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Category 2′s Mad Dash to June Finish Line

May 8, 2013 in Regulations, Risk | Permalink

There are only 33 days left before all the firms that the US Commodity Futures Trading Commission (CFTC) designated as Category-2 entities must central clear the majority of their over-the-counter (OTC) swaps trades and the next four or five weeks and it looks like it will be hellish for more than half of them.

Do not expect anyone working to meet this deadline to attend your Memorial Day barbecue or expect them to have any thoughts on summer blockbusters that opened before June 11.

According industry research firm Celent, 48% of buy-side firms are still looking for clearing or collateral management partners, 24% are almost ready to meet the deadline and 28% are ready to clear trades and handle the new collateral requirements, according to data from the firm’s latest research report Maximizing Collateral Advantage.

Celent analysts interviewed more than 25 Tier-1 (30%), Tier-2 (33%) and Tier-3 (37%) buy-side firms based in Europe (33 %), North America (33%) and Asia (26%) for this study.

A Celent analyst shared these findings during an industry round table on strategic margin management, which Omgeo and DerivSource hosted yesterday.

Although the numbers sounds dire, one round-table attendee estimated that although Category 2 has more members than Category 1 or Category 3 but that those firms trade swaps only three or four times a year. He added that the market already clears most of the OTC swaps volume and has since March 11, when Category 1′s swaps dealers, major swaps participants and active funds began meeting their mandatory clearing obligations.

I’m much better at citing sources usually, but I needed to promise not to quote or identify participants or attendees directly to attend this no-press industry event.

Panelists and attendees also questioned the conventional wisdom that an estimated 2,000 counterparties will need to clear trades. Many thought the figure was closer to 600 and that 2,000 might have referred to sub-accounts, but not financial institutions or legal vehicles.

By the wee hours of June 11, most buy-side organizations will know how well they prepared for the CFTC deadline when the first margin calls start arriving. Those who did a good job of taking into account the added clearing and affirmation expenses will be fine. Those who had not are going to have some real uncomfortable conversations with their supervisors.

If you are in London and want to benchmark your firm’s preparedness against that of your industry colleagues, Omgeo and DerivSource will host the same event locally on May 23. It’s worth a look.

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SEF Operations Rules Delayed, Again

February 13, 2013 in Regulations | Permalink

For anyone who attended the TabbForum’s Fixed Income 2013 and heard CFTC Commissioner Scott O’Malia suggest that the industry may see the vote happen as early has mid-February, the news is a disappointment. At least there’s a bit of a silver lining in the news for us regulatory, market-structure and technology nerds – we will not ruin our Valentine’s Day by waiting for the voting results.

According to a report published by The Wall Street Journal yesterday, US Commodity Futures Trading Commission (CFTC) officials decided to move back the regulator’s vote on the operation rules for swaps execution facilities (SEFs) to March 1. Although that date is not carved in stone.

Whenever the CFTC releases the rules, whether in two weeks or two months, it will be a serious cluster… quilting bee.

I’m not saying this because I doubt the CFTC’s competence: The CFTC commissioners and staff are among the hardest working people in the industry. It is about delivering prescriptive rules for a brand new market structure that incorporates at least six electronic-trading models (request for quote last look, request for quote firm, request for stream, continuous stream, scheduled auction and central limit order book) as well as support for voice trading.

Most of the financial markets of which I can think grew up organically. The regulators did not come on to the scene until these markets had major issues, which required tighter regulation and oversight.

Now, however, dealers and their clients will enter this environment from a standing start. Not only will they have the challenge of learning the “rules of the road” while searching for liquidity across about 20 planned SEFs, they will need to deal with a rapidly changing landscape as the SEF market consolidates to a handful of facilities that can attract enough liquidity to stay viable.

It’s like being stuck in a car with a student driver who is trying to master the use of the clutch for the first time while stuck in bumper-to-bumper construction on an expressway. The only difference is that you’re putting millions of dollars at risk and not a few thousand for a new clutch and transmission.

The SEFs are the bastard children of the designated contract markets (DCMs) and over-the-counter (OTC) trading markets. Nobody wanted them, but everyone has to deal with them thanks to the OTC markets playing it fast and loose for several crazy years.

In all likelihood they will exist as a bridging mechanism trading a limited set of instruments as they pass from being OTC contracts to swaps-based futures trading on DCMs.

There’s been a lot of industry discussion about creating a level playing field between swaps and swaps-based derivatives trading since the instruments are “economically equivalent.” They might be highly similar, but they are not equivalent. Just consider the respective processes when on party cannot honor their trade obligation.

Also, should there be a level playing field between SEFs and DCMs?

Congressional intention of the Dodd-Frank Wall Street Reform and Consumer Protection Act was not to create a new financial market just for the thrill of it. It was to move a large amount of risk out of an opaque market to a transparent one.

The process has already begun in the interest-rate swap (IRS) market as the CME Group and Eris Exchange launched their IRS-based futures products at the end of 2012. As investors become more comfortable with these new instruments, DCMs will launch other offerings to meet client demand.

Yet, “swaps futurization” is not the only liquidity issues facing SEFs. There is not one single dealer that wants to see its high-margin OTC products trading on a SEF. This is why there is such a push to have the CFTC decide which contracts should be made available to trade on SEFs rather than the SEFs themselves. The regulators would take more time deliberating which contracts to select than an individual SEF operator looking to boost its trading volume, thus protecting a dealer’s OTC margin a little longer.

Eventually there will be two types of liquidity available on SEFs – the transient liquid instruments that DCMs will turn into futures contracts once and those less liquid products that have enough demand to warrant electronic trading but not enough to warrant similar futures contracts.

How long will it take for the swaps market to reach this expected level of equilibrium?

If I knew that, I would shut down this blog and live off an obscene amount of wealth some place where they have no word for snow.

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SEFCON III: Still Waiting

November 14, 2012 in Current Events, Regulations, Risk, Trading | Permalink

 

Why post a clip from director Peter Hunt’s 1972 movie version of 1776 in a blog post about yesterday’s SEFCON III conference hosted by Wholesale Markets Brokers’ Association (WMBA)?

I could not think of a more appropriate cultural reference that reflects the industry’s frustration and anticipation to have the Dodd-Frank rule making done and dusted. Besides, it’s a great movie that you should watch in its entirety anyway.

The original SEFCON 2010 conference was supposed to be a one-shot deal that brought interdealer brokers together to discuss implementing Dodd-Frank’s Title VII.

At the end of last year’s SEFCON II conference everyone hoped that regulators would finalize all the rules by SEFCON III.

Well, everyone was highly over-optimistic on that one. You could hear the audience roll its eyes as one moderator asked his panel what topics everyone would be discussing at SEFCON VIII.

The event’s speakers and attendees are some of the smartest people on Wall Street, but the answers to too many questions were “We just don’t know yet.”

I chalk it up to poor timing. The US Commodities and Futures Commission (CFTC) and Securities and Exchange Commission (SEC) finalized a number of new rules over the past 12 months, but they are far from finalizing all of Dodd-Frank’s rules.

At least there was a lot of novel discussions on swaps “futurizaton,” thanks to recent actions by the CME Group and the IntercontinentalExchange. Few people thought that the trend would go beyond the energy market, since energy swaps were originally look-a-likes for energy futures.

CFTC Commissioner Scott O’Malia, who moderated one panel, shared on piece of good news when he acknowledge that the CFTC staff recently finished work on the latest five rules, but couldn’t share the details yet. Fellow CFTC Commissioner Bart Chilton, also in attendance, shared his optimistic view on the pace of rule making given its scope.

The audience even heard from two members of the US House of Representatives’ Committee on Financial Services, Scott Garret (NJ5-R) and Jim Himes (Conn4-D), who promised bipartisan effort to clarify Congressional intent for Dodd-Frank.

However, I expect a slowdown in rule making during the lame duck session of Congress as both parties try to avoid taking the US over the fiscal cliff.

After they accomplish that, hopefully, President Obama needs to appoint a new CFTC chairman as Gary Gensler’s terms ends on January 20, 2013.

No one knows how long the confirmation process for the new chairman will take, which means the CFTC could be without its tie-breaking vote for months and further hampering rule making.

I really hope I’m wrong on this one.

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CFTC’s Gensler Testifies on Increased Transparency

July 17, 2012 in Current Events, Regulations | No comments

The fallout from Peregrine Financial Group continues as US Commodity Futures Trading Commission (CFTC) chairman Gary Gensler testifies before the US Senate Committee on Agriculture this morning, where he identified the regulator’s plan to improve the protection futures commission merchant (FCM) client funds.

According to his published statement, available on the regulator’s website, the CFTC approved a set of rules proposed by the National Futures Association (NFA) regarding improved controls for segregated and Part 30 secured accounts.

The Chairman also would like to increase transparency by letting self-regulatory organizations (SROs) and the CFTC electronically access FCM bank and custodial accounts without prior FCM permission as well as having the FCM provide clients with details on where and in what fashion their assets are held. He also suggests that the CFTC should consider enhancing the controls on how FCMs handle customer accounts and creating new rules on SRO’s requirements for conducting examinations and audits.

These suggestions might prevent future Peregrine and MF Globals from happening, but what are the chances that the regulator would be able to capitalize on these changes? Chairman Gensler points this out in his testimony.

 

The Commission’s limited resources have historically not allowed for direct oversight of FCMs.  There are 46 staff members, including 35 audit staff, on the CFTC’s examinations team who oversees four SROs, which in turn have responsibilities for more than 1,000 entities.  On top of the current lack of staff for examinations, our responsibilities are expanding to include reviews of many new market participants.  For instance, there are currently 115 FCMs, and staff estimates a similar number of swap dealers will ultimately register.  More frequent and in-depth examinations are necessary to assure the public that firms have adequate capital, as well as systems and procedures in place to protect customer money.  Greater coverage by regulators – like having more cops on a beat – will improve integrity and heighten the deterrent effect of the review process.

 

Is it me, or does this situation spell  ”systemic risk” in 18-point bold lettering?

It would be nice to view Peregrine and MF Global as individual incidents, but they cannot. These are the results of years of poor regulatory oversight of the industry. Or to quote the Wizard of Omaha Warren Buffet, “It’s only when the tide goes out that we learn who has been swimming naked.”

I bet in the weeks and months ahead we will see more damp, flabby backsides flapping in the wind.

Don’t lay the blame at the feet of the CFTC as some do. The CFTC staff is among the hardest working professionals in the regulatory space. It’s weakness, along with its sibling regulator US Securities and Exchange Commission (SEC), is that it is not self-funded or partly self-funded.

Every year the US market regulators traipse up to Capitol Hill and pitch their budgetary needs and that’s when politics really where politics truly makes an unholy mess of it. As a result, the regulators tend to get just enough funding to cover some basic necessities but not near enough to keep up with the rapid evolution of the market.

By keeping the regulators on a short fiscal leash, the US Congress allows firms to continue to swim naked at the peril of the entire financial market.

 

 

 

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You May Be a High Frequency Trader If…

June 22, 2012 in Regulations, Trading | No comments

Earlier this week, one of the Technology Advisory Committee (TAC) working committees presented the US Commodities Futures Trading Commission (CFTC) a proposed four-point definition of high-frequency trading.

It’s important to remember that this definition is nothing more than a recommendation to the CFTC. As CFTC Commissioner Scott O’Malia stated publicly in the past, the working group’s definition will be the straw-man definition that will spur industry discussion and lead to an eventual regulatory definition.

According to the working group members, their goal was to keep the definition broad enough to capture any future practices within the existing definition and avoid narrow language that might lead to regulatory arbitrage.

Given the rise of high frequency trading has forced more firms to focus on market data and trade messaging latency as well as algorithmic execution like never before, how do you know whether your strategy would be considered high frequency trading under the proposed rule?

Here is definition as the working group presented it to the CFTC:

 

High frequency trading is a form of automated trading that employs:    

(a) algorithms for decision making, order initiation, generation, routing, or execution, for each individual transaction without human direction;

(b) low-latency technology that is designed to minimize response time, including proximity and co-location services;

(c) high-speed connections to markets for order entry; and

(d) high message rates (orders, quotes or cancellations).

 

Most people in the industry would agree that all four points accurately describe high frequency trading, but it still leaves the regulators and the industry the challenge of turning a subjective concept into an objective definition. What qualifies as low latency technology, high-speed connections and high message rates?

Any fixed figure would be outdated almost immediately, which leaves regulators using fixed ratios to define high frequency trading. Yet the management, documentation and reporting of staying between those regulatory lines would be prohibitive to all but the largest firms with the deepest IT pockets.

The TAC has managed to grab the low-hanging fruit with its recommendation, now the hard work really begins.

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