FTT: TO BE OR NOT TO BE?

Mark Hemsley, CEO of BATS Chi-X Europe, outlines his views on the likely outcome for the FTT in Europe.

The Financial Transaction Tax (FTT) has been cause for regulatory, legal and industry debate on a European and national level. Some ‘Tobin tax’ proponents have staunchly supported the need for a pan-European, homogenised approach to an equities (and derivatives) tax, in some cases politically motivated to compensate for the fallout caused by the 2008 financial crisis. Others have outright opposed the notion voicing concern about the real implications on liquidity and that the tax will ultimately hurt the end investors as the charges and market impact implications are passed along the order execution chain. There have already been national implementations in France and Italy, which are influencing the debate on the shape of the 11 country European FTT.

At the beginning of September 2013, the Legal Service for the European Council delivered an opinion that the Counterparty principle being proposed for the FTT Directive would be contrary to EU law. This is a critical finding.

The Counterparty principle proposed that any non-FTT zone counterparty dealing with another firm within the FTT zone would be liable to pay the FTT. This fundamentally changes the effect of the FTT since it would have to predominately rely on the Issuance principle (i.e. based on whether the security was issued in a FTT zone country). It also potentially changes the dynamics within the FTT zone group since the overall predicted FTT income is reduced and some countries may find themselves spending a lot of time and effort chasing tax revenues on behalf of FTT zone countries that have the highest number and turnover of “issued” securities.

We have always taken the view that it will be very difficult to put in place something consistent at a pan-European level when some countries object so strongly to its implementation. Even the enhanced co-operation procedure, which draws together the 11 FTT zone countries, may not be enough to reconcile the legal and operational complexities that need to be resolved for the FTT to be implemented on a multinational basis. Instead, we may be left with a national approach to implementing transaction taxes in any countries wishing to participate.

National legislators need to be cautious not to hinder the competitiveness in Europe and also hinder the competitiveness of Europe as a whole. We have already witnessed financial services firms holding back on their entry and investment into Europe because of uncertainties about the FTT. The general trend we have seen is a move away from trading equities in those countries with a FTT towards those that do not. Whilst the political objective of ensuring that the financial sector pays for the recent financial crisis still has supporters, the proposed FTT is a very crude approach since it will damage the equity markets. The equity markets continued to function well through the crisis unlike many other parts of the financial framework and the FTT does not touch areas of the financial markets where considerable problems were identified. We agree with Tabb Group’s summation that ultimately this will make trading only more opaque for the investor. The legislators must be careful what they wish for.

INCREASING TRANSPARENCY?

Anthony Belcher, Director of EMEA Pricing and Reference Data, at Interactive Data investigates whether regulation is driving increased transparency in CDS pricing.

The sheer volume of recent rule making in the US concerning OTC derivatives is compounded by the fact that, in some cases, the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) are advancing separate rules that while similar in substance, have nuanced differences given the types of instruments that each agency is responsible for overseeing.

With the introduction of European Markets Infrastructure Regulation (EMIR) there is no doubt that the combination of these regulations on both sides of the Atlantic will result in what were previously opaque OTC markets becoming far more transparent.

However, these rules are also creating a unique paradox. While they will facilitate access to trade-centric information, the wealth of new information poses as much potential to complicate the valuation activities of financial firms as help them.

The following describes some of the challenges resulting from this new landscape.

Thinly traded derivatives

One dynamic easily lost in the euphoric headlines ushering in a new era of transparency for OTC derivatives is that certain types of derivatives are, and will likely continue to be, illiquid. The US corporate bond marketplace outpaces the global volume of daily trading in single-name CDS by five times. The most actively traded CDS names traded only 10 times per day on average.

Consequently, while publicly reported trade data will be an important and necessary input to a derivative’s valuation, the relative dearth of trading activity on any given day is likely to require the use of methodologies and models that incorporate additional inputs.

Most firms will likely need to continue investing in their valuation processes, taking into account multiple inputs including, but not limited to, information such as dealer data (broader market colour and specific quotes), curves from leading interdealer brokers, reference rates and related trading activity from cash bond markets (in part, because the bond markets are more liquid).

Aggregating data for reporting

The ‘real-time’ reporting of derivatives transactions is one mandate that is prone to creating additional challenges for firms seeking to incorporate such data into their valuation processes. For example, the discrete fields that will be required for counterparties to report transactions to swaps data repositories vary from agency to agency, and the various regulators may use different terminology for the same data.

Beyond synthesising these details, there are also different timing requirements for reporting trade data, including delays on the reporting of block trades for example. In addition, the use of entity identifiers remains inconsistent; most dealers use their own proprietary IDs. While there is hope that the Legal Entity Identifier (LEI) initiative will alleviate this issue, gaining the global consensus necessary to implement this initiative is taking much longer than initially expected.

Consequently, it could require significant near-term investment to reconcile different IDs for the same entity if firms utilise multiple swap execution facilities, or aggregate publicly available trade information across multiple repositories, each with their own terminology, reporting requirements and timing idiosyncrasies. Given the lack of liquidity cited above, how will that investment be justified?

Pricing from clearing agencies

Another potential valuation issue for firms to navigate involves the role of clearing agencies, which will be tasked with, among other things, providing pricing and valuation information to help set margin requirements. In recognition of the illiquid nature of some of these instruments, it is appropriate to analyse what the valuation data provided by a clearing agency represents.

In this context, derivative valuations from an independent source, unaffiliated with the clearing process, may continue to be a valuable input. More specifically, having access to independent valuations – and the key inputs used to produce them – can help firms compare against required initial margins and changes to those margin requirements over time. With that additional insight, a firm can better evaluate its relationships with various clearing agencies and determine if capital has been committed efficiently.

In addition to the quality of the data provided by clearing agencies who perform central counterparty services, is the issue of when clearing agencies will deliver this pricing and valuation data to their counterparties. The timeliness of valuations from clearing agencies is an important issue, and while some asset managers and hedge funds may be indifferent to when they receive this data, other firms may have more stringent requirements. For example, a mutual fund, which has an obligation to calculate and publish a daily net asset value (NAV), could be subject to significant operational risk by reconfiguring its valuation processes to rely solely, or even primarily, on a clearing agency’s pricing data.

As a non-core activity for these agencies, it’s unclear if they will be able to provide valuations that meet the current standards for processes, controls and transparency that buyside firms are accustomed to. Buyside firms may need to undertake significant due-diligence efforts to understand if this information can meet its requirements for reliable financial reporting.

Scrutiny of valuations

Regulators and auditors have already begun subjecting the valuation process to greater scrutiny. For example, comments from the staff of the SEC and the Public Company Accounting Oversight Board (PCAOB) indicate an increased focus on the determination of fair value measurements used in financial reporting, particularly when valuations from third-party sources (including clearing agencies) are utilised.

In this context, audit procedures will continue to evolve in ways that emphasise that the preparer of financial statements is responsible for the valuation process and for understanding the techniques, inputs and assumptions behind third party valuations. Firms may need to re-examine their valuation processes in place in order to document and catalogue key inputs and methodologies used to support their derivative valuations.

Valuation process complexity

Regardless of whether derivative valuations are being used to set margin, calculate NAVs or support other compliance, risk management or financial reporting processes, gaining access to more trade information will not necessarily ease the valuation burden facing financial firms. As a more transparent derivatives marketplace takes shape, it will be important for firms to avoid being overwhelmed by multiple, potentially disparate and divergent sources of pricing and valuation information.

Firms that are striving to strengthen their valuation processes can ill afford to ignore these new information sources, nor can they become overly reliant upon them. Rather, they will need to thoughtfully modify their existing valuation processes and policies by integrating new information and new information sources. By doing so, they’ll maximise the benefits that regulators and market participants have envisioned.

THE NEW NORMAL?

PJ Di Giammarino, founder and CEO of JWG Group asks how long will it be until we see the derivatives market’s new equilibrium?

With ESMA having declared the US to be ‘conditionally equivalent’ with the EU, what does this mean for your OTC trading business? And how does this fit with the recent trade reporting delay?

Before 2008, world leaders were in talks about how to align the rules for a global marketplace. Then the crisis hit. What followed was a rush to find agreement at the highest level, so that leaders could return to their countries and get the ball rolling on their national regimes. The next four years saw rules fragment, as differences emerged between jurisdictions in timing and approach. Today, in 2013, institutions are living on borrowed time, with delays and no-action letters often the only thing standing between them and non-compliance. So what barriers still stand between us and a functioning derivatives market?

Extraterritoriality

First of all, we have the issue of extraterritoriality. In a world where trading has no respect for borders, there is clearly going to be an issue with which set of rules to apply. Some requirements attach to the entity doing the trading and so can be differentiated, but others, such as dispute resolution in the EU, apply to the trade and so affect both parties. This is especially difficult where the rules conflict between two jurisdictions, putting institutions in a Catch-22, and so require some kind of mechanism (which we will come to later) to reconcile two sets of rules.

However, rule makers, in an effort to insulate their own jurisdictions from extraterritorial threats to market stability, have introduced additional extraterritoriality rules. The EU, for instance, have produced standards on OTCD contracts that have an effect in the Union, and so will be subject to EMIR’s requirements. As currently drafted, this applies to branches of and entities guaranteed by EU institutions. But entities can move over or under the guarantee threshold and it is not clear whether products such as CDSs count towards this threshold. Therefore, these rules greatly complicate compliance for third country firms as they will have to track their counterparties in order to know whether or not they should be playing by EU rules.

Mutual recognition

The only way to escape being subject to EMIR’s extraterritoriality rules is for your country to be deemed ‘equivalent’. Equivalence is a form of mutual recognition, whereby a host jurisdiction recognises foreign firms as compliant for complying with the rules of their home jurisdiction. For comparison, the US’ version is called ‘substituted compliance’. In an ideal world, once a country’s rules are recognised, firms from that jurisdiction should face no additional requirements when trading with the jurisdiction that recognised them.

But this has not proved to be the case. In fact, both the US and EU have created a whole new set of requirements for firms from other jurisdictions. In the US, the CFTC responded to the problem of cross-border trading by first extending the definition of US persons, in order to capture subsidiaries of US banks, but then limited the scope of entity and transaction-level requirements according to the status of the entity in question. The aim purportedly was to scope out non-US entities. However, a single footnote (513) then reverses a substantial part of this by declaring that US branches of non-US SDs/ MSPs (Swaps Dealers/Major Swap Participants) will still be subject to transaction-level requirements. Far from simplifying cross-border compliance, this could well be argued to further complicate the issue.

Similarly, the EU promised a simplification of the rules, stating that it would declare third countries equivalent on a ‘holistic’, country-by-country basis. However, they have yet to deliver on this promise. Not only have ESMA’s recommendations so far failed to provide clarity on whether a country is equivalent or not by instead taking a rule-by-rule approach to equivalence, but have also invented a third category of ‘conditional equivalence’. This means that firms and FMIs wanting to be considered for authorisation by ESMA will have to ‘top-up’ their current compliance efforts with select elements of EMIR, in effect creating a new set of rules for each non-EU country.

Furthermore, in spite of the confusion, regulators are pushing ahead with new requirements. For example, the CFTC refused to delay the 2 October SEF registration deadline, despite calls from the highest levels to do so, and had to issue a host of no-action letters in lieu. Similarly, it looks likely that the European Commission will refuse to delay exchange-traded derivatives reporting requirements, for which ESMA had hoped to be granted time to draft additional standards. Not only will this complicate EMIR compliance in the short term, but will also have knock-on effects for MiFID going into 2014.

In short, a new wave of regulatory protectionism seems to be trumping cross-border co-ordination. Temporary relief from rules does nothing to tie-up the global market; it only delays fragmentation. As Mark Carney (Governor of the Bank of England) wrote in the FT the other day, regulators need to set their differences aside before this stalemate affects volumes and the real economy. Unless that’s their intention of course…

©Best Execution 2013

EVOLUTIONARY CHALLENGES.

With everyone scrutinising the launch of SEFs in the USA, Daniella Huggins* explains the importance of developing industry-wide standards, and why initial guidelines published earlier this year by FIX Trading Community are critical in addressing the business challenges facing OTC Derivatives and fixed income markets.

As global regulatory reforms push the vast OTC derivative markets onto electronic trading platforms, this autumn will witness the achievement of a major milestone with the launch of the new Swap Execution Facilities (SEFs) in the USA, significantly changing the way these products are traded and the structure of the market itself. This development is likely to be carefully monitored on both sides of the pond, in the hope that it will provide an indication of the future shape of the European markets once the rules pertaining to proposed Organised Trading Facilities (OTFs) in the EEA (European Economic Area) are finalised.

With an estimated 40-50 SEFs planning to launch, the prospect of sourcing liquidity across this newly fragmented marketplace presents concerns. Without an early indication as to which of these platforms will be highly liquid, broker-dealers face the technical challenges and financial implications of potentially needing to access multiple competing venues in an efficient manner.

These developments will impact many of the 275+ member firms of FIX Trading Community, the non-profit, industry-driven standards body at the heart of global trading, and so its members have been working together to help firms industry-wide to manage the implications of these developments on their businesses. Much of this work has focused on enabling market participants to connect to the new SEF platforms using standards such as the FIX Protocol, which is used by thousands of firms every day to complete millions of transactions. The opportunity to do so presents the potential to achieve greater cost-efficiencies for all market participants, including the buyside as well as the sellside.

FIX adoption by trading venues around the world is on the rise. Most of the MTFs (Multilateral Trading Facilities) in the EU that were created as a result of the new competitive environment introduced by the MiFID regulations in 2007 have chosen to offer FIX access to their users. Using the same standard made it easier, quicker and less costly for new users to have access, and also made it easier and quicker for new MTFs to penetrate a market where investment firms are already not only huge users of FIX but are also the firms that drive the development and adoption of FIX. The potential for investment firms and SEFs to achieve similar positive results in the fragmented OTC Derivatives markets is proving to be highly appealing.

Work in this direction by representatives of the proposed SEFs and the broker-dealers that wished to connect to them began in 2011 when they came together to work as part of the FIX Trading Community Global Fixed Income Subcommittee to develop guidelines on how FIX could be used to trade swaps on the new SEFs. At that time the Dodd-Frank rules were still in a state of flux, but the group knew that Credit Default Swaps (CDS) and Interest Rate Swaps (IRS) would need to be traded electronically and so began with these. This led to the publication by FIX Trading Community in March 2012 of an initial set of guidelines explaining how CDS and IRS products could be traded using FIX, and at the same time the specification of FIX was enhanced to ensure that it could meet the identified business needs. These guidelines were rapidly adopted by proposed SEFs as the recommendations helped them to begin building core infrastructure that would enable easier access for their users. The relevance and success of these guidelines and FIX standards is demonstrated by the fact that almost all SEFs set to launch in the coming weeks are planning to offer FIX access.

FIX was already enhanced earlier this year to enable firms to meet the CFTC’s regulatory reporting requirements related to swaps data repositories, end-of-day positions, large trades and margining. As the Dodd-Frank rules became clearer and more prescriptive, the group further enhanced the FIX standard, and FIX Trading Community released updated guidelines in September 2013 explaining how FIX can be used to trade the wider range of products now covered by these rules. These updated guidelines also include recommendations for how FIX can be used to support different permutations of cross-asset trades; how it can be used within the fixed income market; enhancements to meet new regulatory developments including the Central Counterparty Clearing House and the Legal Entity Identifier (LEI) initiatives; as well as support for the electronic booking of voice trades.

And the work did not stop there. To trade on a SEF on behalf of a client, key information about that client’s relationship and their associated permissions must first be logged. Without a standardised electronic approach, broker-dealers would face the possibility of this information being requested by SEFs in different ways by the various platforms, requiring significant administrative work and even manual reporting. The new guidelines, which have been recently released, demonstrate how this business process can be carried out in an electronic, automated and standardised manner, presenting the potential to further reduce operational risk and generate considerable efficiency gains and cost savings for market participants.

FIX Trading Community’s work will not end here – further projects are already underway addressing the business challenges facing OTC Derivatives and fixed income markets. To accommodate just the recent regulatory and market changes that have taken place to date the FIX specification has almost doubled in size and with so much regulation in the pipeline the possibility of it expanding even further is looking rather likely!

*At the time of writing Daniella Huggins was global marketing and communications manager at FIX Trading Community.

FRAGMENTATION & CONSOLIDATION.

Hirander Misra, CEO of newcomer Global Markets Exchange Group (GMEX) debates whether new derivatives regulations will fragment markets or make them more transparent, and which venues will play to win?

CONNECTING THE BUYSIDE.

Eric Kolodner, managing director at Tradeweb explains how connecting derivatives trading technology with buyside systems can reduce risk and streamline the entire trading lifecycle.

In recent years there has been an evolution in the use of technology throughout the derivatives trading lifecycle. Buyside firms increasingly recognise that technology is a strategic investment which facilitates a more automated workflow and substantially reduces risk. It’s possible to dramatically streamline institutional execution businesses by integrating trading systems with other internal and external systems to reduce operational risk, while facilitating processing and reporting.

In today’s environment, integration connects functions used throughout the trading workflow. To achieve a fully integrated process, buyside firms need to be able to connect internal risk, compliance, accounting, collateral and order management systems (OMS) with external trade execution and processing functions, such as trading venues and clearinghouses.

Developing a truly integrated trading model was a costly proposition just a few years ago. The evolution of electronic trading and the innovation of regulatory compliant solutions have made it possible for more market participants – large and small – to reap the benefits of an integrated approach.

Numerous benefits

These benefits are noteworthy, especially in a leaner financial marketplace. From a risk management perspective, an automated workflow allows effective data monitoring throughout the trade process to limit the risk of failed or ‘out’ trades, while minimising the need for manual processes, thereby mitigating the operational risk of human error.

Integrated connectivity helps reduce costs, by generating significant time efficiencies through reducing the need for manual data processing and expediting back-office reconciliations. It also helps improve capacity, and clients with a variety of needs benefit from integration by being able to execute multi-legged trades or multiple trades simultaneously, and they can submit requests-for-quote (RFQ) to several dealers at once.

Another important benefit for buyside clients is the ability to allocate trades, either pre- or post-execution, and communicate settlement information to dealers, prime brokers, fund administrators and confirmation vendors.

Direct server-to-server connections using industry-standard protocols such as FIX, XML and FpML, as well as proprietary protocols, allow for the automation of post-trade processing.

Connectivity also helps firms in proving best execution by generating audit trails of each auction, and delivering post-trade summary or compliance reports. Buyside investors with integrated systems have access to real-time analytics and transaction cost analysis that can be used to continually monitor performance.

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Integration improves efficiency

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Managing regulatory reform

Managing the obligations of new and upcoming regulations for clearing, trading and reporting is also substantially easier when internal and external systems are interconnected.

• Clearing

The clearing mandate outlined by the Dodd-Frank Act and in pending European and Asian regulation requires institutional investors to clear most of their over-the-counter derivatives trades through a central counterparty. Mandatory clearing in the US started on March 11 for Category 1 clients, and over the last three months 85% of trades with US clients occurring on the Tradeweb IRS and CDS platforms have cleared. In Europe, in advance of upcoming clearing rules (currently expected in summer 2014), swaps clients are already actively using Tradeweb to execute cleared trades. The end-to-end workflow for these trades is streamlined through trading platform connectivity to derivatives clearinghouses and middleware vendors.

In addition, when a client elects to clear a trade, they are able to use Tradeweb’s first-of-its kind pre-trade credit-check solution, which determines almost instantaneously whether a customer’s available credit is sufficient to back the trade. Once the trade is executed, it is automatically submitted to the client’s clearinghouse of choice in real time.

• Trading

In the US, the final rules for swap execution facilities (SEFs) were published in the Federal Register on June 4, 2013 and became effective on August 5. The new regulation drastically changed the derivatives trading landscape and may result in a transfer of most standardised swaps trading onto centralised, transparent marketplaces. While the period leading up to approval of final rules was marked by a constant stream of new concerns that SEF-based trading would hamper derivatives liquidity in the US, the market behaviour immediately following the rules’ effective date has shown the opposite to be true. In fact, an August 2013 report from Aite Group showed that US derivatives market participants have taken Dodd-Frank trading requirements in their stride, with cleared IRS and CDS trading volume surging in the weeks following the new clearing mandates and final SEF rules.

Although the trading mandate in Europe is not expected to begin until 2015, as a result of the US regulations even those market participants not immediately affected are taking a close look at what they need to do to prepare for future rules and to achieve the benefits inherent in electronic execution.

• Reporting

Trade reporting is also facilitated efficiently through integration, which allows derivatives trades to be electronically processed once they are executed and delivers trade details downstream. Information on all trades that are reported to trade repositories and swap data repositories (SDRs) will be available for clients electronically, thereby removing the need for the client to manually fulfil any regulatory reporting requirements. Mandatory reporting began in the US this year, and is expected to start in Europe in the first quarter of 2014.

From theory to practice

During the lifecycle of an integration project, all aspects of the trading process – including pre-trade order generation, trade allocation and post-trade information requirements

– are considered. Using a collaborative approach, which also takes into account existing client systems, ensures that the most appropriate integration solution for the specific needs of every client is implemented.

Building this connectivity allows firms to address many of the challenges that they are facing in the current environment, while also reaping the benefits of an integrated approach.