Monday, December 22nd, 2014
by GEORGE BOLLENBACHER
As we move from Thanksgiving to Christmas, it is traditional to reflect back on the year that is coming to a close, and to begin planning for the new year. For the capital markets, reflecting on 2014 may result in mixed emotions, so does 2015 look to be any better?
Looking Back
Actually, taking the retrospective view it would be easy to say that 2014 was a pretty good year, at least in the US. Equity prices spent most of the year rising, although the market has looked decidedly toppy in December. The economic indicators have been gradually improving all year, and the December jobs numbers gave everyone a warm feeling, if only for a moment. The Fed’s long period of aggressive easing finally seems to be paying off, even if everywhere else the world seems to be back on its heels. Corporate profits have been robust, except at the big banks, where mounting legal costs never seem to stop. Not bad, really.
But the functioning of the markets, as opposed to the economy as a whole, has been more of a mixed bag. Michael Lewis highlighted one aspect of the problems, and Carmen Segarra another, but the underlying theme of 2014 was one of disappointment – in the levels of liquidity in most markets, in the spreads that market-makers were seeing, in the rising cost of being a market-maker, and in the ability of regulators worldwide to get their acts, literally, together. As large banks ended the year with another round of impending investigations, more cutbacks in investment banking staff, and more exits from trading and clearing businesses, it would be easy for market participants to say, “Good riddance to that year, I hope 2015 is better.”
Looking Forward
But the groundwork for 2015 has already been laid, and thus some of the future should be apparent to the careful observer. So let’s look at some of that groundwork close up.
Regulation
The two major regulatory stories of 2015 will be the implementation of many aspects of the Volcker Rule in the US and the start of mandatory clearing in Europe. Neither of these will be a surprise, of course, but there is lots of uncertainty about how both events will work out. With Volcker, much of the discussion and trepidation relates to the market-making exemption, but the biggest changes may actually be in hedging. And the technology to support tagging of trades into specific exemptions and the monitoring for violations may be immature, if it exists at all. Without technology, trading under Volcker becomes a manual nightmare.
Clearing of derivatives trades is nothing new either, of course, but making it mandatory for a wide range of participants in Europe is new. The increased cost of margin is well documented, and has prompted some buy-side firms to move from swaps to futures, which has further prompted some FCMs to exit the swaps space, but the concentration of risk in the CCPs is only now coming to front-of-mind. Once that concentration is well understood, and the sources of CCP capital become clear, there will be a scramble to enhance the regulation of that sector, leading perhaps to more exits from the business, leading to even more concentration of risk, leading perhaps to even more regulation.
Trading technology
As spreads have fallen in every market, trading firms have predictably moved away from manual, expensive, trading methods toward automated ones. Every month the percentage of computer-executed trades has been rising, so that by year-end half or less of the trading decisions in just about every market are being made by people. In fact, we even have the science-fiction scenario of buy-side bots trading with sell-side bots.
The biggest risk with automated trading is that most of the algorithms are mean-reversion formulas, meaning that the right price for anything is a function of the price of everything else. Experienced traders know that that kind of pricing works well when markets are essentially stable, but breaks down when large secular shifts occur. Looking at 2015, one such secular shift would be the end of the Fed’s many years of easing, and another would be a resumption of the financial crisis in Europe. Or perhaps both of them at the same time.
The people who run the dealer trading bots are well aware of this possibility, of course, and are prepared to shut them down if they see a secular shift. The problem will be that many of the people who could step into the breach and exercise human judgment were let go over the last few years, so we may run short of expertise just when we need it the most. The resulting trading volatility will be reflected in margin calls, which may exacerbate the same volatility, in a sort of feedback loop.
Market Risk
All this means that the risk in the markets will probably be higher in 2015 than it was this year. One simple measure might be in the potential mark-to-market for the largest category of swaps, fixed-float rate swaps. If we assume $420 trillion outstanding notional, 75% of it back-to-back, with an average tenor of six years, the mark-to-market of just the net exposure for a 100 basis-point rise in rates is $5.5 trillion. Given that such a rate rise would also serve to depress the market value of the very Treasuries used to generate the margin, we can see that there could be a tsunami lurking just under the surface of the markets.
What to Do?
So, as this year draws to a close, and the new year beckons, what’s a market participant to do?
- Assess your trading and clearing partners – If the risk in the markets is as high as it appears, it behooves everyone to take a hard look at whom you trade with and where you clear. As trading moves more and more from principal to agency, customers will need to know where their liquidity will come from. If your traditional trading partners are feeling constrained by the capital and regulatory requirements, you need to find that out before you need them to stand up and they aren’t there.
The clearing assessment is at least as important. If CCPs are the single point of failure in the market, you need to know how much capital they have, how they can get more if they need it, and – most importantly – how they screen customers and clearing firms. The CCP space is a competitive business, and competition can lead to lax standards, so you need to be as rigorous with them as they should be with you.
- Assess your trading technology – Whether you are a bank that will be dealing with Volcker in 2015 or a customer, you need to know how your technology will stack up to the new regulatory requirements. Systems take a notoriously long time to develop and test, so your tech providers should be well along on the upgrades you will need next year. Volunteering to be a beta tester for your vendors can give you an early insight into how well they will perform when you need them. If they look iffy, you may need to plan a switch well before the rule changes hit.
- Talk to your regulators – All the market regulators are feeling their way through these changes, along with everyone else. Some of them, like the OCC, have already begun pre-Volcker examinations, as much to learn what’s being done as to pass judgment. If you are embarked on some preparations that they will have to opine on, it is much better to find out early if they have a problem with your approach, as opposed to getting a bad report later. And you might just find that they are as anxious to learn from what you are doing as you are to learn from them.
The second half of December is always thought of as a slack period in the markets, as well as within market participants, but this December may just be the time to put in some extra work. If you do the things we’ve just described, you might just have a Happy New Year all of 2015, while others are playing catch-up.
