by Sid Jacobson

8 Things You Should Know About Margining Uncleared Swaps

Commercial entities, as well as, financial institutions will be impacted by new margin requirements for uncleared swaps. Most will fare better than expected. There are some facts organizations that transact in Swaps should know.

  1. The FDIC and the Office of the Comptroller of Currency approved final margin requirements for uncleared swaps on Thursday October 22nd.
  2. Uncleared Swaps are bilateral Swap transactions between two counterparties that are not margined through third-party central clearing houses, such as the ICE or CME.
  3. Rules are proposed to be phased-in over four years beginning September 2016, as per a prioritization calendar. There will be no retroactive requirements.
  4. The final rule establishes the minimum amount of initial and variation margin that the covered swap entity must exchange with counterparties. Approximately 30% more collateral will be required for uncleared swap transactions, than cleared swaps.
  5. Final rules ease inter-affiliate margining requirements. They require a “covered swaps entity” to collect margin from the affiliate at the outset of a transaction. Both entities were required to post collateral in previous drafts.
  6. Commercial entities, and small banks, will be exempt from clearing when transacting swaps to hedge commercial activity. Exemption does not mean financial institutions will not require collateral. Banks still need to manage their counterparty credit exposures.
  7. A broader list of acceptable collateral is proposed in the final rules than in earlier drafts.
  8. The SEC and CFTC still need to finalize their rules. These rules may be different than FDIC rules. They were consulted on FDIC rules.

The 2010 Dodd-Frank Act requires that all swap transactions are cleared through a central clearing house to reduce systematic risks stemming from default. In theory, clearinghouses provide financial assurance by collecting standardized collateral from all cleared transactions. Many transactions are still contracted bilaterally between two counterparties and some are too complex for common clearing. 75% of Treasury Swaps and between 40-60% of other asset classes are currently cleared.

To encourage clearing and ensure capital adequacy, regulators are required by the Dodd-Frank Act to create collateralization rules for uncleared swaps. Rules for margining uncleared swaps have been under debate for some time due to the many issues such as complexity of transactions, intercompany transactions, regulatory jurisdiction by multiple regulators and global regulatory harmonization. This final rule is good progress, even if not the best answer.

Given the SEC and CFTC are yet to finalize rules, FDIC rules should act as a template, but not a final for commercial end-users of derivatives. Data retention and reporting rules are still essential.

For more information see FDIC Press Release and Links.

Please share your thoughts in the comments section. And, if you like what you have read please “like” this blog, follow me and share with your colleagues and through social media.

Sid Jacobson works with organizations to improve their risk management and compliance capabilities. With over 25 years of experience driving change and growth for companies engaged in energy and derivatives markets, Sid is known for strategic visioning complemented with a successful track record implementing improved commodity strategies, commercial operations, risk management and regulatory compliance. Sid is the founder of Pivotal Risk Advisors.

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by Sid Jacobson

The Relentless Pursuit of Market Manipulation: Are You Armed?

A funny thing happened on the five year journey to compliance with emerging Dodd-Frank regulations. Regulators are relentlessly honing in on existing market manipulation regulations. Particularly, investigations and actions related to Wash Trading and Spoofing.

Investigation costs, fines and penalties have impacted financial institutions, hedge funds, independent speculators and even utilities and commercial businesses. In fact, not only are the SEC, FERC, CFTC, exchanges and market operators on the hunt, the Department of Justice is also pursuing criminal and civil complaints. Organizations that transact in commodity and financial markets must have controls in places to defend against new market manipulation definition and precedent.

What is a Wash Trade?

Wash Trading is simultaneously buying and selling the same commodity or financial instrument, (for brevity, ‘security’), usually at the same price for the same quantity. The trade, typically, results net zero incremental volumetric exposure for the transacting parties, and generally no net gain or loss.

Wash Trading is deemed market manipulation because it can lure market participants into an illiquid market under false pretenses or scare others away from a market they may feel is gamed.

From a company perspective, Wash Trading can falsely “mark” the value of security prices to inflate, (or deflate), collateral/margin requirements and mark-to-market profit and loss statements that often impact compensation.

Wash Trade

Exhibit A: Wash Trading Diagram

What is Spoofing?

Spoofing occurs when a bid, (or offer), is placed in the market with no intention to transact and then is immediately cancelled once other market participants transact or place a bid, (or offer), at higher, (or lower), prices.

Spoofing can falsely give the impression of demand to lure other Market Participants to transact at unfavorable prices, often with the ‘spoofer’.

Spoofing

Exhibit B: Spoofing Diagram

These trading strategies are alleged to threaten underlying market principles that a fair and orderly market is where best bid meets best offer.

Wash Trading and Spoofing are a form of gamesmanship that regulators believe damage the integrity of the market. Yet, detecting intent to manipulate the market is opaque. For example, often transactions are reversed or cancelled because of changing risk exposure or an error. However, regulators are now demonstrating that it is the onus of the transacting party to prove innocence. To the regulators, it does not matter if this activity resulted in financial gain. Intent implies guilt because it can adversely affect other market participants. Intent should be documented at the time of the transaction or a potential violation needs to be detected early.

What is Market Participant Response?

A 2015 Committee of Chief Risk Officers (CCRO) survey on Commodity Risk Management Practices showed some market participants are not implementing robust controls to mitigate and monitor regulatory compliance.

  • Regulatory compliance is status quo for many market participants. Common practice is to ensure rules are interpreted and communicated, ad-hoc review of transactions – followed by high-cost crisis management to respond to any regulatory data requests and inquiries.
  • Market participants are distracted. Over the past five years regulators are still struggling to clearly define many Dodd-Frank rules. And lock-step, market participants are carefully trying to understand and standardize interpretation of these new regulations.
  • Market participants are cost conscious. Market economics have reduced company budgets, and uncertain regulations create fear of regretful spending. In many cases organizations have only implemented highly manual, least-cost compliance processes and systems.

In a time where the stakes of non-compliance is high, it is disconcerting that many market participants are forgoing robust and systematic regulatory compliance for conservative cost management.

What are some market participants doing?

Proactive organizations are improving regulatory training, refining compliance processes and implementing trade surveillance algorithms and case management programs.

  • Regulatory Training – Structured regulatory compliance training enhances traditional regulatory review and synopsis communications. Interactive situational training programs that require pass/fail testing, in-house certification and regular refreshes are becoming an auditable standard.
  • Compliance Processes – Regulation FAQ sheets and access to company regulatory compliance professionals are being enhanced with impact mapping of regulations. Interactive process maps that interpret rules and company guidelines help reinforce training and provide a tool for non-compliance professionals to understand, test and improve compliance processes.
  • Trade Surveillance Algorithms – Complimentary to transaction and risk systems, trade data is staged for evaluation by a suite of comparative and probabilistic analytics that serve as an early detection and case management system. Trade surveillance algorithms identify transaction outliers that may be interpreted by regulators as violating market regulations. When outliers are identified, compliance managers can research and document events at the time of occurrence, and if necessary, escalate for appropriate disciplinary action.

This modern framework demonstrates to the regulator proactive enforcement of compliance that can mitigate sanctions and fines. Legal and staff costs are also mitigated through data retention and early documentation.

Since the banking crisis, emphasis on governing and managing risk exposure to market manipulation has shifted market participant behaviors. It is clear in recent Presidential debates that attention to market manipulation may change in form, but will not wane.

A potential client recently scolded me, “Wash trading is old news. Everyone has it under control.” Evidence demonstrates the contrary. While many are ahead of the curve, many others are still ill equipped.

It is time to be introspective, and ask, “Is our organization doing enough to assure that risk to regulatory exposure is mitigated and if not, what the potential cost and impact?”

Please share your insights and questions. And, if you like what you have read please “like” this blog, follow me and share with your colleagues and social media!

Sid Jacobson works with organizations to improve their risk management and compliance capabilities. With over 25 years of experience driving change and growth for companies engaged in energy and derivatives markets, Sid is known for strategic visioning complemented with a successful track record implementing improved commodity strategies, commercial operations, risk management and regulatory compliance. Sid is the founder of Pivotal Risk Advisors.

If you would like to learn more about our capabilities visit www.pivotalriskadvisors.com.

Examples of Recent Wash and Spoof Trading News:

by Sid Jacobson

Will the revised Dodd-Frank Swap Reporting rules cost you?

Swap Reporting is about to get easier!

On August 19th, 2015 the CFTC proposed sweeping revisions to the Commodity Exchange Act Section 21, Part 45 on how “cleared swaps” will be reported.

Over three years I moderated an energy industry roundtable focused on defining the impacts of Dodd-Frank Act regulations. Of the 25 organizations who participated, a reoccurring debate was related to uncertainty with the obligation of Continuation Reporting once a swap is cleared through a Designated Clearing Organization (DCO). No consensus was reached. Some moved aggressively with automation and attempts at regular reconciliation. Others plodded slowly relying on ad-hoc or delegated reporting. Once a Swap cleared, most organizations assumed the DCO was reporting on their behalf. Yet, many still felt uneasy and exposed.

Proposed Part 45 revisions aim to improve data integrity, reduce reporting redundancies and create a more efficient reporting process. As a result, it also clarifies confusion related to Continuation Reporting.

The greatest impact to market participant’s current processes, (and data systems), is that the proposed rule revisions will now bifurcate a swap cleared with a DCO into an “Original Swap” and two offsetting “Clearing Swaps”. The simplest explanation for this rule change is that in the current Swap clearing transaction lifecycle, the DCO offsets the bilateral Swap with new swaps between the DCO and each transacting party. When this occurs, the bilateral Swap is extinguished and one transaction now becomes three.

The proposed rules more accurately reflect how DCOs clear a swap. However, the rule revisions will also impact the socialized practices of market participants. Despite knowledge of how a swap is cleared, few commonly “think of” a cleared swap as two offsetting transactions and many CTRM systems represent these trades as a single or two manually entered transactions.

Organizations that made investments in compliance reporting may find themselves with a sunk cost and need for reinvestment. For the slower movers it should provide relief and a fresh start to refine compliance processes.

To summarize the proposed rule changes:

  • The CFTC will introduce two new defined terms.
    1. Original Swap – the swap that is accepted for clearing by the DCO whether executed bilaterally, through a Swaps Execution Facility (SEF) or Designated Contract Market (DCM).
    2. Clearing Swap – the swap(s) created by the DCO, where the DCO becomes the counterparty to the swap and the Original Swap is offset. It also includes any Swaps executed directly with the DCO for clearing.
  • The DCO is now the reporting party for the Clearing Swap. As a result the DCO will be accountable for reporting Creation and Continuation Data.
  • The SEF, DCM or Reporting party will be responsible for reporting Primary Economic Terms (PET) of the Original Swap. Confirmation Data reporting will be eliminated if the Original Swap is accepted for clearing.
  • The SEF or DCM will be responsible for designating which SDR the Original Swap is reported. If bilateral, the Reporting Party will choose the Swap Data Repository (SDR).
  • The DCO will be required to report all data for a particular Clearing Swap to a single SDR. In a CFTC example, the SDR for the Original and Clearing Swap is the same.
  • The DCO will be responsible for reporting termination of the Original Swap and Continuation Data for the Clearing Swap; alleviating years of reporting consternation by market participants.
  • More emphasis will be placed on assuring that the Legal Entity Identifiers (LEI) and Unique Swap Identifier (USI) are reported so that the SDR can better track reporting through the lifecycle of a transaction and eliminate inadvertent duplication.
  • Swap Dealers and Major Swap Participants will be relieved by the DCO for reporting daily valuation of Cleared Swaps.
  • Clarity over USI creation by the DCO and additional PET fields are also defined in detail.

The rule changes should be a net benefit to market participants by greatly reducing the rigor of daily reporting requirements and inconsistencies around continuation reporting. However, the near term impact will require new investment into systems and changes in policies and procedures. Despite the 60-day comment period, (and the fact we have seen these comment periods slip sometimes for years (e.g. position limits, margining)); there is high probability that after a few sharpened pencils the rules will be adopted. It is time to mobilize.

Which leads to a new question, how will these additional transactions impact Swap Dealer and Major Swap Participant Thresholds?

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As a special gift to readers, I drafted a transaction lifecycle map that illustrates the decision and impact points of these proposed changes through the lifecycle of a transaction. If you are interested in receiving this document, please request on the contact page.

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Please also share your comments and questions, with particular interest in how you see the rules impacting your organization. Meanwhile, if you like what you have read please like this blog and repost to your social media! If you would like more updates, please sign up below! Thank you.