or HP (in the midst of a buyout and restructuring, respectively) today?

The free market is about taking risks to harvest opportunities. And that is the whole purpose of research – to gain insight and competitive advantage when making investments. To the extent that a research firm is not a regulated entity and/or not governed by the SEC, it’s the firm’s job to maximize its revenue opportunities.

Fairness doesn’t really come into play. As long as various participants and investors are not discriminated against, and the information is available to all to buy, the goal isn’t to be fair – it’s to create a product and harvest revenue. Otherwise, the firm is not doing right by its owners.

So it is understandable that a private company’s goal is to maximize its revenue opportunities; but what about publicly funded universities or government-sourced data?

For universities, at least in my opinion, the issue is the same. A university has a duty to maximize the value of its resources. That is why schools compete for the best students and to attract top teachers, and work to develop the best research. Even state-sponsored universities allocate their capital to the most rewarding endeavors. If state schools don’t invest in teachers, they won’t provide a decent education, their students won’t get jobs, ratings will fall, and students will go elsewhere.

When universities develop research, such as the ISM, that research isn’t given to the world for free. Well, yes, the headline numbers are given away. However, there are typically troves of data, below the headline rates, for which investors and other consumers are willing to pay. While I am not intimately familiar with the ISM, typically similar research breaks out trends by geography, sector and subsector. That information rarely is free. The revenue generated by this type of research is used to cover costs, and, if there is anything left over, to support the university’s financial goals. If the university doesn’t generate revenue from these endeavors, eventually people lose interest and the products get stale.

While private and university research revenue should be harvested with yield maximization in mind, what about governmental data? Surely governmental information should be released to all simultaneously, right?

Government data is probably the only type of information for which a case even can be made for simultaneous release. We the People pay for the creation of this research, and we should all be able to access the results equally. That said, even with public data, if we ran these statistical services with “We the People” in mind as trustees, maybe there is a case to be made for a pay-for-access business model. If the government charged extra for early release, maybe our budget deficit would be the tiniest bit lower. But that argument is probably more extreme than conventional wisdom.

We live in a capitalistic society, and our capital markets are the center of that world. While fairness has been drilled into us since we were little, so has competition. When fairness gets confused with competition, that is when business models break down. While competition isn’t always pretty, it has been at the core of our country and our markets since they were founded. It drives innovation, it drives competition and, like it or not, it drives our way of life.

Derivatives: SEFs – Opening Bell Sounds

Fri, 14 Jun 2013 18:45:00 GMT

Originally Published on PwCregulatory.com

The Commodity Futures Trading Commission issued three final rules that will move bilaterally traded swaps onto execution platforms that offer many-to-many trade functionality. These rules create the standards for registering and operating swap execution facilities ("SEFs"); for requiring mandatory cleared swaps to trade on SEFs or designated contract markets; and for identifying large notional block trades that can still be executed off exchange. Once mandatory execution rules are in force, counterparties that have to centrally clear swaps also will have to execute them on exchange, not bilaterally.

This new Regulatory Brief from PricewaterhouseCoopers LLP describes this new regulatory environment for mandatory electronic swaps trading and highlights considerations for the buy-side and sell-side.

To download the full brief, click here.

Swap Clearing Deadline Anticlimactic

Wed, 12 Jun 2013 14:07:00 GMT

By Valerie Bogard, TABB Group
Originally published on TABB Forum

The Category II swap clearing deadline came and went Monday. But contrary to expectations, swap futures did not see a jump in volume.

Yesterday marked a new era in derivatives trading. June 10 was the deadline for the Dodd-Frank Category II swap clearing mandate, which requires over-the-counter swaps to be centrally cleared. For those who missed the deadline, the question is: What to trade now?

The first wave of the clearing regulation, which hit on March 11, mandated that Category I firms – which consists of swap dealers, major swap participants and active funds – start clearing certain interest rate and credit derivatives products. Yesterday marked the beginning of the second phase, which now regulates Category II firms. This includes commodity pools, private funds other than active funds and entities engaged in banking activities, which means, by TABB Group’s estimate, 500 buy-side firms are now subject to the new rules.

Last month, TABB Group estimated that 75% of these firms would fail to meet the June 10 deadline. The process of moving over to the new legislative requirements – which includes establishing clearing broker relationships, meeting legal and operational demands, and completing training and testing – takes about three months to complete. While waiting to complete this process, traders must continue to trade where products are available. The options for these firms include swap futures, interest rate futures, bespoke OTC uncleared swaps, or simply not trading at all.

Contrary to some expectations, CME Group and Eris Exchange swap future products did not see a dramatic increase in activity yesterday. CME Group did see a slight increase in its swap future volume last week; however, it is difficult to attribute that solely to new client activity.

Neal Brady, CEO of Eris Exchange, said, “We didn’t have a record volume day, and we didn’t expect that either.” He did add, however, that the exchange expects volume to pick up over the next few months. Just as completing the necessary requirements to clear OTC swaps takes time, traders must also prepare for trading a new product.

CME reported that its interest rate futures did in fact see growth in the past month with a broader client base, including Category II firms such as asset managers and hedge funds. CME said part of this could be attributed to the increased interest rate volatility seen over the past few weeks, but analysts will have to wait for more data to come in to see if traders are choosing this product in lieu of OTC swaps as they wait for their clearing processes to be set up. It could be that traders are choosing interest rate futures over swap futures, as they are more comfortable them.

Although it might seem strange, there surely is a percentage of traders who decided not to trade yesterday because they were not familiar enough with the alternative products. CME stated that it did not see a significant uptick in volume yesterday for OTC cleared swaps, although there was an increase last week. Given this, and the fact that swap futures also did not see a huge increase, one can assume that traders either turned to interest rate futures or did not trade. Those not comfortable trading interest rate futures really only have the option of not trading at all, at least for the time being. These market participants might have bet that the CFTC would push back the clearing deadline; the fact that the regulators stood firm in their decision has now put those firms behind.

In the coming months, market participants will have a more complete view of how the mandate affected the derivatives market. We will also get a broader picture of which products traders are using while they become operationally compliant for OTC swaps; and even with their clearing systems in place, traders may decide to stick with either interest rate futures or swap futures.

All in all, yesterday was, for the most part, rather anticlimactic. Laurent Paulhac, senior managing director for OTC products at CME, said, “There was so much written about June 10^thand so much anticipation, that it’s actually not tremendously surprising that there wasn’t much activity.”

Pole Position in the New Swaps Market

Tue, 11 Jun 2013 13:59:00 GMT

By Adam Sussman, TABB Group
Originally published on TABB Forum

Over the years, the value of pole position in NASCAR and Formula One races has been on the decline, as winning has more to do with having the right tools and equipment than where you start. The same can be said about the new swaps market.

Over the past month, the industry has been rightly focused on the complexities, barriers and importance for Category II firms to be ready to clear swaps. However, initial readiness by June 10 is hardly the finish line, and even those in leading positions now could easily fall into the back of the pack. The same holds true for the clearinghouses, trading venues and technology providers that are trying to sell the laundry list of services associated with the overhaul.

On the client side, even if a firm has completed the major steps to being able to clear, it does not mean it is capable of efficiently managing its swaps positions and the related movement of collateral. In other words, being ready to clear by June 10 is not the same as being ready to manage a cleared swaps portfolio.

Some clearing-ready clients will still choose to reduce their swaps activity over the next few months until they have a better understanding of the portfolio, collateral and operational nuances involved. Portfolio margining, collateral management, and safety of initial and variation margin are just three areas that go above and beyond the technical necessities to clear.

Precise and efficient communication with the clearinghouse will be a critical buy-side process that will become more important over time (see: “Swap Portfolios in Transit”). As the buy side looks to terminate, compact and rebalance its swaps portfolio, a single mistake in coding or trade detail could mean that the clearinghouse fails to recognize the true intention of the trade and a sub-optimal margin requirement.

Clearing-ready clients may also scale back their swaps trading until they are ready to clear through multiple FCMs and multiple clearinghouses. TABB estimates that nearly 375 Category II funds will fail to meet the June 10 deadline; but even among those that are ready, how many will have multiple FCM relationships in place? And how many will be able to direct trades from any FCM to any clearinghouse? Reluctance to rely on a single FCM to handle all initial and variation margin may cause some firms to reduce their swap exposure, until they have multiple relationships in place.

Similarly, just because a clearinghouse, trading venue or technology provider seems to be best positioned for success right now, it is hardly a predictor of long-term success. Throughout the entire rulemaking process, we have learned that there is a first-mover disadvantage during this transformation.

The industry has consistently been wrong on the implementation date for the trading mandate. In 2011, in our SEF industry barometer, two-thirds of respondents believed the trading mandates would be in effect by Q1 2012 or earlier. It is also likely that the industry believes that the major changes will take place in the next year. I believe there is a much longer game at stake – that the changes we see this year will only be setting in motion a much greater series of changes.

The uncertainty surrounding the timing and the outcome of the swaps transformation has led to a tremendous amount of jockeying and innovation among the field of contenders. The vertical exchanges are hedging outcomes by focusing on the two core businesses – trading and clearing – but also by focusing on the markets where they are already a formidable presence: CME Group is focused on rates clearing and launched a deliverable swap future (DSF) on interest rates; ICE is clearing credit defaults swap with a plan to launch credit futures. The competition is multi-faceted, with competing contracts on one hand and competing clearinghouses on the other.

Over the past few months there has been an uptick in announcements. The types of announcements that have come out recently have focused on two areas: trading or plumbing. Trading is, of course, the glitzier announcement and the one that has garnered the most attention from the press. Whether it is the various efforts at standardizing interest rate swaps, the launch of credit default futures or the tweaking of existing products, there has been quite a bit of hype in this area, and we do not expect it to calm down anytime soon.

The other type of announcement is on the plumbing necessary for the buy side to handle a cleared swap environment. On Friday, June 6, Tradeweb announced it has launched a service that allows customers to speed up approvals of swaps before they are executed and sent to the clearinghouse. Without this kind of functionality, a client could be waiting minutes or more to have the FCM/swap broker approve and send the trade along to a SEF for execution.

ICAP and its subsidiaries, TriOptima and Traiana, have also been busy on this front. In May, Traiana announced that an FCM successfully completed production testing of its CreditLink service, a way to manage pre-trade clearing and trading limits with DCMs or SEFs. This solution would also help bring certainty of clearing to the market. Then on Friday, TriOptima announced it will be using data reported to the DTCC’s trade repository to help in the reconciliation process.

Earlier in the year, TrueEx announced it had developed an electronic communication tool to help the buy side manage its trade communication with clearinghouses and dealers. The tool is designed to help the buy side make sure that when it attempts to terminate, compact or rebalance a portfolio, the new trades being sent to the clearinghouse are sent with the correct information.

Lastly, Clarus Financial Technology announced the release of an application that allows market participants to view the tremendous amount, but little understood, data that is made available by the Depository Trust Clearing Corporation (DTCC) through its Swaps Data Repository (SDR).

This type of functionality seems more than obvious. But that is the point. How can anyone know how this market is going to play out when the kind of functionality that is taken for granted in mature markets is barely developed for the new swaps world?

CFTC Announces that Mandatory Clearing for Category II Entities Begins Today

Mon, 10 Jun 2013 20:17:00 GMT

Today, the CFTC announced that it has implemented the second phase of required clearing for credit default swaps and interest rate swaps. This so-called “category II” clearing deadline, which applies to buyside institutions such as commodity pools, hedge funds and non swap dealer banks, requires firms to clear derivatives trades through a centralized clearing party. The “category I” clearing deadline, which applied a similar set of rules to swap dealers, was implemented on March 10 of this year.

In a statement issued today, CFTC Chairman Gary Gensler commented:

“Today marks another critical step on the path to financial reform. Most financial entities will be required to bring certain credit default and interest rate swaps into central clearing. Clearing benefits the public by lowering the risk of the interconnected swaps market to the rest of the economy. It also significantly promotes competition by broadening access to the market.”

To read the full CFTC announcement, click here.

To read Tradeweb CEO Lee Olesky’s op-ed about the category II clearing deadline, which was published Friday in The Financial Times, click here.

SEF Rules Entered Into Federal Register, Become Effective August 5

Tue, 04 Jun 2013 16:03:00 GMT

Today, the CFTC entered the final rules for swap execution facilities into the Federal Register. They will become effective August 5, 2013.

Last month, the Commission’s five members – three Democrats and two Republicans – voted 4-1 in favor of the new rules. The final version of the new standards will bring bilateral trading to an end, and transfer trades to centralized, transparent marketplaces.

To read statements from each of the commissioner from the public vote, clickon their name: Scott O’Malia, Bart Chilton, Gary Gensler, Mark Wetjen, Jill Sommers

To read the full rules, click here.

The European FTT Is Finished

Fri, 31 May 2013 13:35:00 GMT

By Rebecca Healey, TABB Group
Originally published on TABB Forum

In a supposed victory for banks and trading organizations, the European Commission apparently will scale back the financial transaction tax significantly. But here are 5 reasons why the anti-FTT lobby should not relax just yet.

A report from Reuters yesterday confirms weeks of suspicion that most of the politicians in Brussels were beginning to realize that the EU-11FTT was just too complex and draconian to implement in its current form. Yet understanding that the FTT will have a devastating impact on any economic recovery – it is not just a damaging tax on financial services that we can ill afford – is a vital argument that must not get lost in the political rhetoric.

The apparent revised proposals, according to Reuters, will be scaled back considerably; it is estimated that annual revenues could fall to as little as €3.5bn. The tax will fall to just 0.01% on shares and bonds, rather than the 0.1% initially proposed. In addition, the Jan. 1, 2014, start date will be delayed, with the tax on bonds held off until 2016; the planned levy on derivatives could be dropped altogether.

As we discussed in our recent video, “FTT: The Cold, Hard Facts,” the announcement by Bayer and Siemens of the impact of the FTT on European companies, their day-to-day financial dealings and, most important, the impact on workers’ pensions would appear to have sent the right message to Brussels. Yet the current discussions remain in the corridors of political power: European politicians may have realized the folly of the initial proposals, but this will be a difficult message to sell to the general public. There will be no public support for this proposal from German Chancellor Angela Merkel’s coalition until after the election in September.

However, this is no landmark victory – the anti-FTT lobby should not relax just yet. We need to continue highlighting the folly of such a tax for the following reasons:

These latest proposals, together with an announcement by France yesterday, indicate a shift toward allowing derivatives trading to continue unfettered. Initially, the tax was proposed as a way to make the financial sector bear some of the costs of the economic crisis and reduce systemic risk. The executive committee of the EC estimated that the FTT could lead to a 15 percent decline in the trade of shares and bonds and a 75 percent reduction in the volume of derivatives trading – widely regarded as the most risky form of financial speculation rather than a valued hedging tool. The latest proposals would appear to leave the “risky” element wide open and equities bearing the full brunt of the tax. There will be a backlash to this at some point.
Current taxes are unaffected. Discrepancies among national governments remain and are unlikely to be resolved.France announced that it is interested in scaling back the tax on derivatives markets while controversially extending the levy to currency trades. Meanwhile, Italy remains committed to excluding bonds from the tax. The considerable administrative burden in adhering to European taxes still exists.
Even a revised EU-11 FTT will not collect the funds it claims – it fundamentally goes against market behavior. If the tax is reduced and imposed purely on equities and bonds, the incentive remains for market participants to shift to alternatives, either in terms of asset class or geography.
In addition, the countries involved would still have little say in how the funds are spent, and where. This is something that is of increasing concern to certain nation states. Germany, the Netherlands and the UK categorically do not want a European tax where revenues would flow into the EU's own budget.
The latest announcements of youth unemployment in Italy reaching 40.5% -- the highest level in 36 years -- as well as record levels in Spain and Greece show that tackling youth unemployment is as essential as ever. But would we be better served by encouraging financial services firms to offer apprentice schemes rather than crushing banking institutions?

While shrinking economies and rising unemployment continue to challenge European governments, some nation states will continue to push for an FTT. Arguments that financial trading is under-taxed relative to the rest of the economy may be technically correct, but the idea that implementing the FTT is beneficial because banks derive excessive profit from trading shows how little some politicians understand capital markets today.

E-Trading of OTC Derivatives: The Impossible Just Became Possible

Thu, 30 May 2013 13:13:00 GMT

By Rebecca Healey, TABB Group
Originally published on TABB Forum

The electronification of the over-the-counter derivatives market is happening much more quickly than anyone would have guessed. And it is driving a shift from the use of equity derivatives primarily for hedging to their use in the pursuit of alpha.

“OTC derivatives trading electronically? Never gonna happen.” A trader told me this only a couple of months ago. He may just want to eat his words.

In fact, the speed at which the supposedly sacred OTC derivatives markets will succumb to the vagaries of automated trading will happen at a far greater rate than most of the market suspects. New requirements for improved trade reporting will spearhead widespread uptake of automated workflows, transforming the equity derivatives market in the process.

EMIR Has Landed

EMIR technical standards on OTC derivatives regulation 648/2012 will require all counterparties to comply with operational risk management requirements – including timely confirmation, valuation, reconciliation, compression and dispute resolution – by mid-2013. The automation of workflows not only will enable firms to meet regulatory requirements, it will open up new opportunities to hedge risk, calculate margin and source liquidity, as increased use of data and technology will ensure the transition from a largely OTC bilateral market to electronic trading.

Meanwhile, as the need for trade certainty takes center stage, the introduction of the STP process will become the catalyst for the explosion of automated trading.

Turquoise, part of the LSE Group, announced this week that it will introduce trading in single-stock options, initially offering reporting of trades in single-stock options for 19 UK mining and energy listed companies. The introduction of trade reporting for UK options on June 10 will allow investors who already trade single-stock options and futures on other LSE-operated platforms to net their positions at LCH Clearnet.

From Hedging to Trading

Historically, European equity options have failed to reach the level of US interest; and interest from market participants remained centered on using options for hedging purposes rather than as a trade in its own right. However, the reasons for trading equity derivatives are already shifting as the cost of the insurance is becoming larger than the payout. Depleted margins and bank deleveraging due to Basel III are increasing the cost of hedging in the traditional sense. There is now little appetite for market makers to offer to warehouse risk for anyone other than the most lucrative clients. Increasing initial margin requirements plus onerous capital charges are removing the incentive to trade a large swath of non-clearable “exotic” derivatives. As a result, clients are being forced to standardize their product usage.

Investors are diversifying away from cash equity holdings at the same time as the derivatives product spectrum is becoming increasingly vanilla. This influx of new participants is transitioning the use of equity derivatives from a predominantly hedging function to a trading opportunity and altering the structural makeup of the market in the process.

Systemic Risk to Liquidity Risk

Similar to the changes in cash equities markets, traditional market makers will be forced to exit as automated trading gradually encroaches on their market share. Market participants will resort to greater levels of technology in order to transact their trades. Automated trade flows will lead to average trade sizes shrinking to avoid market impact, creating an increased feedback loop attracting further diversity of market participants and creating challenges for bilateral phone trading, hastening its demise.

While the move from a labor-intensive voice process to a centralized, transparent pricing module appears to be a slam dunk requirement for the buy side, the increased level of transparency will morph systemic risk into liquidity risk. The obligation to hold more collateral for OTC transactions will create additional pressure to hold liquid-only assets. As participants fight for dwindling liquidity in a reduced number of names, the liquidity premium will increase, and less actively traded instruments will become increasingly scarce.

Breaking down silos and resolving inefficient usage of collateral will now become a priority for firms obligated to hold more collateral for OTC transactions. Without an automated workflow process, efficient management of collateral will be impossible to manage. Without an optimal way to analyze the availability of collateral, there will be no way to ensure the ability to trade.

The ability to harness any available liquidity across the widest spectrum of instruments will require increased use of technology, irrespective of whether this is via a central limit order book, auction or RFQ process. The automation of the workflow process will make the step from partial to full automation merely a hair’s breadth away.

Technology is set to become the essential lifeline. As the evolution of OTC derivatives trading will transform the market from a predominantly voice-brokered industry to an electronic STP model, trading European derivatives successfully will become increasingly dependent on a combination of low-latency trading, global fund flows, data, trade analysis and, ultimately, economies of scale. The impossible has just become possible.

SIFMA Strongly Disagrees with CFTC’s Final SEF Rules

Wed, 29 May 2013 13:30:00 GMT

By SIFMA
Originally published on TABB Forum

Shortly after the CFTC approved Thursday [5/16] the final rules governing swap execution facilities, SIFMA released a statement arguing that the new rules 'will negatively impact investors and hinder the ability of American businesses to manage risk.'

SIFMA today released the following statements after the Commodity Futures Trading Commission (CFTC) voted on final rules governing swap execution facilities (SEFs).

Kenneth E. Bentsen, Jr., acting president and CEO, stated:

“While SIFMA will review the CFTC’s new SEF and execution rules in detail with our members, upon first read we strongly disagree with the CFTC’s final rules and believe as drafted they will negatively impact investors and hinder the ability of American businesses to manage risk contrary to intent. Restricting an institution’s ability to manage risk will discourage responsible capital management, limit job creation and dampen economic growth.

“The CFTC’s decision to impose a minimum bid requirement for certain swap transactions executed on SEFs will impair market liquidity at the expense of all market participants, ultimately harming the everyday investors that the rule aims to protect.

“We are equally troubled by the CFTC’s rule for determining block sizes. SIFMA believes that the CFTC’s methodology in determining block sizes is flawed and results in arbitrary outcomes that are not based on observable market data. Although the determination in the first year is an improvement on what had been proposed, we believe that it is too restrictive and not adequately justified. Additionally, we strongly support the efforts of Commissioner O’Malia to propose amendments that would have injected credibility and objectivity to the process. We urge the CFTC to reconsider the methodology for determining block trades after the initial phase-in period.”

Timothy Cameron, managing director and head of SIFMA’s Asset Management Group (AMG), added:

“SIFMA’s Asset Management Group continues to believe that any minimum-bid requirement will tie the hands of portfolio managers who already have a fiduciary obligation to serve the best interests of their clients. Requiring portfolio managers to broadcast their trading position more widely than they would otherwise choose could negatively impact the prevailing price of their trades, making it more expensive and difficult to hedge their clients’ risk. SIFMA strongly believes that professional investment managers, and not the government, should determine appropriate trading strategy.”

Buy Side Backs Bloomberg Margin Request

Fri, 17 May 2013 14:05:00 GMT

By Will Rhode, TABB GROUP
Originally published on TABB Forum

IFMA has come out in support of Bloomberg’s request to the CFTC to reduce the 5-day VaR calculation if initial margin for swaps to the same 1-day VaR requirement for futures. But shouldn’t it be left to each DCO to determine margin requirements based on how it chooses to compete in the marketplace?

The Asset Management Group (AMG) of the Securities Industry and Financial Markets Association (SIFMA) has written to the CFTC in support of Bloomberg’s letter requesting relief from the 5-day VaR calculation of initial margin for swaps vs. the 1-day VaR requirement on futures. In its letter it states:

AMG believes that the minimum liquidation time of 5 days for Non-commodity Swaps (a) is arbitrary and overly conservative, (b) is based on a fundamentally flawed assumption as to differences in liquidity between futures and swaps, (c) creates an artificial economic incentive for market participants to use futures rather than swaps and (d) is contrary to Congress’s goal of promoting trading of swaps on swap execution facilities (SEFs). We strongly believe that the minimum liquidation time for Non-commodity Swaps should be the same as for Futures and Commodity Swaps – i.e., 1 day – with DCOs using their reasonable and prudent judgment to set higher liquidation times for particular types or classes of transactions where warranted by their specific liquidity characteristics as evidenced by quantitative analyses derived from sources such as swap data repository data.

While we at TABB Group sympathize with the buy side’s struggle to deal with new clearing costs associated with swaps trading, and while we appreciate the illogic of an un-level playing field in margin treatment for what may be two economically equivalent products, we question the degree of intervention that the CFTC should take in determining DCO margin requirements. Should it be the CFTC that determines these things, or the DCOs themselves?

The AMG letter continues:

Rule 39.13(g) provides that DCOs shall employ models that will generate margin requirements adequate to cover the DCOs’ potential future exposure to a clearing customer’s position based on price movements between the last collection of variation margin and the time within which the DCO estimates that it would be able to liquidate a defaulting clearing member’s positions. Under the final rule, the models must assume, unless an exception is granted, that it will take at least one day to liquidate futures and options (“Futures”) and agricultural commodity, energy commodity and metal swaps (“Commodity Swaps”) and that it will take at least five days to liquidate all other swaps (“Non-commodity Swaps”). In the preamble to the final rules, the Commission explained that these “bright-line” minimum liquidation times would provide certainty to the market, ensure that margin requirements would be established for the “thousands of swaps that are going to be cleared” and prevent a potential “race to the bottom” by competing DCOs.

The question becomes: How literally should the industry interpret the “bright line” drawn by the CFTC? This appears to be more an attempt at guidance, rather than an outright prescription. More to the point, Dodd-Frank has mandated for competition in clearing, so shouldn’t it be left to each DCO to determine the margin requirement based on how it chooses to compete in the marketplace? Some DCOs will opt to become more conservative in their margin calculation as they seek to demonstrate their risk management expertise and stability. Others will emphasize their ability to offer savings through margin efficiencies and cross-product netting. The point is, it should be up to the DCO to determine how it wants to define its value proposition, not the CFTC.

To that end, we believe that the AMG misses the point when it says: “Surely, it could not have been Congress’ intent in adopting Title VII of the Dodd-Frank Act for the Commission to create a market structure that would move liquidity away from swaps and into futures.”

The intention of Congress and Dodd-Frank is quite clear: reduce systemic risk. This is true of the transparent trading mandate, central clearing and trade reporting. So it seems unnecessarily risky at this point to demand that the CFTC reduce swap margins just as clearinghouses are being intermediated into the derivatives market to improve financial market safety.

The AMG is right to point out that the appropriate liquidation time for derivatives will be affected by a number of factors, including the trading volume, open interest, and predictable relationships with highly liquid products. But we believe that should be left to the DCOs, which are the experts in such matters, to determine.

CFTC Votes SEF Rules Forward

Thu, 16 May 2013 18:05:00 GMT

Today, the CFTC met to vote on final rules for swap execution facilities (SEFs). The Commission’s five members – three Democrats and two Republicans – voted in a public meeting on new platforms for swaps that will bring bilateral trading to an end, and transfer trades to centralized, transparent marketplaces. Critics say that the final rules are watered down, and as a result, a victory for Wall Street. Commissioners Jill Sommers and Scott O’Malia echoed those sentiments at the vote in their prepared statements.

Statements from each of the commissioner can be seen by clicking on their name: Scott O’Malia, Bart Chilton, Gary Gensler, Mark Wetjen, Jill Sommers

The Commission voted 4-1 in favor of the new rules.

More information on the final SEF rules can be found in the following Q&As and fact sheets:

Final Rulemaking Regarding Core Principles and Other Requirements for Swap Execution Facilities
Interpretive Guidance and Policy Statement on Disruptive Practices
Final Rulemaking on Procedures to Establish Appropriate Minimum Block Size for Large Notional Off-Facility Swaps and Block Trades
Process for a Designated Contract Market or Swap Execution Facility
Q&A – Core Principles and Other Requirements for Swap Execution Facilities
Q&A – Interpretive Guidance and Policy Statement on Disruptive Practices
Q&A – Process for a Designated Contract or Swap Execution Facility to Make a Swap Available to Trade and Schedule to Phase in Compliance with the Commodity Exchange Act

Failure to Meet OTC Clearing Deadline Will Be Costly

Thu, 16 May 2013 13:27:00 GMT

By Will Rhode, TABB GROUP
Originally published on TABB Forum

The failure of many buy-side firms to meet the June 10 Category II OTC clearing deadline will lead to a compression in US swaps trading activity and a liquidity drain of approximately US$55 trillion in notional terms.

The June 10 date for Phase Two of the OTC clearing mandate is fast approaching, yet a large portion of buy-side firms are still not ready. TABB Group estimates that 500 buy-side firms will fall under the Category II mandate and that 75% of them, or 375 institutions, will fail to meet the deadline. When looking at Separately Managed Accounts (SMAs), the universe is much wider, with as many as 3,000 funds still needing to get Know-Your-Customer (KYC) documents in place before an intermediary will set them up for clearing. This failure to meet the deadline will lead to a compression in US swaps trading activity and a liquidity drain of approximately US$55 trillion in notional terms.

May 15 is the absolute cut-off date for selecting a Futures Commission Merchant (FCM). This will give a buy-side firm a week to complete legal documentation, two weeks for account opening and, if it is lucky, a day or two for testing.

Those commodity pools, hedge funds, and non-swap dealer banks that fall under the Category II definition but have yet to turn their attentions to clearing face a severe risk of being locked out of the swaps market after June 10. The same problem applies to those that should have complied with the Category 1 deadline of March 10 but managed to delay, as well as to those insurance companies that are reconsidering their Category III status. In practical terms, it takes three months to complete the process – from opening up a clearing relationship, to the final testing of trades (see Exhibit, below).

Source: Citigroup, TABB Group

Buy-side firms have to negotiate legal documents with FCMs, middleware providers, and Derivatives Clearing Organizations (DCOs), as well as with executing brokers. From an operations point of view, they have to establish connectivity to clearinghouses, set up Legal Entity Identifiers (LEIs), and upgrade their trade management and portfolio reconciliation systems. For those firms only now turning their attentions to the clearing challenge, some of the stickier negotiations around collateral haircuts and margin financing will have to be foregone in order to expedite the onboarding process.

Questions abound. Will there be a legal bottleneck as players rush to comply with regulation at the last minute? How will a clearing broker’s time and resources for onboarding be allocated? Will some market participants be temporarily locked out of the swaps market come June 10? Will they have to find alternative ways to meet their investment objectives? Will firms that have prepared for clearing face liquidity challenges as latecomers create drag in the system? What will that mean in terms of their ability to manage risk effectively? Will the new infrastructure be able to handle the sudden escalation in clearing volumes? How will buy side firms handle portfolio risk in the event of a major market disruption?

The one thing we do know: The period of procrastination is over.

Litigators Must Love the CFTC

Fri, 10 May 2013 13:51:00 GMT

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

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

First, the CME threatened to sue the CFTC over SDR rules, sued them, then dropped the suit last year after evidently getting what it wanted.
Then, the DTCC threatened to sue the CFTC for caving in to the CME and relaxing SDR rules.
Meanwhile, Bloomberg, already a little impatient with the CFTC being in its third year of issuing final SEF rules, finally had enough of (in its view) disparate margin treatment of similar financial products (swaps vs. swap futures) and sued the CFTC.
Just two hours after the CME downplayed Bloomberg’s lawsuit during its first-quarter earnings call, the DTCC finally pulled the trigger and did sue the CFTC.

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

Tradeweb Names Top 10 Derivatives Twitter Accounts

Mon, 06 May 2013 21:00:00 GMT

Describing the revolution of breaking news doesn’t even require 140 characters; it can be summed up in just one word – Twitter. And in a shifting landscape of emerging technologies, tight deadlines, and new regulations, finding the right source for your financial news can keep you a step ahead.

That’s why Tradeweb assembled their list of the top ten Twitter feeds for news on derivatives reform, trading, and technology. Armed with this list, your timeline will become your own, customized financial news crawl.

To read the full list, click here.

Managing Swap Portfolios Is About to Get Even More Complex

Mon, 29 Apr 2013 13:40:00 GMT

By Will Rhode, TABB Group
Originally published on Tabb Forum

Already complex, swap portfolio management will become less forgiving with the implementation of the next clearing mandate in June. Buy-side firms need new technology that can help them streamline the process of trade terminations, compactions, fund rebalances and back-loading.

As the next clearing mandate hits June 10, buy-side firms are going to need new systems to help them manage their swaps portfolios. Today’s imperfect science of swap terminations, compactions and fund rebalancing will have to be perfected, since clearinghouses will only recognize precisely coded trades for netting purposes. If there is one mistake in any one of the 85 fields required by the CME Trade Register, for example, an offsetting swap designed to terminate a pre-existing position will count as an additional line item. Rather than eliminating the problem, this will create a new problem for traders.

Swaps portfolio management is already an operationally complex task, with the messaging of multiple Excel files containing multiple line items, the negotiation of trade prices, collective affirmation, and the delivery of the final trade packet – mostly manually managed. That said, while a bilateral dealer may today forgive a decimal error or an incorrectly labeled line item, a clearinghouse won’t. Without a system that can communicate with the clearinghouse in order to ensure all necessary fields and coding requirements are met prior to execution, the buy side will find it impossible to manage its swaps portfolios effectively through:

Terminations of existing bilateral swaps;
Compaction, which allows traders to replace multiple swaps with different coupons; and maturity dates with a single economic equivalent position;
Fund rebalances that transfer swap positions from one fund to another;
Or, when the specific risk of the bilateral swap must be retained, back-loading the swaps into the clearinghouse.

Even as the CFTC rules stipulate that certain swaps must clear, the portfolio logic of converting all swaps is increasing. The clearing mandate, escalating bank capital charges, a new margining regime for bilateral trades, and a desire to realize portfolio margining efficiencies all play a part in driving the industry toward clearing. Even though the Dodd-Frank clearing mandate does not require ‘grandfathering’ of pre-existing swaps into clearing, once any sizable volume of swaps are centrally cleared, it will make little sense to manage both old and new swaps with different operational and margin requirements in a single portfolio.

This is a heavy operational lift, however, since the world of bilateral trading has engendered a proliferation in line items. Now the process of rationalizing swap portfolios will need to begin, even as regulators raise the bar with a new real-time clearing requirement. Given the bottlenecks likely to occur as funds simultaneously look to comply with the clearing mandate, the need for new technology solutions that can help streamline the process of back-loading, fund rebalances, trade terminations and compactions is paramount.

The FSB’s Report Card on Derivatives Reform

Fri, 26 Apr 2013 13:20:00 GMT

By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.
Originally published on Tabb Forum

Earlier, I covered a report to the OTC Derivatives Regulatory Group (ODRG) meeting on resolving the international requirements for derivatives reform that the G20 passed in 2009. As it happens, the Financial Stability Board (FSB) published a report card on this same subject on April 15.

It shouldn’t surprise us that the cross-border aspect of derivatives reform is so much in the news today, since that is where the next big efforts will have to be made. Global market participants that are still heavily focused on Dodd-Frank are in danger of missing the bus, which is getting ready to leave the station.

The report card doesn’t start off on a positive note. It reads:

“While progress has been made in moving these markets towards centralised infrastructure, less than half of the FSB member jurisdictions currently have legislative and regulatory frameworks in place to implement the G20 commitments and there remains significant scope for increases in trade reporting, central clearing, and exchange and electronic platform trading in global OTC derivatives markets.”

Like a reproachful teacher, the FSB takes the jurisdictions to task for their slow progress:

“The FSB reiterates that, even though standards are still being finalized in a few areas, sufficient international guidance is overall available to jurisdictions to decide and implement policy frameworks for ensuring the G20 commitments are fully met in their jurisdictions, and that any necessary reforms to regulatory frameworks should be made without delay. This includes ensuring that there are no legal barriers to reporting all OTC derivatives contracts to trade repositories (TRs) and to the central clearing and organised platform trading of standardised OTC derivatives contracts... The FSB urges jurisdictions to clarify their respective approaches to cross-border activity, and to resolve any conflicts and inconsistencies as quickly as possible to provide certainty to stakeholders.”

Then the report gets into the details of the three major efforts: reporting, clearing, and centralized trading. Inreporting, the FSB points out one of the biggest problems to date: the lack of standardization in reporting data. “Only a small number of jurisdictions are placing obligations on market participants relating to non-centrally cleared transactions, such as trade confirmation timelines, portfolio reconciliation and compression, and trade valuation practices,” according to the report.

It also emphasizes another significant reporting issue, access to trade data by cross-border regulators. “Reporting a counterparty’s identity to TRs may be limited by domestic privacy laws, blocking statutes, confidentiality provisions and other domestic laws,” the FSB says. It also urges the jurisdictions to “continue to monitor the development of or changes in such laws and their proposed reporting requirements to ensure that any planned reforms adequately address barriers to reporting OTC derivatives transactions.”

With regard to clearing, the report says, “Jurisdictions must rapidly implement the G20 commitment to centrally clear all standardised products, in order to reduce systemic risk and to minimise risks of regulatory arbitrage between jurisdictions.” It points out three reasons why the clearing mandate hasn’t been completely adopted:

“Insufficient standardization. Some jurisdictions consider that currently there are not sufficiently standardized OTC derivatives products in their jurisdictions for central clearing to be viable.
“Availability of CCPs. Even where standardization is sufficient for central clearing to be viable, some jurisdictions report practical difficulties in implementation because no CCP is accessible by market participants located in their jurisdiction that offers clearing for the OTC derivatives products most actively traded in their markets.
“Use of incentives. Some jurisdictions have indicated that they expect that central clearing of standardized OTC derivatives will occur in their jurisdictions without mandatory obligations, due in part to the various incentives that market participants will face, including, for example, the requirements under the Basel III framework for banks and the margining requirements for non-centrally cleared trades.”

The FSB is skeptical of the reliance on incentives, and urges jurisdictions that do so to “recognise there is a risk that jurisdictions that have applied mandatory requirements may not regard their regime as equivalent. As international work increasingly focuses on implementation monitoring, the FSB will pay particular attention to the risk of regulatory arbitrage resulting from differences in jurisdictions’ implementation of central clearing reforms, across those jurisdictions imposing mandatory obligations and those that have not.”

Finally, on centralized trading, the report recognizes that this is perhaps the most difficult requirement, acknowledging that:

“Only a very small number of jurisdictions have requirements in force in this area. Many jurisdictions indicate that reform efforts are first being focused on implementing reporting and clearing requirements, or that further analysis is required of market liquidity before implementing trading requirements. However, this should not delay the enactment of legislation and regulation that would permit the implementation of trading requirements once they are determined to be appropriate for particular products.”

So the FSB gives the member jurisdictions a barely passing grade in derivatives reform, and, like a diligent teacher sending a note home, “The FSB Chairman has written to all member jurisdictions requesting confirmation that legislation and regulation for reporting to trade repositories are in place, as well as their committed timetables to complete all OTC derivatives reforms. He stressed that the need for prompt action on TRs should not in any way diminish the need for rapid completion of reforms in other areas, such as central clearing, capital and margining, and trading on exchanges or electronic platforms.”

Of course, as any teacher can attest, the parents have to take the warnings to heart or there will be no improvement in the classroom. The big question with this report card is: Will the jurisdictions care, or will they drop it in the trash on the way home?

Manipulation, Terrorism or Blowback: Is Twitter a Regulated Newsfeed?

Wed, 24 Apr 2013 13:18:00 GMT

By Alexander Tabb, TABB Group
Originally published on Tabb Forum

Everyone within the institutional capital markets knows that we exist in a hyper-sensitive, latency-dependent world in which time is no longer measured in minutes or seconds, but milliseconds and microseconds. So it is no real shock that the hack of the AP newswire Twitter feed Tuesday had such an immediate and discernible, but short-lived, impact.

At 1:07 pm (EST) unknown parties appeared to have gained unauthorized access the AP Newswire Twitter feed and tweeted to approximately 2 million followers that two explosions occurred in the White House and that President Barack Obama was injured. Subsequent to the tweet, the @AP Twitter account was suspended. But the damage had been done.

Immediately following the tweet, the markets reacted, with the S&P dropping approximately 11 points (~0.6%) and the Dow Jones Industrial Average dropping 144 points, or ~1%. Each rebounded within minutes, but millions of dollars were potentially gained or lost in the upheaval. During the disruption, S&P ETF volume increased dramatically, clearly indicating how sensitive the markets are to significant or potentially catastrophic events.

This gets to the real question: Was today’s hacking an attempt to manipulate markets, financial terrorism, or just an unforeseen side effect of an Internet hoax?

The case for market manipulation seems a bit weak. While it is true that the markets reacted with a rapidity that many will find scary, the AP Twitter account and the markets are too many steps removed from each other to ensure that hacking the account would in fact create this type of disruption. There likely are too many variables at play for a premeditated market manipulation event to make sense. However, the SEC and others will look at this closely, and if this was indeed an attempt at market manipulation, they will make every effort to uncover the truth behind it all.

As for financial terrorism, once again it is possible, but less probable. Though the Syrian Electronic Army claimed responsibility minutes after the hack, their motivation appears to be more geopolitical or cultural than financial. And again, the linkage between the AP Twitter feed and the markets is just too tenuous for me to believe that financial terrorism was the intended end goal. In addition, while the effect was significant, it was localized and short lived. Yes, individual investors and institutions were impacted; but the level of that impact has yet to be fully realized.

This leaves the third possibility – the perpetrators were looking to fulfill some as-yet-unknown goal, with the impact on the financial markets merely unintended. In the intelligence world that is called ‘blowback’; in the markets, oftentimes it is characterized as a ‘black swan’ event. Either way, an educated individual could assume that the events, while related, were not intended. Yes, the perpetrators were interested in creating havoc with their message; but the message’s impact on the markets could be looked at as an unforeseen consequence.

For me, the larger implications of the AP Twitter hack are driving my interest in the story. The fact that current events affect the markets is nothing new; as long as there have been exchanges, they have been impacted by outside events – from weather and war, to famine and the false reporting of an attack on the White House. What is new is the speed with which this now occurs. Back in 1849, the news traveled as fast as Paul Julius Reuter’s carrier pigeons; today, it moves as fast as a Tweet.

News analysis, webcrawlers, and the mining of unstructured information are just the logical conclusion of what started in 1849. Today, tweets and any other content added to the web are analyzed for their financial impact and digested in hours, minutes and, increasingly, milliseconds.

Tuesday’s micro-disruption, however, was not created by trading algorithms or smart order routers; they were just one part of a chain of events that was set off by the hijacking of AP’s Twitter account. The root of the problem lies not with automation, but with the more macro concepts of what constitutes a data feed and how a feed should be secured. This failure was one of security and procedure, not market structure.

Markets react to news – that is their purpose. Today’s events exposed a vulnerability not in the fast-paced, hyper-news sensitive market environment, but in what essentially is a news feed. Historically, news feeds were expensive infrastructures built by large market data complexes. Today, news feeds can be developed by people, organizations, and businesses by just signing up for a Twitter account. How do we secure that?

So what was the end-game of Tuesday’s attack? It is too early to tell. But I can already envision attorneys gathering in conference rooms throughout the city. And you can bet your bottom dollar that regulators (both financial and non-financial), government agencies and SROs will be pouring over the events, trying to understand exactly what happened. Certainly, a full review and analysis of how the events unfolded and what can be done to ensure that other sources of validated news are not compromised in the future is warranted. And I can only assume that news agencies and trusted sources of information such as the AP will move to a more restrictive regimen, controlling who has access to their accounts and where official tweets can originate (e.g., limiting outgoing tweets to a specific IP address or device), and avoiding “Password123” and other hackable credentials.

No matter how soothing a regulatory answer would be, though, at the end of the day, this event is all about how markets react to news, legitimate or not. And while it would be great to outlaw the dissemination of lies (oh, wait, it is outlawed), it may not always be possible to stop. And if you are trying to stop markets from reacting to news – be it real or fake – good luck, as news has financial impact, and the markets are the mechanism we use to price this impact.

That said, the faster we react to news, the faster we can either get it right or get it wrong. After all is said and done, if you live by speed, sometimes you die by speed. But if you’re careful and patient and have the right risk controls, hopefully you survive till tomorrow.

The Ultimate U.S. Swap Reporting Deadline Cheat Sheet

Wed, 17 Apr 2013 21:13:00 GMT

Weighing in at 200,000 words, the CFTC’s final rules governing the reporting of swaps data transactions isn’t the easiest collection of information to digest. But like it or not, the documents are must-reads for many swaps market participants because they contain dozens of reporting compliance dates that will be phased-in over the course of the year. Thankfully, now there’s an abridged version of the highlights.

Davis Polk’s Annette L. Nazareth and Gabriel D. Rosenberg were kind enough to do all of the heavy lifting and published the key dates in the March 2013 edition of Futures Industry magazine. They were also good enough to make the summary table available to the readers of DerivAlert.

The table breaks out reporting deadlines for three types of reporting:

SDR Reporting – Under these requirements, swap counterparties must report a host of information about swaps to new swap data repositories that are registered with the CFTC.
Real-Time Reporting – Under the real-time reporting requirements, key information about swaps must be publicly disseminated via swap data repositories.
Historical Swap Reporting – Counterparties to historical swaps entered into before the compliance dates require reporting to swap data repositories are still required to report information to the repositories.

Following is the complete breakdown:

Can the SEC Save Civilization?

Wed, 17 Apr 2013 13:35:00 GMT

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

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

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

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

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

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

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

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

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

Three Steps Banks Can Take to Prepare for Regulatory Change in Asia

Mon, 15 Apr 2013 13:52:00 GMT

By Theo Hildyard, Progress Software
Originally published on Tabb Forum

At a time when the reputation of the financial industry needs all the support it can get, the ongoing Libor scandal has shaken investor trust even further. As a result, financial firms should prepare for far-reaching regulatory change and stricter rules.

The ongoing Libor scandal is one of the most serious breaches of control in an industry where risk and compliance failures are routinely front page news. At a time when the reputation of the financial industry needs all the support it can get, yet another scandal has shaken the trust that society places in this vital part of our global infrastructure. And the scandal shows no sign of going away, with regulators around the world placing a further 16 financial institutions – in addition to Barclays, RBS and UBS – under investigation in the UK, Europe, US, Singapore, Japan and Korea.

As authorities continue to investigate banks’ operations and possible involvement in rate-rigging, reports of widespread and serious market manipulation in Asia have started to emerge. Earlier this year, Reuters reported that the Monetary Authority of Singapore (MAS) found evidence of electronic communication between traders from several banks about the rates submitted to set prices of non-deliverable foreign exchange forwards (NDFs).

While the jury is still out as to how the authorities will deal with these reports, banking institutions in the region should start preparing for far-reaching regulatory change and stricter rules that will, in all likelihood, severely impact their operations in Asia. Here are 3 practical steps that banks can take to pre-empt new regulation and prepare for change.

#1: Assess existing resources

Research firm Ovum found that senior IT buyers from banking are on the lookout for innovative systems and control solutions that improve efficiency as reforms increase operating costs. Technology spending throughout financial markets is expected to grow from $73.4bn in 2012 to $76.2bn in 2013. On the ground, however, banks are telling us they face constrained budgets and cuts to operating costs. A logical first step when responding to change, therefore, is to look to existing systems and resources to determine if they are capable of rapidly responding to regulatory change.

It is possible that the bank already has technologies in place that are ready to respond to change with minimal disruption. For vendor-led solutions, a farsighted vendor may already be investing in new capabilities ahead of the regulation being finalised. For in-house solutions, the solution may have been engineered in such a way as it is possible to add new controls and scale out the coverage.

However, with a history of underinvestment when compared to front-office technology, compliance technology is often characterised by inflexible point solutions that do not lend themselves to rapid and cost-effective enhancements. Program managers should look to get a clear view of how systems will need to change, as well as to identify available resources and determine if those resources can implement the change quickly. If the mountain is simply too sleep to climb, it is better to ring fence budget early and plan for a new program of work.

#2: Consider how actions by a regulator in one jurisdiction will impact your operations in other parts of the region

Unlike Europe, Asia is a highly fragmented market with more currencies, exchanges and regulatory jurisdictions. Yet, despite the fact that there is less regulatory integration, the actions of the Singapore authorities could easily cascade into the other markets. Banks will need to be prepared for similar compliance regulation in other markets, such as Malaysia, Indonesia, Thailand and the Philippines.

We have seen how the plethora of regulatory changes implemented by the MAS over the past few years – from Licensing and Conduct of Business to Financial and Margin Requirements Regulations – sets the benchmark and other regulators in the region soon followed suit. When this happens, it is the responsibility of the Chief Compliance Officer (CCO) to ensure that the company is compliant with laws, regulations and internal policies, while minimizing disruptions to operations as much as possible.

CCOs, therefore, should take an enterprise-wide approach to ensure preparations for change occur across the region. It may be necessary to escalate the business case for new compliance technology to the highest levels of the organization to ensure consistency in approach and funding for potentially large and international regulatory change programs.

#3: Acting on the change

When the regulators finally act, banks need to mobilize resources rapidly – both budget and people. CIOs should immediately start gathering internal support to ensure that they are prepared to comply within the timeline issued by the authorities.

Where existing systems are not equipped to respond to these compliance orders within the timeframe given, there is clearly a case for new technology. Firms will want to consider the extent to which new solutions can be customized and adapted to future change so as not to be in the same position when the next crisis occurs.

A pre-emptive analysis of the likely regulatory landscape and plan of action to respond to change will help banks map out their strategy for the next 12 months as they anticipate the actions of regulators. Furthermore, if an institution can demonstrate it has been proactive ahead of new regulation, it will likely be subject to less scrutiny from the regulator and have more runway to execute its plan.

By acting on the three steps above, CIOs, CCOs and managers will be better prepared to comply within the timeframe issued by the authorities as well as to minimize disruption to their operations. After all, the way to overcome the challenges of modern financial regulation is to future-proof tomorrow’s business today.

LCH.Clearnet Unveils Mandatory Clearing Checker and Regulatory Timeline

Thu, 04 Apr 2013 21:34:00 GMT

LCH.Clearnet added two new tools to their SwapClear website to help swaps market participants keep up with some of the latest regulatory developments. Click through the links below to try them out:

The Mandatory Clearing Checker provides a quick hands-on test to see which interest rate swaps are mandated for clearing in the U.S. by the CFTC.

The Interactive Regulatory Timeline lets users quickly compare the major regulatory deadlines for derivatives reform in Europe and the U.S., as well as information on expected Basel III and CCPS-IOSCO developments.

LCH.Clearnet’s SwapClear is a 12 year old global clearing service for interest rate swaps. For more information on SwapClear, click here.

The Dodd-Frank End-User Experience: What’s Happening April 10

Thu, 04 Apr 2013 13:41:00 GMT

By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.
Originally published on Tabb Forum

When it comes to trade reporting, Dodd-Frank cuts some slack for end users, or non-financial companies using swaps to hedge business risks. But inter-affiliate swaps are not exempt from reporting requirements, and firms need to be prepared now.

One of the areas where the Dodd-Frank Act (DFA) and the ensuing regulations appear to cut some slack is for end users, defined as non-financial companies (a category that oddly includes small banks) using swaps to hedge business risks. The DFA and the regulations exempt end-user trades from mandatory clearing and SEF trading (whenever SEFs actually come into existence).

However, one area where end users are not exempt is in trade reporting. Granted, most market-facing end-user trades will be done with a swap dealer (SD); and for those trades, the SD has the reporting responsibility. There is, though, one other kind of trade that end users will have to report on: inter-affiliate trades.

This turns out to be a big deal for end users, because of the popular practice of doing financial market trades in a trading subsidiary and apportioning them internally to the various operating companies. This practice allows the end user to manage all its trading relationships through one entity -- for example, executing one trading agreement per counterparty as opposed to executing a separate agreement between each operating entity and each counterparty.

On April 1, 2013, the CFTC released a final rule exempting inter-affiliate trades from certain clearing requirements, but not from these reporting requirements. In fact, the rule says that the reporting party “shall provide or cause to be provided the following information to a registered swap data repository or, if no registered swap data repository is available to receive the information from the reporting counterparty, to the Commission, in the form and manner specified by the Commission,” and then lists a set of information to be provided for uncleared trades in addition to the regular reporting.

The reporting requirement is made worse by the fact that deliverable FX forwards are swaps for reporting and business conduct purposes. Although there may be a limited number of commercial companies that use traditional swaps, virtually any company that operates internationally uses FX forwards. Whether you are buying raw materials overseas, selling your product overseas, meeting an overseas payroll or borrowing in another currency, forward FX trades are part of almost every company’s daily business. And every time a company channels these trades through a market-facing subsidiary, it creates a DFA reporting requirement.

On the surface, this may look like overkill. After all, what difference do transactions between wholly owned affiliates make to overall market risk? That is the argument the Coalition for Derivatives End Users made in its February 26, 2013, comment letter to the CFTC, and in a January 29, 2013, presentation given on its behalf to the House Agriculture Committee staff by the law firm Gibson Dunn. In the letter, the Coalition points out, “Because end users use inter-affiliate swaps to manage the internal risks of the commercial enterprise and, hence, are able to net swaps on an enterprise basis, the number of inter-affiliate transactions can significantly exceed the company’s market-facing swaps, which adds to the reporting burdens on end users.”

There is no indication that the CFTC is planning to weaken the end-user reporting requirement for inter-affiliate trades (although they certainly could), so perhaps we should take a look at the actual impact of these trades on market risk. The first thing to understand is the impact of bankruptcy rules on counterparty exposure. History is full of examples in which one affiliate of a company filed bankruptcy while other affiliates did not, leaving counterparties to the bankrupt affiliate unable to access other resources. So anyone doing business with a market-facing affiliate would, one supposes, have a good understanding on that affiliate’s financial condition and resources. Otherwise, a counterparty might find itself holding the obligation of a thinly capitalized trading subsidiary that has defaulted while better capitalized operating subsidiaries operated behind a corporate wall. The CFTC may be mindful of this possibility in requiring the reporting of inter-affiliate trades.

We should also be aware of the global jurisdictional issues involved in derivatives trading. If a market-facing affiliate is in one jurisdiction -- say the US -- and the internal counterparties are in others -- say Europe and Japan -- the inter-affiliate trades do have an impact on the regulators. If the US’s rules on, or definition of, end-user exempt trades are different from the rules in Europe or Japan, and if they are different again between market-facing and inter-affiliate trades, then the inter-affiliate trades are important to the regulators.

And, finally, we shouldn’t be too trusting in the assurances that end-users only do swaps to hedge their risks, so that inter-affiliate trades are just tidying up a perfectly benign use of these products. The reporting rules aren’t made for the benign situations, but to catch the trades, or end users, that have run amok. And before we pooh-pooh that possibility, we should remember that Enron would probably have qualified as an end user at the time it blew up.

In the meanwhile, April 10 is literally just around the corner, so end users need to be just about ready to report their inter-affiliate trades. Fortunately, the CFTC has specifically allowed reporting through third parties, so end users that have an FCM can probably arrange their reporting through that relationship. And, also fortunately, this reporting requirement isn’t real time, because these trades aren’t available to the public. But relying on the CFTC to delay the requirement or water it down is very much a long shot. Your horse might come in, but you really need to be prepared if it doesn’t.

CFTC Shows Anticompetitive Behavior With Swap Margin Rules

Tue, 26 Mar 2013 14:10:00 GMT

By Neal Wolkoff, Richardson & Patel, LLP
Originally published on Tabb Forum

Another lawsuit may be headed the CFTC’s way over the implementation of Dodd-Frank rules, and the terror of administrative agencies, Eugene Scalia, may be filing it on behalf of Bloomberg. Mr. Scalia, a partner at Gibson Dunn, prevailed on behalf of ISDA in its suit challenging the CFTC’s imposition of position limit rules. He also beat back an SEC rule-making -- but I am not commenting on that; I’m just pointing out his success with the financial regulators.

This time, Scalia is representing Bloomberg L.P., which intends to launch a SEF (an exchange designed for the execution of swaps trades), but is objecting to the CFTC’s rules that would require interest rate swaps to have a margin requirement covering a possible price move over a five-day period.

Interest rate swap futures, and futures in general, do not have any CFTC margin mandate; instead, they have margins set by the exchanges, usually to cover a possible one-day price move. The additional collateral requirements for swaps would clearly cost investors more than maintaining a comparable position in interest rate futures.

Considering all the effort and fuss made by the CFTC and Congress to make sure that swaps are an “open access” market, unlike the vertically integrated trading and clearing operations of the major futures exchanges, this proposal would certainly drive business to the futures exchanges under a “closed access” model and hurt the new entrants to swaps executions that hope to compete.

And, in the case of interest rate swaps, the margin requirements for SEF-traded positions compared to exchange-traded positions does not make sense. Margins are put in place to protect the clearinghouse and its members from the default of another clearing member. Margin requirements are intended as a buffer to protect any clearing member, and thus the clearinghouse that guaranties that clearing member, from having to meet a customer’s loss with its own funds. The thought is that a futures contract can be liquidated immediately should the need arise. Of course, some futures contracts may be too illiquid to provide for quick liquidation of a failed position and should require more than a one-day margin coverage.

Interest rate swaps, on the other hand, are very liquid, and their economic risk can always be hedged with euro-dollar futures contracts should liquidity unexpectedly dry up. The risk, in other words, is less with an interest rate swap than with a thinly traded futures contract, yet the CFTC allows the futures contract to be margined at a far lesser level than the highly liquid swap.

The CFTC has, at best, a small body of direct experience in setting margin requirements, and it has rarely if ever intervened in an exchange’s margin decision. The CFTC’s blanket rule on swaps margins takes away the decision on proper margin levels from the clearinghouses, which really do have the expertise to evaluate risk and determine appropriate margin levels.

Bloomberg is looking to compete in the interest rate swaps space that Dodd-Frank envisioned opening to robust market competition. The CFTC’s one-size-fits-all margin rules for the swaps markets are indeed arbitrary, and show the agency pulling its punches when it comes to seriously laying the foundation to open the largest segment of the over-the-counter derivatives markets to competitive forces.

Celebrating ‘Dodd-Frank Day’

Fri, 15 Mar 2013 13:50:00 GMT

By Will Rhode, TABB Group
Originally published on Tabb Forum

March 11 was officially "Dodd-Frank Day" -- the day most active users of swaps in the US were required to begin complying with the central clearing mandate, arguably the single biggest pillar in the G20’s 2009 commitment to overhaul the over-the-counter derivatives market. It was a momentous occasion, the impact of which we can already observe.

Since last November’s announcement by the Commodities Futures Trading Commission (CFTC) of a timeline for the clearing of interest rate swaps, basis swaps, FRAs, overnight index swaps, and US and European index CDSs, two trends have started to emerge. The first is a visible uptick in client clearing for interest rate swaps. The second is a negative effect in credit default swaps (CDS) clearing – possibly the result of the so-called swaps futurization trend.

In terms of interest rate swaps, clearing at the CME has increased 59%, to reach US$904 billion in outstanding interest as of March 5. Meanwhile, at the two largest clearinghouses for CDSs in the US, the CME and ICE, clearing volumes have fallen since the CFTC’s November timeline announcement.

ISDA Makes Case for Non-Cleared OTC Derivatives

Wed, 13 Mar 2013 17:09:00 GMT

Just two days after the CFTC’s mandatory clearing rules for OTC derivatives went into effect, sparking a litany of industry commentary and a threat from Bloomberg to file suit against the CFTC over swap collateral rules, ISDA is out with a paper making the case for the role of non-cleared OTC derivatives in the global economy.

The paper lends some industry support to the premise that onerous collateral requirements could ultimately harm the swaps market. In its press release, ISDA writes:

The International Swaps and Derivatives Association, Inc. (ISDA) today announced the publication of a paper, Non-Cleared OTC Derivatives: Their Importance to the Global Economy.

The non-cleared segment of the over-the-counter (OTC) derivatives market includes many important products with significant value to the economy. These products enable industrial companies and governments to effectively finance and manage risk in their operations and activities and help pension funds meet their obligations to retirees. They help support economic growth by enabling banks to lend to corporate and individual customers. They play a vital role in virtually every industry – from financial services to international trade to home mortgages.

Current regulatory proposals regarding margin requirements for non-cleared OTC derivatives pose significant threats to the continued functioning of this vital market segment. Such proposals also fail to fully consider the lessons learned regarding margin practices during the recent financial crisis.

The paper explains what non-cleared OTC derivatives are, who uses them and why. It outlines the evolution of clearing in the OTC derivatives markets, why some – but not all – OTC derivatives will be cleared, the types and benefits of non-cleared OTC derivatives and the impact of the regulatory proposals in this area.

To download the full paper, visit the ISDA website by clicking here