Derivatives

vice president, SunGard’s capital markets business

Finally, a Trading Advantage from the Dodd-Frank Act

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This blog post was originally published on FOW.

The Dodd-Frank Wall Street Reform Act (the DFA) requires agencies to promulgate hundreds of new rules.  With the promulgation of these new rules, which generally require additional or different automation processes, come marketplace opportunities, including trading advantages that are often overlooked by those participants scrambling exclusively for DFA compliance.  This obscure rule change could lead to opportunities concerning the lifeblood of trading – data.

A primary goal of the DFA was to increase transparency in the formerly opaque swaps market.  The Commodities Futures Trading Commission (CFTC) issued a final rule imposing real-time reporting of transaction and pricing data and public dissemination requirements on registrants and registered entities for all publicly reportable swaps. Therefore, any arm’s-length transaction between two parties that results in a corresponding change in the market risk qualifies as a publicly reportable swap.

A publicly reportable swap transaction that is executed on or pursuant to the rules of a registered swap execution facility or designated contract market relieves the counterparties of an initial reporting obligation. Conversely, off-facility swaps are reported by a counterparty by means of a defined hierarchy, or alternatively by agreement.

In both instances transactional information must be reported to a swap data repository (SDR).  Significantly, in either instance the real-time public reporting rule drastically expands the content and amount of disseminated transactional information. Which also means that the potential visibility of transactional information, also know as tick data, provides new and potentially significant opportunistic advantages for those market participants that have direct data access and an active cross-structural position management system.

The final rule requires dissemination of publicly reportable swap transaction, pricing and volume data through electronic means in a non-discriminatory manner. However, the rule provides a significant exception, known as the embargo rule.

The embargo rule, enumerated under Title VII §43.3(b)(3) expressly allows a designated reporting party to, in addition to reporting to a swap data repository, directly disclose transaction and pricing data relating to a publicly reportable swap transaction if: (i) disclosure is limited to market participants, customers or counterparties; (ii) disclosure is made at least concurrently with the transmittal of such data to a registered swap data repository; (iii) market participants are provided advance notice of such disclosure; and (iv) disclosure is non-discriminatory.

Taken together, the exception allows access to potentially pre-publicly disseminated transaction data to virtually any party affiliated with a swap dealer or major swap participant; or a member of a swap execution facility or designated contract market.

The pre-disseminated data is valuable because swap transaction data reported to a SDR may be significantly slowed. This is true because in some instances a SDR may require additional or comparative information from the counterparties or facility prior to public dissemination, which slows the process and concurrently gives market participants a distinct data possession time advantage. Also, a SDR must, according to the rules, parse and withhold identifying information. This anonymity processing requirement, when applicable, likely gives market participants a distinct data possession time advantage.

The pre-dissemination advantage can be seamlessly leveraged by monitoring and managing real-time data with a configured trading management infrastructure capable of cross-asset inputs and a compilation of both exchange-traded and intricate over-the-counter (OTC) swap data into a single comprehensive platform.

While the agencies promulgate new rules, traders and market analysts will generally require additional, different or enhanced automation processes to leverage the new opportunities that result.

While you’re here…

vice president, SunGard’s capital markets business

Is Collateral Scarcity an Opportunity in Disguise?

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This blog post was originally published on TabbFORUM.

Collateral as a means of endorsing a promise is as old as human interaction itself. Collateral is even prescribed in the Bible as an ordinary business practice. In fact, a relevant verse of the Book of Exodus reads, “If you take your neighbor’s cloak as security for a loan, you must return it before sunset.”

Similarly to biblical times, almost all modern pledge practices require some form of collateral to enforce a promise. Unlike in biblical times, today collateral can be managed through interconnected repositories and facilitate real-time collateral management across products, counterparties, and regulatory requirements. This process is known as collateral optimization.

What is exponentially more complex today is that the types of acceptable collateral that may be pledged to enforce a promise are being limited – specifically for those promises known as swaps or derivatives. Changes in collateral useability are sometimes regulatory-imposed, and other times constitute a change in risk management practice. Either way, the result is a migration toward enhanced risk and valuation sensitivity that invariably fuels technology-based process improvements.

Today’s industry-wide dilemma is a combination of regulatory imposition and substantive changes in trading culture stemming from recent massive defaults. As a result, firms must deal with a consequence known collateral scarcity. Collateral scarcity is a relatively new concept that transcends almost every conceivable corner of the capital markets. Collateral scarcity by definition is simply a presumptive shortage in the amount of acceptable or purposefully useable collateral.

As collateral scarcity continues to evolve, market participants will likely perceive inherent and enhanced value from purposefully useable collateral. To that end, those firms with the tools and/or processing capabilities will likely view this as an opportunity. Conversely, those at risk, or those that cannot compete based on a lack of capacity, will likely complain and could miss the opportunity to evolve.

Some market participants have chosen to sidestep technology-driven collateral scarcity solutions by lobbying. For instance, market participants have been flooding regulators and designated clearing organizations (DCOs) with letters attempting to lobby their respective position. And while lobbying can be useful, firms must still recognize that even if the rules are modified, adjusted or revised, there will remain significant operational and functional challenges that need to be addressed –and most likely addressed with technology.

For instance, collateral optimization processing likely solves for the data storage and analysis of collateral reuse, concentration and inventory. Those firms that anticipate a faltering collateral supply or constraints on acceptable or purposefully useable collateral will make a clamorous shift toward technology-based collateral optimization that: (i) consolidates the global available inventory; (ii) understands current collateral posting requirements; (iii) takes account of current collateral postings; (iv) respects eligibility, haircuts, substitution rights and many other constraints; (v) allocates collateral against requirements holistically such that the overall funding cost of the collateral is minimized (iv) calculates collateral conversion scenarios.

For example, from a “quasi-regulatory” DCO perspective within the cleared swaps context, changes in the form and substance of acceptable collateral posted to a DCO places a qualitative burden to anticipate conversion scenarios. A collateral conversion scenario facilitates a holistic view of assets across products, classes and geographies, and provides an intelligent optimization mechanism that accurately quantifies a max-purposed collateral use. This is a distinct opportunity for service providers such as FCMs and asset managers as the source of these high-grade assets.

From a regulatory perspective, restrictions on collateral form and substance also perpetuate the collateral scarcity dilemma. For instance, on October 17, 2012, the SEC proposed that margin requirements for non-cleared swaps may only be satisfied by cash or securities and money-market instruments together with a collateral haircut. This is not a surprise and is generally consistent with ancillary regulatory guidance. Those securities brokerage firms that are not banks must hold in liquid capital a fixed percentage of any collected collateral and those firms that are banks must comply with the Basel III implementation standards both of which result in collateral scarcity that can only be mitigated through an intelligent optimization strategy. In the context of these mandates, if firms choose to complain rather than prepare, they could put themselves at a competitive disadvantage.

Firms dealing with the complexity of collateral scarcity require a collateral optimization engine that provides visibility and processing of collateral across all traditional business silos to maximize the efficiency of use of the global inventory and minimize the cost of funding of collateral. The system must account for tri-party collateral scenarios, disparate capital charge classifications, and enterprise-capable portfolio aggregation – which are all required under the joint rules.

For firms dealing in swaps, derivatives, repos, securitized funding and related transactions, collateral optimization has arguably emerged as the most pressing issue of 2012 and into 2013. Unless a firm’s trading activity has not evolved since biblical times, it will need a collateral optimization engine to remain competitive in today’s markets.

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vice president, SunGard’s capital markets business

Only the Beginning for Exchange and Clearing Innovation

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This blog post originally appeared on FOW. It was also covered in the John Lothian Newsletter.

As global regulators move to implement new rules designed to control the swaps markets, the world’s futures exchanges are responding with bold and innovative structural changes intended to reduce or eliminate certain regulatory burdens faced by their customers, including increased trading costs and additional expenditures associated with alternative risk management processing methods.

As a basis for the change, the Dodd-Frank Act and the subsequent regulatory definition of a swap expressly exclude futures and options on futures. As a result, on October 15, the Intercontinental Exchange (ICE) intends to convert an entire class of over-the-counter cleared swaps into listed futures. This change is meant to ameliorate some of the negative effects of the Dodd-Frank rule-based disparate treatment among swaps and futures, including higher margin costs. Through this action, the ICE effectively creates a hybrid instrument class that will trade, margin and clear as futures, yet concurrently adhere to the enhanced segregation and protection rules under the new swaps regime.

The new segregation rules, which generally apply to swaps pursuant to Section 4d of the Commodity Exchange Act, impose enhanced requirements onto brokers to segregate their customers’ funds to protect against fellow-customer risk that is inherent in the futures clearing model. The ICE has effectively answered this regulatory burden by modifying its rulebook and implementing structural efficiencies through the identification of a hybrid instrument class known as “covered product.” The ICE is contemplating a covered product that is functionally equivalent to a future/option and simultaneously receives the segregation benefits attributable to swaps. The introduction of the covered product also alleviates customers’ increased trading costs that are a likely result from the newly imposed gross margin rule.

Because the ICE as a designated contract market (DCM) may self-certify its contracts as futures, at first glance the transition to covered products look as though the ICE is attempting to circumvent or avoid swaps rules through a simple re-classification of its products, which under certain circumstances may be construed as evasion and would constitute a Dodd-Frank rule violation. However, the ICE swaps-to-futures transition, and concurrent introduction of covered products is likely compliant because the covered products anticipate being cleared through the Section 4d account, which explicitly satisfies the Dodd-Frank rule implementation. That is, although cleared and managed as futures/options, from a segregation perspective, the ICE is treating covered products as swaps together with the enhanced protections.

From an operational perspective, covered products also solve for what would be additional expenditures associated with alternative risk management processing methods. Accordingly, the CFTC Rule 1.73, which sets forth pre-trade risk management requirements, would apply to clearing members that are FCMs, and Section 23.609 would apply to clearing members that are SDs or MSPs. Under the rules, clearing members of a designated clearing organization (DCO) would be required to establish risk-based limits and trade compliance for each account based on position size, order size, margin requirements, and/or similar factors. This means that all participants – even those that are not involved in agency business – need to comply with Rule 1.73, with the requisite technology. Finally, the rule contemplates that only authorized trades within the parameters set will reach the market, providing the member firm is operating within a pre-defined limit schedule.

Although the CFTC has stated that it “envisions that each clearing member will comply with Rule 1.73 using procedures and technology appropriate to its business model and customer base,” by establishing and maintaining systems of risk controls reasonably designed to ensure compliance. However, trade origination complexity exposes many member firms to violations because of the source, method, or structure of the trade. Therefore, the move toward covered products and re-classification provides operational relief to the DCOs customers. This is true because covered products, such as those being introduced by the ICE, contemplate the continued use of an industry-standard pre-trade risk management and position monitoring system providing high-capacity control across multiple markets and products. Although the CFTC does not prescribe the manner of risk limits, it envisions member-based filters and configurations that can be set either to auto-reject orders or to notify the trader with an alert which may be adjusted to a particular market or product.

More significantly, the introduction of covered products and re-classification is a foreseeable trend, as other clearinghouses will likely provide similar relief and innovation. In fact, CFTC Commissioner Scott O’Malia said “the decision by ICE to speed up the transition of its cleared OTC energy contracts to futures reflects regulatory uncertainty, and is likely to be replicated by other exchanges.” The ICE has likely moved to modify its rulebook and re-classify its swaps contracts because market participants have expressed concerns about issues ranging from increased collateral demands, gross margin netting burdens, and inflationary trade costs, as functionally disruptive to the current state of clearing and trading activities.

Specifically, beginning on November 8, gross margin rules require that initial margin should be determined with respect to each customer position on the same basis that the clearinghouse would determine margin on the account of an FCM, thereby requiring market participants to hold these related positions in separate accounts with separate margin requirements. Therefore, the ICE seeks to preempt collateral demand changes and inflationary trade costs by introducing the covered product.

Additionally, and consistent with this trend, the CME Group is rolling out a new product called “swap futures,” in mid-November. In addition to independent trading viability, swap futures are intended to provide ancillary support to privately negotiated swaps that may trade off-facility, or possibly on affirmation platforms such as swap execution facilities (SEFs). Like the ICE’s covered product, the CME’s swap futures are hybrid instruments and seek to reduce initial margin costs by calculating on a portfolio or netted basis rather than the gross basis under the new rules. Also, swap futures are standardized to account for position limit scheduling and pre-trade monitoring on a multi-dimension level – including market, desk and individual client, as required by the rules, and without any additional risk management processing configuration.

Swap futures and covered products introduced by the world’s futures exchanges contemplate economic and structural innovation through products that are compliant, efficient and able to leverage industry-standard pre-trade risk management and position monitoring systems. As Dodd-Frank continues to drive change, it looks like this is only the beginning for exchange and clearing innovation.

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vice president, SunGard’s capital markets business

Can Bank Dealers Win the Swaps Collateral Optimization Race?

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This blog post originally appeared on Wall Street & Technology.

While the $270 billion of annual revenue that over-the-counter (OTC) securities and derivatives dealers collect from trading will likely fall by at least 20 percent once mandatory clearing becomes effective, new revenues driven by collateral optimization services for non-cleared swaps are likely to backfill that lost revenue.

Collateral optimization will allow dealers supervised by U.S. banking regulators – which we’ll call “bank dealers” – to operate under specific margin collection rules to collateralize non-cleared swaps, including segregation, calculation, and netting.  This is known as the joint margin proposal, which is margin collection-based. That is, it focuses on the margin collection responsibilities of bank dealers rather than the margin posting obligations of their counterparties. This is analogous to the authority, power and discretion provided to designated clearing organizations (DCOs) under the cleared swap rules.

Swaps that are not novated, or subject to the rules of a DCO, are generally referred to as “non-cleared.” Unlike cleared swaps where margin rules are governed by DCOs, non-cleared swaps, which comprise the majority of traded swaps today, will likely have their margin rules controlled by bank dealers through an interconnected series of straight-through automation processes.

Bank dealers, which are subject to heightened and enhanced oversight through prudential supervision, have the greatest potential upside in the development of this market. They are uniquely constrained by increased capital maintenance and exposure requirements prescribed by Basel III, and concurrently are best positioned by their interconnectedness, affiliations, and technological capabilities to build out compelling value propositions around their collateral optimization capabilities. In order to seize the potential revenues under the joint margin proposal, bank dealers will likely utilize a margin calculation and analysis engine that can model multiple scenarios of allocation of collateral between margin requirements across multiple business activities and trading books.

Collateral optimization services are positioned to serve as both key elements of a compliance mechanism purportedly satisfying the business conduct standards under Dodd-Frank, as well as a means to facilitate the non-cleared swaps marketplace. This is possible because the joint margin proposal states that initial margin may be calculated on a portfolio or netted basis rather than the gross collection requirement for cleared swaps. As a result, collateral optimization benefits can be recognized within and between commodity, credit, equity, foreign exchange and interest rate-based swaps – including economically equivalent swaps where an exemption from clearing may be asserted.

To be truly strategic, a dealer’s collateral optimization solution requires a straight-through approach linking pre-trade analysis, margin monitoring, collateral valuation and transformation, up to post-trade processing; all powered by sophisticated algorithmic models. For example, with these capabilities, a bank dealer can offer a bona fide end user optimization services analyzing its clearing options. This is accomplished by conducting a number of pre-trade “what-if” scenarios with different margin requirements, counterparty specific CSAs, netting benefits and possible capital charges to derive a total cost of trade that can be used in combination with its present value to recommend which counterparties would minimize collateral costs for a given profitability target. An example of the added value of this analysis would be whether to invoke an end-user exception, or not, and what if any, cost efficiencies exist. More value can be offered to the end-user by pushing a selected what-if scenario straight-through to the dealer’s execution services or if margin calculation and collateral optimization services are able to continuously rebalance the allocation of collateral. This would be an effective strategic collateral allocation service that could lead bank dealers to attract new customers and discover new revenue.

Bank dealers that use a collateral optimization solution that does not adequately support a compliance perspective, scenario analysis, re-hypothecation calibration, investment foresight, asset weighting, or risk analysis in an integrated manner will likely miss this business opportunity.

Alternatively, bank dealers that do not choose to invest in a model-based margin calculation and collateral optimization solution must instead rely on a table grid approach that conservatively sets margin requirements as a percentage of the notional amount of the swap. For these dealers the recoupment of lost transactional revenue is unlikely as customers are likely to look for dealers where their collateral will be used to maximize their market benefits.

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head of Valdi Options US, SunGard's capital markets business

The Time Has Come for Options Dark Pools

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This blog post originally appeared on Advanced Trading.

Many people think dark pools are a complicated concept. But there are three points about dark pools and the U.S. equity trading market that even a casual observer in the financial services industry will recognize:

1. Dark pools primarily serve the needs of institutional investors and traders who need to execute very large amounts of stock with limited price movements

2. Dark pool participants appear to place a premium on remaining anonymous – so much so that they’re willing to put an above-average amount of faith in the dark pool operator to protect the inner-workings of such a marketplace

3. Dark pools pose a tangible threat to the growth prospects of listed equity exchanges, based on recent assertions about how dark pools and other trading operations now make up 40 percent of equity trading volumes

Now perhaps you’re thinking, “Thanks for the summary, Russ. Gotta go.” But I’m not finished yet; my interest isn’t in equities. Equities are so 2008. In my world, equities are nothing more than a hedging instrument and an input to a pricing model. Options will be the playground for the trading community in 2013 and beyond.

And you know what’s going to grow options trading for the masses? Options dark pools. Yes, you heard me correctly.

I’ll give credit here to firms like Ballista and Pipeline as they initially put together the first iteration of what an options dark pool could look like. The only downside to these business models was the fact that after they matched buyers and sellers, the final options trades still needed to be executed on an exchange (as was and still is required).

In order to make options dark pools a reality, the industry needs structural change and regulatory approval whereby options dark pools could exist in a similar structure to how equity dark pools operate today. Crazy? Maybe. Controversial? Likely. A way to grow interest and increase participation in options trading? Definitely.

I have no major problems with the existing options exchange structure. We’ve heard the basic justification for exchanges on many occasions: clear and transparent markets, known entities, decent safeguard, etc. All reasonable points. However, isn’t it useful to shake things up a bit from time to time? Can’t the status quo be challenged every so often to keep an industry on its toes? Exploring a different yet viable way of doing things has a number of positive outcomes.

Dark pools for options would certainly change the options trading landscape, but it would not lead to trading Armageddon as some might suggest. Although options by their very nature are quite different from equities, that hasn’t stopped the options industry from incorporating aspects of equity trading into its own business practices. Decimalization, penny prices, maker-taker fees and other practices all got their initial traction in the equity space and eventually made their way into the options space. The options industry was legitimately wary as each type of equity construct made its way into options trading, but options traders eventually adapted.

Market participants will adapt to options dark pools, too.

What overall utility could options dark pools actually bring to the industry? Actually, a lot of the value in options dark pools would look surprisingly similar to those found in equity dark pools.

One of the biggest options industry gripes is that large traders can’t do trades in big enough size in listed markets. If set up intelligently, specialized options dark pools could be geared towards providing larger size to its participants with less price displacement. Also, if given a choice, many options traders would likely gladly take greater amounts of anonymity in their trades, especially since many trades (like spreads) have multiple legs involved. Next, true options dark pools would be the conduit for more high-frequency firms to join the options trading arena in greater numbers, as their trading models would likely be more easily accommodated. Lastly, options dark pools provide intriguing competition for the existing options exchanges and force all parties to hone their business strategies and serve their targeted customer niches with much more acumen.

Realistically, options dark pools will not be approved any time soon. In this Dodd-Frank era of regulation and compliance, the clear trend is toward more exchange-type trading, not less. If the options industry wants to continue to expand its volume and its visibility, however, it would be wise to once again follow their equity brethren’s lead and jump into the pool.

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general manager, Stream GMI, SunGard’s capital markets business

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IS PURSUING THE DODD-FRANK END-USER CLEARING EXCEPTION WORTH THE TROUBLE?

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The Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission, (SEC) in a much anticipated ruling, have approved the final definitions of “swap” and “security-based swap.” In addition, the so-called “end-user” exceptions have been finalized.

Swap participants seeking an end-user exception will generally applaud the decision that exempts them from submitting swaps for central clearing. However, these participants may be surprised to learn that the additional burdens of noticing, documenting, and reporting, may make that decision more burdensome than beneficial.

For instance, if a swap participant seeks an exception, it must first file a notice with the CFTC, and additionally provide proof that it is using the noted type of swap to hedge or mitigate qualified commercial risk. The exception-seeking swap participant must then notify the Commission of how it generally meets its financial obligations associated with the swap. And finally, there are ongoing reporting burdens that require an excepted entity to report to the Commission or to a data repository, on a swap-by-swap basis, or annually for reduced activity. If the exception is invoked, each exempted entity is held responsible to hold itself open to the CFTC for any additional information that is required. This information may include trade capture details, position valuation, risk modeling, settlement, or other relevant trade-related data that must be adequately maintained.

Notwithstanding the inherent credit and operational risks that exist in all bilateral non-cleared swaps, resource considerations are necessary prior to seeking approval for a clearing exemption.

The practical implication makes the invocation of an exemption even more uncertain. That is, although the margin rules are not yet finalized, and the proposed rules do not impose margin requirements onto non-financial swap participants, there is a conflicting requirement that certain swap participants must have credit support arrangements in place to govern the rights and obligations of the parties, including margin. And these swap participants have a heightened responsibility to manage their swaps activities.

Logically, these entities are likely the counterparties of those seeking an end-user exception. However, these entities have an independent duty, separate and apart from any exception consideration, to model and manage all swaps. The heightened compliance requirements will likely pass to those swaps entities that seek to qualify for an end-user clearing exception.

One must consider that once these costs, including trade life cycle technologies, are passed on to the exception-seeking swap participant, together with the additional burdens of noticing, documenting, and reporting, is the end-user exception really worth the trouble?

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trading and client connectivity, SunGard’s global trading business

THE STATE OF LISTED DERIVATIVES

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2011 saw the highest volumes ever recorded across the world’s listed derivatives markets. Despite some quieter early months in 2012, the longstanding volume growth trend still appears to be in place, led by the surge in commodity trading and by booming currency futures volumes. Several factors continue to drive this trend: wider buy-side market awareness, particularly in emerging markets, more flexible investment mandates at many firms, and the need to hedge against persistent cash market volatility.

But look more closely, and things don’t seem quite so rosy. Deal sizes are shrinking, driven in part by growth in the use of algorithmic trading strategies, and client demands continue to grow for DMA and algo access to an increasing number of global exchanges. Coping with these amid rapid changes in market conditions, such as the commodities boom, and in increasingly competitive conditions, is clearly no rest cure. And trading and clearing costs for the brokerage community remain relatively high: the pricing pressures due to inter-market competition in equities have not yet translated to the world of derivatives, with its proprietary contracts and vertical trading/clearing silos.

Adding to these direct business pressures, in the wake of the global financial crisis the derivatives sell-side is also receiving unprecedented levels of regulatory attention. The largest issues are of course those associated with global regulators’ drive to push OTC business onto electronic platforms and central clearing. As the OTC and exchange traded markets become more alike, we can expect significant impact on the way that brokerage firms structure themselves to address their clients and interface to trading venues. But while we wait for these changes to take effect, the primary regulation-driven focus in most exchange-traded brokerage businesses is on risk management.

This former Cinderella area of business operations is now central. Derivatives position risk forms part of firm-wide considerations, but two core issues are specific trading room concerns:

  1. Pre-trade risk management traps some major risks – including many erroneous and/or limit-breaking orders – at the most appropriate time: before they hit the markets. Responding in some cases to direct regulatory demands, many firms are extending and tightening their electronic pre-trade controls, with latency considerations ultimately determining how much it is practical to do before sending an order to market.Guidelines published by FIX Protocol Limited, recently updated and extended to cover futures and options, are a useful contribution to developing best practices. In Europe, the 2012 ESMA Guidelines for automated trading engines are also relevant: fortunately for firms striving to stay in compliance, the ESMA risk management requirements are broadly consistent with the FPL recommendations.
  2. The biggest issue in commodities is of course position limits. While legal tussles continue over the Dodd-Frank/CFTC rules, implementation may be required by year-end 2012, and we await ESMA’s crafting of the MiFID 2 principles into new European regulations.Full compliance with the CFTC rules in their current form implies assessing real-time global positions in a range of commodities: this will be very demanding for U.S. firms trading internationally and across multiple listed and OTC markets. There must be concerns about potential regulatory arbitrage as long as these rules are not applied worldwide.

Keeping up with all of this change is not easy. But it’s not only about compliance: it is enabling risk managers to win budget and resources for projects that they have long thought important or even necessary. The end result, one hopes, will be fewer concerns about business survival if we face another market meltdown.

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CAN FORMER POLITICAL HOTSPOTS BECOME OPPORTUNITIES?

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Investors have many tools at their disposal to overcome obstacles when they explore new and emerging markets. One factor beyond their control, though, is the political environment. Thus when investors search for new markets, they often skip over countries and regions that have even a hint of political unrest.

While this seems generally a prudent course, not all political and economic transitions lead to chaos or war. Some countries learn from their growing pains. They can develop stable democracies with thriving economies that harbor investment opportunities, including those for futures markets.

Of course, there are hotspots where political unrest has seemed to eclipse potential or even established trading opportunities. But, when a country passes the “healthy skepticism” test, is it time to consider them?

Take, for instance, South Africa and Indonesia, which are examples of where opportunities can flourish after major periods of political unrest.

While the politics of South Africa are evolving, so is its economy. Foreign investment has grown substantially in part because of the good business infrastructure, which includes the futures markets.

In 2001, the Johannesburg Stock Exchange (JSE) acquired the South African Futures Exchange (Safex), which resulted in a hub for equities and derivatives trading. (The JSE retained the Safex branding for the commodity and equity derivatives markets.) The commodities market provides price discovery and risk management for grains, precious metals and crude oil markets. The financial derivatives market offers a platform for trading futures and options.

Since the merger, the JSE has taken many steps to open itself up to international trading such as adopting the FIX electronic protocol for trading and working with third-party suppliers of hosted market connectivity. The JSE offers electronic trading, clearing and settlement in equities, financial and agricultural derivatives and other associated instruments.

Another former hotspot is Indonesia, which has youthful demographics, sustainable domestic consumption, and an $813 billion economy that is expected to expand by approximately 6% this year—roughly the same rate as 2011. For futures, there are two trading venues —the Jakarta Futures Exchange (JFE) and the Indonesia Commodity and Derivatives Exchange (ICDX), which serve as the trading venues for indigenous commodities. The JFE and ICDX are aggressive competitors, particularly in the gold and crude palm oil markets. The ICDX is also a trading venue for coal, natural gas, cocoa, coffee and tin. The JFE and ICDX support electronic trading and a variety of market connectivity options that provide widespread access for overseas investors.

While no indexes exist to help measure and predict political unrest, it is clear that major shocks to the political system will reverberate through the economy, including the futures markets. Some turmoil may even halt trading on the major exchanges.

Yet some of today’s hotspots could eventually become attractive investment opportunities once the political factors have settled into somewhat predictable patterns. When once tumultuous countries and regions stabilize, they are likely to need more foreign investors and, as long as there are opportunities, investors will oblige.

To make the most of those opportunities, investors will need good partnerships with stable trading and investment management firms on the ground. They will also need IT providers that know the region and have established inroads into the country’s current networking and IT infrastructure.

global head of connectivity, SunGard’s global trading business

CHINESE METALS

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This blog post also appears on Finextra.

Cross-border M&A among exchanges has proved difficult lately. The latest attempt, the purchase of the London Metal Exchange by Hong Kong Exchanges and Clearing, might actually go through - but with what result?

Hong Kong Exchanges’ bid for the LME follows several failed exchange merger attempts of last year (NYSE Euronext/Deutsche Boerse, LSE/Toronto’s TMX, and Australia’s ASX/Singapore Exchange). The bid is not transformational, as there is very little synergy potential – it is mainly one party bringing its target acquisition closer to its (almost) primary market. The LME sets the price for the vast majority of the world’s base metals and HKEx stands at the gateway to China, the world’s largest consumer and producer.

The price being paid is eye-watering: £1.388 billion is almost a 75% premium over the £800 million reported as NYSE Euronext’s bid before it dropped out of the running last month – though the ICE bid allegedly came very close. It values the LME at 180x net income and at 22x the last traded price for the exchange’s shares. It opens up HKEx to accusations of overpaying, but then again, how do you value something unique? The LME is comfortably the major center for the trading of metals derivatives contracts, with a global market share of about 80%.

The price and assurances on the maintenance of transaction terms and LME’s business model look likely to win shareholder approval – though could ICE try to disrupt the party as it did a few years back in Chicago? The approval of the UK regulator looks a little more complicated (political interference is possible, with yet another UK exchange passing into foreign hands), but may well be granted: the LME will remain under UK oversight, and HKEx has undertaken to maintain a robust governance structure (although this last promise might merit examination, coming as it does from an exchange which has six of its 13 board members appointed by the Hong Kong government).

In the wake of the announcement of the bid’s acceptance on Friday June 15, 2012, HKEx’s share prices tanked (though recovered some ground on Tuesday), indicating negative market sentiment that is partly due to the high price being paid, but may also signal concerns over the strategic issues that will determine the success or failure of the investment.

The HKEx strategy depends not only on the continued vitality of Chinese growth, but also on the loosening of rules that impede Chinese firms’ access to foreign exchanges. The determining factor may ultimately be the willingness of the China Securities Regulatory Commission (CSRC) to allow HKEx to compete on the same terms as the mainland Chinese exchanges. Small wonder, then, that we see nervousness reflected in HKEx’s share price.

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vice president, risk solutions, SunGard's capital markets business

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A LONG TIME AGO, IN A GALAXY VaR, VaR AWAY…

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This blog post originally appeared on FOW, and also appears on TabbFORUM, Securities Finance Monitor, and in the John Lothian Newsletter.

In recent months, there has been an interesting twist in the story of VaR, the central measure of market risk, capital requirements, and one of the targets of criticism in the aftermath of the credit crisis. Not much comment has been made of it, but VaR has been adopted as a key plank in the central clearing of derivatives, precisely because of its ability to produce a meaningful single number. This is ironic given that it was this single number, and its attendant lack of insight into the deeper tailed risks, that led to much debate about VaR’s suitability as the key metric, and the role it played in risk management leading to the crisis. And coincidentally, it seems the story of VaR is paralleled well by the journey of young Anakin Skywalker in George Lucas’s prescient epic Star Wars.

To fully appreciate the turnaround, it’s worth looking briefly at the origin of Value-at-Risk.

Obviously complex metrics have their roots in many areas, and tend to be cross-fertilized evolutions rather than single-point revolutions, and VaR is no different. What can be said though is that the emergence of complex derivatives and the growth of those instruments in the late 80s and early 90s did pose a problem for institutions looking to capitalize adequately for adverse market movements. This is not unlike the issue faced by the Jedi Council as they searched for the “one to bring harmony to the Force” at a time of growing tension within the Galactic Republic.

The financial industry’s risk problem was twofold. The increasing complexity of the derivative books created risks that were hard to quantify under traditional small movement measures. Simultaneously, the siloed nature of financial firms led to “natural hedges” (or risk offsets) between trading positions being lost in the risk aggregation. The result was an interesting problem where the risks were either being (vastly) understated or (vastly) overstated.

The answer, VaR, appeared a perfect solution to this twin-horned dilemma. By determining the sensitivities of all of the traded instruments at a firm, to a range of the most commonly observed drivers (interest rates, volatility, FX rates), the problem could be reduced to then using those sensitivities in a range or distribution of scenarios, itself determined by a correlation process across the observable market data, and finding the worst results at required percentiles (i.e. the 99th worst result). This was uncannily similar to the discovery of the gifted pod racer, Anakin, whose natural powers would be molded by his master-to-be, Obi-Wan Kenobi so he could become the future Jedi hero.

Determining this “parametric VaR” involved many approximations and smoothing, but was a huge step forward in the search for a number that best expressed the risk position of an organization.

Improvements in the underlying mathematics continued, as second order movement in the underlying risk drivers were added, but it was the exponential increases in computing power that paved the way for improvements.

The drawbacks in the parametric approach became obvious, and are well documented, so the next step was to move to full revaluation of the underlying trades under the distribution of scenarios. Two main avenues were explored and adopted: Historic VaR and Monte Carlo VaR. Historic VaR uses actual histories to directly create the scenario distribution, while Monte Carlo uses statistical analysis and correlation data to generate a range of possible future scenarios. Portfolios are then valued under each of the scenarios and the worst cases at specific percentiles are again found and reported.

It is at this high point, VaR’s very own “Battle of Coruscant,” that things start to go awry.

The aim of VaR was always that the “minimum loss that should occur, at the frequency of the percentile selected.” What this means is that the VaR number, when working, should never be a maximum loss number, but was always the minimum loss that the portfolio would incur at a frequency determined by the selected percentile (once every 100 days for 99th percentile). What was never intended was that this should be seen as an indicator of the losses that could occur with less frequency, but be far more devastating.

The very neatness, scalability and simplicity of VaR – its ability to capture so much complex information into a number – led regulators to pick it up and embed it as the risk measure, rather than a key risk measure. Once it was linked so completely with the capitalization demanded by the regulators in most jurisdictions, with the only choices left being which of the three VaR methods to use, its centrality in any subsequent crisis was all but assured. It was truly on the path to the “dark side.”

Once the crisis hit, and pre-crisis risk management was scrutinized with the crystal clear lens of hindsight, VaR was found to be imperfect. Many pointed out that it did not deal well with extreme events, deep tail risks, emergent risks and specifically regime change risks. This was not news to those who had conceived and/or used VaR for a long time, echoing master Yoda’s initial and ongoing misgivings about Obi-Wan’s gifted protégé. It was simply restating certain limitations that had always been caveats of the metric. The interesting thing is that even given the storm around the calculation, no suitable replacement could be found, a situation that remains to date.

Of course, the recent crisis was rooted in credit and liquidity. One of the driving changes across the world has been to take individual institutions out of the systemic default loop via the mechanism of central clearing. This most importantly covers swaps and credit default swaps.

Central clearing relies on daily margin calls by the central clearing agencies, so it’s natural that some kind of measure would be required to cope with complexity while delivering a single number that could be used for this margin. After analysis and experimentation, the most appropriate number was found to be…Historic VaR.

Value-at-Risk, the same measure implicated as a contributor to the credit crisis, was called forth to be the central tenet of the solution to that crisis. This is possibly the greatest twist of fate since Lord Vader rose from his knees to cast the emperor into the deep chasm running through the second Death Star.

Different clearing houses use different driving parameters, but the method remains the same. To experienced risk folks, none of the above is new, and is in fact a ridiculously abbreviated history of such an important metric, but it does show the unintentional irony of industry genuflections and trends.

May the Force be with you…

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