From theOTC Space – CDS Futures | Can This Pig Sing?

CDS Futures | Can This Pig Sing?

August 14, 2013 by pttmonitor 0 Comments

The $24.7 trillion Credit Default Swap market (2012 Gross Market Value, According to ISDA and BIS) is one of the last untapped exchange-traded derivatives markets.  The question remains is the market ripe for a CDS futures contract, or as Mark Twain famously put it, “Never Try To Teach A Pig To Sing.  It Wastes Your Time And Annoys The Pig.”  So, can this pig finally sing?

The InterContinentalExchange (ICE) believes it is the right time and launched a CDS Futures contract (Ticker: WIG) on June 17, 2013.  The contract is based on Markit’s liquid CDX.NA.IG 5Y series.  The contract is complementary to the current “on the run” OTC traded CDX.NA.IG 5Y swap as the futures contract is priced on the theoretical value of the next CDX.NA.IG series.  This “When Issued” structure creates an option valued on the next CDS series.  In other words, it is a vehicle to hedge near term macro-economic credit risk (as opposed to immediate term credit risk with an OTC swap).

The chart below shows trading in the Sep 13 CDS future.  Although less than impressive, it is important to look back to the introduction on US Treasury futures in 1976/1977 as a point of reference.


Initially, Treasury futures (and a sister GNMA future) were not a success.  When they finally launched, volumes were only a few hundred contracts per day.

Low volume on this new contract is not a surprise, given the “when issued” impact of the CDS future and the effect on final settlement.  Many counterparties may be on the sidelines until the new contract goes through the first final settlement.

Is Dodd-Frank & EMIR Equal To The End of Britton Woods?

OTC swaps and specifically CDS’ do not have a “Nixon Shock/end of gold standard” fracture with currency and inflationary volatility.  These waves of volatility served as the “tipping point” for currency and interest rate futures.  Like the currency markets of the early 1970’s, OTC CDS swaps are a custom forward market.  Thus, the CDS future is in many ways similar to currency futures as both vehicles create standard models for the exchange of counterparty risk.

As market forces will not drive the adoption of a CDS future, will regulation and regulatory pressures do it?  Title VII of Dodd Frank changed the execution, clearing, and capital structures of the CDS swap market.  Let’s take a look at changes in the OTC market as compared to the ICE futures.  First and foremost, margin and transaction costs are now highest for customized products and lowest for standardized exchange-traded products.

Category Bilateral Swaps OTC Cleared Futures
Liquidity Liquid Highest Liquidity Illiquid
Margin Highest, TBD Higher Lowest
Margin Calculations 10-day VaR 5-day VaR 2-day VaR
Transaction Costs Basel III Capital Requirements FCM and associated LSOC costs FCM Margin/Cost of Carry
Termination/Compression Intra-party and Compression Intra-party and Compression Exchange
Valuation and Reporting Intra-party Intra-party  & SEF Exchange

Dodd Frank, EMIR, and Basel III changed the rules but internal momentum is still hard to overcome.  Any OTC CDS futures development must be co-dependent with the existing OTC swap market.  Exchanges are the ultimate networked organization where liquidity begets liquidity.  Therefore, for the futures to gain liquidity, the following Tipping Point actions must occur simultaneously.

  1.  Outstanding rules and margins for non-cleared bi-lateral swaps must be completed and implemented.  This includes implementation of Category 3 participants in centralized swap clearing.
  2. Banks must decide (or be convinced as part of increased CDS market scrutiny) to utilize CDS futures.  This benefits banks on the Basel III capital requirements side and the overall CDS market in terms of transparency.
  3. For parties interested in hedging credit risk on a macro-level, substitution value of the CDS future must be greater than the disincentive of a new, riskier product.  In other words, the perceived opportunity cost of trading CDS futures is very high.

June 2013 was a volatile period.  Volatility was not just related to central bank intervention and QEIII discussions.  Operational volatility in the OTC market was the result of new rules and margins for Category 1 and 2 participants.  In hindsight, given the confusion around central clearing, market participants are still trying to adjust to the fluidity of new swap rules rather than eyeing a complementary credit risk solution.

In this context, it is important to not underestimate the gravitational pull of the existing swap market.  Traders, banks, and counterparties have underlying relationships with swap desks (and not necessarily with a futures counterpart).  Transacting with two desks lowers your relative importance in a market that depends on relationships.

So, can this pig sing?  Well, we don’t know yet.  Once the music director finishes writing the final score and the band makes an entrance, then we’ll know whether this little piggy has a market or this little piggy gets none.

Seth Berlin, Principal, Performance and Thinking Technologies

Seth Berlin is a Principal Strategist at Performance Thinking & Technologies (PTT).  PTT focuses on risk modeling, compliance, and investment operations for private funds.

Reuters – Swaps clients plan US bank exodus


NEW YORK, Aug 12 (IFR) – US banks are at risk of losing overseas swaps market share as European clients have begun making every effort to avoid getting caught up in costly cross-border derivatives rules that were finalised by the CFTC last month, and come into effect this October.

European hedge fund and asset managers are threatening to transfer their swaps trading activities away from branches of US banks and towards European competitor houses to ensure they avoid the reaches of Dodd-Frank, which mandates an array of costly compliance measures, including the central clearing of standardised over-the-counter derivatives.

Many European clients would rather ditch their US bank relationships than bear that cost – just one of the unintended consequences of bad rule-writing according to dealers.

“It’s the one rule that risks the most competitive disadvantage,” said a lawyer at a US dealer. “There’s no way these clients are going to clear with us at this stage.”

Swaps executed by a European client with the foreign branch of a US bank will be required to clear through a central counterparty starting on October 9 – the date that an exemption from compliance with the CFTC’s recently finalised cross-border guidance will expire.

US banks say the deadline is unreasonable and compliance will be near-impossible. And at least one of the CFTC commissioners sympathises.

“My frustration has consistently been with the Commission establishing arbitrary dates that we pluck out of thin air to establish compliance without asking, ‘is this possible?'” said CFTC commissioner Scott O’Malia.

“The cross-border guidance should have required notice and a comment period to find out if the time periods for compliance are adequate. We claim to be having a comment period but I suspect that anyone who does so will have their comments completely ignored.”

Conversely, the October clearing deadline comes two months before the CFTC forces US branches to comply with the rest of the agency’s transaction-level requirements, such as trade execution, documentation, and real-time public reporting.

“The CFTC is asking us to pull a rabbit out of a hat,” said an executive at the London branch of a US bank. “They have offered ‘substituted compliance’ but the European rules are not even done yet. Nobody in their right mind thinks we can demonstrate substituted compliance by the deadline.”



For end-user clients, mandatory clearing can be a costly business. Clients must negotiate and document relationships with clearing houses and clearing member banks, and are required to post initial margin against all swaps that are passed through the system.

The CFTC guidance provides that foreign branches of US banks could apply to substitute their home country compliance for US rules in cases such as these if the rules were considered “comparable and comprehensive”.

It is likely to be the longer-term answer for most European branches of US houses, but the European rules for clearing are not yet finalised, leaving nothing concrete for comparison.

Some banks are moving to plan B, which involves transferring all client relationships from their foreign branches to affiliates – a separate legal entity that would protect European funds from the clearing mandate.

But that would not be easy, considering that firms such as JP Morgan have more than 10,000 clients booked through their UK branches.

“There are a number of impediments; it’s very difficult to move clients to another legal entity. Plus, many of those affiliates have regulators of their own who will raise concerns about wholesale transfers of clients,” said the lawyer.



US banks say they have sent the Commission requests for an extension to the deadline, by way of no-action relief or some other format. Given the Commission’s penchant for issuing no-action relief – the agency has issued more than 100 in connection with Dodd-Frank to date, a pushback of the compliance date seems possible – if not likely.

If history is anything to go by, the CFTC is likely to keep the industry in suspense until the eleventh hour.

“There’s no rhyme or reason for how the no-actions are issued,” said O’Malia. “It creates a confusing ad hoc process that leaves a lot of people trying to understand a lot of moving parts when we are not following the Administrative Procedure Act. We’re using and abusing the no-action relief system.”

The development represents another trough in the often tumultuous process of aligning cross-border implementation of new rules for the OTC derivatives market between Europe and the US.

For the past two years, US banks have been warning that the CFTC’s hurried pace in implementing the rules of Dodd-Frank would put US dealers at a competitive disadvantage.

Just over a year ago, the agency issued proposals that would have forced branches of US banks to comply with all transaction-level requirements in July of this year.

But European entities and US lawmakers levied heavy criticism of CFTC chairman Gary Gensler’s approach to international harmonisation of derivatives rules.

In response, Gensler pledged closer co-ordination with European regulators in a joint statement with the EC’s internal market and services commissioner Michel Barnier just before the original proposals were due to take effect.

The scaled-back proposal reduced the CFTC’s powers in determining whether foreign regulations could be substituted for US rules and issued no-action relief for most requirements until European regulators could catch up.

But the proposal may still have over-reached, according to banks. Whether the US banks are able to move their clients over to affiliates in time or the agency issues a no-action relief remains to be seen, but for the moment banks are facing a significant cross-border dislocation.

The EMIR Delusion

The EMIR Delusion
by Michael Beaton
DRS’ Michael Beaton explains the potential problems with counterparty classification under EMIR now and with upcoming regulatory obligations


Under EMIR, parties to OTC derivative transactions are classified as either:

• financial counterparties (“FC”);
• non-financial counterparties which have exceeded the clearing threshold (“NFC+”); or
• non-financial counterparties which have not exceeded the clearing threshold (“NFC-”).

Whilst primarily used to determine whether a counterparty is subject to the obligation to clear, in reality a number of different EMIR requirements can apply depending on the exact counterparty classification. This poses few practical problems with respect to the sell-side as the definition of “financial counterparty” is relatively static in nature. However, classification as an NFC+ or NFC- is a function of the gross notional value of derivatives contracts executed by the party in question and so is liable to change over time. Unfortunately, the impact of the consequences that flow from this fact are not restricted to the non-dealer community, highlighting the fact that understanding, confirming and monitoring of counterparty classification represents the first step in ensuring general EMIR compliance for both buy-side and sell-side firms – a step which many firms are yet to take.

EMIR Current Status

EMIR came into force on 16 August 2012. However, the regulation is, in part, an example of enabling legislation in which many of the detailed provisions are published in secondary legislation (in the form of regulatory technical standards (RTS) and implementing technical standards). As a result, many EMIR obligations – including those relating to reporting and clearing (generally regarded as the main focus of EMIR) – do not yet apply. Current estimates suggest that the EMIR reporting requirement is unlikely to take effect before 23 September 2013 (and then only with respect to interest rate derivatives and credit derivatives) and the first clearing of trades under EMIR is unlikely to occur before Q1/Q2 2014. Nonetheless, this should not be taken to mean that aspects of EMIR do not currently impact market participants or that planning for its implementation can be delayed. In reality, a number of EMIR provisions which require an understanding of counterparty classification are already in force and more are looming on the horizon, as detailed below.

EMIR Provisions Already in Force

EMIR Counterparty Classification Reporting

Under Article 10(1) of EMIR, from 15 March 2013, all non-financial counterparties (i.e. both NFC+ and NFC-) that enter into OTC derivatives contracts that exceed the clearing threshold must notify their competent authority. In practice, regulators such as the Financial Conduct Authority (FCA) require non-financial counterparties to notify both when they exceed, and no longer exceed, the clearing threshold.

Timely Confirmation Requirements

Under Article 11(1)(a) of EMIR, from 15 March 2013, FCs, NFCs+ and NFCs- have been required to put in place documented policies and procedures with their counterparties to facilitate the confirmation of non-cleared OTC derivative contracts within specified deadlines. The exact deadlines are a function of transaction type, the date upon which the transaction was executed, but also counterparty classification.

Unconfirmed Transaction Reporting

Under Article 12(4) of the “Risk Mitigation RTS” , from 15 March 2013, FCs are required to establish procedures to report, on a monthly basis, the number of unconfirmed OTC derivative transactions that have been outstanding for more than five business days. Whether a transaction has been unconfirmed for more than five business days depends on when it should have originally been confirmed, itself a function of counterparty classification.

Upcoming EMIR Obligations

Portfolio Reconciliation

Under Article 11(1)(b) of EMIR, from 15 September 2013, counterparties to OTC derivatives transactions are required to establish “formalised…robust, resilient and auditable” processes in order to facilitate portfolio reconciliation. Furthermore, pursuant to Article 13 of the Risk Mitigation RTS, the frequency with which any reconciliation must be performed is again a function of counterparty classification.

The Reporting Obligation

Under the RTS dealing with trade reporting , a number of the data points to be reported to trade repositories (as detailed in Table 1 of the Annex to the RTS) are a function of EMIR counterparty classification. For example, in reporting the “Financial or non-financial nature of the counterparty”, parties to OTC derivatives transactions are required to distinguish between FC and NFC status. Additionally, in reporting against the “Clearing threshold” field, counterparties are required to further distinguish between NFC+ and NFC- status. Finally, NFCs- are not subject to the requirement to report collateral, mark to market, or mark to model valuations, an exemption which implies an understanding of whether the reporting party actually has NFC- status.

The EMIR Delusion

Anecdotal and empirical evidence would suggest that the market is currently doing very little in the way of understanding, confirming or monitoring EMIR counterparty classifications. As of 14 May 2013, only seven entities had adhered to the ISDA 2013 NFC Representation Protocol, the purpose of which is to enable parties to amend ISDA Master Agreements to reflect their status under EMIR as FCs, NFC+ or NFC-. Moreover, the alternative solution offered by the British Bankers’ Association (see this blog post for more detail) seems yet to have been adopted to any material extent by the dealer community. Although there is some encouraging talk within the market regarding the creation of a central database to house EMIR counterparty classification data, by its very nature, this will take a significant amount of time to develop and will face many legal and logistical hurdles along the way.

The current situation will not be allowed to persist for much longer. Buy-side firms cannot simply avoid the issue or expect dealers to ride to the rescue. As per the ESMA EMIR Questions and Answers document, from 15 March 2013, NFCs which trade OTC derivatives have been obliged to determine their own status against the clearing threshold and notify their National Competent Authority accordingly. This can only be right given that the clearing threshold is calculated by reference to the total gross notional value of OTC derivatives executed by a party (calculated on a 30-day rolling average basis) – a metric that, in almost all circumstances, will be available only to the party in question and not to any single dealer.

For their part, sell-side firms must avoid the misconception that EMIR counterparty classification is entirely the responsibility of clients, that counterparty classification information will simply fall into their laps or that there is currently nothing that needs to be done once this information is acquired. The ESMA EMIR Questions and Answer document makes clear that dealers must obtain representations from their counterparties as to EMIR status. Once obtained, these may be relied upon unless the dealer is in possession of information which clearly demonstrates that they are incorrect. This implies both a requirement to make contact with clients for the purposes of initial classification and the establishment of a process to monitor continuing accuracy of EMIR status.

Once obtained, robust procedures will be necessary in order to govern the maintenance and use of counterparty classification data. In reality, it is likely that much of the obligation to report will be delegated, either to dealers or to third parties. As a consequence of this, the reporting party will understandably require trade counterparties to accurately reflect their EMIR status at all times. Moreover, the limits on the extent to which dealers can rely on client representations regarding EMIR classification implies a change of process in order to mitigate risk in this area. Similarly, changes in process will be required in order to comply with unconfirmed transaction reporting requirements, as even those regulators (such as the FCA) which do not require FCs to submit information unless requested, still require firms to have procedures in place to do so when requested. Timely confirmation and Portfolio Reconciliation requirements promise to go even further, requiring firms to apply counterparty classifications (and recognising that these classifications may be subject to change) in the context of executing potentially large-scale amendments to portfolios of derivative documentation.

Both FCs and NFCs need to act now in relation to client classification. The nature and impact of the EMIR obligations which reference client classification should be fully scoped. A remediation plan which makes realistic assumptions about the level of resource and timeframes required in order to implement change should follow. The process is unlikely to be quick or easy. However, the current situation will not continue for much longer and any firm that can show its regulator that it is making efforts to tackle the issue of EMIR compliance generally and counterparty classification specifically is likely to be in a much better position that those who continue to operate under the EMIR delusion.

What the ICE/NYSE Merger Means for the Industry courtesy of the TABB Group

With each passing day, the acquisition of NYSE Euronext by ICE seems more likely to receive final approval. Here are 5 ways the deal will impact the capital markets.

February 15, 2013, marked the end of the Hart-Scott-Rodino Act waiting period in the acquisition of NYSE Euronext by IntercontinentalExchange(ICE). With each passing day, the acquisition seems more likely to receive final approval. As we await the next phase of regulatory approval from the SEC, we wanted to share a few thoughts on how we believe the acquisition will impact current clearing, reporting and trading operations, as well as how the two exchanges can benefit from the merger.

1. Need for Physical Trading Floor

The future format of the NYSE trading floor seems to be on the minds of everyone. There are analyst speculations that ICE’s CEO, Jeffrey Sprecher, will close the trading floor, as was done to the New York Board of Trade in 2012 four years after it was acquired by ICE. However, according to interviews, Sprecher has expressed intentions to keep the physical trading floor intact.

[Related: “It May Be ‘Bye-Bye to the Big Board,’ But the NY Times Should Get Its Story Right”]

Both companies have robust electronic trading, and Sprecher has acknowledged the value of NYSE’s legacy in voice brokering. As technology continues to dominate the exchange space, there has been recognition of the value of voice brokering (by which the NYSE is defined). The market has ironically become too complex to rely only on computer-to-computer trading, showing the physical trading floor still provides an intrinsic value in keeping an orderly marketplace.

2. Impact on Clearing

US-based firms that are major players in the derivative space will benefit by having a local trading and clearing venue, through reductions in clearing costs and operational risks. Typically, coordinating multiple back-office processes and reconciliations between the US and UK calls for duplicate efforts, resulting in back-to-back bookings to flatten balance sheets and delays in handling breaks; having the ability to manage these operational processes will make for a more efficient process.

Title VII of the Dodd Frank Act, which requires central clearing for certain derivatives contracts, has limited NYSE’s presence in the US-based interest rate swaps clearing business. Currently, the NYSE has a small presence in the US-based interest rate swap clearing business, due to a lack of access to a central clearinghouse, now mandated by the Dodd-Frank Act. Through the acquisition, NYSE will be able to benefit from ICE’s presence in European fixed income derivative trading and clearing.

3. Impact on Market Participants

Reductions in clearing costs can translate into cost savings for market participants. Just last year, ICE had to increase its trading and clearing fee due to “regulatory burdens,” and with the merger of NYSE Euronext, ICE will also have to compete with other exchanges on transaction costs. Even if fees increase after the merger, market participants would still fare better than if the two companies operated independently. This newly merged exchange will be able to offer a larger array of products and services, so that market participants can look to fewer companies for trading execution and clearing services, thereby decreasing expenses associated with initial client on-boarding.

4. Impact on Reporting

NYSE’s core data products make U.S. market data free and available, using consolidated tapes, giving transparency to last-sales price and quotes. It also sells its non-core data products to analytics traders, researchers and academics. ICE will be able to leverage NYSE’s experience in data reporting, as it looks to setup its own swap data repository (SDR), in order to meet CFTC mandates for real time swap reporting.

[Related: “Commissioner O’Malia Talks Derivatives Reform: Assessing and Improving the Change”]

ICE has already set up a registered SDR — and the ICE Trade Vault, which will offer both recordkeeping and reporting services for credit default swaps. However, as reporting requirements go live for additional asset classes, it will be necessary to offer data recordkeeping and reporting services to these as well. This is where NYSE’s existing core data products can benefit ICE.

5. Benefits in Merging of Exchanges

Although ICE and NYSE’s product offerings differ vastly, the functions of trading, clearing and settlement demands often overlap, and both are registered with the CFTC as designated contract markets. Efficiencies can be gained when these two exchanges tackle the requirements in swaps reporting and recordkeeping, external business conduct rules and documentation standards in this era of heightened standards for SIFI. As regulatory mandates increase the operating costs for exchanges, it is becoming prudent to explore additional mergers.


TMX Atrium has a wide range of customers including venues, buy side, brokers, clearers, ISVs, market data vendors.

TMX Atrium covers a wide range of the financial community.

Venue City Country
Alpha Trading Toronto Canada
BATS Europe London UK
BATS US Weehwken USA
BME Madrid Spain
BOX Secaucus USA
CBOE Secaucus. USA
CNSX Toronto Canada
Borse de Luxembourg Luxembourg Luxembourg
Burgundy. Stockholm Sweden
CHI-X Canada Toronto Canada
CHI-X Europe Slough UK
CME Chicago USA
Deutsche Boerse Frankfurt Germany
Direct Edge Secaucus USA
Equiduct London UK
FX All Weehwken USA
HotSpot Jersey City USA
International Sec Exchange New York USA
LMAX London UK
London Metal Exchange London UK
Match Now Toronto Canada
Montreal Exchange Toronto Canada
Moscow Exchange Moscow Russia
NASDAQ OMX (Nordic) Stockholm Sweden
Oslo Bors London UK
Nordic Growth Markets Stockholm Sweden
NYSE Euronext (Europe) Basildon UK
NYSE Euronext (US) Mahwah USA
Omega ATS Toronto Canada
Pure Trading Toronto Canada
Sigma-X London UK
TOM Stockholm Sweden
TRAD-X London UK
TSX Toronto Canada
Warsaw Stock Exchange Warsaw Poland

Futurised Swaps – Video of the CME and LCH Point of View at the CFTC Roundtable

Futurised Swaps – Video of the CME and LCH Point of View at the CFTC Roundtable
The CFTC had a large meeting to discuss futurised OTC products, below is a 15 minute extract of the full 6 hours where Kim Taylor (President of their Clearing Business) and Dan Maguire (President of Yorkshire, and a Senior in SwapClear US), speak about the topic.

Key points from Kim

Capital was insufficient to cover market losses in the crisis, leading to a spiral of margin calls and a bail out, Dodd Frank is the US approach to solving this problem
The DFA is one solution, to redesign the OTC market, and enhanced use of Futures is also a legitimate approach to the same goals
There are 40-50 ‘line items’ for Deliverable Swap Futures, meaning 40-50 distinct products
There were 60,000 ‘line items’ for Lehman in SwapClear. BH: I don’t count each slight permutation of an IRS as a distinct “product”, so an IRS based on ACT/360 isn’t so different from a swap based on ACT/365, in my opinion
The diverse set of line items in the OTC market prevents liquidity formation. BH: I disagree, true liquidity can be measured from market activity by looking inside MarkitWire / SwapClear, and then into the CME Deliverable Swap Future stats.
Compare turnover of trades to open positions, in futures the market rotates 25 times per year, in OTCs about 2.5 times (no background data provided)
There are an estimated 5m participants in the futures market, compared to 30,000 in the OTC market.
BH comments:
But do those 5m all trade deliverable swap futures? And would they step up to take the other side of a DSF when CME were trying to sell off a defaulters portfolio?
The SwapClear model mandates that surviving members must participate in the auction process, of which there are now around 70 corporate groups representing a large proportion of the whole swap market.
Are traders in DSFs obliged to participate in a liquidation situation?
The reduced number of line items means trade netting is an order of magnitude better in futures than OTC
BH: Both CME and SwapClear provide trade netting of OTC IRS in their CCPs, it’s relatively easy, although not intrinsic to the IRS product the way a future contract is
Methods of liquidation in Deliverable Swap Futures
Open market sale
Private negotiated sale
Competitive auction
For an OTC default CME only use a competitive auction, due to the different profile of an IRS portfolio
An FCM must post the minimum CCP margin, but can collect more if they wish
Key points from Dan

SwapClear contains 60-70% of the global OTC IR swap market
SwapClear has cleared $19trn of the $20trn buy-side Swaps anywhere in the world (i.e. other CCPs have only captured $1trn of buy-side business)
SwapClear clears $2trn notional per day, higher than implied by Kim perhaps
Also torn up $170trn of IRS (I assume he means in partnership with TriOptima / TriReduce)
Workflow for OTC is now more standardised, the flow from execution to clearing is much smoother
OTC products hedge non-standard risks – the raison d’être of the market
The portfolio at SwapClear when Lehman defaulted was 66,000 IRS in 5 currencies, $9trn of notional, maximum maturity of 30 years
30% to 40% of Lehman’s IM was used during the Default Management Process, the remainder returned to the estate of Lehman / their administrators
No-one in SwapClear lost a penny as a result (is that a US cent or an English 1p?)
Rate risk can be transferred and transformed, but doesn’t “disappear” so transmuting OTC Swaps into Futures will just move the problem, not solve it
Why would a $10m DV01 in exposure attract a 2 day VaR holding period on an Exchange, and the same risk as an OTC cleared product attract a 5 day holding period?
The key is: do you have access to liquidity in a default?
Shouldn’t the holding period in any market be derived from the liquidity [and other key issues in a default], rather than by top down regulatory mandate?
I cut Dan off slighty short on the video, sorry Dan.

My key points

You can download a spreadsheet of volumes of DSFs here:
More work needs to be done to relate the holding period on a VaR calculation back to the participants in the market, and conditions in a default.
Likewise the legal basis which obliges (or doesn’t) oblige folks to take a defaulters positions need examination
The point about DV01 above is worth more examination
Source videos, 6 hours long:

TESS Connect & Go overview including Customers list

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Interest Rate Swap Futures: Finally the Right Time (Source: TABB Group)

Interest Rate Swap Futures: Finally the Right Time
After three decades of increasing use of OTC derivatives for risk transfer, regulation is compelling market participants to turn to futures as capital-efficient, low-cost alternatives for generic risk transfer.

A History Lesson

After three decades of increasing use of OTC derivatives for sophisticated, customized and even generic forms of risk transfer (call it “swap-ification” of risk), the frameworks being implemented via Title VII and Basel III are compelling participants to migrate to more generic products for trading and hedging.

Market participants have begun turning to futures as capital-efficient, low-cost alternatives for generic risk transfer. Hence the new era of “future-ization.”

In the interest rate markets, competing swap futures recently began trading. While past initiatives for interest rate swap (IRS) futures have been unsuccessful, we think it will be a different story this time.

Many solid capital market offerings have not been successful due to poor timing or the lack of sufficient impetus for participants to adopt them. For example, Blackbird, a technology start-up, launched an electronic swap trading platform in 1999. The innovative trading platform leveraged technology in the IRS markets and could be considered similar to a present-day alternative trading system (ATS) or swap execution facility (SEF). Unfortunately, the timing was off: there was no compelling need or regulatory impetus driving dealers or participants to trade on the platform.

[Related: “Swaps Futurization: Issues, Debate, and So Many Open Questions”]

CME launched the original interest rate swap futures contract more than 10 years ago, but it never gained traction. While the product has obvious merits (as a cleared hedging alternative to mitigate counterparty risk), it has yet to attract sufficient volume or liquidity or use on a widespread basis. This can be attributed to a variety of factors at the time of launch. Cost (clearing cost and initial margin) was comparatively high relative to a swap. The future contract’s structure, which called for cash settlement and did not offer the same convexity as a swap, did not appeal to participants. Furthermore, existing market convention at the time, the use of CSAs to mitigate counterparty risk, was viewed as sufficient.

Transaction costs as measured by capital and margin are now directly related to the degree of customization offered by the product used. As depicted below, highly customized swaps that are not clearable will be most expensive and subject to CVA Var under Basel III, and will likely require 10-day Var calculations for initial margin (IM). Standard swaps that are required to be cleared will carry a 2% capital risk weight with 5-day Var IM and FCM imposed clearing costs. Futures will have significantly lower IM requirements, clearing and capital cost. This cost structure is no accident: it provides incentives for the use of generic and standardized products that can be centrally cleared and easily managed in a stressed or default scenario.

Accordingly, the introduction of new generic futures contracts, deliverable swap futures from CME and quarterly cash settled contracts from Eris, are likely to have cost-driven reasons for broad use. Both offer capital efficiency through favorable treatment, 2-day Var margining (at present, with 1-day Var likely in the future) versus 5-day Var margining for cleared swaps or Eris’ flex-futures. Participants have a choice between cash settlement (Eris IMM contracts) or swap delivery (CME contracts).

We do not see either contract replacing the swap market. Yet, both offer attractive, capital-efficient alternatives for generic risk transfer at a time when participants, particularly banks, face significantly higher capital and funding costs.

Factors making these instruments compelling alternatives to cleared benchmark swaps include: favorable capital treatment (for both the end user and clearing FCM); lower IM requirements; increased netting and margin offset with other listed products; and lower clearing cost. In addition, differences in execution requirements (key SEF/DCM final rules and core principals are still pending), including lower block trading thresholds, may result in greater flexibility for futures execution relative to swaps.

Futures contracts also offer operational benefits relative to cleared swaps. These include ease of termination, no need for compression and the ability to use existing infrastructure and technology. The use of futures may allow some participants to avoid some, or all, of the new swap market regulation. These advantages are augmented by participant’s familiarity and comfort level trading futures contracts electronically.

Working against these contracts is the cost of rolling a hedge forward and the lack of current trading volume and liquidity.

Expected Evolution of the IRS Markets

As the swap markets become more electronic, we expect both swaps and swap futures to trade side-by-side.

The evolution toward futurization is the result of cost differences of trading products with similar risk profiles. Regulation has created economic incentives to transfer generic risk through generic products. Using a customized product, such as a swap, to take a directional view on rates or swap spreads will no longer be the most cost-efficient way to express that view. While many see this as the futurization of the swaps markets, it is actually the reversal of the swap-ification of generic risk transfer.

Who will trade these products?

Dealers trying to balance their cleared swap risk positions at CCPs, particularly as alternatives to cleared swaps for non-cleared end-user transactions

Participants seeking an interest rate or swap spread position that do not want or need the customization of a swap, nor the need for unwinding and/or compression

Participants seeking to maximize nettable offsetting risk with other futures products

Participants that actively trade the markets (HFTs, arbitrage players, etc.)

Firms wishing to operate under a single regulatory framework

Smaller firms frozen out of FCM clearing access
Why now? As the clearing mandate phases-in (and subsequently the trading mandate), the costs involved will become tangible and begin to accrue. Firms will adopt strategies that minimize the all-in cost of a transaction over its expected lifecycle. This will include execution-related cost as well as funding. We expect firms to reevaluate the criteria used in their hedging programs and to more closely consider the costs and benefits between acceptable basis risk and the “perfect” hedge.

When will volume grow? Likely over the same phase-in period.

As seen in the chart below, current volume in the 5 Year Deliverable Swap Futures contract is rather modest, although not that different from the early days of the Treasury Bond contract, which averaged just over 200 contracts per day in late 1977/early 1978.

The realistic potential trading volume for IRS swap futures is significant. Recent daily activity in the benchmark 5- year IRS averaged around US$10-15 billion notional reported to DTCC (spot starting 5-year IRS contracts only). It is plausible, if not likely, that a significant percentage of this generic risk transfer could easily migrate from swaps to futures (in addition to volume from futures traders, speculators, and other ISDA and non-ISDA participants). These are conservative estimates but illustrate baseline market potential.

So while swap futures in the past have not gained traction, the market environment today is ripe. There is clear impetus for firms to adopt risk-equivalent, low-cost alternatives to cleared swaps. The economic incentives hold true for banks, swap dealers, speculators and end users alike. The evolution will continue as risk transfer migrates to the most efficient and lowest-cost products. In many cases these are likely to be swap futures contracts.

The rules of the game have changed. In response, participants will change the way they play.

In the end, the swap futures contract failed to generate discernible volume and liquidity because there was no compelling reason for participants to trade the contract. To the contrary, IRS liquidity concentrated in the inter- dealer market, combined with the relatively low cost of trading swaps in terms of capital, margin and execution cost, proved superior.

There were compelling reasons to turn to the OTC markets to transfer risk. The swap markets offered a highly liquid market for participants to transfer risk, both in customizable and generic terms. The depth and liquidity of the IRS market, created by customized end user hedging, made it the more attractive market for generic risk transfer.

Back to Today

Title VII of the DFA changed the rules and market structures for the OTC derivative markets. Basel III similarly altered the quantity of capital needed and its associated cost for banks and financial firms. The cost structure for OTC derivative transactions has changed dramatically, in addition to changes in methods of execution and post-trade requirements. These factors will affect market participants (both directly and indirectly) through their reliance on bank dealer liquidity as their trading counterparty.

To write, or not to write? – The Dilemma for ISVs and their role in the success of a new trading platform,

To write, or not to write?

12 February 2013

Nasdaq’s new trading platform NLX is gearing up for launch in London. Sentiment is shifting in favour of the prospects for the MTF. This highlights the dilemma for ISVs and their role in the success of a new trading platform, argues William Mitting.

Six months ago you would have struggled to find anyone in London who thought that NLX, the new London-based exchange from Nasdaq OMX, would succeed.

The prevailing wisdom was the plan to launch six interest rate contracts replicating the most liquid on Liffe and Eurex was too simplistic, the margin efficiencies intangible and the distraction of regulation and rising costs elsewhere too great to guarantee the involvement from the banks and prop trading firms that it needs for a successful launch.

Today all the talk in London is of NLX. After six months of painstaking road-showing and collaboration with local participants by Charlotte Crosswell and her team at NLX there is a real buzz about the launch around the City.

Much of that buzz is coming from the proprietary trading houses. Attracted by the lower fees, the lower participation from HFTs expected on the platform and the belief that the banks, who are expected to benefit from the margin efficiency enabled by portfolio margining across the yield curve, will provide liquidity, London’s largest prop houses are increasingly talking up the prospects of the MTF.

This rapid shift in sentiment poses a challenge for those ISVs who made the call not to write to the MTF for its launch. The highest profile among those ISVs is Trading Technologies, which is not expected to be ready for the launch of NLX.

FOW understands that TT has been in negotiations with NLX over writing to it but has not yet reached agreement on how that will be funded. TT and NLX declined to comment on any negotiations. Initially this was widely viewed as a significant blow to NLX’s chances, but as the buzz around the platform grows, some are asking if TT has made a mistake.

Jeff Mezger, head of market connectivity, told FOW that TT had “not ruled out connecting to NLX” at its launch and see the benefits of margin efficiency but was currently focused in-flight projects such as the connection to Eris Exchange and its beta stage MultiBroker platform.

“We take into account a number of factors when prioritising the projects we work on. For exchange projects we take into account exchange location, familiarity with the exchange platform, connectivity costs, client interest, exchange volume, asset classes, products traded and the changing regulatory environment.

“We also take into account what other projects we have in flight and the availability of resources to work on the project.”

This dilemma of whether to connect to a new trading platform is a relatively new phenomenon in derivatives markets but will become more of an issue as new platforms launch in the wake of industry efforts and new regulations aimed at opening up competition.

All ISVs have limited manpower and resources to write to new platforms and the decision of whether to do so is often made with little visibility as to whether that platform will succeed.

Usually one or a number of customers will help to fund the connection, sometimes the platform or exchange will pay the majority of the cost and for “dead certs” the ISV will fund it in the knowledge that it will see a return on investment. However, what constitutes a dead cert is becoming less clear as markets proliferate.

Steve Grob, director of group strategy at Fidessa, said: “The whole dynamic of ISVs connecting to venues has changed since Mifid was introduced back in 2007. Volumes that were concentrated in two or three exchanges were spread over multiple platforms.”

This altered the economics of connectivity as it meant that brokers were having to spread the same volumes over multiple venues and this inevitably led to downward pressure on gateway pricing. At the same time, the number of platforms launched with uncertain prospects is increasing.

When Liffe launched its Connect platform at the turn of the century, many ISVs wrote to it and made a decent return doing so. As the derivatives market becomes more fragmented thanks to Dodd Frank and EMIR, it is harder to predict which platforms are worth the investment.

“The challenge is picking the markets that have the best chance of success,” says Steve Woodyatt, chief executive of Object Trading, which will connect to NLX on day one.

Hamish Purdey, the chief executive of Ffastfill, which is also going live from day one, agrees: “It takes significant commercial judgement. Any ISV has competing priorities and the challenge is finding the ones with the greatest return on investment.”

For fledgling exchanges, a major ISV writing to it can provide a significant boost and it is not unheard of for exchanges to pay large sums to global ISVs to write to them. However, this is rare and in most instances ISVs must make a call on the commercial benefits of connecting to a new exchange.

The fact that the cost of switching to a new provider can be high means that if a large ISV does not write to an exchange, its customers, if unwilling to fund the connection themselves, are often left with no options and the decision not to connect can be contentious.

However, as competition grows in terms of connectivity providers and software-as-a-service operations makes the process of switching provider less arduous, a shift in sentiment in terms of the market’s perception of the need to connect to an exchange can potentially wrong foot ISVs.

RTS has announced publically that it will write to NLX from launch and FOW understands that Fidessa, Sungard, Object Trading, Stellar and Orc are also among those ISVs providing day one access.

TT and Marex’s STS are among the notable absences from day one trading (although FOW understands STS will be up and running shortly afterwards) but there is still some distance to run and TT could still commit before the launch date, which is expected for early Q2. However, the NLX example has brought to the fore a very modern dilemma for ISVs in the derivatives business.

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