Illuminating Markets – a vision for cash and collateral management

Roberto Verrillo, Head of Strategy and Markets at Elixium, outlines his view on the key issues in the repo and collateral market.

Changes to the regulatory environment that have already taken place, and those that will occur over the next few years, have put us on a path that will change the industry forever. The impact on how the industry executes its business has been fundamentally changed.

The result of these changes has been an almost uniform decline in profitability for investment banks. Many operations have already begun efforts to re-structure large areas of their business to maintain return on equity (ROE) levels that are acceptable to their shareholders. This process will continue for several years yet.

I suggest reading ICMA’s excellent report written by Andy Hill “Perspectives from the eye of the storm” for more information about the current and future evolution of the repo market.

Basel III significantly increases the cost of doing business, taxing risk and market-making via increased capital requirements and increasing the cost to certain activities by requiring higher quality and amounts of capital. (See leverage ratio and liquidity coverage/net stable funding ratio -Basel III[1]). The more balance sheet intensive a particular business area is, the higher the “hurdle rate” for returns should be. In this regard market making (via capital costs for holding positions) and repo stand out.

Many firms have not yet implemented an exhaustive study of what these hurdle rates ought to be. These are not standard across the industry but are firm specific and are calculated using varying inputs particular to each individual institution and their relevant regulatory requirements. Ultimately these metrics will decide what each institution’s balance sheet will be and the required ROE.

We believe that as this process of re-pricing and charging business areas for the regulatory cost of partaking in certain businesses (and transactions) progresses, the market will find many more institutions cutting back and re-structuring their current business models, or simply pulling out of certain markets or product lines altogether.

NSFR (Net Stable Funding Requirement) rules under Basel III are calibrated such that longer-term liabilities are assumed to be more stable than short term liabilities. This will lead to greater demand for longer dated deposits, particularly corporate deposits which are treated favourably for banks under the rules.

NSFR provides for different, Available Stable Funding (ASF) and Required Stable Funding (RSF), weightings depending on the type of counterparty and the residual maturity of the transaction. This will make many financing transactions that are still viable under current regulatory capital treatment extremely onerous. Fifty percent RSF weightings will be applied to all loans (including reverse-repos) to non-banks, regardless of the residual maturity of the transaction, and independent of the underlying asset. In other words, this would mean that all reverse-repos with non-banks under one-year maturity would require the provision of stable funding against 50% of the value of the reverse-repo. For example, a bank transacting a $100 million overnight reverse in AAA government bonds with an insurance company or hedge fund would carry a requirement for $50 million of (long term) stable funding, even if this reverse was match-funded by repo.

The FRTB (Fundamental Review of the Trading Book) due to be implemented in local regulation by 2019, is a supervisory framework for the next generation of market risk regulatory capital rules for international banks. It will add further granularity to this process by identifying how profitable each business is within an institution at a “desk Level”.

It will also overhaul the standardised approach to market risk, forcing big banks to calculate and report it for the first time, radically altering the way that modelling approval is granted and policed, Value-at-risk (VAR) will be replaced with expected shortfall (ES) as the standard risk measure, redefining the boundary between banking and trading books. Approval by the regulator will be required, at a desk level, for banks to operate using their own internal models.

An ISDA study of 21 sample Banks concluded that, as a result of FRTB implementation, the overall increase in market risk capital, would be between 1.5x and 2.4x compared to current levels.

Current implication for repo

The cost of providing balance sheet to customers that may simply require a home for their cash has become increasingly prohibitive, leaving some banks having to turn away short term deposits/repo’s and/or charge what might look like unreasonable costs for either accepting said deposits or only offering the facility to clients from whom they generate revenue on other products as part of a wider relationship.

Because of this lack of willingness to, or difficulty in, pricing collateral transactions, many of these transactions have become economically unviable. Backward-dated pricing and resulting dysfunctional collateral markets are in evidence not only during reporting periods such as month, quarter, half and year end, but increasingly over a “normal” date run – volumes and liquidity are both showing signs of drying up.

“Previously, business lines might have been kept as part of the core business strategy, even if they did not meet the hurdle rate for returns. But in time banks will become more ruthless and cost aware about whether these activities can be a valid part of a long-term business model.

“Repo, as a standalone product, is no longer profitable. Repo desks have gone from being profit centres to cost centres. This has already happened; whether yet realised or not” – Andy Hill -ICMA.

“The provision of repo pricing and liquidity by banks has become more of a value-added service for clients, largely subsidised by other, more profitable businesses. “ ICMA quarterly report Q4 2015 – pages 25-28.”

Improving efficiency

There has been an exodus of banks from non-core businesses, but even in areas where they remain active, banks can make significant cost savings by accessing liquidity pool providers (such as Elixium) for distribution.

Harmonisation of settlement

Basel rules are implemented as the Capital Requirements Directive in Europe and the specific capital requirements for EU firms are based on their MiFID permissions.

There is increasing interest secured financing transactions, with the market moving from unsecured to secured financing and impending enactment of regulation surrounding the margining of OTC products. There is a stream of regulation that will have a significant impact on collateralised markets which involves harmonisation of settlement discipline regimes across Europe. The industry will have to identify an efficient operating model to manage these changes.

“4.6 Market access and interoperability

Activity description

The activity covers market practices or legislation that obligate or restrict the settlement of (stock exchange and/or central counterparty-cleared) transactions in a specific issuer CSD. The consequence for foreign investors, custodians and/or investor CSDs in such (issuer) markets is that access to settlement flows is restricted owing to the unfair competitive advantages established in those issuer markets. The restriction implies that entities wishing to offer settlement services on these securities need to become participants in the issuer CSD or central counterparty.”

Page 46 ECB Harmonisation Progress Report 13/04/15

http://www.ecb.europa.eu/paym/t2s/progress/pdf/ag/fifth_harmonisation_progress_report_2015_04.pdf?986629e468a824c5d0069151574ead5c

In an environment of litigation and lawsuits is it reasonable to suggest to pension funds, hedge funds, sovereign wealth funds asset managers, CCPs, corporate treasurers, local authorities and other government entities such as public utilities should be precluded from access to a transparent trading facility for the re-investment of their short end cash and or securities or for sourcing collateral/margin?

http://www.reuters.com/article/2015/11/26/interestrateswaps-lawsuit-idUSL1N13K2IE20151126

In Europe, EMIR sets out a legislative framework for Central Counterparties (CCPs), trade repositories and OTC derivatives. This framework includes new requirements covering capital requirements, risk managements and organisation.

MiFID2 will be introduced with a view to de-restricting market access on a non-discriminatory basis. There is a requirement for Multilateral Trading Facilities to implement non-discriminatory rules regarding access to its facility.

MiFID2 introduces additional pre and post-trade transparency requirements for a number of financial instruments, these proposals aim to create a level playing field for the regulation of all organised trading. The trading obligation in Europe will be introduced in the Markets in Financial Instruments Regulation (MiFIR).

Mandatory Swaps Margining and the effect of Mandatory Swaps clearing on collateral markets;

Initial Margin (IM) and Variation Margin (VM) for uncleared OTC derivatives will be phased in from September 2016 through to June 2021. The US will start IM from September 2016 for the largest of counterparties but the EU has delayed the start of IM until June next year.

Clearing banks that traditionally put up money to support default funds within CCP’s are increasingly reluctant to do so as they have to hold a significant amount of capital on their balance sheet to support this business.

Variation margin to CCPs must be in the form of cash – there is a need for collateral to cash transformation and the size of the potential problem cannot be underestimated as banks step away from providing balance sheet to support short dated, low margin repo activity.

CCPs are working to engage buyside counterparties via differing initiatives be they sponsored or direct CCP membership.

It is envisaged that mandatory swaps clearing in Europe could create unprecedented demand for high quality liquid assets (HQLA) and its transformation, for use in initial and variation margining of swaps.

Eventually CCPs may offer cross-netting capabilities across a range of products.

Elixium – re-engineering collateral markets.

Elixium is an all to all collateral trading platform that addresses the current fragmentary nature of the market.

Standardised processes and protocols facilitate a transparent, efficient marketplace that simplifies the process of ‎rapid counterparty diversification amongst all institutions seeking to raise cash or collateral.

Connecting traditional players with new entrants and addressing the growing demand and supply of cash and collateral presents an exciting opportunity for Elixium.

The repo and collateral market is a critical source of funding for many institutions but remains balance sheet intensive. As institutions come under pressure as a result of regulatory changes such as the Liquidity Coverage Ratio and Net Stable Funding Ratio, a reduction in balance sheets has impacted the depth and cost of liquidity available.

It is broadly accepted that the market will see more buy-side entrants, and all-to-all trading. The Elixium all-to-all marketplace has been developed specifically to facilitate access to a much wider counterparty base, which previously, have been restricted from direct participation by overly complicated legal and restrictive trading structures.

Legacy trading models are no longer as relevant in today’s market as they once were. As regulation creates new challenges and reshapes the traditional repo market-making model, stakeholders are trying to adapt and innovate both to meet those challenges and to exploit potential new opportunities.

Roberto Verrillo is head of strategy and markets at Elixium.

[1] Basel III is the global framework of principals that are agreed internationally which local regulators are consequently expected to implement into local law. It is worth noting that the US and EU are not 100% aligned on leverage ratio. (See CRD IV for the EU rules)

R3 patent application unveils its vision for future of blockchain technology

R3 executives speak publically for the first time about Project Concord and their vision for the future of blockchain technology.

Distributed ledger and blockchain technology represents a once-in-a-generation opportunity to transform the economics of data management across the financial industry.

However, R3 believes the blockchain and distributed ledger platforms that led to this breakthrough moment were never designed to solve the problems of financial institutions and do not meet all their needs. These include tight linkage to the legal domain, an obligation to prevent client data being shared inappropriately and interoperability with existing financial infrastructure.

As reported in the Wall Street Journal, the R3 blockchain consortium filed a patent for its Corda shared ledger platform.

Corda is the outcome of the analysis R3 undertook on how to achieve as many of the benefits of distributed ledger and blockchain technology as possible but in a way that is sympathetic to, and addresses, the needs of regulated financial institutions.

The platform enables firms to record and process financial agreements using smart contracts, as explained in depth in R3 CTO Richard Gendal Brown’s latest whitepaper.

Corda is part of Project Concord, R3’s overall vision and roadmap for transforming financial services infrastructure. Concord will address challenges such as governance, internal record keeping and regulatory reporting across the financial services marketplace.

With a number of successful prototypes having already been completed on the Corda platform and an alpha launch of Concord scheduled for 2017, the next year looks set to be a turning point in the history of financial technology.

Big data overdrive hurting bank profits

With more and more data available, making sense of vast amounts of content efficiently can boost profits by at least five percent a year.

Sell-side banks operating in the FICC markets are producing more and more data, and it is widely acknowledged that there is tremendous minefield of value often hidden within this data that can be of great use to an institution’s trading, regulatory, audit and compliance functions.

But for many institutions, aggregating and gauging this data to make sense of key trends accurately remains a significant challenge. So far, it is proving to be timely, costly and hurting banks’ profits.

The 2016 global study released by Qlik and Wall Street Journal (WSJ) surveying financial service companies about the usage of data and analytics revealed 57% found data information too complex to process, analyse and disseminate in a timely fashion. Yet nearly 80% of respondents believed that leveraging insights from data could boost revenues by at least five per cent annually.

As Duncan Ash, a Senior Director of Global Financial Services at Qlik, says: “Analytics is still the most prevalent in head-office functions, and the people in the field that need it the most are getting it the least.” He added that “firms struggle with the volume and complexity of data, and with the basics of communications and data management.”

This potential rewards on offer has led to a rise of specialist technology vendors that scrutinise and standardise data and do the hard work for their clients. One such as example is Mosaic’s MSX platform, which aggregates multiple sources of transaction data into a singular resource. This enables banks to meet regulatory requirements by building a more comprehensive view of client’s trading activity while creating better audit trails for regulators.

Steven Hatzakis, a financial services industry consultant and a registered Commodity Trading Advisor, said in a column on Finance Magnates that as analytic tools have evolved, so have visual dashboards. “These include not just numbers but adding colors or other variables that indicate changes as reporting and related gauges become dynamic. This is a common trait seen within trading platforms in capital markets and it is used in order to make it easier for technical data to be comprehended quickly.”

As Diane Castelino of Mosaic Smart Data says, “The next and most advanced stage is breaking into the field of predictive analytics and machine learning, where the ability to predict future client trading behaviour based on historical patterns sets institutions streets ahead of their peers.

“In what has become a challenging trading environment for all, the real winners in the race to harness and utilise big data will be those institutions that partner with the technology specialists that deliver expertise and innovation on a cost effective, modular basis and educate staff to use the technology effectively.

Diane’s whitepaper on big data and going beyond the hype can be read here.

Oliver Wyman and JP Morgan urge asset managers to engage with blockchain

Asset management is just one of the many areas of financial services investigating how blockchain can be used to streamline operations and reduce costs.

It’s clear from the report from consultancy firm Oliver Wyman and American investment bank JP Morgan that there are significant benefits on offer if the asset management community adopted blockchain technology.

More robust and consistent data sharing, seamless transfer of assets and settlement flexibility are just a few of the possible advantages that blockchain could bring to the asset management industry, allowing them to offer improved product solutions and data management.

However, the technology is still very much in its infancy so it may be some time before these benefits are truly realised. The report suggests that elements of blockchain are likely to be applied within four waves, with 2030 suggested as the year when the full benefits will ultimately be realised.

The report also suggests that asset managers must move away from their traditionally passive approach to new technology and actively engage with blockchain if they are to reap these benefits in a timely manner, recommending research and collaboration with regulators and developers take place at an early stage.

The full Oliver Wyman and JP Morgan report can be found here.

London’s position as the world’s FX trading centre is damaged by Brexit

London’s position as the world’s main currency trading centre would be threatened by a British exit from the European Union, with Frankfurt, Paris, New York and Dublin likely to be the main beneficiaries, according to a survey of foreign exchange (FX) market professionals.

As reported in Bloomberg and Reuters, the research team at Chatsworth Communications polled 12,000 members of the ACI Financial Markets Association, the largest global trade body representing the international currency markets, for their personal views ahead of the UK Referendum vote on 23 June.

Key findings:

  • Two-thirds (65%) of respondents believe a UK vote to leave the EU would negatively affect London’s position as the world’s largest FX trading centre, while 13% believe a Brexit would have a positive impact.
  • Of those concerned about the negative impact on London, more than 70% identified Frankfurt as the trading centre most likely to benefit from a Brexit, followed by Paris (49%), New York (40%) and Dublin (28%).
  • 80% of all respondents believe the UK will vote to remain in the EU.

London’s dominance of the foreign exchange market has grown exponentially as the size of the market expanded, and is, by far, the largest and most established centre for currency trading. Nearly 41% of global trading goes through London, more than double the market share of New York, according to data from the Bank for International Settlements (BIS)*.

Currency trading increased globally to an average USD 5.3 trillion (GBP 3.8 trillion) per day in 2013. The vast majority (75%) occurred in five jurisdictions: London (41%), New York (19%), Singapore (5.7%), Japan (5.6%) and Hong Kong (4.1%).*

Detailed findings:

A UK vote to leave the EU will…

  • Positively affect London’s position as the world’s largest FX trading centre: 13%.
  • Negatively affect London’s position as the world’s largest FX trading centre: 65%.
  • Have no effect: 22%.

How do you think the UK public will vote?

  • The UK will vote to remain in the EU: 80%.
  • The UK will vote to leave the EU: 20%.

Which global trading centres do you think will benefit the most if the UK votes to leave (NOTE: answered only by respondents who believe a Brexit will have a negative impact on London)?

  • Frankfurt: 71%.
  • Paris: 49%.
  • New York: 40%.
  • Dublin: 28%.
  • Zurich: 14%.
  • Hong Kong: 8%.
  • Singapore: 7%.
  • Geneva: 7%
  • Dubai: 4%.
  • Tokyo: 4%.

How long have you worked in the FX industry?

  • Less than one year: 0%.
  • 1-2 years: 9%.
  • 3-5 years: 10%.
  • 6-10 years: 16%.
  • 11-15 years: 17%.
  • 16-20 years: 18%.
  • More than 20 years: 30%.

Microsoft and R3 partner to accelerate adoption of blockchain-inspired technologies

Tech giant Microsoft and Chatsworth client R3 today announced a strategic partnership that will accelerate the use of blockchain-inspired distributed and shared ledger technologies among R3 member banks and global financial markets, as reported by the Wall Street Journal and Bloomberg.

These technologies enable enterprises and business network participants to complete financial transactions with greater speed, security, cost-efficiency and transparency relative to solutions currently used.

As part of the partnership, R3 will use Microsoft Azure as a preferred cloud services provider in its R3 Lab and Research Centre, where distributed and shared ledger technologies are being developed and tested and use-cases carried out based on an extremely rigorous, empirical-evidence based process.

The Lab and Research Centre has quickly become the centre of gravity for use-case testing and evaluation of blockchain-inspired technologies, bringing together banks, non-banks, both established and start-up financial technology companies, trade associations and regulators.

R3 and consortium members will have access to Microsoft’s expanding ecosystem of Blockchain-as-a-Service (BaaS) partners including Ethereum and ConsenSys, Ripple, Eris Industries, Coinprism, Factom, BitPay, Manifold Technology, AlphaPoint, IOTA, BlockApps STRATO, Tendermint LibraTax, and many others that will aid in the development, testing and deployment of distributed ledger applications in cloud, hybrid and local environments.

Settlement risks involving public blockchains – R3

Entrepreneurs, investors and enthusiasts claim that public blockchains are an acceptable settlement mechanism and layer for financial instruments. But Chatsworth client R3 argues that public blockchains by design cannot definitively guarantee settlement finality, and as a result, they are currently not a reliable option for the clearing and settling of financial instruments.

Read the full article by R3’s Tim Swanson on TabbFORUM

ParFX adds Citi and JP Morgan as founding members

Citi and JP Morgan have joined ParFX as founding members, the trading venue said on Wednesday, taking the number of core members to 14 and bringing the company closer to introducing prime brokerage clients in the coming months. The less-than-a-year-old platform says the addition of Citi and JP Morgan represents a validation of the idea that foreign exchange trading is changing and the platform is gaining momentum.