By Alex Lamb, head of business development Americas and head of marketing, The Technancial Company
While most of us are completely familiar with what we need to observe and validate in day to day risk management of exchange-traded derivatives (ETDs) in order to be in control, it isn’t the same in the OTC world.
To use a driving analogy, there was a time where the argument existed that better control could be maintained by keeping the manual gearbox and clutch combination. That is no longer true for various reasons. Technology has advanced, with metrics being fed back to a computer for almost all the variables that affect a car’s performance and stability. Various automated controls (gearshift and traction as well as engine management as a few examples) are employed continuously to improve safety and performance control. What is clear is that all the data inputs in a car are local and available, enabling a complete picture (at least in the computer’s CPU) to be available to all the control components. Thus overall control of the car is much more certain than when we were dependent on the ‘seat of the pants’ approach. Speeds are higher, tolerances smaller and competition fiercer!
In the post Mifid ETD world, better control has or at least is beginning to become a reality - more is now known about orders and trades as they are placed and executed, how they interact with the markets, how they impact credit as well as market risk and most importantly provide a holistic view of a particular account’s risk profile. How close to the limits being alerted or what actions to take for a limit breach are all part of the trading environment’s first line of defense against a potential problem or loss of control. How quickly the information is delivered and how quickly it can be responded to is also key.
If we are to have a comprehensive view of the risk an account is exposed to, surely it would make a lot of sense to incorporate all the orders and trades into that single view. Then you would be able to act in accordance with that complete and single picture. Typically, however, OTC transactions are only captured post-trade, residing in trade capture systems that are not real-time. There are alternative trading systems that support OTC markets in equities but currently no visible marketplace(s) for interest rate swaps (IRS) or currency swaps. Clearing of these transactions is now part of the mainstream, reducing counterparty risk after the trade.
What is missing is the ability to control an order that would breach a limit until it has become a trade – by which time it is too late. What if there is an adequate ETD hedge that offsets the bulk of the market risk in the portfolio that the swap represents, or vice versa?
If we consider the total number of IRS and FRAs traded daily and then focus on just the bulk - US$ and EUR denominations, these are a massive percentage of the overall daily interest rate risk volumes, yet almost none are vetted prior to a trade. Yet almost every Eurodollar Future can be seen as an order before it is traded in microseconds…
Consider USD equivalent for the major currencies (mainly USD and EUR) at LCH and CME (adding Eurex cleared Swaps would add even more to the huge volumes)
IRS more than 1.35 Trillion per day (Source LCH)
FRA more than 2 Trillion per day (Source LCH)
Eurodollar Futures 3.3 Trillion per day (Source: CME)
Arguably there is good reason to consider the risks these invisible trades present during the trading day, and preferably before the order is executed. The bulk of the swaps and FRAs are ‘Vanilla’ meaning that their parameters are pretty standard (aligned to CME Eurodollar settlement dates) and that the market in them should be very liquid. Not being listed at a visible exchange leaves a massive gap in today’s risk controls. CFTC Commissioner Dan M. Berkovitz, in dissenting to proposed changes in the regulations that SEFs are under (5th November 2018), rightly believes that the SEFs should play a role in trading, not just as a blotter, but also in managing risk and liquidity. How can one measure liquidity without seeing all the participating orders in the market? What if liquidity drops and positions are too large relative to the daily traded volumes?
The swaps and FRA markets in the US$ sector are now larger than the Eurodollar futures markets in value: it is about time they are traded in the open to ensure that real time activity can be monitored as part of the overall risk exposure in an actively traded market. What is there to prevent another ‘Griffin’* debacle(sic) of overtrading and no-one being aware of the total size of the exposure until the trades are on the books? Make the orders, responses to RFQs visible and risk can be at least seen, so that it can also be controlled or restricted before it becomes too big and too difficult to reduce in an orderly manner.