Articles

Electronic Trading and Flash Crashes – Part II

Part I of this article discussed electronic trading, the differences between algorithmic trading (AT) and high frequency trading (HFT), types of systems/platforms, exchange traded versus OTC transactions, and other considerations such as colocation. In Part II, we will address different strategies and the three main flash crashes/events.

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Blockchain – Where We Have Been & Where We Are Going

2016 was the year that saw the rise of Blockchain. Increased interest from the mass media, corporate titans across America, and the US government all led innovative approaches to using the technology. And one thing is certain – 2017 heralds much of the same trend. By the end of 2017, early-adopter financial institutions will have Blockchain firmly ensconced in their business models, according to experts.

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Electronic Trading and Flash Crashes – Part 1

Quite often, the media has pointed its fingers at electronic trading as the cause of various flash crashes. When delivering training on Electronic Trading, I often find that people are confused by the various terms and intricacies of this market. I thought it might be a good idea to give an overview of electronic trading and then look at the flash crashes to help explain the connection between them.

This article is broken down into two parts: Part I is a primer to electronic trading and Part II discusses trading strategies and the three main flash crashes (May 6, 2010 in the U.S. Equity Markets; October 15, 2014 in the U.S. Treasury market; and October 6, 2016 in Sterling, which some refer to as a “Flash Event”).

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The New Fiduciary Rule

In April 2016, the U.S. Department of Labor (DOL) issued its final rule expanding the “investment advice fiduciary” definition under the Employee Retirement Income Security Act of 1974 (ERISA), modifying the complex of prohibited transaction exemptions for investment activities in light of that expanded definition (the “Rule”).

This is the first major rewrite to the fiduciary definition since ERISA was enacted in 1974 and is a key part of the White House’s “middle‐class economics” initiative. The DOL’s motivation for the Rule is to “level the playing field” and to ensure that investment advice given to investors is in their best interest. To do so, the DOL seeks to mitigate conflicts of interest that exist among firms, advisors, and their clients and to address concerns that firms and advisors are incentivized to recommend products or services that may not be in the best interest of the customer.

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The Long and Short of It: An Overview of XVA

The evolution of counterparty credit risk started with counterparty (credit) limits, settlement limits and exposure measurements such as potential future exposure. This progressed to the use of unilateral collateral, then the bilateral exchange of collateral. To assist in the pricing for the cost of dealing with a counterparty in a derivative transaction, the markets have developed a family of metrics including CVA, DVA, FVA, ColVA, KVA, and MVA, which have now been collectively dubbed XVA (xVA). The icing on the cake, or maybe still building the cake, is that the Bank for International Settlements (BIS) recently announced their intention of removing one of the approved methods for calculating CVA for capital charges. So what is CVA and all the other VAs?

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Migration to T+2 Settlement

Reducing the trade lifecycle by 24 hours will enable market participants to better manage counterparty credit risk, optimize cash flow, enhance liquidity and harmonize the US with international settlement cycles. It also reduces the risk of investors to the default of a broker such as what the world’s financial markets experienced with the collapse of Lehman. Adding to the positive outcomes of T+2 will be the cost efficiencies that may be found after the remediation and business process re-engineering work takes place.

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The Long and Short of It: An Overview of STACR and CAS

Fannie Mae and Freddie Mac now have issued numerous credit risk transfer notes in this ever evolving market. This article summarizes some of the highlights of the issues/securities called Structured Agency Credit Risk or STACR, which are issued by Freddie Mac, and Connecticut Avenue Securities or CAS, which are issued by Fannie Mae.

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Enterprise Risk Management: A Modern Consensus from Corporate Studies

Enterprise Risk Management (ERM) is one of the hottest areas in the risk management discipline today, with new advances in technology and communications creating both opportunities and challenges in the area. Experts have conducted considerable research in the field of ERM in the last fifteen years and it’s useful to understand how the consensus set of best practices in the area has evolved.

ERM is a significant evolution versus traditional risk management techniques in that it encompasses all areas of an organization and looks at the overall set of risks that result from interrelated processes, people, and structures across the organization.

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Understanding Central Counterparties (CCPs)

Central counterparty clearing houses, or more simply central counterparties (CCPs), have emerged from the 2008 financial crisis as lynchpins of the global derivatives markets, and therefore, a critical part of the infrastructure of the global financial system.

But what exactly are CCPs, and what role do they play? What risks do CCPs face and how do they manage and mitigate those risks? The answers to these questions and more can be found in this article.

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Stressed Over Stress Testing

Stress testing has been an important part of bank risk management for many years, with some form of a test used for the analysis of credit, liquidity, and market risk exposures. Given this, you might wonder why recent regulatory requirements for stress testing have proven so challenging and have resulted in adverse findings for so many banks.

It turns out that the process for producing well-substantiated answers to questions around capital adequacy is actually quite complicated. Compliance with the stress testing requirements have caused institutions to realize that the proper evolution of cash flows, earnings and the level of capital require the simultaneous analysis of all risk factors; risk exposures are not additive. Banks are expected to resolve this fundamental issue as well a long list of other challenges in order to prove that their representations on capital adequacy can, in fact, be relied upon by regulators. Regulatory requirements continue to evolve and the bar of expectations appears to rise with each new round.

This article discusses the major components of a stress testing process and describes some of the challenges with which banks are contending.

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The Birth of a New Type of Bond — Reverse Yankee

The idea of borrowing on an uncovered basis in a low interest rate foreign currency has been around for many years. The Swiss franc in the 1980s, the Japanese yen in the 1990s, and more recently, Hungarian consumers taking out mortgages denominated in euros are just three examples of what once seemed like a way of saving money that has turned out to be a financial disaster. Borrowers saved in interest cost, but when it came time to repay the principal, they incurred significant losses because the currencies they borrowed in had appreciated dramatically. Historically, low interest rates have been associated with strong currencies, and high interest rates have been associated with weak currencies.

The euro, with a very few notable exceptions, cannot be regarded as a strong currency because of the Greek scenario. Yet German government bond yields have been negative and are still very low. So what does this mean for European Capital Markets? An opportunity to innovate! And that is what has happened in the first six months of 2015 with the emergence of the “Reverse Yankee” bond market.

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Comparing and Contrasting CCAR and DFAST

The Federal Reserve System’s regulatory responsibilities include the oversight of bank holding companies (BHCs), savings and loan holding companies, state member banks, and systemically important nonbank financial institutions (SIFIs). The Fed has reacted to some of the negative outcomes associated with the recent financial crisis by creating a new framework and programs for the supervision of the largest and most complex financial institutions. Among these is an annual assessment of whether BHCs with $50 billion or more in total consolidated assets have effective capital planning processes and adequate capital to absorb losses during stressful economic conditions. This annual assessment includes two related programs: (1) The Comprehensive Capital Analysis and Review (CCAR) and (2) Dodd-Frank Act Supervisory Stress Testing (DFAST).

While DFAST is complementary to CCAR, both efforts are distinct testing exercises. Both rely on similar processes, data, supervisory exercises, and internal resource requirements.

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The Federal Reserve Tools: Past and Present

Pundits all seem to agree that, later this year, the Federal Reserve will finally raise rates. Some seem to think that will occur in June while others believe it will be September. Regardless of when it happens, now would be a good time to review how the Federal Reserve actually goes about raising rates. This article reviews the Federal Reserve’s role, how they control the Fed Funds rate, and the tools used to accomplish these goals; it is not designed to be an in-depth look, but more of an overview.

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Municipals Update: the Good, the Bad, and the Groundbreaking

We thought it might be helpful to update our municipal bond market view from last year with our “crystal ball” for 2014. In this article, we will examine the overall market for any changes and insights to the future. Next, we will review two issues that have essentially been resolved. Lastly, we will move on to the legal environment where “groundbreaking” rulings will have major consequences for either pension funds, municipalities, or both.

Are there any new concerns for 2014? Read more to find out.

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Accepting a Regulatory Gift: Exceeding Rising Credit Risk Quantification Standards

All of us fall short at times. Sometimes, our solid performance in one context causes us to over-estimate our ability to perform at a higher standard in another context. Sometimes the unwanted failure notification letter (or unwanted examination findings) can be a productive catalyst to elevate our game.

Unfortunately for bankers, standards do not remain constant, and much can change from decade to decade. The annual publication of Federal Reserve scenarios (baseline, adverse, and severely adverse), particularly when combined with the history of the same macroeconomic factors back several decades, is a risk management “gift” that will soon be opened by many community bankers.

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Binary Options: Portfolio Destruction Theory or Market Wizardry?

It is important to view Binary Options in the correct light. They have fantastic features which, when applied correctly, can add tremendous value. Yet as a standalone investment strategy they are far too risky for the average investor with limited capital and, more importantly, limited ability to consistently stomach negative returns.

For average clients, being successful with Binary Options then more closely represents luck being on their side (like playing Roulette at the casino), than being successful at investing. One should look at risk adjusted returns and apply capital in vehicles or instruments that are skewed in one’s favor.

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GSEs and Housing Finance Reform

Affordable housing has been a goal of the US Government since the Depression. Fannie Mae and Freddie Mac (the government-sponsored enterprises, or GSEs) were created to lower the cost of, and make financing more available for, Americans to purchase a home. The GSEs developed a secondary market for mortgages, which further reduced financing costs and expanded credit availability.

Prior to 2008 the GSEs were publicly traded shareholder corporations which had the advantage of carrying an implicit guarantee from the federal government. Both GSEs had a line of credit with the US Treasury Department, and both were exempt from state and local income tax on corporate earnings.

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The Volcker Rule—Where to Begin?

As part of the on-going Dodd-Frank Act rules and regulation implementation, section 619, more commonly known as the Volcker Rule (Rule), was finalized in December 2013 with a few tweaks during the first quarter of 2014. The main undertow of the Rule is to prohibit, “[a] banking entity and nonbank financial company supervised by the Board (Board of Governors of the Federal Reserve System, hereinafter FRB) to engage in proprietary trading and have certain interests in, or relationships with, a hedge fund or private equity fund.”

After testing the rule making partnership between financial regulatory agencies as seen with the Securities Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) Joint Final Rule for Identity Theft, three additional agencies joined the rule making collaboration for the Volcker Rule. Together the SEC, CFTC, FRB, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) outlined the compliance requirements banking entities engaged in “significant” trading operations are required to establish, conform to and implement. The final compliance rule becomes effective on April 1, 2014. However, the comprehensive conformance period extends to July 21, 2015.

From a Compliance Department standpoint, where do you begin?

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The Perfect Storm: October 2008

There have been a plethora of reasons given by the media for what created the subprime/credit crunch crises. However, in speaking with people within the industry, as well as friends and family, it appears not everyone understands the various reasons culminating in the credit crunch of 2008.

No one reason, but the right blend of ingredients coming together simultaneously created the perfect storm. This article does not purport to explain all the details, but rather to summarize the different reasons—as reported by the media and those that were not—and how each reason was a cog in the “perfect storm” wheel.

It is important to note that the article attempts to cite and reference the reasons presented by the media and does not necessarily indicate agreement or disagreement with them.

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Collateralized Loan Obligations

Collateralized loan obligations (“CLOs”) are structured financial transactions where certain types of loans, usually highly leveraged syndicated commercial credits, are pooled together and transferred to a trust entity called a special purpose vehicle (“SPV”).  In this article we will discuss the following:

  • The parties involved in a CLO
  • The CLO Stages of Development
  • The CLO Market: From 1.0 to 2.0
  • Impact of Dodd-Frank Legislation
  • And the Benefits and Risks of a CLO

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Detecting Early Warning Signs

Appreciating that volatilities and uncertainties in our financial markets are accelerating, the ability to anticipate problems in individual issuers/borrowers is a highly valued skill. The effectiveness of how we can best spot the numerous red flags, and subsequently, how we interpret them, will be the determinate factors for success or failure in investing. Unfortunately, there is no magic wand or singular tool that addresses this rather subjective issue…

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The Impact of OTC Clearing on Operations Departments

Since the G20 Summit in 2009, Operations Departments of financial services firms have been hard at work re-engineering work flows, upgrading and implementing new systems, and acquiring new skill sets to support the requirements of the Dodd-Frank mandate for clearing OTC Derivative contracts.

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Interest Rate Swap Futures: An Introduction

The financial crisis has brought about many changes to the global financial system. One of these changes are the clearing requirements implemented by the Dodd-Frank Act for over the counter (OTC) derivatives such as interest rate swaps. These complex requirements have also increased interest in interest rate swap futures as an alternative hedging instrument.

Although they have been around for a while, swap futures have never been very successful, most likely because the OTC dealer community was unwilling to support them. But now it seems the playing field may be leveling out as OTC and futures transactions both require margin—with futures having somewhat less onerous requirements. This introduction looks at the similarities of the contract specifications, their differences, a brief review of net present value and some basic applications.

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Looking through the ICE at Electronic Trading

If there was ever any doubt about the importance of electronic trading in today’s capital markets, surely the acquisition of the New York Stock Exchange by ICE (the Intercontinental Exchange, Inc. based in Atlanta, and one of the first electronic derivatives exchanges) would put the notion to rest. Looking at the corporate evolution of ICE is a bit like looking at the evolution of electronic trading itself, and it is an excellent primer on the evolution and future of electronic trading.

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Unlucky 2013 for the U.S. Municipal Market—Fact or Fiction?

The municipal market has been around for over 100 years and has been the primary engine for state and local governments to finance schools, hospitals, homes and all types of basic infrastructure.
The market is deep and liquid and stands at about $3.7 trillion as compared with the $8.4 trillion corporate bond market.1 Due to their tax-exempt status, the majority of municipal investors are individuals and mutual funds.

Fixed income investors continue to search for yield and high credit quality. They can get 1.69% for a AAA rated muni versus 1.84% for a comparable treasury. After factoring in the tax advantage, munis look like an excellent investment. So why worry?

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Risk Reversals

Risk reversal is a commonly used term in the FX markets. Specifically, a risk reversal is:

  1. An option strategy combining the simultaneous purchase of out-of-the-money calls (puts) with the sale of out-of-the money puts (calls). The options will have the same expiration date and similar deltas.
  2. A market view on both the underlying currency and implied volatility.

This article:

  • Describes the origins of the risk reversal
  • Defines the volatility smile and skew
  • Examines specific example of quotes
  • Investigates a hedging example

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