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The Magazine From OTC Space | News, Articles and Opinion on the Capital Markets

EDITION 1 | SUMMER 2014 www.theotcspace.com

EMIR Progress and What Next?
risk management
Replicating CCP Margin Models
Sharp Cost Increases Ahead
Decision Support and Analytics
Swap Futures - The Next Big Thing?
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 1


elcome to the In Europe, the dust is settling
first edition of on Trade Reporting, and with
The OTC Space “Rocket”, the six CCPs now authorised
News, Articles and magazine from under EMIR, the timetable to
Opinion on the The OTC Space. mandated clearing in Europe is
Inside we have a mix of articles becoming more clear. Between
Capital Markets
from the website, plus new November 2014 and Summer
articles bringing you up to date 2015 ESMA and the European
with developments in the market. Commission will require
Bill Hodgson The OTC Space site contains European firms to put OTC
Owner and editor expert knowledge from people business through CCPs, rather
bill@theotcspace.com who work within the industry, than bilaterally now. Email bill@theotcspace.com
+44 (0) 77 1171 5311 and in many cases have to live Some data suggest many firms Twitter @theotcspace
with the practical issues raised by have already taken the plunge, Web theotcspace.com
To discuss the bespoke new regulations, new processes but there is a suspicion that many
marketing opportunities and services. others are unprepared.
available with The OTC Space, Never before has the OTC As costs increase for transacting
with many options to enhance markers undergone such rapid OTC business, either as a result
your brand, products and far-reaching transformation, of margin at CCPs, capital
and services, contact with the dual pressures of the charges, funding charges or
Nicole Taylor Dodd Frank Act in the US, fees, will we see a retreat from
Business development and the European Market the OTC market we’ve known,
nicole@theotcspace.com Infrastructure Regulation to a lower volume more vanilla
+44 (0) 77 8000 8598 (EMIR) in Europe. use of the tools available, and a
As of writing, the big change resurgence of Exchange products
Mariangel Gonzalez is the move to execute OTC for hedging risk? No one knows
Senior Designer business on Swap Execution right now and there isn’t sufficient
Facilities (SEFs) in the US. data to support that theory, but
Nikki Easton On face value this seems to be a in this edition some of the factors
Production Designer continuation of services already are considered which might drive Bill Hodgson
offered Inter Dealer Brokers, this outcome, and some of the Bill has worked in the capital
Printed by Print Resources but in fact is far reaching in data available shows where we markets for more than 20 years
that both vanilla and complex stand right now. on key pieces of the market
© The OTC Space 2014 trades must become electronic, infrastructure. Contact Bill for
plus the buy-side are obliged to Bill Hodgson Owner and editor consultancy, training, project
participate too. June 2014 and programme management.
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 2

Contents Events Calendar

Regulation Risk Management Selected events which we believe are of interest

to readers
6 EMIR: A Progress Report 25 Replicating CCP methodologies for WHEN WHERE WHAT
validation, pricing and
10 Volker Rule Hedge Accounting resource managment 9th Sept
US West
Trade Tech West Coast
See www.is.gd/ufwfGE
11 Clearing House Authorisation 29 Decision Support and Analytics
for more details
Collateral World Summit
Under EMIR, a Score Sheet For Clearing 23rd Sept London See www.is.gd/i9DBf6
for more details
12 Backwards? Regulators Systemic 35 Comparing VaR and SPAN Trade Tech Post Trade
Risk: Have Got It Reduction 28th Oct London See www.is.gd/S3mbe4
for more details
38 Ten Tips to Understand Credit Risk
14 Smooth Sailing Ahead? to Central Counterparties 16th Oct Amsterdam
8th Annual Collateral
Management Forum
See www.is.gd/sbYnXa
Economics Trading Clearing and Settlement World
26th Nov London See www.is.gd/4CtdZf
16 How Big is the OTC Market Really? 39 Swap Futures: The Next Big Thing? for more details

Clearing Post-Trade Processing

Visit www.theotcspace.com regularly,
to find out the latest.
17 Clearing Houses: Winners and Losers 40 European Trade Reporting:
19 The Indirect Costs of Central Clearing What’s the Point?

Management State of the Market

23 The Difference Between a Boss 43 State of the OTC Markets in 2014
and a Leader ... and What This
Means For Generation Y
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 3


Jon Skinner Amir Khwaja Mas Nakachi Diana Higgins Sandy McFadzen
Over 15+ years I’ve Amir has more than Mas is OpenGamma’s Diana is a credit Sandy is a highly
helped eight of the top twenty years experience Chief Executive Officer. risk management effective business
twelve global investment in OTC Derivatives Prior to OpenGamma, consultant based in consultant and project
banks define and deliver and Technology. Mas spent 9.5 years London with over 15 manager. His focus area
critical business and His prior positions at Calypso where he years of experience is risk and regulation
operational strategy includeDirector of was most recently the in commodity trading related change within
changes. I have a Master Risk Management and director of business including gas, electricity, banking and markets
of Arts in Mathematics Financial Engineering development for the rates, oil, metals, and coal. She institutions. He is an
and a one-year post- at Calypso Technology fixed-income and credit has managed distress expert in his field of
graduate qualification in (2005-2012), CTO at business. In this position, events and has also set financial derivatives risk
Advanced Statistics and SunGard Trading and he was responsible for up, transformed and management, analytics
Probability from Jesus Risk (2002-2005), CEO ecosystem development, closed down credit risk and trading processes.
College, Cambridge, & Founder at Kronos marketing, client support departments in major He values a reputation
England. Software (1998-2002). and new product European Energy firms. for uncompromising
Amir started his career development initiatives, Diana has experience competence and is
at Chase Manhattan as well as strategic client in managing multilateral known as someone who
(now JPM) as an IT acquisition for Calypso’s and bilateral portfolio can understand complex
graduate trainee in largest business solution compressions. She issues and drive a team
1988, after a degree in segment. Mas earned has written, defined, to get things done.
Mechanical Engineering a Bachelor of Science reviewed and updated
from Imperial College degree in Finance with a credit policies for
London. Amir is CEO minor in Philosophy from energy corporations,
of ClarusFT.com the Leonard N. Stern subsidiaries and clearing
School of Business at houses.
New York University.
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 4


Penny Davenport Ben Larah Sol Steinberg Peter Walsh Paloma Migone
I worked in Financial Ben Larah is a New Sol is a seasoned My specialisms include, As a journalist writing
Services for 18 years. York based Manager financial executive with full life-cycle sales on a variety of topics
I mentored a large at Sapient Global subject matter expertise management, banking from finance to politics,
number of people during Markets. He specialises in OTC derivatives, and financial services Paloma has worked
my career. I believe in valuations and risk, Market structure, sales and marketing, IT for publications in the
companies get the best with a particular focus Trade Lifecycle, intensive Programme UK, New Zealand and
out of their staff if there on rates and credit Valuation, Financial Management, Canada. Most recently,
is a strong connection derivatives. Ben has Technology Systems, Risk Measurement in London, she led
between the goals of the worked on a number Strategic Design, and Management, derivatives coverage for
corporate and those of of projects including Commercialization CRM, Enterprise T​he Trade News and
the individual. I apply implementing a of assets, and Risk Data Management, contributed to other
this philosophy to my derivatives platform Management. Sol was Compliance (KYC, The Trade publications.
executive coaching at a large financial the recipient of Risk AML, IFRS reporting)
programme. In 2010 institution, and advising Magazine’s award “Best and Retail and
I decided to retrain as buy-side institutions risk analytics initiative Commercial Banking.
a professional coach on market-risk 2012” & “Best risk
which has helped me to measurement methods. analytics initiative (Sell
formalise many of the Side) 2013” and FTF’s
techniques I used during award for “Most cutting
my very successful edge risk contribution
career. I have faced many 2013” for developing,
of the same challenges as project managing, and
you. architecting the SMART
risk analytics tool.
The OpenGamma Platform for Margining


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Perform full IM and VM replication across
clearing houses
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London: +44 20 3725 3333 | New York: +1 917 831 5852
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 6


nlike in the US,

EMIR: EMIR will not be a

‘big bang’ event. The

A Progress authorisation and rec-

ognition of European
central counterparties (CCP)

Report will occur individually and on a

separate timeframe. There are
two major components of EMIR
The European Market Infrastructure regulation – clearing and report-
Regulation (EMIR) is a response ing – as well as additional com-
to the G20 recommendations to ponents for non-cleared business
and the improvement of opera-
regulate over the counter (OTC) tional behaviour in the markets.
derivatives in the wake of the 2008
financial crisis. In broad terms, the Brisk Activity
aim is to impose clearing, reporting l The International Swaps
and greater transparency obligations and Derivatives Association
on a broad range of market (ISDA) report in February
2014 estimated that around
participants. The problem is that the 90% of clearable interest rate
rules jump straight to the solution swaps were already being
rather than defining success criteria cleared by the end of the sec-
for reducing systemic risk in the ond quarter of 2013 ahead of
global capital markets. the G20-inspired rules. The
Dodd-Frank Act’s rules on
central clearing came into ef-
by bill hodgson fect on 11 March 2013, but the
majority of buy-side institu- ing so would allow an escape The new OTC workflow
tions were required to comply route for counterparty risk.
with subsequent deadlines on l The timetable leading up to
requires tight integration,
June 10th and September 9th mandated clearing in Europe with trades flowing from a
2013. Europe is expected to re-
quire central clearing of OTC
has a sequence of events over
the next nine to 12 months. It
SEF or OTF into a clearing
derivatives by January to mid- starts with European CCPs house and achieving
2015. This then begs the ques- having to achieve both ‘com- clearing finality within
tion of whether the market pleteness’ for their EMIR ap- 10 seconds (at the CCP)
needs to be mandated to clear plication and then ‘authori-
at all? But the hazard of not do- sation’ as a fully approved in the US
Regulation Rocket • Edition 1 | Summer 2014 • theotcspace.com | 7

CCP. Once this occurs for a l CME OTC clearing has 375 retrospective transfer of trades
first CCP, the European Se- participants into clearing platforms. A new Latest issues
curities and Markets Author- term which is causing concern
ity (ESMA) has six months to Implementation Challenges is ‘front loading’, implied by the Immediately before the made towards moving
submit draft Recommended for Clearing Members way the clearing mandate in Eu- February 12th reporting start the OTC market to a more
Technical Standards (RTS) to Firms implementing clearing will rope is to be applied. date, ESMA published new organised basis, with all
the European Commission for face new challenges both for their Two key dates define a front guidance on trade reporting, business labelled with
approval. Given the authori- internal operations and systems, loading period; the first is the including examples of how a Legal Entity Identifier,
sation of NASDAQ OMX and also from a regulatory point date on which a CCP is author- to construct a unique trade and reported to a Trade
on March 18th the predic- of view. The new OTC work- ised under EMIR and the sec- identifier (UTI). This has left Repository for regulators
tion for this to occur is at the flow requires tight integration ond is the date when a product the industry wondering how to learn from. Clearing has
earliest November 2014 or at from front office to back office, is mandated to clear by ESMA. the incremental guidance become a way of life for
the latest around March 2015. with trades flowing from a SEF In the time period between the fits in with any published many firms, with smaller
The Commission and Euro- or OTF into a clearing house and two, any trades executed outside implementation timeline or firms now having a matter
pean Council have up to three achieving clearing finality within clearing, which would be then regulatory expectations. of months to prepare for the
months to review the RTS 10 seconds (at the CCP) in the mandated to clear, will need to To muddy waters further, clearing mandate.
where the application process US. The traditional workflow in- be back loaded. ESMA has written to the Regulators have more
can include a phase-in period volving execution, confirmation, The gap between the two pe- Commission asking for work to do, in improving
for specific products. and then clearing over a period riods could be anywhere from clarification on whether the effectiveness of trade
Many CCPs in Europe have been of days is no longer allowed. nine months to just less than two certain FX and commodity reporting, and considering
attracting new members and cli- This means firms have no choice years, according to regulatory es- products are in fact the systemic effects of large
ents as there is a business case to but to make use of processing timates. This is creating uncer- derivatives – the answer scale clearing – but as with
adopt clearing without a regula- platforms with good connectiv- tainty over pricing in the OTC to which could cause any large project, hindsight
tory mandate: ity and workflow tools, to enable markets because a trade execut- more rework for the should inform new thinking
l LCH.Clearnet SwapClear has all steps of the process to be as ed outside clearing has different implementation of EMIR. and progress towards better
89 members and 715 buy-side seam-free as possible, including pricing from one inside, especial- Much progress has been market infrastructure.
clients as of February 28th up-front credit line checks, rout- ly as the margin and capital re-
2014 ing to a CCP, responding to the quirements of the two are differ-
l EurexOTC clearing has 32 novation step, and then settling ent. Banks will need to consider
members, and as of January multi-laterally with each CCP. their approach to pre-mandate
2014 132 buy-side clients trading and may price trades as
l ICE CDS Clear has 12 mem- Front Loading – if they will be cleared, given that
bers and launched client clear- Pay It Forward the initial mandate in Europe is
ing in October 2013 with an Over the years the term ‘back likely to cover products already
initial 5 buy-side clients loading’ has come to describe the being cleared.
Regulation Rocket • Edition 1 | Summer 2014 • theotcspace.com | 8

At the beginning of May ucts clearing, the current mar- quirements as well as authorisa-
ESMA wrote a letter to the Euro- ket leader in terms of notional tion of TRs. Business challenges: big ticket items
pean Commission to ask that the cleared (see chart on page 18) Stepping back and re-visiting
period between CCP authorisa- is ICE with CME, Japan Secu- the purpose of trade reporting,
tion and the finalisation the clear- rities Clearing Exchange and the aim is to give regulators the
Collateral Global Credit
ing mandate technical standards LCH.Clearnet capturing smaller data they need to begin to meas- Reporting disputes clearing Hubs
be excluded from front-loading, amounts of the market. ure the risks within and between
and that from then on only trades From a clearing members’ users of derivatives, and to pro-
with a minimum remaining ma- point of view, the network of actively set targets for the reduc-
turity be included in front-load- other CCP members is what tion of systemic risks. Segregation Portfolio
SEFs models compression
ing. The outcome of this letter is makes the most difference – for Looking at the 85 data fields re-
not yet known. a small firm being courted by a quirements from ESMA, the end
local CCP, then the decision be- result is a set of fields to repre-
Regional Clearing – comes a commercial one based sent many OTC and exchange Uncleared 60 sec
Here to Stay? on cost. If it is a small firm traded products in a smallest set margin rule
Given the political push for mov- trading with large global coun- of common fields possible. The
ing OTC products into clearing, terparties, the network is bigger point is that the most that can
a business opportunity has arisen by far at LCH SwapClear and be learned from the current data
to capture domestic OTC busi- CME for example. The result being reported in these fields is
ness, which had previously been is that margin calculations that who did the trade, roughly the
excluded from some CCPs due will benefit from maximum net- size and maturity, and ancillary
to membership requirements. ting, rather than splitting the details. It will in no way enable
For example, new regulations portfolio between a local and regulators to perform risk ana-
from the US caused the lowering global CCP. lytics on the data or validate the
of the CCP membership criteria, risk calculations of any reporting
which used to include capital, Trade reporting – Early entity. Non-Cleared Business –
credit rating, portfolio size and Signs of Chaos As of now, statistics seem to in- The enduring legacy
other measures. Another operational component dicate that many firms have yet Meanwhile, it is easy to forget
Regulation has driven an up- of EMIR is gathering data on all to request or receive a Legal En- that the non-cleared business
surge in regional clearing with OTC and exchange traded de- tity Identifier (LEI), which is fun- will be with us for many years to
new OTC rates products being rivatives inside newly-created damental to start reporting. The come. EMIR sets out a series of
cleared in Poland, Hong Kong, trade repositories (TRs). The UK’s Financial Conduct Author- new operational targets for these
Singapore and Australia. It is February 12th deadline passed ity has already indicated it will ob- trades including regular portfolio
thought that CCPs in China, with a flurry of commentary on serve a grace period before taking reconciliation, timely confirma-
India, Korea, Chile and Brazil the haphazard way this process enforcement action against firms tion and an approach to dispute
could follow suit. In credit prod- has been conducted, with late re- not actively reporting. resolution.
Regulation Rocket • Edition 1 | Summer 2014 • theotcspace.com | 10

Volcker 2012. Due to the complications

of the legislation, the ban was
The Volcker Rule only requires
that a transaction be “reason-
Buy-Side Opportunities
Sourcing liquidity will become

Rule Hedge not finalized until now. ably” correlated to the risks it is
intended to hedge.  Federal agen-
fragmented and expensive in the
future. Banks will likely take on a

Hedge Accounting cies did not propose a “high” heavier brunt to understand and
There exists a large chasm correlation was necessary in or- navigate the differences between
between front office perfor- der for a transaction to fall under the Volcker Rule and hedge ac-
mance indicators and account- the hedging exemption.  counting.  Asset managers can ex-
On December 10th, 2013, ing methods. This difference be- pect banks to transfer these costs
five US federal agencies comes exacerbated when hedge Reduced Liquidity to them. Liquidity is still neces-
adopted a final rule to accounting is considered.  Hedge Banks may decide to avoid the sary. Buy-side firms are starting
accounting utilizes past market multiple risks and liabilities as- to rely on each other for liquid-
implement the Volcker performance in order to project sociated with the conflictive na- ity sources via peer-to-peer trad-
Rule. The effective date of future expectations. A recent ture of hedge accounting and ing platforms.  Vendor firms can
the Volcker Rule is April example of the stark contrast the Volcker Rule. Banks have start to understand the liquidity
1st, 2014. However, the between hedge accounting and become reluctant over the years needs of this segment by inter-
agencies have extended the front office is the JP Mor- to take on inventory positions viewing asset management firms.
gan Chase $6.2 billion trading due to the Volcker Rule’s hin- Upon completion of their market
the compliance deadline
loss in 2012, formerly known as drance on market making activi- research, vendors may create new
until July 21st, 2015. the “London Whale”. The bank ties.  The foreign exchange mar- trading platforms and strengthen
claimed that the hedge was a kets have exhibited evidence of present ones to allow buy-side

broad hedge against a portfolio this reduced liquidity.  Buy-side participants to connect with each
he Volcker Rule of corporate loans. participants have reported that other within shorter time frames.
by sol Steinberg
prohibits an insured Hedge accounting says oth- market-making banks are trim-
depository institution erwise.  FAS 133, an account- ming risk appetite and becom- Conclusion
and its affiliates from ing rule under the Financial ing less willing to warehouse The combination of the Volcker
the following activities: Accounting Standards Board, overnight positions. Due to Rule and hedge accounting may
l Engaging in “proprietary requires banks and other pub- this inactivity, there is reduced transfer proprietary trading to the
trading” licly traded companies to clas- liquidity in non-deliverable shadow banking sector. However,
l Acquiring or retaining any eq- sify hedges according to the forwards (NDFs), options, buy-side participants will need li-
uity, partnership, or other own- risks they are meant to offset.  and swaps. As a substitute to quidity as the details of the Vol-
ership interest in a hedge fund Companies need to identify a warehousing positions, asset cker Rule are ironed out and fu-
or private equity fund; and hedge as either mitigating cash managers within the FX mar- ture legislation looms. Vendors
l Sponsoring a hedge fund or a flow risk, interest-rate risk, or a kets have stated that the same can help asset management firms
private equity fund combination of the two.  In oth- banks are acting more like bro- and even partner with them to
The ban was originally slated to er words, a “broad hedge” does kers. They simply take an order facilitate satisfying their liquidity
be implemented on July 21st, not qualify under FAS 133. and pass it on. needs.
Regulation Rocket • Edition 1 | Summer 2014 • theotcspace.com | 11

Clearing House
CCP Domicile Regulator Authorisation
ATHEXClear Greece

Authorisation Under BME Clearing



20 May 2014


CME Clearing Europe UK BoE
n Europe CCPs must apply for and CSD & CH of Serbia Serbia
by bill hodgson receive authorisation to continue to op- Eurex Clearing AG Germany BaFin 10 April 2014
erate under the new European Mar- EuroCCP Ltd UK BoE
ket Infrastructure Regulation (EMIR). European Commodity Clearing AG Germany BaFin 11 June 2014
4 (as of May 13th) are now authorised for a Holland NL AFM 03 April 2014
variety of products, ESMA list them on their HELLENIC EXCHANGES S.A., HOLDING, CLEARING,
website (http://www.esma.europa.eu/page/ Greece HCMC
Registries-and-Databases) under the heading ICE Clear Europe UK BoE
“Central Counterparties authorised to offer IRGIT SA (Warsaw Clearing) Poland
services and activities in the Union”. KDPW CCP Poland 09 April 2014
It is assumed that the majority of these KELER CCP Ltd Hungary MNB 04 July 2014
CCPs will eventually be authorised and be
LCH.Clearnet Ltd UK BoE 12 June 2014
ready to take on additional clearing business
LCH.Clearnet SA France AMF 22 May 2014
once mandated clearing becomes applicable
(Now ICE Europe)
mandate contains many variables, a wide esti-
NASDAQ OMX STOCKHOLM AB Sweden Finansinspektionen 18 March 2014
mate of the arrival of the first mandate varies
National Clearing Centre (MoEx) Russia
between December 2014 and April 2015.
Various data indicate that take-up of clear- NOS Clearing ASA Norway
ing has been significant for OTC products OMICLEAR – SOCIEDADE DE COMPENSACÃO DE Portugal CMVM
globally, and that the mandate will only affect
firms who have held out to avoid clearing, but Finanstilsynet
Oslo Clearing ASA Norway Norway
who will also face new margin requirements
for non-cleared OTC business from the end
SIX x-clear AG Switzerland
of 2015, so will then see a changed cost base
for either approach to OTC business. Finanstilsynet
VPS ASA Norway Norway
Regulation Rocket • Edition 1 | Summer 2014 • theotcspace.com | 12

Backwards? Regulators In particular, there are specific barely ever hear the two aspects
aspects where the two need to both mentioned in the same arti-

Systemic Risk: Have Got interact quite closely:

1. Extraterritorial / cross-
cle / discussion or blog post – the
focus being on the give and take

It Reduction
between domestic and foreign
border treatment for OTC market regulator or between the
derivatives regulation. banks and the markets regulator.
The fact that even within the US
the bank regulators are typically 2. The interaction between
I often notice that the different regulators and the different associated responsible for capital regula- OTC capitalization
interacting market participants, utilities and commentators dissociate tion (e.g. Fed, OCC, FDIC) but (bank regulators) and
regulations of bank capital (e.g. Basel III) and accounting rules the market regulators are typi- the bilateral margin and
(e.g. US GAAP, IFRS) on one hand from regulations of market practice cally responsible for derivatives clearing mandates
market practice / mandates (e.g. (markets regulators).
(e.g. clearing mandate, mandatory bilateral margin) on the other. CFTC, SEC) clearly makes even In this case we’ve spent what
Re-associating these may hold the key to making, rather than inhibiting more tricky the cross-border dis- seems like 3 years or more imple-
systemic risk reduction happen in practice as well as resolving the cussion between markets regu- menting the clearing mandate,
cross-border regulatory discussion. lators. Here a balance is needed only to discover now (in my case
between two approaches to pro- at least) that:

tecting tax payers: l CCP proliferation more than

n one sense, dissociation is tion could range between allow- l explicit regulation of foreign outweighs the CCP risk con-
by jon skinner unsurprising as the regula- ing banks and market participants subsidiaries by the home regu- solidation benefit unless high-
tors responsible for each are to do whatever they like subject to lator which are otherwise logi- ly flexible arrangements are
largely separate i.e. BCBS and holding enough capital to protect cally in a different location, le- created which don’t exist to-
accounting standards boards the system from their worst ex- gal jurisdiction and regulatory day to allow each participant
– together with national banking cesses and between prescribing regime, and to consolidate their risk in one
prudential regulators for the for- very precisely what they do under l parent company minimum CCP whilst clearing at several
mer and CFTC, ESMA, SEC for strong penalties for non-compli- capitalization “in consolida- per asset class.
the latter (though there are some ance – leaving capital regulations tion” across all the group en- l The main benefit of CCPs in
overlaps e.g. CFTC/SEC regu- straightforward and a relatively tities as the last layer of pro- aggregate is therefore mitiga-
late minimum capital for FCMs). thin layer of final protection. tection from residual risks in tion through initial margin and
Also the clearing mandate is upon Common sense says that a subsidiary entities in locations default fund contributions –
us – while bilateral margin rules balance needs to be struck but and regulatory regimes which which being naturally conserv-
and most of the Basel III are some it is not really clear where in the are different from the home atively defined is an expensive
way off. At extremes in theory the regulatory system responsibil- regulator’s. solution.
balance of systemic risk regula- ity lies for striking that balance. Despite this crucial trade off we l The large measure of the open
Regulation Rocket • Edition 1 | Summer 2014 • theotcspace.com | 13

A thought:
Once the bilateral
margin and capital
rules are in place, it would in a separate portfolio (if not).
make sense to keep the In either case they will not do
clearing regulations but make their job to reduce risk.
clearing itself an elective choice l Tear-ups to reduce risk can be

once more to free up counterparties Another thought: done in theory but this would
to reduce bilateral risk if they Not that we have be a highly costly approach
mutually choose to do so this opportunity, but in from both a realized P&L
given the incentive to hindsight it may have been and an infrastructure cost
reduce better to regulate capital and perspective.
the costs. bilateral margin first and let this l Portfolio back-loading to clear-

incentive drive clearing – limiting clearing ing on a mutual elective basis

regulations to the other aspects apart may happen to some degree
from the mandate. Should bilateral as the cost of not doing it out-
margin and capital have come weighs the cost of doing in
before clearing? Is the OTC some cases. The regulations do
systemic risk regulation not push this though.
backwards? Of these tools clearly 2 (putting
on new trades) is the most ef-
ficient – were it to be allowed.
However, at least in outline the
will roughly triple the counter- clearing and bilateral margin
party risk driven RWAs and mandates seem almost to focus
therefore capital set aside on on preventing these kind of risk
them. Whilst this will act as an reduction trades and the alter-
incentive to reduce their risk, natives cost seem to point to an
on its own this will be quite effect of entrenching the legacy
punitive without the means to portfolios systemic risk – only
and uncollateralized systemic will take the form of grossing respond to the incentive by re- to slowly rolling off over many
risk is contained not in cleared up two portfolios – one initially ducing the risk. years as portfolios mature.
trades but in the pre-mandate margined and one remaining l When putting on new trades to And all of this for the sake
legacy portfolios which are as is. reduce risk, the trades put on of stemming the creation of
exempted by both the clear- What then are the actual means will either be mandated to clear systemic risk on new trades. It
ing and bilateral margin man- to reduce these systemic risks? (if a mandated product and appears without more detailed
dates. Even with regard to bi- l Crude aggregate estimates of client) or mandatorily subject estimates that one effect cancels
lateral margin this exemption the intent of Basel III is that this to initial margin and effectively the other out.
Regulation Rocket • Edition 1 | Summer 2014 • theotcspace.com | 14

Smooth Sailing this year, some providers believe

packaged trades may help attract
Described by European Markets
Basel III (CRD IV)
Europe is introducing new mini-

further buy-side participation on and Security Authority (ESMA) mum standards on bank capital
the platforms. The Commod- chairman Steven Maijoor as “the adequacy by the Basel Committee
ity Futures Trading Commis- biggest overhaul of financial mar- through the Capital Requirements
sion (CFTC) earlier this month kets in a decade,” MiFID II is Directive IV. The standards,
Regulatory reforms outlined a phase in approach for set to have a substantial impact which were reviewed following
have been at the packaged trades – trades that in- on the industry. ESMA last week the financial crisis, have been set
forefront since the clude groups of products, such as released a consultation paper on to strengthen the resilience of the
a number of swaps, or a swap and the new regulation, which is set to banking sector, improve risk man-
global financial crisis a bond – on SEFs. The first stage make changes to dark pools, data agement and increase transpar-
hit nearly six years began on 15th May for packaged fees and high-frequency trading, ency. The European Commission
ago – and it won’t be transactions in which all compo- and asked for public feedback by is phasing in the leverage ratio
taking the back seat for nents are swaps that have already 1st August. There is still a lot of over five years starting with 60%
a while yet. been made available to trade. The work to be done before MiFID in 2015 and rising up to 100% in
following deadlines, which in- II takes effect however, as ESMA 2018, following concerns that a

clude packaged trades with dif- needs to draft regulatory techni- fast implementation could slow
arket participants ferent variables, are 1st June, 15th cal standards on more than 100 down bank lending.
by paloma migone
working globally June and 15th November. requirements within the directive,
may have passed as well as provide advice to the Margin Requirements for
the hurdles of some Trade reporting – European Commission. Un-Cleared Trades
new OTC deriva- collateral and valuations The Bank for International Set-
tives rules under the Dodd-Frank It was a race to the finish line when Central clearing tlements’ Basel Committee and
Act and the European market in- trade reporting began in February The countdown for clearing was the International Organization of
frastructure regulation (EMIR), this year. Market participants on triggered by the authorisation Securities Commissions in Sep-
but there are more rules to come both sides of the trade must now of the first central counterparty tember released the final docu-
over the next few years. As the in- report OTC derivatives transac- (CCP), Stockholm-based Nasdaq ment on rules requiring market
dustry continues to prepare for a tions to one of six regulatory-ap- OMX, in March. From that point, participants to post initial and
deluge of regulation to kick-in, we proved trade repositories (TRs). ESMA has up to six months to variation margin on non-cleared
have put together a list of regula- Inconsistent and missing data produce technical guidelines on trades. The new rules are aimed
tion with the most impact in the flowing to TRs has made trade clearing houses and products. at reducing systemic risk around
next two years: reporting challenging so far. And The European Commission and the OTC derivatives market, and
starting from 12th August, market European Parliament will then will be phased in over four-years
Packaged trades participants will also be required have three months to back the beginning in December 2015.
With swap execution facilities to report collateral and valua- standards, meaning mandatory Physically settled FX forwards
(SEFs) experiencing flat vol- tions of trades, presenting a new clearing can take effect as early as and swaps are except from initial
umes since their launch earlier obstacle to tackle. December this year. margin requirements.
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 16


How Big is
carcely a day goes by life does it acquire significant val- directly comparable with oth-
without a press article or ue (which can be both positive or er financial instruments (see
speech mentioning in its negative). Even then the value will below). This also implicitly

the OTC introduction the “more

than $600+ trillion
likely remain a very small fraction
of the notional value.
eliminates double counting at
CCPs because an in the money

Market Really?
OTC derivatives market”. Whilst trade for one bank will be out
this may liven up the subject, this How has ISDA tried to help? of the money for the other.
unnecessarily inflames concern. ISDA produces companion half l $3.7 trillion gross credit expo-

Here’s why. yearly figures which eliminate sure (after netting before collat-
What do the hundreds of trillions mean and double counting of CCP trades eralization) and $1.1 trillion net
how can we compare this with other markets? What are the figures? (makes sense) and also all of FX credit exposure (after netting
The quoted figures come from the derivatives (not sure I understand and collateralization). This last
Bank for International Settlements the rationale). The latest is: ISDA figure measures the total coun-
by Jon Skinner (BIS) half yearly reporting on OTC 2012 H1 which notes $417 terparty “current” exposure in
OTC derivatives market activity – trillion adjusted open notional. the market. Whilst valid, a de-
published on their website. The This also emphasizes the point gree of statistical error can be
latest is: BIS OTC 2012 H1 which that after netting and collateral the expected given this is derived by
notes $639 trillion open notional. real aggregate exposure is a tiny multiplying together numbers
fraction of the notional. Whilst from two different surveys.
Why inflammatory? helpful, $417 trillion is in practice
Because $639 trillion is way bigger just as inflammatory as $639 tril- Is that all the risk?
than the global aggregate of al- lion and it is worth further empha- No. All the above are measures
most anything (GDP, government sizing the market value and credit of current exposure only. Poten-
debt, global securities issued, … exposure numbers produced. tial future exposure beyond this is
etc. etc.) and is not a measure or significant given OTC products
How does OTC compare with other markets? an approximation of the value of Are market value and credit are often relatively long duration
Comparison of global market values at the same point in time (end 2010) all OTC trades outstanding. exposure available? (maybe averaging 7 years or more).
Yes. BIS also collects gross mar- Note 1: market values in other
Bonds $94trn Why not? ket value as part of the survey instruments do not measure po-
Unlike bonds where the notional which collects notional values. tential future exposure either.
Loans $70trn value and market value are close ISDA combines this with netting Note 2: initial margin, default
together (one being within a few % and collateralization effectiveness fund contributions and CCP /
Equities $54trn of the other), an on-market inter- percentages it collects to estimate bank capital are all buffers against
est rate swap has near zero mar- further credit exposures: potential future exposure.
OTC Derivatives $21trn ket value on trade date whereas l $25.4 trillion gross market
notional could easily be $100m or value[1] – a decent measure of [1] Gross market value is the sum of in the
money trade values across all reporting banks
Source: OTC figures from BIS OTC 2010 H2. Other figures from McKinsey end 2010 global financial stock
more. Only through interest rate the current value of all gross – before netting out of the money trades and
movements through the swap’s swap assets held by banks and before collateral
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 17


Clearing Houses: April 2014

Winners and Losers

Open = Open interest, an amount reported by the CCP, method of calculation not disclosed to us
SGX figure is cumulative, not open business, so not strictly comparable
Eris offers Standard and Flex futures on IRS, cleared at CME

Clearing continues to increase around the world, although don’t mistake IRS IRS CDS FX
a reduction in notional in the charts for going backwards, many CCPs are
ICE Clear $928bn
working with their Members to reduce the notional amounts of business
using portfolio reduction techniques, so some CCPs appear to have lost CME $27trn $11bn $54bn $0

notional, but in reality this is to be expected. Eris $10bn

SwapClear US $26bn
by bill hodgson
ICE Clear $349bn

CME Not public Plans Plans

Eurex $29.5bn

Notable points from the chart: the total amount of Swap Futures open LCH.Clearnet $401trn $40bn $117bn
interest at $21bn, the take up of these KDPW CCP Not public Plans (Jan ’14)
l ICE dominates Credit Derivatives clearing products is significant (nearly the same
with a total Open Interest of $1.2trn, the size at SwapClear LLC) but still small NASDAQ OMX Not Public

next nearest is CME with $54bn a ratio of compared to the total size of the OTC Johannesburg SE Plans
22 to 1 IRS market
Singapore Ex $321bn $214m
l LCH.Clearnet dominates Interest Rate l Clearing in China for OTC Rate Swaps

Swap clearing with a total notional of has begun with an announcement in Hong Kong Ex $700m Plans
$401trn, the next nearest being CME with January by Shanghai Clearing House, Japan SCC $14trn $8bn
$27trn, a ratio of 15 to 1 with 15 Members and around $1bn
l LCH.Clearnet have an active FX NDFs of notional cleared. In addition Korea Not public Plans

clearing business with $117bn of open Hong Kong Exchange also have ASX Not public
interest, SGX also have some flow with a foothold with $700m of OTC IRS CCIL Small Live
$214m cleared.
l There are still lots of announced l Clearing in Korea of IRS is in a voluntary
Shanghai Clearing House $1bn Plans

intentions to clear FX and some for IRS phase with clearing becoming mandatory Plans
but little in public about progress. in June 2014 Brasil, BM&F Bovespa
l With the addition of Swap Futures from l ASX in Australia are now actively clearing
Central registration and valuation: Late 2012?

CME and Eris, you can begin to see IRS but haven’t yet made any data Chile Plans Plans
the relative size of each business, with available on their volume of business
Clearing Rocket • Edition 1 | Summer 2014 • theotcspace.com | 18

Interest Rate Swaps (Notional outstanding)

CCP Region Nov 2013 Apr 2014 Change (Nov 13 – Apr 14)
CME US $16trn $27trn $11trn
SwapClear US $30bn $26bn $4bn
SGX* Singapore $299bn $321bn $22bn
SwapClear Global £437trn $401trn $36trn
NASDAQ QMX Scandinavia $16bn Not public n/a
JSCC Japan $10trn $14trn $4trn
HKEx Hong Kong - $700m n/a The Capital Markets:
Shanghai China - $1bn n/a News, Articles and Opinion
*SGX publish cumulative totals rather than outstanding notional

CDS (Open Interest)

CCP Region Nov 2013 Apr 2014 Change (Nov 13 – Apr 14)
ICE US $891bn $928bn $9bn
ICE Europe $342bn $349bn $2bn
CME US $48bn $54bn $6bn
Sign up for our
CDSClear Global $31bn $40bn $9bn FREE weekly update via email
JSCC Japan $7bn $8bn $1bn at www.theotcspace.com

FX (Notional outstanding)
CCP Region Nov 2013 Apr 2014 Change (Nov 13 – Apr 14)
CME US $0 $0 None
ForexClear Global $130bn $117bn $13bn

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Clearing Rocket • Edition 1 | Summer 2014 • theotcspace.com | 20

The Indirect
he cost of clearing is
also going up due to
macro business rea-

Costs of sons. Over the past few

years, Futures Com-

Central mission Merchants (FCMs) have

under-priced client clearing with
a “land grab” objective, at unsus-

Clearing tainably low prices. As a result,

the economics of client clearing
are quickly becoming untenable
for many – hence BNY and RBS
The all-in cost of participating in dropping out of the business re-
the OTC derivatives market is about cently (and inevitably there will
be more). Part of the argument
to go up sharply – either through will come down to your belief in
central clearing, or as a result of the whether you can win profits in the
new BIS (Bank for International execution space - or whether you
Settlements) margin requirements need to provide the clearing ser-
for non-cleared derivatives, effective vice to encourage customer loy-
alty with reduced execution fees.
from December 2015. The choices Reduced competition will en-
clients in particular are making now able survivors to consolidate mar-
are not easy and caveat emptor ket share and push up prices to
should be front of mind, especially levels that can actually support
when choosing a clearing member. their business. The end result will So, what are the other l Complexity is increasing along
of course be higher prices paid lessons that can be learned with the need for tools to man-
by clients for client clearing. Our as we step deeper into age it.
by mas nakachi research shows that not only are this new and not always l Central Counterparties (CCPs)

there a wide range of prices be- so transparent world of need to provide members and
ing charged by banks for their clearing? clients with explicit detail on
clearing services, but the basis on l Expect to see Clearing Brokers their OTC margin models. If
which they are calculated are in- continue to fine-tune their fees they don’t do this voluntarily,
consistent, making it tricky for an as they seek to claw back the regulators will probably make
apples-to-apples comparison [see true costs of clearing from their them do so anyway.
table below]. clients. l Whilst the details of CCP
Clearing Rocket • Edition 1 | Summer 2014 • theotcspace.com | 21

margin models are available to Sample fees charged by Clearing Brokers

members, the details of the de-
fault fund calculations can be
bank annual fee (per account) add-0ns
more opaque. Expect further
investigation by regulators into ETD: $6 per lot
how IM (Initial Margin), DF $60,000 or
Citibank OTC: $750 per trade
$120,000 for low volume usage
(Default Fund) and the default OTC: +50 bps on IM maximum
waterfall are calculated and in-
teract, such as VM (Variation ETD: €200,000 for 100k lots ETD: €2 per lot
morgan stanley
Margin) haircutting and utilisa- OTC: $500,000 for 1,000 trades OTC: $500 per trade
tion of non-defaulters’ IM asset
pools. $1.50 per trade, €100 per cash
$60,000 + $10,000 once,
l Eligible assets to cover IM will jp morgan movement,€250 per security movement.
Minimum of $240,000
expand, given the wide range at OTC: + 60bps on IM
some CCPs compared to others.
ETD: £5 per lot
What a CCP regards as a stable barclays
OTC: £750 per trade
asset needs to accommodate the Minimum £150,000 revenue
OTC: + 50bps on IM for an ISA
squeeze on high-quality liquid
assets going forwards. Up to $60,000
l Another growing need is li- ubs Minimum $250,000 per OTC +20bps on IM, variable
quidity management, for which or ETD relationship
the starting point is the ability
to predict and analyse the in- goldman sachs
Minimum of $6,000 for first currency, ISA: Maximum +75bps on IM
creased number of daily margin $2,400 for additional currencies OSA: Maximum +50bps on IM
l The systemic effects of a VaR ETD: €5 per lot
€60,000 per ISA
model used so prolifically in a deutsche bank OTC: €500 per trade
Minimum €250,000 revenue
+75bps on IM
stressed market has to yet to be
seen in practise, but is some-
thing the whole market must be ISA = Individual Segregated Account.
wary of. OSA = Omnibus Segregated Account
Clearing Rocket • Edition 1 | Summer 2014 • theotcspace.com | 22

Fees from Clearing Houses under EMIR The models adopted by each most of clearing and the different
Under EMIR the CCPs must also publicly dis- CCP vary widely, given that they costs that need to be taken into
close the fees they charge for their various account each have different strengths in account to optimize the capital
models. Here are some examples, excluding the product sets, and focus on differ- allocation decision across clear-
usual membership fees, only those relevant to ent national or vertical markets. ing venues, clearing brokers, and
the new EMIR accounts: Shopping around isn’t so easy, as listed versus OTC products.
price is just one component of
your choice of CCP. In relation Sources of Data For Fees
CCP annual fee to amounts charged by the All the data in the tables above
Nasdaq OMX £500 once only Clearing Brokers, the CCP is taken as accurately as we can
Varies but £3000 (Individual) charges are minor. understand it from the websites
LCH.Clearnet The competition for business is of the respective organisations.
£1,000 (Omnibus)
evident from the varied fee struc- Links to all the sources are pro-
€2,400 (Individual)
€4,200 (Omnibus) after the first
tures above. As the European vided at a central resource page on
Mandate draws closer, we may The OTC Space site here: http://
CME europe £0 see adjustments to their models as www.theotcspace.com/rocket
ice europe £0 Clients arbitrage the various mod- where any corrections or clarifi-
eureX Fee waiver until January 2016, if on-boarded by May 2014 els to get the best deals. cations to this article will also be
In the next article in this series, published if necessary, given the
euroccp €6,000 we’ll be looking into making the possibility of updates or changes.

4 S I G H T X P O S E C O L L AT E R A L
• Boost revenues by optimising your Collateral usage
• Centralise Collateral Management across business lines
• Turn Collateral Management from back office function For further details visit
into front office trading tool. www.4sight.com
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 23


The difference between a boss and their careers and to give credit

a leader ... and what this means for

where credit is due. Almost all
employees today have a chan-
nel to their Boss’s Boss, or even

Generation Y their Boss’s Boss. If due credit

wasn’t given, Gen Y would de-
mand it.
Most leaders of men question themselves at some point. This is especially true for thing through effective delega- 4. Bosses blame but Leaders
today’s Bosses who are trying to be strong leaders of Generation Y, a group who are tion and a positive coaching solve. The blame culture is on
atmosphere using lots of lis- the way out as Gen Y require
famously challenging and demanding. Generation Y were born between 1977 and tening and questioning tech- a culture of cooperation and
1994 which makes them aged 20 to 37 today. niques. Gen Y do not like to problem solving. The idea of

be told what to do and want to ostracizing a problem person
hey are known as be treated like adults, whatever on a team wouldn’t fly today.
by penny Davenport tech-savvy and im- their age and experience. The workplace is expected to
mune to most tradi- 2. Old school Bosses relied on be a more emotionally mature
tional sales and man- their authority to get things place even if this doesn’t al-
agement techniques. done. Think back to a Victo- ways happen.
They’ve seen it all. The rapid ex- rian factory or the military. We The gap between a Boss and a
pansion of the internet, cable TV all used to do exactly what we Leader had widened over recent
and latterly social media has led were told. This rarely exists to- years as the demands of Genera-
Gen Y to be very flexible (some day as social and employment tion Y has affected the norms at
might say flighty) with respect mobility means people have work. To keep your talent happy,
to fashions and trends. In busi- a choice as how to be treated. ensure both you and your man-
ness, Generation Y have very lit- Strong leaders generate en- agers are switched on to the
tle loyalty. The concept of a job thusiasm and create goodwill communications styles and tech-
for life has all but disappeared (on to get things done. Gen Y de- niques which are expected. Offer
both sides). So, how can you be a mand respect. freedom as Gen Y are self-reliant
strong leader and give Gen Y what 3. Bosses use people and take the and won’t look to a leader for di-
they need to be productive, and credit whereas leaders develop rection. Their goal is to complete
friction-free, in the workplace? people and give credit. The old- tasks in the most efficient way
1. Bosses drive employees but fashioned way was to direct possible, while still doing them
leaders coach. The traditional your team as to what to do and well. They don’t work well under
Boss drives and “tells” employ- face-off to your superior with a management style that boom-
ees what to do. A strong lead- respect to the chain of com- ers often preferred, with the boss
er empowers employees and munication. Generation Y ex- giving orders. Give them the free-
trusts in them to do the right pect their leaders to invest in dom to make their own decisions.
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 25

Risk Management

Replicating CCP
anks have become very sophis-
ticated in how they capture and
optimise the use of key economic

methodologies for resources like funding value adjust-

ment (FVA), credit value adjust-

validation, pricing and

ment (CVA), capital and balance sheet across
their business. Many have set up dedicated
‘Resource Management Units’ or similar to

‘resource management’ perform this function. Mandatory clearing

means that such resource costs associated with
portfolios of OTC derivatives are increasingly
Replicating CCP methodologies not only improves control through sensitive to the risk methodologies employed
validation it also enables the development of sophisticated portfolio by CCPs, most notably for initial margin.
In this article we explore the opportunities
measures, analogous to CVA, for pricing and managing the cost of presented by adopting novel risk measures
clearing. Early adopters are already considering how pricing in the based on replicating CCP methodologies.
‘Margin Value Adjustment’ can help efficiently manage their OTC These include traditional control functions
derivatives portfolios. like validating margin calls. But perhaps the
real payoff is in using simulation techniques
by Sandy McFadzean to understand the marginal lifetime cost of
funding a cleared position, leading to differen-
tial pricing and balance sheet optimisation of
OTC derivatives portfolios. Firstly, let’s con-
sider the methodologies themselves.

CCP methodologies
CCPs aim to reduce systemic credit risk in the
markets they serve by redistributing losses due
to member default and preventing vicious cir-
cles of contagion and panic during times of
market stress. They achieve this by maintaining
various risk sensitive buffer funds designed to
be used up in a specific order, in a ‘risk water-
fall’ arrangement. CCP members contribute to
these funds, and are exposed to their loss in dif-
ferent ways governed by legal agreements and
now by regulatory standards.
The exact nature of the risk waterfall will
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 26

vary from CCP to CCP, although a VaR type approach. Regu- pleted default fund from mem- banks have no systematic way of
regulatory standards are driving latory standards now stipu- checking these amounts – they
bers or using bail in from share-
commonality. Generally speaking late confidence levels and holders. These are difficult to simply pay them out, day after Development
the order is guided by a ‘defaulter close out periods as well as model though banks need to be day, on the assumption that the Approaches
pays first’ philosophy, incentivis- parameters defining lookback CCPs are doing their sums right.
aware of the liabilities they cre-
ing ‘good behaviour’ and reducing periods. The level of trans- ate. Beyond their ability to re-However CCP systems and peo-
As with many new challenges
stress on surviving members. A parency varies significantly capitalise themselves, CCPs may ple are not infallible. There are
and opportunities there are
typical structure may be default- between CCPs. Most provide distribute remaining losses on many ways that their calculations
various development approaches
er’s variation margin, defaulters’ some kind of ‘what if ’ tool as their members by winding up can go wrong and lead to errone-
available to banks. Some may
initial margin, defaulter’s default part of their reporting suite ous calls. Clearly ‘over calls’ are a
their clearing services, although
choose to implement in house
fund contribution, CCP capital, but these are not truly inde- these should be viewed as very worry but banks should also be
solutions, perhaps leveraging
survivors default fund contribu- pendent. While some CCPs extreme events. For a large CCP concerned about ‘under calls’, af-
existing CVA architecture. Others,
tions, used in that order. Further publish their methodologies their occurrence would probably ter all, IM is protecting them from
in particular those who’s risk
arrangements can be made for and much of the required in- the failure of other banks.
indicate a more or less total col-
architecture is based on a vendor
loss sharing in cases of such ex- put data, others are complete- lapse of the global financial sys- There is little that can be done
platform will look to specialist
treme loss that the CCP service is ly opaque. Even at the more tem. on the day about erroneous
software houses for a solution.
wound up. transparent end, CCPs may Although elements of IM and calls, and these cannot necessar-
We are already seeing several
The methodologies employed include add-ons and multipli- default fund methodologies re- ily be unambiguously detected.
vendors offer products in this
to determine the contributions ers in IM calls, for example main unpublished, and their be- However Margin replication can
area, some of which have already
to these funds are clearly impor- based on bank’s relative size in haviour in extreme circumstancesstill highlight CCP errors and
been implemented by a few early
tant for members to understand. the market, which they reserve aid in the recovery of interest
difficult to predict, banks can col-
Although some of these are quite the right to vary as they see fit. on over calls. Further, by imple-
lect time series data during busi-
opaque, we believe that banks are These can make the behav- menting well controlled margin
ness as usual, and may be able to
increasingly anxious to under- iour of IM in extreme circum- replication and daily reporting
use these to build empirical mod-
stand the basis on which they are stances difficult to predict. els. Such models could be quite members are not only protect-
calculated. Taking them in order: l Default fund contributions are accurate during normal market ing themselves against potential
l Variation margin is generally generally opaque, although we losses, they are incentivising the
conditions, and so provide useful
quite transparent as it is simply expect them to be a function of information for day to day pur- CCP to ensure the accuracy of
the mark to market of the port- initial margin and possible rela- poses. We now consider some their calls, helping to ensure the
folio using either public market tive size in the market. As such applications of replicating CCP integrity of the system as a whole.
prices, or derived from observ- they cannot be easily replicated methodologies. Validation is perhaps the most
able market data. This should without access to privileged data obvious use case for IM repli-
tie in closely with the bank’s that CCPs are required to protect. Margin Validation cation, however we are increas-
own valuations. Should these funds prove insuf- CCPs make margin calls to their ingly seeing the front office take
l Initial margin is designed to ficient, CCPs have legal rights to members, and are sometimes le- an interest in the potential appli-
cover close out risk and will call more capital, either through gally empowered to execute pay- cation of IM calculation to pric-
generally be calculated using requiring replenishment of de- ment on member’s behalf. Many ing, which we will consider now.
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 27

Portfolio measures and pact of the new trading activity The ‘Margin Value FVA. The marginal impact is then
optimisation on the cost of funding the IM Adjustment’ the effect of a new trading activity
Optionality now exists on how (and other funds) called against The cost of funding IM for a given on this portfolio measure.
OTC derivatives are cleared. the portfolio by CCPs. In other portfolio is a function of the IM Measures for the default fund
For example, certain interest words, every new trade, or trad- posted over the entire lifetime of would be less exact as the meth-
rate swaps are now accepted ing event, will have an impact on the portfolio, not just the amount odologies for these are gener-
at multiple CCPs. For certain the amount that the portfolio IM calculated today. Assuming that ally not published, but using data
counterparties banks will will cost to fund over its lifetime. the ‘Instantaneous IM’ is some that is available, empirical mod-
retain legacy ‘old style’ Credit Clearly this number is related to kind of VaR, then calculating els could be calibrated and the
Support Annexes (CSAs) while IM somehow but can it be calcu- it requires the valuation of all lifetime funding costs estimated.
signing the ‘new style’ CSAs that lated, pre execution, and incor- trades in the portfolio, and Armed with such analytics, the
require initial margin, becoming porated into pricing in the same the application of an array of front office would have a power-
mandatory under regulations. was as CVA? yield curve shifts, representing ful tool for managing the cost of
An un-collateralized bilateral Were it possible to calculate historical or simulated scenarios, clearing in a similar way to other
derivative position attracts a CVA such a measure for the various and finding the maximum net key economic resources. Fur-
charge, as does the period of risk clearing venues available, prior move for the portfolio. To build ther, by comparing portfolio costs
exposure even with collateral to execution, then firms would an IM profile, the VaR would need across different clearing venues
under old style CSAs. In most have the ability to offer different to be considered over simulated large portfolios can be optimised,
banks the mechanisms for cap- prices for different trading ven- future evolutions of the yield ensuring the most efficient use of
turing this charge and ensuring ues. The clearing cost add-ons curve shift array. key economic resources given the
trader’s P&L accurately reflects would be sensitive to the overall The use of risk neutral mod- available clearing options.
credit risk are well established. swap portfolio between the bank els to simulate the evolution of
Many also calculate CVA pre-ex- and its counterparty, incenti- interest rates is well established. Conclusion
ecution and integrate it into pric- vising the creation of the most Monte Carlo techniques are used The costs of doing business in
ing. CVA is a portfolio measure, balance sheet efficient distri- to create many simulation paths, OTC derivatives markets are
where the important number is bution across venues. Such and first order moments used to increasing. Regulatory changes,
the marginal effect of the new optimisation could also be estimate values such as Poten- tightening bid-offer spreads and
trading activity on the portfolio carried out as a bulk process. tial Future Exposure (PFE), Ex- expensive funding mean that
CVA, rather than the standalone An optimisation algorithm run pected Positive Exposure (EPE) key economic resources need
CVA for that trade. on an existing portfolio on the and Expected Negative Exposure to be carefully managed. Costs
A cleared trade does not at- introduction of a new clearing (ENE). Using a similar approach will vary across clearing venues,
tract CVA in the same way – the venue could crunch the num- an IM profile could be gener- both CCP and bilateral. There is
counterparty risk is mitigated bers and generate suggested ated, using ‘historical’ scenarios a growing need for analytics that
by clearing – but there is still novation opportunities. So how augmented within each path on model these costs, and enable
an analogous ‘charge’ resulting could such comparative meas- a rolling basis. The total funding banks to manage risk and price
from the need to pay IM (to a ures for the cost of CCP (and charge could then be estimated competitively. As is often the case,
CCP or bilateral counterparty). IM sensitive bilateral clearing) by integrating using a funding early adopters are likely to have an
This charge is the marginal im- clearing be calculated? curve in a similar way to CVA or advantage.
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 29

Decision Support and

backup Clearing Broker when analytics tools. Whilst trading
offered a client portfolio desks tend to be aligned around
the vertical markets, risk deci-

Analytics For Clearing Foundations sions cut horizontally across all

Before performing any high level of these which mean your plat-
analytics, you need a platform form needs comprehensive ca-
into which you can acquire, store pabilities for vanilla OTC prod-
New regulations are transforming how banks and the buy-side process Over the and manage market data, credit ucts, but also complex options
Counter (OTC) derivatives business, and in particular making the relationship data, reference data and trade and strategies.
between process choices and cost of the highest importance. For instance, U.S. data required for pricing, analy-
sis, counterparty and internal Portfolio Loading
regulations insist that the journey from execution to clearing take mere seconds, organisational management. Once the foundations are in
which makes limit checking pre-trade vital to smooth the path for each trade. Data needs to come from mul- place, adding your portfolio into
tiple sources, be put through a your platform is necessary. From
quality process to handle miss- a trade processing point of view

ing or inaccurate data, and stored you need to align portfolios with
by peter walsh his environment l How will my margin require- in such a way as to make build- the actual book structure of your
generates a new raft ments change over the next ing curves and performing pric- firm, and record that within your
of strategic and tac- 3/6/12/24 months? ing, simple. It is easy to under- Risk platform. For analytics pur-
tical decisions to be l How can I reduce my margin estimate how difficult this task poses, you need to cut across the
made and monitored requirements? can be, as the quantity of data book structure to look for wider
by Clearing Brokers, and their cli- l How much capital should I be to be received and checked can opportunities to combine busi-
ents, around the choice of venue holding for my cleared / un- be large, and the effects of small ness at CCPs or by offsetting risk.
for clearing and managing the cleared business? errors can skew pricing across a Your risk platform needs tools to
economics of their portfolios. For l How do I monitor all these pa- whole firm. An example would import or take feeds from your
a user of both exchange traded rameters in real-time? What be rounding errors on a single internal systems, in real-time,
and OTC products decisions controls can I put in place? curve point, causing the pricing across all assets classes, and
such as: l For a Clearing Broker, issues of OTC Rates and Fixed Income should have flexibility of file for-
l Which Central Counterparty such as: trades to be incorrect. mat including FpML, FIXML
(CCP) should I use? l How do I explain to a potential The next component is pric- or other flat file formats as well
l Do I have sufficient limits with client what their margin will ing models, which cover both as flexible real-time application
a SWAP Execution Facility be? OTC and Exchange Traded De- programming interface (API’s)
(SEF), Clearing Broker or CCP l How can I help a client man- rivatives (ETD) products. Many which use technologies such as
to keep trading? age their limits and Initial Mar- firms trade across all assets C, C++, C# , Java and increas-
l Is the margin call from the gin (IM)? classes including Interest rates, ingly web-based API’s.
Clearing Broker correct and l Managing intraday limits for a Credit, Equities, Bonds both
valid? (Either overnight or client OTC and ETD and need to val- Risk Models
intraday) l Being able to perform as a ue everything as inputs to their Next you need to configure your
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 30

risk models, for cleared and un- Before performing any high level analytics, you
cleared business. At the mo-
ment un-cleared business tends
need a platform into which you can acquire,
to be margined relatively sim- store and manage market data required
ply using net mark-to-market for pricing. Data needs to come from multiple
or a percentage of notional. For sources, be put through a quality process to
cleared business you need ac-
cess to models which replicate handle missing or inaccurate data, and stored
those used at CCPs, in particular in such a way as to make building curves and
Standard Portfolio Analysis of
Risk (SPAN) and Value at Risk
performing pricing, simple.
(VaR) for both ETD and OTC
The table below gives some
examples of the configuration of access to clearing and therefore calculations it is worth under-
VaR for various CCPs, which on must help the client manage their standing the basics of how His-
the face of it is a complex list, but margin and credit lines, to avoid toric Simulation (HS) and Mon-
in reality are built on the same failed trades. te Carlo (MC) VaR are carried
foundations with specific design out, as management decisions,
decisions made by each CCP Flavours of VaR, Historical corporate appetite to risk and
to express their view on how to Simulation, Monte Carlo relationships with trading and
measure IM. and SPAN clearing partners are all impact-
Value at Risk (VaR) is a statistical ed by these fundamental tools.
The intermediary role technique used to measure and An appreciation of SPAN is also
In the U.S. the clearing model quantify the level of financial risk important as this is another tool
treats the futures commission within a firm or investment port- typically used by CCP’s to estab-
merchant (FCM) as an agent, so folio over a specific time frame. lish margin amounts.
has the advantage of not being a VaR is used by risk managers With HSVaR the model takes
party to the trade in-between the in order to measure and control the past few years of market his-
client and the CCP. In Europe a the level of risk which the firm tory to re-value a portfolio, and
Clearing Broker sits between the undertakes. The risk manager’s derive a predicted loss with an
client and the CCP so becomes job is to ensure that risks are not assumption on a holding pe-
a party to two trades which then taken beyond the level at which riod and confidence level. The
impacts costs of margin, capital the firm can absorb the losses of choice of market history, either
and credit lines. A client will look a probable worst outcome. Given a continuous period or selected
to their intermediary to provide the focus on capital and margin stressed periods gives flexibility,
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 31

Table 1: Examples of the configuration of VaR for various CCPs

Notes: SPAN = Standard Portfolio
CCP Service Access Model History Holding Confidence Filtering ANalysis, an approach developed
and licensed by CME
CME OTC Direct Multi-Factor
FHS = Filtered Historic
as does the length of the periods.
Eurex OTC Direct Unknown Simulation, VaR with weighting Whilst history is not a guide to
ICE OTC Direct Multi-Factor of scenarios to reduce future market scenarios, the way
volatility clusters
LCH.Clearnet OTC Direct MCVaR 99.70% markets have behaved in the past
HSVaR = Historic Simulation
VaR, same as FHS but I can’t find
gives the model a basis to illus-
CME OTC Direct FHS 5 days 99.00%
their filtering method trate possible outcomes.
10 years /
LCH.Clearnet OTC Direct FHS 2500 5 days 99.76% EWMA EWMA = Exponentially Weighted MCVaR uses a synthetic ap-
fx (ndfs) Moving Average, a method of proach to generating the un-
Singapore OTC Direct Not public
Exchange weighting historic scenarios in a derlying scenarios, by stepping
VaR model
HKEx OTC Direct FHS 5 days 99.7%/ES through time using random mar-
GARCH = Generalised Auto
ASX OTC Direct FHS 5 years 5 days 99.70% EWMA Regressive Conditional ket scenarios, and recording the
CDCC ETD Direct SPAN 2 days 99.00% Heteroskedasticity terminal profit or loss of a trade.
CDCC Repos Direct SPAN ES = Expected Shortfall Repeating these random paths
IOSCO: 90% confidence minimum many times gives a wider range
CME OTC Direct FHS 5 years 5 days 99.70% EWMA
www.bis.org/publ/cpss101a.pdf of possible outcomes, and can
CME ETD Direct SPAN 1 day
be used for portfolios contain-
5 years /
Eris Flex Futures Direct FHS 1260 5 days 99.70% ing options where historical data
Eris Standard Direct SPAN 2 days doesn’t hit the strike price. MC-
750 + VaR is the most computationally
Eurex OTC Direct HSVaR 5 days 99.00% GARCH
250 stress expensive as there are few com-
HKEx OTC Direct FHS 5 days 99.7%/ES putational shortcuts using this
HKEx OTC Client FHS 7 days 99.7%/ES method.
RATES 5 years / SPAN, traditionally used by
JSCC OTC Direct FHS 1250 5 days 100.00% EWMA
Exchanges for Futures and Op-
KDPW OTC Direct FHS scenarios 5 days 99.50% EWMA tions, is an approach for simu-
5 years / lating a defined set of scenarios
LCH.Clearnet NLX Direct FHS 1250 5 days 100.00% EWMA
where the price of the contract,
LCH.Clearnet Nodal Direct HSVaR 2 days or the volatility of the market are
LCH.Clearnet RepoClear Direct FHS 5 years / 5 days 100.00% EWMA varied in permutations, to explore
how the portfolio behaves. The
LCH.Clearnet SwapClear Direct FHS 10 years / 5 days ES EWMA
2500 permutations are usually price
LCH.Clearnet SwapClear Client FHS 10 years / 7 days ES EWMA
moves up or down of 0, 1/3, 2/3
2500 or 3/3 of a ‘scanning range’, plus
Singapore OTC Direct Not public each of those with an upward or
downward move in volatility giv-
Source: Public Data on Initial Margin Models ing 13 unique combinations of
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 32

In the US the clearing model treats the FCM as Initial Margin to their un-cleared of bilateral firms. sign up for multiple CCPs for
bilateral portfolio. This will cre- the same product set e.g. Inter-
an agent, so has the advantage of not being ate considerable new work with VM & IM prediction est Rate Swaps, there will be an
a party to the trade in-between the Client all OTC users as the rules are U.S. regulations have moved the increasing benefit to modelling
and the CCP. In Europe a Clearing Broker sits not simple. The BIS proposal re- OTC market towards that of an the effect of each trade prior to
between the Client and the CCP so becomes a quires IM to be calculated: Exchange and CCP, by making execution.
l Separately for each asset class: the time gap from execution to The other area for modelling
party to two trades which then impacts costs of Interest Rates & FX, Equity, clearing short, and raising the in- and prediction is on intraday
margin, capital and credit lines. Credit and Commodities direct penalty for failing to clear funding for margin calls. Some
l Historic scenarios must include a trade, that of paying a termi- CCPs update their curves in-
a ‘stressed period’ and have not nation fee. Firms have moved to traday to capture market move-
market scenarios. SPAN can also more than 5 years of history place pre-execution limit moni- ments to monitor margin re-
take into account opposite posi- l Scenarios cannot be weighted toring in place to avoid failed quirements and make intraday
tions in different months of the or filtered – meaning periods trades, but this needs to take margin calls. Firms may leave in-
same contract, and the closeness of high volatility will drive the into account the two main limit traday calls to chance, but having
of a contract to physical delivery, IM amount for long periods criteria, that of the intermedi- the ability to replicate the CCP
plus other adjustments measur- l The model must be approved ary (Clearing Broker or FCM) approach, and anticipate intra-
ing specific risks for options. by your regulator and the intended CCP. More day funding needs may avoid late
It seems beholden upon many l Amounts of IM must be ex- than one firm offers market in- funding charges, and enable pre-
of us in the capital markets to changed gross between par- frastructure to enable execution funding at lower cost.
learn and understand how these ties, and held such that they are platforms to manage limits, but TMX Razor Risk provides the
models work, the opportuni- available quickly in a default all of these rely again on calculat- capability to compute the IM
ties and threats they bring to the – implying the use of a third ing the effect of adding a trade to and VM on your portfolio in
capital markets – as these are at party custodian a portfolio and the resulting eco- real-time to underpin these deci-
the core of our lines of defence Observers have pointed out that nomic effects. sions. Feeding the same trades as
to risk. given the data inputs to operate Risk platforms need to provide those cleared into Razor Risk, af-
a typical historic VaR model, and the ability to react in ‘real time’ ter each novation event, will keep
Un-Cleared Business the range of products in a typical to trade events, such as answer- both Razor Risk and your cleared
For bilateral OTC business now, OTC portfolio, the unique ap- ing the question “which FCM portfolio in-sync, you then have
the margin requirements are not proach firms will take to valuing should I use for this trade” or a real-time dashboard providing
imposed by any regulator, so rely trades, and calibrating their VaR “what will the effect of this trade risk managers with the ability to
upon the policies of the two par- model, it is unlikely two parties be on my IM at any eligible predict intraday margin calls due
ties to negotiate and implement will arrive at a similar figure for CCP?”. At the moment the pools to market moves or additional
a Credit Support Annex. From the IM on a bilateral portfolio of liquidity at each CCP tend to trades.
December 2015 firms must adopt – something which suggests the be discrete, but over time if more Another factor in meeting CCP
new rules from the BIS to apply use of third parties to serve pairs banks and more sell-side firms margin liabilities is selection of
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 33

assets, being cash or securities. ing IM becomes a material cost At the moment the pools of liquidity at each CCP tend to be discrete, but over
Each CCP has a different sched- reduction, through two effects;
ule of eligible assets, each with 1) understanding which trades time if more banks and more sell-side firms sign up for multiple CCPs for
their own haircut to cover price in your portfolio are key to your the same product set (e.g. IRS), there will be an increasing benefit to
volatility. Factors to be consid- IM amount and 2) knowing how modelling the effect of each trade prior to execution.
ered to find the ‘cheapest’ asset your IM will change over time as
include the funding cost, the in- trades mature.
terest paid by the CCP on cash, A risk platform should offer the right tools to manage their
the CCP haircut, the match of these tools, in the case of un- portfolio in all the circumstanc-
assets versus liabilities (not all derstanding the output of a VaR es described above, in order to
assets can cover all liabilities), calculation, you will want to see make decisions which can lead to
and the repo rate of securities – data on the specific trades in- cost reductions. Decisions you
in which case all available assets cluded in the final IM figure, will need support for include:
can be ranked to indicate the op- captured by the 99% confidence Calculating the impact of each
timum asset to deliver. This ap- level (or whatever the CCP uses) trade on capital and IM funding
proach can be re-iterated each such that you can choose to put costs, using Historical, Monte
day for assets already held at the on risk reducing trades (at a cost) Carlo or SPAN methodology.
CCP to suggest candidate assets to bring down your IM. l Optimising the CCP venue or

to withdraw and replace, to con- In case 2, your risk platform bilateral trade choice to mini-
tinue to ‘optimise’ the assets you should have the capability to ex- mise capital, collateral and IM
hold at each CCP. plore the future of your portfolio, funding costs
using Monte Carlo VaR and by l Predicting future IM require-

Forecasting dynamically rolling forward to- ments as portfolios mature

Prior to entering into a CCP rela- days date, make a prediction on l Reducing margin/collateral
tionship, it is wise to analyse their your IM level over time. Know- overheads. Intra-day analysis
margin models to understand ing how your IM behaves over improves liquidity and collat-
the relative cost of your portfolio the next months or years may eral funding requirements
in IM. At the same time, you will enable portfolio adjustments to l Pre-deal limit checks to avoid

also be considering your choice anticipate maturing trades, but failed trades
of intermediary (an FCM or also to predict funding costs. TMX Technology Solutions and
Clearing Broker) who may have the Razor Risk platform can de-
obtained Regulatory approval to Conclusion liver this, and much more.
also offer cross-margining be- Relying upon external parties to TMX is a registered trade-
tween the cleared and un-cleared tell you the risk in your portfo- mark of TSX Inc. and Razor Risk
portfolios. Once you are have an lio isn’t the way forward – firms is a trade-mark of Razor Risk
active CCP portfolio, manag- need to equip themselves with Technologies Pty. Limited.
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 35

Comparing VaR and SPAN

Following on from the “Beat the Experts” (www.is.gd/0ig8ZF) thread,
John Philpott posed some excellent questions on the differences between
the Value at Risk (VaR) and Standard Portfolio Analysis of Risk (SPAN)
market-risk measurement methods:

“Why is SPAN supposed to be deposited upon trade execution

by ben LARAH better suited to listed futures to the Futures Commission Mer-
and options (uniform notional chant (FCM), Clearing Broker
amounts, expirations, strikes and through to a clearing house.
etc) and HVaR supposed to be The IM needs to be maintained
better suited to OTC derivatives
(different maturities, coupons, throughout the life cycle of the
strikes, rates etc) when derivative trade. It is therefore
calculating initial margins for essential to be aware of the dif-
centrally cleared products?” ference between the IM calcula-
tion methods, which are usually
either VaR based or SPAN based.
The brief Q&A below con-

tains some of John’s questions,
hilpott’s questions but it also covers VaR and SPAN
are highly on-topic, questions posed at a higher level.
especially given the Obviously there’s enough to ex-
central-clearing man- plain about VaR and SPAN to
date set to go into ef- cover an entire textbook, but for
fect for Tier 2 firms on 10 June, brevity I’ve chosen the select few
2013. The impact on such firms questions below. If anyone wish-
will include a significant drag on es for me to delve deeper into the
returns (www.is.gd/BU0E3C) topics discussed (such as the dif-
for their portfolios, if they are en- ferent types of VaR, the various
gaged in hedging strategies using ways of measuring “shifts”, more
cleared derivatives. detail about how exchanges de-
One of the significant causes termine SPAN scanning ranges,
of the drag, other than fees, is the etc.) I’d be happy to follow this
initial margin (IM) required to be up with a sequel to this article.
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 36

Q: On a high level, how are SPAN and

VaR calculated? Q: How are the sizes of those “risk-fac-
tor shifts” determined?
For SPAN, the clearing houses
A: SPAN uses 16 scenarios in which a risk
factor (e.g. today’s price, today’s volatil-
ity), or combination of risk factors, are shift-
A: For SPAN, the clearing houses tend to
choose 14 shifts that represent reason-
able moves in the risk factors (such as price
tend to choose 14 shifts that
ed by an amount determined by the clearing and volatility), and 2 shifts that represent “ex-
represent reasonable moves
house. The portfolio market value (MV) is treme” moves in the risk factors. For VaR, as in the risk factors (such as price and
recalculated under the 16 different market mentioned in the previous answer, the shifts volatility), and 2 shifts that represent
shifts, and the differences between these and tend to be historically determined. “extreme” moves in the risk factors.
the original portfolio MV are calculated. The However, the clearing house needs to de-
largest of these 16 differences, representing cide how many days’ movement in the mar- For VaR, the shifts tend to be
the most severe loss in market value, is used kets a risk-factor shift represents. For SPAN, historically determined.
to set the SPAN requirement for the portfolio the risk-factor shifts are typically presumed
margin. to occur under a 1-day or 2-day “time hori-
VaR (or, to be more specific, historical zon” (i.e. the size of the shift represents two
VaR) can use any number of scenarios, typi- days’ worth of movement in that particular
cally 1,250 or 2,500 scenarios. Today’s risk risk factor). For VaR, the time horizons de-
factors (e.g. interest rate yields) are shifted pend on the relationship between the client
by an amount determined by how they’ve and the clearing house, as well as the finan-
moved historically. The MV of the portfolio cial product under consideration. For exam-
is recalculated under all 1,250/2,500 shifted ple, IR swaps cleared directly through LCH. Approach to Interest Rate Scenarios (PAIRS)
scenarios, and the differences these and the Clearnet SwapClear use a 5-day time horizon is very similar to VaR; the main differences are:
original Portfolio MV are calculated. These for IM calculation [for Members], but IR l (i) Instead of taking the MV difference that

differences are then ranked in order (from swaps cleared through LCH via an FCM use represents the percentile-cutoff value of
largest +ve MV difference to the largest -ve a 7-day time horizon [for Clients]. the distribution as the margin requirement
MV difference), and the VaR requirement for (i.e. the VaR), they instead take a mean-av-
the portfolio margin is determined by where
the clearing house wants to cut off this distri-
bution of losses. For example, if the clearing
Q: You’ve just called LCH.Clear-
net SwapClear’s methodology
“VaR”, but on their website they call it
erage of all the MV-difference values that
fall below the percentile-cutoff value. This
is called an Expected Shortfall (ES) meas-
house uses a 99% VaR model, then the VaR “PAIRS”... why did you do that? ure.
requirement is the portfolio MV difference
value that 99% of the scenarios fall above (and
1% of the scenarios fall below). This percent-
A: Because VaR may be (and often is) used
colloquially to describe any “VaR-like”
methodology, even if there are slight variations
l (ii) They filter the historical returns to give

more weight to recent historical move-

ments, instead of using raw historical-re-
age cutoff is called the “confidence level”. and enhancements to it. The LCH Portfolio turns.
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 37

Q: Why is SPAN a suitable risk-meas-

ure for exchange traded derivatives
(e.g. equity/commodity options), but
in reality. Therefore, in order to reflect real-
istic yield curve movements in the scenario
shifts, historical VaR is used, as the historical
There is no definitive answer
as to which historical VaR or
not a suitable risk measure for customis- data set already has the correlation informa- SPAN will result in the greatest
able OTC derivatives (e.g. IR swaps)? tion embedded within it.
margin requirements- this depends
A: This is due to the properties of the
exchange-traded instruments vs. the
Q: How do the differences between on the prevailing historical market
OTC derivatives. Exchange-traded options the SPAN and VaR measures im- conditions at the time when
tend to have fixed properties (e.g. expiry, pact the margin calculations? Is the VaR
strike) so that the risk-factor shifts for SPAN requirement larger than the SPAN re- the risk-measures
(e.g. price, volatility) can be applied easily to quirement? are calculated.
the exchange-traded contracts, and contracts
in the portfolio can be easily netted together.
In addition, the risk-factors tend to be con-
A: Apart from the different time-horizons,
the major difference lies in the relative-
ly static nature of SPAN parameters vs. the
stant in time (as each exchange-traded op- relatively dynamic nature of historical VaR
tion has a fixed maturity) so one doesn’t have parameters.
to be concerned with the term structure of SPAN parameters don’t tend to change
risk factors. frequently, so the 16 shifts are constant un-
For OTC derivatives (such as IR swaps) the til the parameters of the model are updated.
maturity dates are flexible, so the risk factors Historical VaR, however, tends to have a look
possess a term structure dependence. SPAN back period of 5y (in the case of 1,250 sce-
therefore isn’t suitable because its shifts tend narios) from today’s date. This means that
to be simple and constant in time (e.g. “shift every business day, the oldest historical simu- be greater than those calculated by SPAN. If,
the implied volatility by +10%”). If a simi- lation will “roll off ” and the newest historical however, no significant periods of financial
lar logic were applied to an entire yield curve simulation (using yesterday’s market values) distress are included in the look back window
(e.g. “shift the yield curve up by 10 basis will “roll on”. for historical VaR, then the IM requirements
points”), then this would contain an embed- The upshot here is that, unless the histori- calculated by VaR can be smaller than those
ded assumption as to how instruments in cal simulations are filtered or smoothed, the calculated by SPAN.
the yield curve tend to move together (i.e. a daily difference between historical VaR calcu- So there is no definitive answer as to which
correlation assumption- in this case the cor- lations will be volatile if the oldest scenarios historical VaR or SPAN will result in the
relation between all the yield curve instru- took place during times of significant market greatest margin requirements- this depends
ments is 100%). Such parallel shifts aren’t distress. So therefore, depending on the his- on the prevailing historical market conditions
realistic, as the correlation assumption of torical market conditions in the market-cycle, at the time when the risk-measures are calcu-
100% doesn’t reflect how yield curves move the IM requirements calculated by VaR can lated.
Risk Management Rocket • Edition 1 | Summer 2014 • theotcspace.com | 38

Ten Tips to Understand 10 tips to analyse credit risk aspects with

Central Counterparties (CCPs):
Credit Risk to Central #1
Check the CCP’s credit rating (if any is available), or analyse their credit
risk. As any other company they aim at making profits, have a capital

Counterparties #2
structure and take risks as any business would.
Can CCPs keep topping up the “skin in the game or SIG” if their
business expands? (how is this amount calculated?)

Who are the other clearing members or clients (if you are a
#3 member of a club, you would want to know who are the other members
The default of HanMag CPs take collateral l The CCP should tap first into
and how strict are the new membership policies). How likely is the
Securities clearly shows from clearing members the collateral provided by the clearing member defaulting on margins and / or running out of cash to top
after calculating varia- defaulting client or clearing up the default fund?
that trading with Central tion and initial margin. member (either provided as Does the CCP have stop losses rules or maximum position limits
Counterparties (CCPs) If on a given day, a client Initial Margin or Default Fund #4 by clearing member or by client? If not, a client with a high concentration
is not credit risk free or a clearing member fails to post contribution) of activity may bring trouble if at one point it cannot provide margins, the
impact on value could be worse if prices change significantly.
margin, the collateral posted on l Then use the “skin in the game

the previous day should be suf- or SIG”, which is the CCP’s Can the CCP cope operationally with calculating and calling for all
by diana higgins ficient to cover any losses. How- own money that is set aside to
#5 the client’s/clearing members’ margins, timely and accurately? HanMag’s
problem seems to stem from being short of collateral to cover a default,
ever, if the CCP had collected fund eventual shortage of mar- and finding itself under-margined due to an operational failure in its margin
insufficient variation margin to gins if one of the members de- algorithm.
pay those clients with a position faults. Check for the CCP’s calculations transparency and your own
opposite to the defaulting client l ...and then the money contrib- #6 ability to agree or dispute initial and variation margin. Make
and / or if market prices move uted by the clearing members sure you are capable of challenging the value of the collateral posted, as
and the initial margin that had to the default fund. opposed to relying on the CCP estimating this value timely and correctly.
It is your cash and securities and you do not want to give more than you
been posted by the defaulting However, this order has not al- are obliged to.
party is not sufficient to cover ways been the case, and it looks Does your clearing member pass on the risk over to you as a
the new exposure, then the CCP like there is no regulatory re- #7 client, or is the clearing member a shield between the client and the CCP.
would have a shortage of col- quirement for at least some
lateral. EMIR (Article 43, No 3) non-EMIR Central Counterpar- As a client, check how your cash moves from when it takes off from
#8 your account, then travels through the clearing member and lands
suggests that if there is a short- ties (CCPs), as in Korea’s based on to the CCP. Watch out for netting, haircuts, segregation, portability
age of collateral, the process to HanMag’s case. alternatives, inter-operability. What instrument, who has it, where is it
cover the losses follows an order To avoid being caught by a sur- kept, when does it move and how much are the questions you need to ask
in relation to the cash you provide as collateral.
or “waterfall” as follows: prise, clients and clearing mem-
bers should make it a priority to Default procedures how quickly can the CCP settle open positions upon
#9 default? What are their porting procedures? How often do they practise
analyse credit risk to CCPs. these procedures with members?
#10 Read the CCP’s and clearing member’s rules before you join…
they are not just standard “small print”.
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 39


Swap Futures: The Next Big Thing?

In late 2012 CME launched the first of a hybrid he CME Deliver- that 2 day margin for the same $600trn this is a ratio of 75,000
product, a future traded on exchange, with able Swap Future is market is nonsense, where as to 1.
the price linked to the OTC IRS market, and a response to the dra- CME strongly believe that within In light of this move, a recent
matic changes in US their execution environment they story suggested that the London
deliverable into a physical Interest Rate Swap. and EU regulation, can manage the default of a trad- Stock Exchange Group (LSEG)
making bilateral and cleared In- ing firm more quickly than in the owners of LCH.Clearnet are
by bill hodgson terest Rate Swaps significantly OTC market. looking to provide a similar con-
more expensive. CME’s answer CME has in effect won that ar- tract, and the ability to offset such
is the DSF which is subject to gument, so you might think that Futures against their gigantic pool
margin using a 2 day holding pe- there would be a rush for this new of OTC IRS risk within Swap-
riod, rather than 5 days for a pure product, enabling interest rate ex- Clear, something which might
OTC IRS. Much argument has posure to be hedged more cheaply. prove compelling. In Frankfurt
ensued on the merits of that dif- In the chart below we can see the Eurex are rolling our their Prisma
ference, with detractors arguing activity on the CME US exchange platform to enable the cross-mar-
on their DSF contracts. The vol- gining of OTC and Exchange
ume shows a typical growth pat- Traded Interest Rate business,
CME Deliverable Swap Future Activity tern, which spikes around the providing reduced margin re-
From Launch to Present Day
March, June, September and De- quirements across a combined
cember dates when holders of the portfolio. Once any of the verti-
140,000 contracts would see them exer- cal groups provides trading desks
120,000 cise into real physical Rate Swaps with a compelling cost saving, it
within the CME OTC clearing would seem inevitable that busi-
100,000 Open Interest
platform. Many firms may wish ness will move to take advantage
80,000 to trade out of those positions and of these new tools.
become holders of an OTC IRS. Meanwhile in the back-office,
60,000 The Open Interest pattern the needs of the teams processing
40,000 shows stead growth from launch ETD and OTC business are con-
to a level of around 80,000 – verging, it seems that the combi-
20,000 100,000 contracts, worth $100k nation of products into a single
0 each, so equivalent to around margin call may be the catalyst
03 Dec 03 Jan 03 Feb 03 Mar 03 Apr 03 May 03 Jun 03 Jul 03 Aug 03 Sep 03 Oct 03 Nov 03 Dec 03 Jan 03 Feb 03 Mar 03 Apr $8bn - $10bn value. Whilst this for organisational change, and
2012 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2013 2014 2014 2014 2014
is significant, when compared to systems integration, to realise the
Source: CME Website the OTC market itself of around benefits of cross-margining.
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 40

Post-Trade Processing

hose of you that read and the last one is for the week
my articles on Swap ending 11th April 2014, so two
Data Repositories weeks old. Lets show the Interest
(www.is.gd/Bk8LrO) Rate data from each weeks Table
will know that I am a 1 report.
great proponent of the value of From which we can see that:
the CFTC regulated real-time l OTC Interest Rates positions

public dissemination feeds avail- are €382 trillion in the week

able in the US. So it was with ending 11th April
great interest and anticipation l These consist of almost 5 mil-

that I went to the European Trade lion trades (contracts), giving

Repository websites. I knew that an average contract size of €77
current EMIR trade reporting million
regulation is not real-time but l There is a large increase in the

T+1 and the public data is to be week ending 4th April or 1.5
published weekly. Despite this I million trades or €112 trillion!
expected to find interesting and l While I would like to believe this

valuable information. is year end related volume, given

Lets start with the three ma- the huge numbers that is not
jor trade repositories; DTCC possible

European Trade
(www.is.gd/NKfZqD), UnaVista l Much more likely to be report-

(www.is.gd/dnqzGd) and Regis- ing coming on stream that was

TR (www.is.gd/C98YVS) and not present before

Reporting: What’s focus on two Asset Classes: In-

terest Rates and Credit. DTCC
l ETD Interest Rate positions

the Point?
Repository. are €60 trillion in the week end-
ing 11th April
The DTCC Derivatives l These consist of 290,000 con-

Repository tract positions

It is now more than two months since European EMIR Trade Limited Public Data can be found l Volumes in the week ending

Reporting came into operation. Time to see whether teething problems here (www.is.gd/5hDyKB), what 21 March look suspicious, but
have been solved and look at what the public data shows. does it show? Firstly for each As- may be down to the IMM date
set Class and split for OTC and when volumes rolls to the next
ETD there are weekly reports of contract
by AMIR Khwaja Outstanding positions and num- l ETD gross notional is 16% of

ber of contracts. These start from OTC gross notional, or put

12th February 2014 (the com- another way the OTC Inter-
mencement of EMIR reporting) est rate market is more than 5
Post-Trade Processing Rocket • Edition 1 | Summer 2014 • theotcspace.com | 41

Table 1: DTCC OTC Interest Rates Table 2: DTCC ETD Interest Rates Table 3: DTCC OTC Credit
Date Gross Notional (EUR) Total Contracts Total Date Gross Notional (EUR) Total Contracts Total Date Gross Notional (EUR EQ) Total Contracts Total

14/02/2014 281,618,067,777,873 3,411,294 14/02/2014 120,987,211,642,465 285,384 14/02/2014 11,218,651,094,113 1,421,178

21/02/2014 232,030,889,764,662 2,789,748 21/02/2014 129,087,984,584,039 301,397 21/02/2014 11,914,065,014,095 1,519,370
28/02/2014 245,402,617,473,354 2,920,844 28/02/2014 60,919,446,668,499 311,717 28/02/2014 12,285,052,226,423 1,554,747
07/03/2014 260,596,175,825,661 3,140,237 07/03/2014 64,440,900,951,737 299,253 07/03/2014 12,383,610,927,825 1,530,420
14/03/2013 287,740,958,658,671 3,607,125 14/03/2013 62,631,598,612,311 301,455 14/03/2013 13,850,045,686,776 1,643,054
21/03/2014 275,568,119,886,743 3,554,348 21/03/2014 33,658,592,113,212 50,030 21/03/2014 12,060,462,456,389 1,465,311
28/03/2014 272,636,953,812,904 3,490,513 28/03/2014 67,153,396,706,986 299,385 28/03/2014 14,348,004,654,958 1,601,639
04/04/2014 384,543,245,530,659 4,964,243 04/04/2014 66,816,761,340,761 295,617 04/04/2014 14,588,439,519,236 1,616,292
11/04/2014 382,449,619,613,884 4,964,172 11/04/2014 59,734,233,426,059 290,401 11/04/2014 14,981,235,292,876 1,647,540

Source: DTCC website

times as large as the ETD one there is no data, we cannot see l No new transactions the €382 trillion at DTCC are than the DTCC public data.
l (This is based on figures re- currency, product, maturity. The Oh well, underwhelming to say the same trades: Super :-( Probably not even of passing ac-
ported to DTCC, which is not data currently available is only the least, what can we see from l Open Trades at 13 million can- ademic interest. Onward.
the whole European picture) of passing academic interest, so this? not just be OTC, in-fact must
Aggregate totals for outstand- I will show a table of Credit Vol- l The Interest Rates gross no- largely be ETD, (as SwapClear REGIS-TR Trade
ing notional and number of umes and move swiftly on. tional is €402 trillion, similar has ~ 2.5 to 3 million trades) Repository
trades is of limited value. Even to DTCC, and not surprising l Can we really add OTC trades What can we get from REGIS-
comparing the weekly changes UnaVista Trade Repository as we know that LCH.Clearnet and ETD trades and expect any TR? The public data is available
is fraught with difficulties; ma- What can we get from the LSE SwapClear reports to UnaVista meaningful figure? I think not here (www.is.gd/g2ammt). And
turing trades, terminations, new UnaVista Repository? The public (We know SwapClear shows l Credit is tiny at €44 billion there are two reports available;
trades etc. What we need is not data is available here www.is.gd/ $400 trillion (www.is.gd/inw- compared to the €15 trillion at aggregate open positions and ag-
only outstanding volumes by LlIIc2 (registration required). Gpu) outstanding) and major DTCC gregate transaction volumes, both
currency, product, maturity but After registration, the only data Swap Dealers report to DTCC l Presumably this is because have weekly and monthly ver-
also the new transactions in the I was able to see is the following: (Don’t forget that in Europe LCH.Clearnet Credit is re- sions. The Aggregate Open Posi-
same period by currency, prod- l No weekly history both sides to a trade are re- ported to UnaVista while ICE tions at least has currency break-
uct and maturity. Unfortunately l No OTC or ETD Breakdown! quired to report) is reported to DTCC downs, however again there is no
while there are place holders on l No Currency, Product or l So we may assume that the Overall the UnaVista public data OTC and ETD breakdown! Lets
the DTCC page for such reports, Maturity €402 trillion at UnaVista and is even more under-whelming take a look at the Aggregate Open
Post-Trade Processing Rocket • Edition 1 | Summer 2014 • theotcspace.com | 42

Table 4: UnaVista Aggregate Public Data

Date Asset Class Outstanding Notional EUR Open Trades
EMIR Trade repository public data Trade Identifier (UTI) in the
26/04/2014 Commodity 3,947,042,808,603 23,037,822
reporting is now operational, and public data, means we cannot
26/04/2014 Credit 44,550,869,014 25,291 aggregate weekly reports are being address this).
26/04/2014 Currency 766,397,913,007 29,038,340 published, by the three main TRs; l This means we cannot get

DTCC, UnaVista and REGIS-TR. The an overview of the European

26/04/2014 Equity 42,881,281,599 22,889,103
data is very disappointing, it has no market volume.
26/04/2014 Interest Rates 401,843,254,137,675 13,320,880 real-word use. EMIR regulations l Aggregating OTC & ETD trade

26/04/2014 Other 156,661,723,181 123,853 have failed so far to produce counts and notionals is not
anything useful in terms of public useful.
26/04/2014 Unclassified 58,663,448,681 5,871,701 data. l There is none (or little) currency

26/04/2014 Total 406,859,452,181,760 94,306,990 This is because: and product detail available.
l The public data is at too high an l The data is far from timely,

aggregate level. first as it is only reported T+1

Table 5: REGIS-TR Aggregate Positions l Aggregating across TRs is to TRs (and not real-time as it
Date Currency Commodities Credit Forex Equity IR Other Total Currency
impossible. (Both parties should), secondly as it is being
reporting, possibly to different made public on a weekly basis
14/02/2014 Total EUR 42,957,584 518,764 8,116,839 6,835,779 4,580,160,546 1,701,790,300 6,340,379,813 TRs, means we don’t know with a lag of one or two weeks.
21/02/2014 Total EUR 38,612,815 520,591 6,009,114 10,564,115,862 2,309,371,413 1,101,176,785 14,019,806,581 whether we are double-counting l There is no trade level data with

or not, and the lack of a Unique prices and notionals.

28/02/2014 Total EUR 39,124,954 519,231 7,019,409 10,564,732,829 2,301,306,576 1,101,341,833 14,014,044,832
07/03/2014 Total EUR 40,340,004 495,698 11,031,318 10,564,718,592 2,287,437,716 792,917 12,904,816,246
14/03/2014 Total EUR 41,952,976 497,993 13,487,156 10,564,747,631 2,291,303,213 769,652 12,912,758,622
Positions data. look too large
21/03/2014 Total EUR 41,626,989 494,364 12,011,741 10,563,915,226 752,252,151 482,392 11,370,782,863
l Interest Rates shows a €750 l Credit shows €507 billion,
28/03/2014 Total EUR 41,129,683 487,663 11,232,201 10,564,079,591 754,991,113 563,667 11,372,483,918 trillion open position! (this is which at least is believable
04/04/2014 Total EUR 41,038,351 498,234 11,029,174 10,564,206,792 758,395,283 637,107 11,375,804,942
larger than the whole OTC And the transaction volumes
market ever reported by the report?
11/04/2014 Total EUR 41,839,104 503,686 9,438,553 10,564,288,941 749,892,407 854,111 11,366,816,802 BIS at around $600trn) The total transactions in the
17/04/2014 Total EUR 48,260,019 507,927 9,925,193 10,564,399,999 750,985,200 911,864 11,374,990,201 l Mind you this is down from week of April 7-11, by Asset
€2,291 trillion on March 14th! Class, presumably this includes
Source: LSEG and REGIS-TR websites l Even with the DTB Futures both OTC and ETD trades mak-
franchise, I don’t know what to ing it much less useful, so there
make of these figures, they just you have it.
Rocket • Edition 1 | Summer 2014 • theotcspace.com | 43

State of the Market

State of the OTC Markets in 2014

The first part of 2014 has seen introduction of SEF trading to US markets, as required by the CFTC.

by amir khwaja

he products required The Competition
to trade are limited but Amongst SEFs
on-SEF volumes have We can now see data on which
been increasing and SEFs have won business, with
off-SEF decreasing to smaller firms lost in the rounding
the point that both are now simi- so not appearing on the chart.
lar in volume. This is excellent Tradition, Bloomberg and Tul-
progress given that only par va- lets each have a market share of
nilla swaps that are spot starting or around 20%, with Bloomberg
IMM in specific tenors are man- splitting the two IDBs. ICAP and
datory and even for these there are BGC, the other two IDBs, follow
exemptions for package trades. with 14% and 13%. TradeWeb
March as a common financial as a D2C SEF makes a good
year-end month had the highest showing with 7%. Bloomberg
monthly volume. dominates with two thirds of the
CDX NA IG volumes show volume, while GFI is next with
that on-SEF trading is now four 13%. TradeWeb and ICE fol-
times larger than off-SEF. The in- low with 8% and 5% respectively,
dex rolled to a new series (22) in while each of the remaining have
March, which accounts for the less than a 1% share, including
higher volume in that month. MarketAxess and the other IDBs.
State of the Market Rocket • Edition 1 | Summer 2014 • theotcspace.com | 44

Summary of 2014 So Far

Source: ClarusFT

Chart 1: Trading on SEFs Chart 3: Trading on-SEFs Chart 5: SEF Trading Share of Vanilla USD IRS
1st Jan to May 23rd, Vanilla USD IRS, Notional, USD 1st Jan to May 23rd, CDX NA IG, Notional, USD 1st Jan to 23rd May
$1,200bn $200bn 22% Tradition
21% Bloomberg
$900bn $150bn 20% TulletPrebon
14% ICAP
13% BGC
$600bn $100bn
7% TradeWeb
(RFQ model)
$300bn $50bn 2% DealerWeb
(CLOB model)
1% GFI
$0 $0
01 Jan 01 Feb 01 Mar 01 Apr 01 May 01 Jan 01 Feb 01 Mar 01 Apr 01 May
2014 2014 2014 2014 2014 2014 2014 2014 2014 2014

Chart 2: Trading outside SEFs Chart 4: Trading off-SEFs Chart 6: SEF Trading Share of CDX NA IG
1st Jan to May 23rd, Vanilla USD IRS, Notional, USD 1st Jan to May 23rd, CDX NA IG, Notional, USD 1st Jan to 23rd May

$2,000bn $120bn
22% Bloomberg
21% GFI
$1,500bn $90bn 20% TradeWeb
14% ICE
$1,000bn $60bn 13% TulletPrebon
7% MarketAxess
$500bn $30bn
1% Tradition

$0 $0
01 Jan 01 Feb 01 Mar 01 Apr 01 May 01 Jan 01 Feb 01 Mar 01 Apr 01 May
2014 2014 2014 2014 2014 2014 2014 2014 2014 2014
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