Eurex Group July 2013
Institutional
Insights
What is inside
(tap to get there)
Editorial 1
Thought leadership 3
Riding the...
Institutional Insights July 2013
www.eurexgroup.com 2
conversations with all your partners and
from all parts of your indu...
Institutional Insights July 2013
www.eurexgroup.com 3
And now I turn the focus to you.
Conversations, by their nature, req...
clearing of most derivatives contracts will
be done through central counterparties
(CCPs) allowing for aggregation of
info...
moving a step closer to futures contracts.
As regulatory demands begin to stretch
the limits of OTC contracts, this is cre...
www.eurexgroup.com 6
Institutional Insights July 2013
8
This is even more evident in the U.S. where collateral and margin ...
www.eurexgroup.com 7
Institutional Insights July 2013
wave of futurization. The push towards
transparency and transferabil...
Following the 2008 financial crisis and
the resulting market volatility, the situation
led to a dramatic widening of yield...
Clearing insightRenaud Huck
the mid-term segment of the French
yield curve. Launched in March this year,
we’ve experienced...
In conversationDeepesh Shah and Olivier Zeyssolff
At Eurex Clearing, we thought long and
hard about this and recognized th...
term impact on all market participants –
and in particular on how the buy side
operates and transacts on a day to day
basi...
But you could also ask “I used to trade
OTC derivatives with a very small
number of counterparties and then I had
very str...
And my role and what I believe the
market should be looking at and thinking
about is how can we make sure that
this tail r...
If you had to abide by certain of these
rules, you would have to change your
business model, mobilize liquidity that
would...
we will then have a much better idea
of what to expect as far as depth and
liquidity of this market are concerned.
Eurex: ...
World Bank more upbeat
on global economic
prospects as risks wane
Washington – The World Bank offered
a refreshing view on...
www.eurexgroup.com 17
Institutional Insights July 2013
Uncertainty, market volatility due to
U.S./Japan QE questions
There...
Contact information
We are looking forward to your
feedback. So don’t hesitate to
contact us at
institutional.insights@eur...
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Eurex Institutional insights 201307

  1. 1. Eurex Group July 2013 Institutional Insights What is inside (tap to get there) Editorial 1 Thought leadership 3 Riding the next wave of futurization Trading insight 8 Clearing insight 9 In conversation 10 With Olivier Zeyssolff about risk management Market insight 16 Conversations... I was told that writing the opening for a new publication would be a therapeutic and inspiring exercise. With Imagine Dragons’ Night Vision blaring in the background, the task started. Where to begin? What to say? What’s important? How long? What tone? Sedate? Humorous? Contempla- tive? Provocative? Irreverent? What’s the story? Three weeks ago it was my privilege to spend a considerable amount of time with Richard Hytner, Deputy Chairman of Saatchi & Saatchi. And one of his phrases fortuitously echoed in my mind as I wrote this – “Always be genuine”. Institutional Insights was conceived following an accidental game of join the dots. At Eurex Group we have a simple yet incredibly genuine dream (yes you read correctly – I just said dream). Passionately shaping the derivatives industry. We organize markets globally. This was dot number one – this is what we do and the spirit in which we do it. Dot number two was the recognition that shaping an industry means shaping ideas. Ideas are only shaped if you’re having EditorialDeepesh Shah Olivier Zeyssolff Chief Credit Officer, Tudor Group Clive Tillbrook Global Managing Editor, MNI Renaud Huck Head of UK Buy Side Relations, Eurex Group Kathryn M. Kaminski, PhD KTH, MIT Deepesh Shah Vice President, Business Development London, Eurex Group
  2. 2. Institutional Insights July 2013 www.eurexgroup.com 2 conversations with all your partners and from all parts of your industry. The third and final dot was an awareness that our role as an exchange is to bring people and markets together – so why not ideas? As an organizer of markets, who better to bring together the various constituents with the goal of sharing ideas – by having conversations? Next came the question of how? To be authentic, stifling ideas through censorship is clearly out of the question. Not only is this against the principles of stimulating writing, it’s also against the principles of having a conversation. We’ve therefore assembled a host of spirited permanent writers who all share at least one common trait – they are all passionate about their work and their respective fields. And they want to talk about it from their unique perspectives. Over the next months, we’ll also be welcoming guest contributors with only one mandate – be interesting, be open, and be genuine. The goal here is not to lecture but to catalyse debate. And finally the question – what? We begin this first edition with the increasingly hot topic of futurization. Some say futurization is the natural evolution for over-the-counter deriv- atives. Others believe it is impractical due to inflexible constructs and liquidity risks. Futurization is not a new topic, but it is an underexplored topic and therefore worthy of discussion. We’re very pleased that our lead writer – Kathryn (Katy) Kaminski of KTH Royal Institute of Technology, MIT Sloan and the Stockholm School of Economics has been able to shed light on this subject in her own unique and balanced style. Katy will be tackling a number of challenging and thought-provoking topics in the months ahead for Institutional Insights. I’m also delighted to welcome Olivier Zeyssolff, Global Head of Credit Risk with Tudor Capital Management as our guest interviewee for this first edition. I have no doubt that you’ll find Olivier’s views on the challenges faced by buy side firms, his concerns about systemic risk and thoughts about how the future could evolve, both engaging and insight- ful. The title of this publication is, after all, Institutional Insights. As Head of Buy Side Relations in London at Eurex Group, Renaud Huck is keen to share his thoughts about the state of the industry, current trends, concerns and reasons for optimism. And as you’ll see later, he has an encyclopaedic knowl- edge of the markets and strong views on a range of topics. In this edition, Renaud comments on asset protection as well as sharing an update on the success of French government bond futures. Lastly, Clive Tillbrook, Global Managing Editor at MNI, will leverage his network of bureaus around the world to bring you the latest news, analysis and intelli- gence. In this edition, we cover the June 2013 Global Economic Prospects report issued by the World Bank. Deepesh Shah Vice President, Business Development London, Eurex Group
  3. 3. Institutional Insights July 2013 www.eurexgroup.com 3 And now I turn the focus to you. Conversations, by their nature, require two or more participants. Therefore I’m doing something I’ve been urged not to do – I’m opening up my inbox: deepesh.shah@eurexgroup.com Please use it. Do you have an opinion on something you’ve read? Do you agree or disagree and why? Do you have a hot topic that you’d like to see us cover? What do you really care about? Do you want to write something yourself? Or do you simply want to say hello and introduce yourself? Whatever your reason for writing to me, please do write. Like all creative processes, this publication will evolve together with you. I hope you enjoy reading this be it at your computers, on the Tube (or sub- way) on your iPads or in your bathtubs. Let the “dots” be joined! Deepesh, on behalf of the team Thought leadership Kathryn M. Kaminski Riding the next wave of futurization The world of derivatives as we know it is ripe with change. Prior to the credit crisis, derivatives trading was taking place on two very different fields: over-the- counter (OTC) via dealer networks and exchange-traded derivatives (ETD) via centralized clearing houses. Although in theory the nature of derivatives contracts should be roughly the same, in application the rules, as well as the structural way these contracts change hands, varied substantially. The mess that unfolded in 2008 led to a sharp review of the way derivatives contracts are cleared, collater- alized and change hands. In an attempt to “level the playing field” on both sides and create a more cohesive and less dis- jointed approach to derivatives markets, legislation such as the Dodd-Frank Act in the U.S. and EMIR in Europe spearhead the restructuring and reorganization of how derivatives trading will be conducted.1 Setting the stage for futurization The derivatives industry is a 700 trillion dollar business. Historically, exchange- traded derivatives have taken up a smaller piece of the pie maintaining a small frac- tion of the total notional value (roughly 10 percent). Most OTC derivatives con- tracts are held by a few of the largest 1 John E. Parsons from MIT discussed this analogy and futurization in his blog: Betting the business, financial risk management for non-financial firms. See bettingthebusiness.com Kathryn M. Kaminski, PhD CAIA, KTH Royal Institute of Technology, MIT Sloan and the Stockholm School of Economics
  4. 4. clearing of most derivatives contracts will be done through central counterparties (CCPs) allowing for aggregation of information for reporting, multilateral position netting, and cross validation. The share of derivatives that are not centrally cleared will become low4 and regulatory costs in the form of increased reporting, operating, and collateral are set to impact all users of OTC derivatives products. New players are also entering the swaps markets by registering as swap execution facilities (SEFs)5 , creating competition for swap dealers. Transaction costs, oper- ational efficiency and collateral manage- ment should bring down differences between OTC and exchange-traded products. Despite this move, there are still plenty of adjustments to be made and room for growth.6 For example in 2012, 60 percent of all derivatives in the U.S. were swaps. There is a migration towards exchange-traded products but it is happening gradually. For example, today, futures/forward contracts which are mostly exchange-traded have climbed to 19 percent of total notional value in derivatives from 11 percent in 2006. www.eurexgroup.com 4 Institutional Insights July 2013 2 OCC Q4 Report 2012 3 Title VII of the Dodd-Frank Act focuses specifically on swaps and in the U.S. there is a legal distinction between swaps and futures. In the EU, EMIR attempts to deal with counterparty risks and transparency in a more pluralistic manner by creating a list of all derivatives that must be centrally cleared as well as which derivatives should have mandatory trading. The list includes the standard options, swaps, futures, cash settled commodity derivatives and other exotics. Implementation in the EU will be phased in over the next few years. 4 Those which are not cleared will be possible via exception or with collateral constraints above the five-day margin requirement for vanilla OTC swaps. Implementation in Europe is still in process and discussion. 5 In the EU, these include multilateral trading facilities (MTFs) and organized trading facility (OTFs). 6 This is especially true in Europe where implementation is delayed until 2014 or later. The path leading to futurization banks. A closer look at these banks, or at least the top tier banks by size, shows that only a very small percentage (around 4 percent) is held in exchange- traded derivatives. Reasons for this distribution have been attributed to the previously lower costs in trading off- exchange and potential difficulties in dealing with block trades on exchanges. The core of the action, in both total notional value and in banking trading revenues (17 trillion in 2012 to be exact)2 , is in OTC interest rate swaps. New regulation aims to tighten control regarding reporting, registration, and mandatory central clearing of many, especially vanilla OTC contracts.3 Central Most derivatives are OTC • Systemic risks • Concerns over collaterization, transparency Regulation • Mandate central clearing of all vanilla OTC • Increase reporting, registration, and collateral costs Increased competition in the clearing/execution space • Enhanced role of CCPs and exchanges • New players entering registering as SEFs Migration towards ETD • Futurization of OTC products
  5. 5. moving a step closer to futures contracts. As regulatory demands begin to stretch the limits of OTC contracts, this is creating further incentives for futurization which may allow users to circumvent some of these issues. The new wave of futurization: swap futures Swap futures (or futurized swaps) are new, exchange-traded variants of swap contracts which are meant to mimic swaps. To use an analogy, futures are to forwards as swap futures are to swaps. To appease users of swaps, these new futures contracts are an attempt to keep some of the customizable features of swaps while maintaining some of the advantages of a centralized exchange. Exchanges will allow for more flexibility on delivery options.7 Exchanges will also allow for more flexibility on block trades (something that was debated at the recent CFTC discussion panel in February 2013). Exceptions and modifi- cations will make swap futures fit some- where in the gray zone between tradi- tional swaps and traditional futures contracts. The key advantages of swap futures include transparency, lower collateral requirements, possibly reduced registration requirements, and ease of trade when highly liquid. The key disadvantages may include lack of cus- tomization, delivery limitations, concerns for block trades, and the potential for liquidity issues. A simplified comparison of contracts is presented in the following table. www.eurexgroup.com 5 Institutional Insights July 2013 7 For example in the U.S., deliverable swap futures were recently launched. These are futures contracts which provide delivery of an OTC swap at maturity. The advantages of these contracts are that during the life of the future, the contract, as a futures contract, is eligible for much less stringent collateral and margin requirements than the delivered OTC swap contract. Forwards/futures Swaps Notional value Q4/2006 I I Options Credit derivatives I I Notional value Q4/2012 Forwards and futures take a bigger piece of the pie – development of the derivatives market in the United States What is futurization? Futurization is the migration of traditional dealer based bi-lateral contracts into similar standardized “futures-style” contracts which are centrally cleared and exchange-traded. This idea is by no means novel. In fact, this is exactly why futures contracts came about; to mimic bilateral OTC forward contracts. The futures market structure is meant to address counterparty risks, lack of transparency, and lack of transferability (“non-fungible” structure) of bi-lateral OTC contracts. An aggregated exchange- traded structure allows for collateral reductions, multilateral position netting, and risk mitigation across pools of counterparties. The new wave of futuri- zation of swaps and other OTC deriv- atives is occurring to adhere to some of the same issues. By mandating centralized clearing, OTC derivatives are already
  6. 6. www.eurexgroup.com 6 Institutional Insights July 2013 8 This is even more evident in the U.S. where collateral and margin requirements for swaps are treated differently than futures. In the EU, these distinctions are less clear as EMIR focuses on a contract by contract basis. The jury is still out in the EU how this will play out. Futures are to forwards as swap futures are to swaps Exchange-traded Cleared Rare, ~2% Standardized Daily margin required for collateral Low Futures OTC** (U.S.: exceptions, EU: exception for physical delivery) Depends Mainly delivery Customized Depends Moderate (varied) Forwards exchange-traded with exceptions Centrally cleared with exceptions May depend, contract dependent Standardized with some flexibility 1–2 days margin required for collateral Low Swap futures OTC* (U.S.: SEFs, EU: MTFs and OTFs) Most cleared** with exceptions Mainly delivery Customized, more standardized* 5 days required for collateral (may vary as well) Low*, moderate (for bi-lateral, uncleared contracts) Swaps Trading Clearing Delivery Transparency Collateralization Counterparty risks *This characteristic will be in effect post regulation implementation of Title VII of the Dodd-Frank Act and EMIR. **There are some exceptions for forward rate agreements and FX. Physical delivery and some customized swaps may also be exempted. parties are designated as systemically important entities or entities that are “too big to fail”. Critics of this structure are weary of vertically integrated clearing and execution. In addition, new users of futures also have concerns about potential basis risk and liquidity issues with new products that may not be adequately customizable. Issues related to block trading, flexibility, and increased delivery options are of high priority. Proponents of futurization cite the long and successful history of futures markets, the benefits of more migration to futures, and the potential for cost reduction and flexibility in new futures products. Core issues of contention: the pros and the cons There are some concerns about the appli- cability of futurization in a market that is focused on customization. General con- cerns are related to regulatory arbitrage, systemic risk, and potential issues with lack of customization and usability. Opponents screaming regulatory arbitrage cite concerns related to the asymmetries in fees and collateral across similar con- tracts.8 Their concerns are that markets driven by regulatory arbitrage may have unclear consequences. Cross border issues and differences in regulation across the globe may complicate things even further. Systemic risk is another key issue. In a post Dodd-Frank and EMIR world, with man- datory clearing and contract migration onto exchanges, large central counter-
  7. 7. www.eurexgroup.com 7 Institutional Insights July 2013 wave of futurization. The push towards transparency and transferability has already begun. Yesterday’s challenges may be addressed, but the perils and challenges that lie ahead in derivatives markets remain unclear. Despite many opposing views, it does remain evident that the future of derivatives markets is futurization. References Rodriguez Valladares, Mayra, Futures and Futurization: Full Steam Ahead on Dodd-Frank, MRV Associates, 19 November 2012. Kurbanov, Rashad, Swap Futurization – The emergence of a new business model or avoiding regulation and retaining the status quo?, DerivSource, 13 February 2013. Acworth, Will, Futurization: Market Participants Clash, Futures Industry, 10 March 2013. Litan, Robert, Futurization of Swaps: A Clever Innovation raises novel policy issues for regulators, Bloomberg Government, BGOV Analysis, 14 January 2013. Parsons, John E., 3 points on the futurization of swaps, Betting the Business Blog, 31 January 2013. Futures markets have a long-standing relationship with regulation. They were designed with a keen focus on transpar- ency, transferability, reduction of counter- party risk, optimized collateral costs, and risk mitigation. Yet, it is important to emphasize that futures gain much of their success in numbers. Illiquid futures contracts are not as popular and have added liquidity risks especially with con- tracts that are marked to market so frequently. Proponents of futurization suggest that increased volumes in futures markets may help diversify product offerings. For example, one positive sign has been the relatively eventless 18 trillion dollar migration from energy swaps into futures in the fall of 2012. Increased volumes may help make room for new contracts which can better mimic longer dated swap contracts. Consistent with anecdotal comments from energy traders who switched to futures, cost reduction, lower collateral requirements, efficiency and flexibility are the commonly cited advantages for using futures. Lastly, similar to how futurization of forwards created futures, proponents of futurization can argue that the current wave of futurization in OTC derivatives is simply a natural development of modern financial markets. Consistent with futurization of the past, this wave will help level the playing field and increase flexibility. Concluding remarks The derivatives industry is a 700 trillion dollar business. Regulatory forces and demographics in this industry are migrating contracts from dealer net- works onto exchanges spawning a new
  8. 8. Following the 2008 financial crisis and the resulting market volatility, the situation led to a dramatic widening of yield spreads. Eurex Exchange responded with the introduction of the Italian govern- ment bond (Buoni del Tesoro Poliennali – BTP) segment in 2009 which has become extremely successful with over 15 million contracts traded since launch. Then, in 2011, due to the continuing European sovereign debt crisis, even the spreads of core European countries over Germany widened. Spreads remain wide and volatile in this segment. In order to react to the new market conditions and the increasing market demand for a dedicated French hedging instrument, the 10-Year Euro-OAT Futures (with a delivery window of 8.5–10.5 years) were born at Eurex Exchange in April 2012. On a more anecdotal note, it is the revival of an old glory, the Notionnel futures of the Matif, and it takes me down memory lane to the “good old days” during my time as a floor trader on the Matif floor for JP Morgan – trading French futures contracts. The French government bond futures offer market participants a listed futures product which in terms of credit risk lies between Germany and Italy. Customers at Eurex Exchange can now replicate and hedge most of the existing long end interest rate/credit risks in Europe using our Bund, OAT and BTP Futures. The Euro-OAT Futures launch was the most successful fixed income futures launch in recent history across all ex- changes globally. In May 2013, one year after inception, the total cumulative volume stands at approximately 9 million contracts. In May 2013 alone over 1 million contracts were traded. The next logical step was to expand this successful segment – the majority of market participants suggested Mid- Term Euro-OAT Futures (with a delivery window of 4.5 –5.5 years) in order to facilitate hedging and basis trading on www.eurexgroup.com 8 Trading insightRenaud Huck Institutional Insights July 2013 1,100 1,000 900 800 700 600 500 400 300 200 100 275 250 225 200 175 150 125 100 75 50 25 Order book volume Open interest OTC volume Jun 2012 Sep 2012 Dec 2012 Mar 2013 Euro-OAT Futures: traded contracts & open interest (in thousands) Renaud Huck Head of Buy Side Relations, Eurex Group
  9. 9. Clearing insightRenaud Huck the mid-term segment of the French yield curve. Launched in March this year, we’ve experienced steady growth as the Eurozone begins to stabilize. To support all of these innovations, and to offer our clients the full spectrum of trading opportunities in the fixed income yield curve, Eurex Exchange also supports the short-term interest rate segment with a new initiative of its three month EURIBOR Futures. So far, the market signals have been very positive – but i’ll update you on this topic, as well as our other plans in the next edition of Institutional Insights. www.eurexgroup.com 9 An entirely new regulatory program was initiated by the G20 in 2008 featuring the shift from bilateral OTC trading to OTC clearing. The details are still being finalized but we’re not very far from having a complete script. One feature of this new era is that of segregation models. This is quite an all- encompassing term so what exactly are we talking about here? We should be more specific and define properly what the models of segregation are, what the purpose is and what will be its role in this new world of OTC clearing. There are several “definitions” of segre- gation floating around so I’d like to provide you with ours. At Eurex Clearing, when we say segre- gation we define it as a full segregation model. A model where collaterals are physically protected and which, in the event of a Clearing Member default, allows the positions and collaterals of the end client to be ported. This is what we have structured and what we offer to our clients. And I mean “ported”, not liquidated. There is a big difference here. While some models theoretically claim to be fully segregated, in practice both positions and collaterals in these models are liquidated (value seg model) and a cash equivalent is returned to the client. Which is fine for some clients – but not all. I don’t see where the value proposition and interest of such a limited model lies. It’s a rather heavy handed approach which is even more disruptive during very distressed market conditions. The default of a Clearing Member results not only in disruption to said Clearing Member but also to their customers and to market infrastructures as a whole – thereby rendering it extremely difficult to liquidate assets effectively. Institutional Insights July 2013 Renaud Huck Head of Buy Side Relations, Eurex Group
  10. 10. In conversationDeepesh Shah and Olivier Zeyssolff At Eurex Clearing, we thought long and hard about this and recognized that under these potentially difficult market conditions, we needed to adopt a very different approach and help our buy side clients as much as possible in making the transition from one Clearing Member to another. A more collaborative process was going to be needed hence in our default man- agement process, we considered that a 5-day interim period where the end clients can transition their clearing activity was necessary – be this via porting or liquidating. The choice is theirs. But above all, the protection of collaterals (away from the clearer and the clearing house) placed in a CSD or ICSD (required by regulators) such as Clearstream, was a must-have in order to offer a practical solution to the trading community in this new world of OTC clearing. The new world is a giant, unchartered territory with new frontiers for Eurex Clearing, and together with you, we’re devising new and innovative solutions. À bientôt! www.eurexgroup.com 10 Deepesh Shah, Eurex Group, spoke to Olivier Zeyssolff, Chief Credit Officer at Tudor Group, about the opportunities and challenges in risk management. Eurex: Could you tell us a bit about yourself? Zeyssolff: I am the Chief Credit Officer for the Tudor Group, a multi-strategy investment management company with assets under managements of approxi- mately USD 13 billion. I oversee global counterparty risk and any non-trading risk we take when we engage in trading activities across all products. We have relationships with FCMs, OTC counter- parties, prime brokers, CCPs and cus- todians. I look at a broad range of both credit and operational risks. Eurex: One of the topics that keeps us busy is regulation, the two of the most important being EMIR and the Dodd- Frank Act. What are the effects of these regulations on your business? Zeyssolff: As you know, back in 2009 the G20 committed to implementing new regulation that would reduce systemic risk and make financial markets more transparent. As an active market participant, we are supportive of these goals. These regulations will have a long- Institutional Insights July 2013 Olivier Zeyssolff Chief Credit Officer at Tudor Group
  11. 11. term impact on all market participants – and in particular on how the buy side operates and transacts on a day to day basis. We have a fairly long experience both in clearing and in posting margin and collateral across all facets of our business. So it’s not really new for us. However, it is a different way of doing business especially in the OTC swap space. The new legislation has had a fairly significant impact in terms of regulatory requirements. It is important that we understand what rules apply to us and that we comply. However, the timing of the implementation of the rules varies significantly between Europe and the U.S. and can be confusing and problematic for market participants. Additionally, a number of rules have yet to be finalized. Eurex: How did you tackle that challenge? Zeyssolff: Tudor has been trading futures actively for a few decades and we have used swap intermediation with our prime brokers for a long time. We have an infra- structure in place to manage these changes. We already have the systems and processes to support clearing. OTC Clearing has become an extension of those established protocols. We are using our main FCM relationships for clearing OTC swaps. We looked at the trading documentation we needed to have in place. These negotiations were new for everyone – for us and for the clearing members – so there was a period of adaptation. There are also a number of operational challenges that need to be addressed, including estab- lishing and testing connectivity with CCPs, setting up legal entity identifiers and upgrading trade management and portfolio reconciliation systems in time for the deadline. We started clearing OTC swaps on 11 April this year. Eurex: How was the experience? Zeyssolff: The experience has been rela- tively flawless so far. We are currently only clearing eligible swaps that fall under the mandatory clearing obligation under the DFA. At the end of the day, this represents only a modest portion of Tudor’s portfolio. It will increase as more products become eligible for clearing. For the current universe, we did not have any major issues with the CCPs or clearing members. I think from an infra- structure perspective we were well- prepared to accommodate this change and therefore it has been a fairly smooth transition. Eurex: What opportunities are you seeing from the transition and what are some of the challenges? Zeyssolff: We now have a new type of product on the marketplace. We trade cash products, OTC derivatives, futures and now OTC cleared swaps. So it is an additional product class which has its own specs and requirements – whether it is margin, margin efficiency, collateral, execution or reporting. We are still in the early days, so if the system expands and works well then I think everyone will benefit from, for example, margin efficiencies. www.eurexgroup.com 11 Institutional Insights July 2013 “We are still in the early days, so if the system expands and works well then I think everyone will benefit from, for example, margin efficiencies.”
  12. 12. But you could also ask “I used to trade OTC derivatives with a very small number of counterparties and then I had very strong margin efficiencies across products. Now I have to trade different types of futures and swaps across differ- ent CCPs which may not have adequate portfolio margining across and between them, so are you really in a better position?” One could argue that you’re not. So it’s not all strictly positive but I would say the OTC clearing market has high potential for operational and capital efficiencies. Eurex: What are your clients telling you? Zeyssolff: One of the concerns of our investors is how their assets are pro- tected, but they know that this is high on the priority list for us. On the OTC derivatives side, we have always made sure that we post initial margin, not to the bilateral counterparty but to an independent third-party custodian. Obviously when we moved to the cleared side whether in futures or OTC cleared, there is some degree of comin- gling with other customers. One could argue that we are losing some of our asset protection in moving to OTC clearing. That’s certainly a drawback, even though the LSOC model is going in the right direction. It is an improvement over the futures model, but it is not as strong as the pro- tection our collateral assets benefit from on the OTC bilateral side. We are talking to market participants and ex- ploring any solution that would get us to or close to full individual account segregation on a fund-by-fund basis. Eurex: You mentioned that you are losing some efficiencies in cross margining, having to spread yourself out between different clearing houses. But what is your view on the too big to fail aspect? Zeyssolff: This really throws a spark into the coals with the potential for an unintended outcome. One of the main issues that must be addressed is inter- connectedness. Clearing does not elimi- nate interconnectedness but creates new connections to CCPs. While these new connections do contribute to operating and capital efficiencies to some extent, concentrating risk at CCPs also creates new nodes of risk across the financial system. My view is that counterparty risk is transformed and reallocated to CCPs but counterparty risk does not disappear from the system. These highly concentrated nodes of risk at CCPs mean that CCPs are in turn potentially becoming “too big to fail”. Eurex: So where do you strike the balance between those two issues – too big to fail vs. capital efficiencies? Zeyssolff: Well, I am a risk person so my perspective may differ from others’. We are speaking mainly about tail risk here. While there will be significant improvements in capital and operational efficiencies, if there is an issue that does flare up, it could be catastrophic. www.eurexgroup.com 12 Institutional Insights July 2013 “One of the concerns of our investors is how their assets are protected, but they know that this is high on the priority list for us.”
  13. 13. And my role and what I believe the market should be looking at and thinking about is how can we make sure that this tail risk is understood and then to some extent provided for. You cannot be complacent about the risk inherent in trading cleared products, and the risks do not disappear when trading on CCPs. So, how do you manage that? We are incentivized by regulators to trade standardized products and move our swaps onto exchanges and CCPs. You try to increase efficiencies by con- centrating them rather than spreading your risk across CCPs. If something happens there, you certainly can’t talk about risk diversification. Is the financial system better off as a result? I still struggle to find an answer to that. There are remaining issues around insolvency laws, cross-border inconsistencies, and it’s unclear whether the institutions would benefit from government systemic support. We should not be complacent about systematically important financial institutions (SIFIs), nor should we be about CCPs. Eurex: Moving onto the future of OTC, with all the restrictions in place for firms such as Tudor, what do you see in terms of the size of the OTC space going forward? Zeyssolff: Well, again, in a world where OTC clearing is working well with a proven track record of operational and capital benefits, then I think participants will make a decision to direct as much business toward cleared products as possible. If you can replicate OTC swaps in a more standardized format, with less punitive requirements for capital, then that’s what will happen. The jury is still out: some say the end of the OTC swap market is nigh and I do not share that view; some say both exchange trades and OTC derivatives markets will reduce in size as a result of additional regulation. There are two types of buy side market participants: the risk takers (the traders who want to take a speculative position), and the hedgers. These latter participants make up a large part of the market so they should not be forgotten. And these professionals may not have the same flexibility to move from a tailor-made OTC bilateral contract to a standardized futures contract, which may be totally inadequate to hedge their specific cash flows. I think there is a chance of creating a two-tiered market. One of the drawbacks of the bilateral market is the lack of transparency where it is difficult to see who does what. But based on academic research and the information out there, we see a huge amount of OTC derivatives that are originated by end users and asset man- agers, who are using these contracts more for hedging and risk protection purposes. The amount traded by risk takers and banks (for their own account) is probably less than half of the total OTC volume. We should keep in mind when implementing regulation with punitive aspects that there are likely to be unintended consequences on the real economy. www.eurexgroup.com 13 Institutional Insights July 2013 About the interviewee Olivier Zeyssolff oversees global counterparty risk as Chief Credit Officer at Tudor Group, a multi- strategy investment management company with assets under managements of approximately USD 13 billion.
  14. 14. If you had to abide by certain of these rules, you would have to change your business model, mobilize liquidity that would otherwise be used elsewhere, and therefore think about the effects of this on the bread and butter of your investment. Ultimately, investors and shareholders pay the price for it. Eurex: Could you conceive that some of these firms would see it as unviable and exit the market? Zeyssolff: One of the key proposals that is not yet finalized is the margining regime for uncleared swaps proposed by BCBS-IOSCO. If it remains as it is, then I probably would say yes. But it’s not too late to amend it. Eurex: One of the major topics of this issue is the futurization. Have you given any thought to this topic? Zeyssolff: We’re entering an era where you have regulators who are incentivizing users to trade instruments which are standardized and can be cleared, as opposed to bilateral transactions. You now have a range of products which have their own margin regime. When you are a company operating in a multi- asset class environment, managing a business can get really complex as a result of the diverging regimes. I wonder if at some point we will see some convergence between these regimes and move, for instance, from a less punitive to a more favorable regime for swap futures and for futures. Eurex: Why hasn’t it happened before? Zeyssolff: You really have to look at who the participants in the OTC market are. I think many of these participants just need tailor-made products and have some specific requirements. I think futurized swaps is not anything new. It has been experimented with for 5 to 10 years, but has never really taken off. So why now? Especially with the different types of margin regimes, if you have some con- vergence and maybe cross margining across the CCPs that is transparent and accepted by the market, then, yes there is potential. Another important aspect we have not touched on and which is key from a trading standpoint is liquidity. The depth of the market is generally better on the OTC side for a large number of contracts. Some futures contracts may exist but they do not have much liquidity, which is what matters for market parti- cipants. They need to have good depth in the market, good price discovery and good liquidity – and this won’t happen overnight. Futurization may happen as a result of the regulatory push toward standardized products, but would it happen naturally? I think we have now gone far enough and the entire market has been mobi- lized around OTC clearing for three or four years. Once the three categories of eligible participants in the U.S. are trading at full speed and they are joined by European markets in late 2014 to 2015, www.eurexgroup.com 14 Institutional Insights July 2013 “One of the key proposals that is not yet finalized is the margining regime for uncleared swaps proposed by BCBS-IOSCO. If it remains as it is, then I probably would say yes. But it’s not too late to amend it.”
  15. 15. we will then have a much better idea of what to expect as far as depth and liquidity of this market are concerned. Eurex: What new innovations are exciting you at the moment? Zeyssolff: As a credit risk manager, the safety of our assets remains my main concern. As I said, we take great pride in protecting our investors’ assets such that we have negotiated and implemented a robust solution on the OTC side. We are constantly talking to our counterparties, our prime brokers and our brokers to enhance the standards for asset protec- tion. So we support anything that moves toward stronger protections. Asset pro- tection is closely linked to insolvency laws, and the extent to which these laws permit such protection. EMIR, in partic- ular, has clear rules about individual client segregation that should be offered by CCPs and clearing members at a reasonable price. Of course not every- one will want to take that route, cost is an issue, but the option should definitely be offered. However, these types of rules are beneficial to market participants if they add more certainty. These are complex issues that will keep us busy for a long time. Eurex: What keeps you up at night? Zeyssolff: Complacency and tail risks of any kind. As we all know there will always be another crisis, the question is where and when? Complacency about “too big to fail”, about large levels of risk concentrated in ever larger institu- tions, banks and CCPs. No participants, whether large or small, can afford to become complacent or less risk disci- plined. This goes back to the tail risk we discussed earlier. Eurex: Are credit risk managers the new rock stars of the hedge fund world? Zeyssolff: If only. Risk management is an integral part of what we do at Tudor across departments as an investment management firm and a market partici- pant. Obviously managing market risk is our primary focus, but credit and counterparty risks have always been high on the radar. We have dedicated significant resources to analyzing and trying to find ways to limit our counter- party exposure, while at the same time maintaining access to markets. I do not see this focus on counterparty risk dimin- ishing at all as a consequence of the new regulation for OTC clearing; the new regulation is only shifting the emphasis somewhat. So we will continue to be focused on that as we always have been. To answer your question, I don’t think we are rock stars, but counterparty risk is a very important piece of the jigsaw and it can be easily overlooked... particularly in good times. www.eurexgroup.com 15 Institutional Insights July 2013 The opinions in this interview are those of Olivier Zeyssolff and do not necessarily reflect the opinion of Tudor Group. “I don’t think we are rock stars, but counterparty risk is a very important piece of the jigsaw and it can be easily overlooked... particularly in good times.”
  16. 16. World Bank more upbeat on global economic prospects as risks wane Washington – The World Bank offered a refreshing view on the global economy in June saying risks have diminished even if growth forecasts are short of impressive, and market volatility reflects uncertainty over the potential end to quantitative easing and should be short-lived. In the semi-annual Global Economic Prospects reports, Kaushik Basu, World Bank Chief Economist and Senior Vice President, stated the outlook is little changed from January, and “in a turbulent global economy that is good news.” “Roughly our view is that the risk sce- nario is better,“he said since the huge downside risks that were a concern “we don’t think that is there.”He described the outlook as an “inverted plateau” saying “We’re now at bottom with slow pickup taking place. From next year we’ll see some improvement.” The report trims the world growth forecast two-tenths to 2.2% from the January forecast, with the biggest downward revisions coming in the euro area and China, as well as other large emerging market economies, while the U.S. was essentially unchanged. World growth is expected to accelerate next year to 3.0% and 3.3% in 2015. The euro area forecast was cut a half point to -0.6% from January, while China's was slashed to 7.7% from 8.4% previously. The report projects euro area growth of 0.9% in 2014 and 1.5% in 2015, while China is expected to see expansion of 8.0% and 7.9%, respectively, the report said. Lead author Andrew Burns said the down- grades are “by and large reflection of what’s already happened rather than what will happen,” including a very weak fourth quarter, particularly in Europe.” For China, Burns said, it is "not the slowing that worries us, since we see that as necessary. China has very high investment rate, that is not sustainable, and if maintained would sow the seeds of future difficulties." The World Bank predicts U.S. GDP of 3.0% this year, 2.8% in 2014 and 3.0% in 2015, barely changed from the pre- vious. But it cut the estimate for Brazil to 2.9% from 3.4% for 2013, while 2014 is expected to improve to 4.0% and 3.8% the following year. India's expansion was cut to 5.7% from the 6.1% forecast in the January report, while 2014 and 2015 suffered smaller downward revisions to 6.5% and 6.7%, respectively. www.eurexgroup.com 16 Market insightMNI Institutional Insights July 2013
  17. 17. www.eurexgroup.com 17 Institutional Insights July 2013 Uncertainty, market volatility due to U.S./Japan QE questions There remains anxiety over the trajectory of stimulus in the United States and Japan – when and how the Federal Reserve will begin to remove quantitative easing, and whether and how much Japan will increase theirs – although it is not a major concern and expected to be short-lived. Burns said there is a state of “unconditional anxiety”, where they and the markets are worried about everything. “We’re worried about quantitative easing rising in Japan and we're worried about quantitative easing falling in the U.S. and it almost doesn’t matter what happens because what we're worried about is change,” Burns said. “Markets are worried about uncertainty of change and we’re worried about the markets reaction to uncertainty of change.” He said commu- nications by central banks will be key to signalling to markets “so that there aren’t surprises, because it is those sharp changes in expectations that create volatility.” The Fed is still new to the process but “they understand they need to provide guidance to markets since sharp changes in expectations create volatility,” Burns said. The Fed is “learning how markets are reacting, so they will be fine tuning going forward.” However, Basu said the volatility – including deep depreciation in emerging markets – is likely to be a short-term issue. Despite the sometimes breathless anxiety portrayed by some in the media, he said he is not concerned. “I think on balance the Fed doing well,” he continued. “The point is no matter what the form of communication, when a change is anticipated market players try to beat others to it, and take up posi- tions in advance of other players, and so there is always a period of turmoil be- cause there is no way of neutralizing that.” “Actually, I’m not very concerned about this trauma because I don’t think it will last for too long. My expectation is it’s an adjustment trauma in anticipation of what is to come, and as soon as the policy changes ... I do expect this trauma to go away." In response to a query, Basu confirmed he was referring to “trauma” not “drama” in the markets, and in three to six months "we will be in a less volatile situation" though he cautioned that there may be other kinds of trauma that could impact markets. Meanwhile, Bank of Japan QE and Abenomics is providing a contrary impact on markets, but Basu said it was “exactly what Japan needed to do.” Although the report acknowledges the policies have led to yen depreciation, he added that was a correction from the over-appreciation of the prior six to eight years and “this correction was needed.” “It has given lift to the economy as a whole,” and while there are undeniably spillovers, other countries also will benefit as Japan recovers so “some of the consequences we will live with.” Burns stressed that Japan eventually will have to tighten fiscal policy to address the debt levels but “it doesn’t have to happen this year or next year.”
  18. 18. Contact information We are looking forward to your feedback. So don’t hesitate to contact us at institutional.insights@eurexgroup.com Subscribe to Institutional Insights You can also follow us on Twitter @EurexGroup and LinkedIn (tap to get there) Published by Eurex Representative Office London 11 Westferry Circus Canary Wharf, London E14 4HE Institutional Insights July 2013 Euro area turnaround hampered by weak confidence Burns said weak confidence in Europe – following the long series of setbacks – is impairing growth since companies and individuals are reluctant to invest. “A key question is when the turning point will come. How strong that recovery is likely to be is going to depend very strongly on confidence,” he said. “People have been disappointed in the expectations of a recovery in the past and so they’re being very cautious. And the fact that they’re being cautious helps to under- stand why growth is so slow to come.” But there also is an upside risk to the World Bank forecast “because as soon as that confidence starts to return, as soon as people start to recognize the economy is recovering, that we’re past the worst of the recovery – and that’s our very strong view – then you will see them returning to the market.” Larger middle income countries adjusting to new normal of slower growth Large developing economies like Brazil, Russia, India and South Africa are finding it hard to return to high, pre-crisis growth levels, Burns said. Although they have recovered, those countries now find it “hard to have strong growth without creating inflation.” They are in the “pro- cess of adjusting expectations to new normal, slower growth.” Another group of countries face a risk of overheating and are showing signs of strain in terms of the supply side keeping up with demand side,” he said. These include the Philippines, Thailand, Vietnam, Colombia and Ecuador among others. For more articles from MNI, please visit www.mni-news.com Neither Eurex Frankfurt AG, nor its servants nor agents, is responsible for any errors or omissions contained in this publication, which is published for information only and shall not constitute an investment advice. Any information herein is not intended for solicitation purposes but only for the use of general information. The information contained in this message is confidential or protected by law. If you are not the intended recipient, please contact the sender and delete this message. Any unauthorized copying of this message or unauthorized distribution of the information contained herein is prohibited. Eurex Frankfurt AG, ARBN 100 999 764

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