A look back at 2017 and highlights the trends wrought by regulation, harmonisation and innovation on the derivatives market. DerivSource Reporter, Lynn Strongin Dodds reports.
As 2017 winds to a close, the derivatives market has been impacted by the same low volatility and uncertainty over Brexit impinging on other asset classes. However, it has also moved to the beat of its own drum with the steady march to central clearing, Blockchain initiatives, cross border harmonisation, alternative Libor benchmarks and of course in Europe, MiFID II preparations.
“The key themes in 2017 have been crypto-currencies, harmonisation, the increase in automation and along with central clearing, electronic trading,” says Radi Khasawneh, senior analyst at TABB Group. “These are all facets of regulation but it is impacting the way people trade and increasing the transparency across derivatives trading.”
The latest crop of studies from the Bank for International Settlements (BIS) and International Swaps and Derivatives Association (ISDA) show that legislation such as European Market Infrastructure Regulation (EMIR) is having the intended effect. While the reports do not offer a full picture, extrapolating the first half figures shows that direction of travel is only one way.
In the first six months, the move to central clearing was most pronounced in credit default swap markets which reported a rise from $4.3 trillion to $4.9 trillion even as the total notional amount of outstanding credit default swaps (CDS) declined slightly, according to the latest BIS Report. Tallying the figures, this translated into a 51% jump of the shares of outstanding CDS being cleared through central counterparties (CCPs) compared to 44% at end-December 2016. This was met with a corresponding drop in bilateral contracts between reporting dealers to $2.9 trillion.
A similar trend was reflected in interest rate derivatives although the move to clearing has been steadily climbing over the past three years. Figures from the ISDA report show IRD cleared notional rose by 28.4% in the first half of 2017, to $89.9 trillion from $70 trillion in the first half of 2016. Overall, cleared interest rate derivative transactions represented $45 trillion or 88.5% of traded notional and 80.3% or 237,549 of trade count.
By contrast, non-cleared notional and trade count dropped by 12.9% and 10.2% compared with the first half of 2016, to $12.2 trillion and 120,932, respectively.
This year also saw trading volumes on swap execution facilities (SEFs) climb with each quarter higher than the corresponding quarter a year earlier. Third quarter figures from Clarus Financial Technology found that incumbent players still have a lock on the business although upstart TrueEx has finally made inroads with $520 billion in the third quarter, a hefty hike of 67% from last year and a 6% year-to-date market share. Tradeweb, which has a 33% market share of gross notional, retained its number one position at $3 trillion from June to September, up 63% from the same period last year, while Bloomberg came in second with a 42% hike to $2.2 trillion and a year-to-date market share of 25%.
“We are seeing a general move to listed and cleared products on the rates and FX side, with a particular growing interest in futures. However, we are also seeing activity on the OTC side driven by different reasons which are dependent on clients’ mandates and strategies.” Gaspard Bonin, Deputy Global Head of Derivatives Execution & Clearing at BNP Paribas.
“Due to big uptick in swaps trading on SEFs, initial margin is becoming more and more important,” says Dr. Tom Davis, Global Head of Derivatives Research at FactSet. “Compression is going to have a large impact on mitigating the MVA (margin valuation adjustment).”
Trade compression, has become a major focus over the past two years for banks due to the more onerous capital requirements under Basel III. This is because the larger the outstanding notional, the larger the capital requirement. The activity enables one or more offsetting derivative contracts to be torn up and replaced with a single contract with the same economic exposure.
The move to initial margin (IM), which kicked off in September 2016 and is being phased in, combined with the continued move to central clearing, also had an impact on the amount of collateral swilling around in the system, according to the most recent ISDA Margin Survey. It estimated that around $1.41 trillion of collateral was posted with CCPs or with the 20 biggest firms that were in the first wave of having to comply with the rules.
Of this amount, IM posted by clearing participants to CCPs for their cleared derivatives trades stood at around $173.4 billion while the figure given to the 20 largest market participants for their non-cleared trades totalled $107.1 billion. Figures for variation margin were an overall $1.13 trillion, split between $260.8 billion for cleared and $870.4 billion for non-cleared. Variation margin (VM) was supposed to come into effect in March 2017 for all counterparties – dealers, hedge funds, insurance companies or pension funds – but those that couldn’t cross the finishing line had a reprieve until September.
Although the studies show that the appetite for OTC transactions is waning, it has not disappeared. “We are seeing a general move to listed and cleared products on the rates and FX side, with a particular growing interest in futures” says Gaspard Bonin, Deputy Global Head of Derivatives Execution & Clearing at BNP Paribas. “However, we are also seeing activity on the OTC side driven by different reasons which are dependent on clients’ mandates and strategies.”
Matt Gibbs, product manager at Linedata also saw an uptick in swap futures because “they are easy and cheaper to use to hedge than OTC instruments even if the hedge is not perfect. “I do not see bi-lateral trades disappearing, but we are seeing a change in mindset with swap futures especially as there are now plenty of options in terms of size of contracts and maturity dates,” he says.
Overall, the interest has been slower than expected, but momentum is gaining with Eris Exchange, a U.S.-based futures exchange, which claims to have a 70% share of all swap futures open interest globally, reporting its pool of open contracts grew at a healthy clip of more than a third this year, hitting a recent peak of 204,741 or $20.5 billion notional.
The MiFiD challenge
The other major regulatory focus that has been absorbing buy and sell-side time is MiFID II, which comes into force on 3 January 2018. “This year has been dominated by MiFID II and the race to understand the implications on operating models,” says Christian Lee, specialist clearing, risk & regulatory at consultancy Catalyst. “This has not been helped by the lack of – as well as late – guidance from ESMA.”
He adds, “There has been a lot of pressure on vendors to develop and help implement solutions especially on the trade and transaction reporting side. All our clients have been heavily involved in this and we see some of the remedial work spill over into the first six months of next year.”
For many firms, the task has been monumental, entailing a move from the manual processing, spreadsheets and database infrastructure used for existing transaction reporting to a much more automated process combining strong data governance and transparency. This has involved among other things the amalgamation and consolidation of data from multiple systems to populate the additional data reporting fields, as well as the integration of systems to scrutinise the integrity and validity of their own data before passing it to their Approved Reporting Mechanism (ARM), who in turn will conduct external market data checks.
The replacement of the Libor benchmark has also been absorbing time although the industry has a few years to prepare for the change. “It is one of the biggest issues and has become a source of transatlantic debate,” says Karim Faraj, Global Head of Front Office Derivatives at Bloomberg. “The discussions will continue into next year but there is increasing nervousness about its replacement.”
The Financial Stability Board’s Official Sector Steering Group and ISDA are mulling over the potential substitutes and developing mechanisms to implement such fall-backs into existing and future contracts. To date, there are two options being proposed. The Bank of England’s Free Rate Working Group is pushing the reformed Sterling Overnight Index Average (SONIA) – a reference rate based on actual transactions in the overnight unsecured loan and deposit market.
Meanwhile in the US, the Federal Reserve Bank of New York-sponsored Alternative Reference Rate Committee favours the Broad Treasuries Repo Financing Rate (BTRFR), which works by reflecting how much it costs to borrow cash secured against US government debt.
Hands across the water
This year though was not just about drawing lines in the sand over different approaches. Real progress was made on the harmonisation front with the Commodity Future Trading Commission (CFTC) and European Commission finally striking an agreement to accept the legitimacy of each other’s rules on swap margin agreements and to allow swap trading venues under their jurisdictions to follow their home region’s rules. The two-part agreement covers the comparability of trading platforms and the collateral or margin requirements that traders have to post.
The EU and U.S have been negotiating for years over this issue, but agreement proved elusive while Barack Obama’s appointees ran the CFTC. Chris Giancarlo was sworn in as a CFTC commissioner on June 16, 2014 for a term expiring on April 13, 2019. However, he began serving as acting chair and then was confirmed in the role in March under the Trump administration.
According to Tom Lehrkinder, senior analyst at TABB Group, Giancarlo, who has years of experience, has been a proponent of global cooperation. “The commissioner takes a pragmatic approach and harmonisation was and is on the agenda, which is good for the market. If the US and EU can agree on some things, it will only be good for the industry,” he adds.
Lehrkinder also points to trends outside the regulatory realm that have gripped the industry. “Crypto currency has become one of the hottest and more topical subjects and is on everyone’s list,” he says. “This is evidenced by the recent moves from CBOE and CME and it will continue into 2018.”
In early December, the CFTC gave the green light for CME Group, the world’s largest futures exchange and its competitor, the Cboe Futures Exchange, to launch bitcoin contracts. Meanwhile, Cantor Exchange, a subsidiary of Cantor Fitzgerald, will also offer bitcoin binary options. They join LedgerX, a swap execution facility that began trading bitcoin options and day-ahead swaps in October.
The moves are seen as a watershed moment for institutional investors who have been eager to get in on the action but worried about the lack of regulation. The CFTC provides that comfort at time when bitcoin prices soared through the proverbial roof at 12,000 in December although has since slipped back.
The CFTC’s move was not the only surprise. Market conditions, namely low volatility, were not expected to persist throughout the year, especially given the spate of European elections in the Netherlands, France and Germany, as well as the uncertainty over the Trump administration.
“Shockingly, VIX trading was at historical lows which correlated with the highs in the SP500,” says Davis. “This could be due to the paradoxical stability of the current administration – nothing can get passed, which means a stable regulatory environment. Wall Street likes a slow-moving environment. If the Democrats win the house, look for volatility to start rising.”
Faraj also believes that firms are changing the way they trade based on a combination of market conditions, a lack of risk taking due to tighter regulations, as well as time spent complying with the raft of new rules such as MiFID. “Volatility increases when people get nervous but there are structural changes keeping volatility low, such as excess liquidity due to QE, rise of passive and thematic investing, as well as strategies that cap the realised volatility or sell the implied volatility to generate yield due to low rates,” he adds. “This phenomenon is sustained by lower risk appetite due to much increased regulation, as well as an increasing market consensus that tends to act as a self- fullfilling prophecy.”
