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The rise of the Texan sharpshooters?

Published in Automated Trader Magazine Issue 29 Q2 2013

There is a story about a Texan who fires a bunch of shots at the side of a barn. Once he's done shooting, he walks over to the barn, paints a target centred on the biggest cluster of shots, and calls himself a sharpshooter. So what, you may ask, does this have to do with swaps regulation?

The rise of the Texan sharpshooters?

(Editor's note: see related story on SEC's deployment of MIDAS here.)

The story gave rise to what's known as the Texas Sharpshooter Fallacy. It occurs when random data points are analysed until a pattern is found, the significance of which is then assigned after the fact. Are leading derivatives regulators setting themselves up to become Texan sharpshooters?

"I do think that there's a sense of: 'We'll figure out what the data is telling us after we get the data', rather than 'What exactly are we looking for, and therefore what data should we collect?' " Mark Calabria, director of financial regulation studies at the Cato Institute, said.

"Unfortunately, there are probably many things in Dodd-Frank that we're only going to figure out how they work when they're actually put into practice, or when an individual firm gets into trouble or failure. So in terms of providing guidance for the market place, I don't find it to be a very good roadmap if one is structuring one's business."

Underpinning much of what regulators have been doing since the famous Pittsburgh declaration of 2009, there is this simple idea: 'If only we had enough information, we could head off some of these problems before they got out of hand.'

It starts with the declaration itself, which by now is probably etched into the minds of scores of market participants, but still bears repeating because in three sentences it sums up so much:

"All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements."

To paraphrase Donald Rumsfeld, the world's OTC market was a known unknown. The G20 reckoned it was possible to turn that into a known known. More than three years since Pittsburgh, the information has now begun to flow.

On December 31, 2012, swap deals began

to be reported to the Commodity Futures Trading Commission (CFTC), as part of the Dodd-Frank legislation and just in time for the G20-mandated deadline. This September, similar information will start to be reported in Europe as a result of EMIR. But will regulators be able to make sense of the data? And what will they do with it?

Cato believes a big problem is that regulators don't appear to have a starting framework.

"Throughout the regulatory process, it's not always clear that there is a theory or framework of what they're trying to achieve. Certainly, a lot of it comes out of an AIG-driven sense that, 'If we just monitor and centralise risk in our derivatives and swap markets, we'll know where everything's at, and we can stop bad things from happening'," he said.

"Unless you have some filter through which to look at the data, just a whole bunch of raw data is unlikely to tell you a whole lot."

Calabria stopped short of saying the data wouldn't become useful.

"I'm not going to say completely that data will not help you generate questions, because it can," he said. "In some sense I think it'll be helpful in giving us a better understanding of how the market works. But I'm sceptical that it's going to answer every question we're looking at. I'm sceptical whether, from a regulatory perspective, it's going to allow you to potentially avoid crises."

That last point, after all, was what Pittsburgh was all about.

Early experiences

The CFTC has begun trying to understand what's coming down the pipe, but the early results have been less than stellar.

In the homogeneous US market, most trades are settled by The Depository Trust & Clearing Corporation (DTCC), which in addition to its role as a clearing and settlement powerhouse is also a trade repository. Swap dealers first began reporting credit and interest rate derivatives into the DTCC Data Repository (DDR). In March this year, DTCC said swaps dealers were submitting OTC information for all five major asset classes into the DDR.

Example of data analysis by Clarus Financial Technology

Example of data analysis by Clarus Financial Technology

In the run-up to this milestone, there was extensive hand-wringing over whether market participants would have everything in place. But Zohar Hod, global head of sales at SuperDerivatives, said: "Despite the uncertainty surrounding compliance, the majority of the larger swaps dealers are ready, as they have been preparing for several years."

Mark Calabria

Mark Calabria

In the DTCC's March announcement, Michael Dunn, chairman of the DDR, said that reporting across asset classes would, for the first time, provide authorities with the information needed to monitor exposure and identify risk concentration in a timely fashion, while also achieving greater public transparency in the OTC market.

But two weeks after Dunn's statement, CFTC Commissioner Scott O'Malia gave a speech in Arizona in which he talked about the regulator's early experience in sifting through the data. "Unfortunately, I must report that the Commission's progress in understanding and utilising the data in its current form and with its current technology is not going well," O'Malia said.

Large amounts of data submitted to SDRs and the Commission were simply not usable. "The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files," he said, referring to the infamous trader whose trades cost JP Morgan billions of dollars and who earned the nickname for his outsized positions.

O'Malia has returned to this issue a number of times. "The breakdown can be traced to one primary factor: the lack of data standards," he said in late April. But he also said he believed the CFTC could fix the problems and ultimately gain transparency. He recommended creating a cross-divisional data unit with a team focused on organising and examining the data, analysing it and developing tools to identify market risk.

Increased visibility

Many believe the data can and eventually will make a difference. Their argument is not that the world's regulators expect to become all-knowing oracles who can divine problems before they occur by identifying patterns. Rather, it is simply that seeing aggregate volume and trends will help highlight trends in risk.

Thomas Riesack, a managing principal at financial services consultancy Capco, said it's already interesting to see the data that is coming from the US, which can be found on the DTCC website.

"So you can see actually what's happening in the market, the volumes being traded on a particular day, the ratio between cleared and uncleared trades," he said. "It's been interesting to see that quite a large number of trades are being cleared already, especially in the larger currencies like euros and US dollars and Japanese yen."

Riesack is not concerned about the early experiences regulators have had. Over time, he expects they will be able to refine requirements and make more sense of it, and that ultimately it will be a useful tool. He said various potential uses come to mind:

• aggregation of risk buckets across regions, countries and single counterparties

• Under EMIR, the valuation of trades outstanding and corresponding collateral posted against this, to answer the eternal debate around notional amount versus valuation

• understanding of counterparty relationships

Cato's Calabria said he doesn't believe it is realistic that meaningful patterns will suddenly appear: "I am concerned that there becomes a sort of obsession with the trees and you miss the forest."

Thomas Riesack

Thomas Riesack

He also believes OTC derivatives regulators may be suffering from a sense of envy. "There's a bit of jealousy looking at the consolidated tape. 'Why can't we do that for derivatives and swaps and futures and everything else under the sun?'"

Even in the equities arena, he argues that having data sometimes is not enough: "Certainly if we go back to the equity model, we still don't really know what the Flash Crash was about. There are certainly theories. And there certainly was a fair amount of decent data before, after and during the day," Calabria said.

Transferring risk

Hod said it is still early, and that over time the changes being wrought in OTC markets will be for the better, at least in terms of making the market less opaque. "I believe that once the dust settles, the eventual result will be more transparency, liquidity and accessibility of swaps and pseudo swaps, such as futures," he said.

"However, there are many issues that remain unresolved. The elephant in the room is whether or not central clearing will reduce risk in the market. I believe it will simply transfer risk - rather than eliminate it - as it will be concentrated amongst a handful of clearing venues, creating institutions that will once again become too big to fail."This is an argument that others have raised.

"The failure of one of the CCPs, or a lack of confidence in its ability to guarantee a trade, could bring us back to a situation we spent years working to avoid. Therefore, it is possible that the ultimate aim of regulators will not come to fruition, and the new rules will only transform the way risk is presented," Hod said.

SDR Srvices – Real-Time Dissemination Dashboard

SDR Srvices - Real-Time Dissemination Dashboard

Calabria said the clearing house requirement is all part of a narrative that policy makers have bought into.

In addition to the benefits from having all the new information, the theory goes, is the idea that a clearing house will be able to manage that risk better than in a bilateral situation.

"And there's also a sense of, if you move away from bespoke products you'll get a more standardised set of products that are easier - more liquid, essentially," he said, adding that unwinding them thus could become simpler if an institution ran into trouble.

"That's some of the thinking and of course I think there's some truth to some of that," he said. On the other hand, he questions why, then, standardised products were not used more before Dodd-Frank.

"The market charges you more for bespoke products, so there's a pretty good incentive for you to get a standardised product if you wanted one," Calabria said. "So you have to believe that either people don't know their own risk, or you have to believe that what the market was offering as an off-the-shelf product was not sufficient to meet their risk."

The push towards standardised products has already led to a bare-knuckles brawl among some market participants and regulators over proposed swaps margin requirements. Bloomberg filed a lawsuit in April to prevent the CFTC from implementing "flawed" regulations that it said would require five times the margin requirements to clear a financial swap than an identical cleared financial swap future.

While swap dealers were able to successfully prepare for compliance, Zod said question marks remain for other market participants.

"The uncertainty amongst the medium and smaller buy-side and non-financial participants, such as asset managers and corporations, remains a concern. There is a lack of clarity around their preparation and they are relying on their service providers, such as fund administrators and clearers, to do much of the work for them," he said.