ETD Markets Can Handle 24/7 Trading, But Adjustments Needed – FIA

A new report from the Futures Industry Association (FIA) argues that exchange-traded derivatives markets are “well positioned” for a transition to 24/7 trading, but that clearing and risk management frameworks will have to change ahead of any change.

The paper warns against “half-measure clearing solutions that create asymmetric or dislocated risk in the system”, adding that arguments for pre-funding margin ahead of weekends or holidays are “imprecise and untethered from market risk”. This, along with other suggestions like CCPs collecting margin losses, but not remitting or netting them during the extended hours, “only shift risk, rather than mitigate risk”, the paper observes.

A related issue it highlights is the need for clearing members to collect margin from clients, something that normally happens quickly after the clearinghouse issues a margin call. This sees clearing members use the wholesale payment system and funding markets to collect from clients, but while several central banks have started investigating or offering extended opening hours for these systems, the paper says these initiatives need to be advanced further before they will be able to suitably mitigate the risk.

Without full clearing operations at weekends and holidays, the paper observes, clearing firms will not know how much risk has accumulated over the weekend – and how much margin it needs to collect – until the clearing process resumes on Monday. In the current environment, clients can post various types of collateral to meet their margin calls, including cash and securities, and clearing members have several ways to meet their funding requirements, including access to the repo markets for US government securities. None of these forms of collateral and funding are currently available on weekends and holidays.

“This creates challenges for timely collateralisation of exposures outside of traditional trading hours,” the paper states. “This also introduces the risk of under-margined exposures, which in turn creates risks for market participants, clearing members and clearinghouses.”

It also observes that further complexity is introduced if only some clearinghouses move to 24/7, while some remain closed, “Additionally, it is important to consider the impact of an increase in basis risk as weekend markets may become untethered from their cash or physical market counterparts,” the paper notes.

The paper takes particular aim at auto-liquidation, a technique used in digital asset markets (from where the push for 24/7 trading is coming), arguing that it is inappropriate in commercial markets. “Today, clearinghouses and their members have a duty to consider market conditions before liquidations,” the paper states. “The current clearing model requires the establishment of a clearly defined default management strategy with provisions for hedging and portfolio splitting prior to liquidation to ensure that any close-out happens at the best possible price.

“This tailored liquidation process is aimed at protecting market participants that use futures to hedge their risks, such as pension funds and agricultural producers. These market participants use derivatives for risk protection, and periods of high volatility where auto liquidation could be triggered are precisely when they need these instruments the most.”

The challenges around liquidity are not ignored by the paper, which warns of the potential for disorderly markets due to thinner conditions, which in turn can trigger risk events such as flash moves. It also highlights the decisions faced by market participants who will need to judge the benefit, or otherwise, of staffing and maintaining technology on a 24/7 basis.

Regulators will also have to change, the paper notes that as markets move to 24/7 trading, there will be a need to examine all aspects of the regulatory framework. It highlights rules related to order handling requirements, execution quality disclosures, the use of customer funds and volatility controls as key areas for consideration.

Adjusted regulations “must be clear, fit for purpose and consistent across trading venues”, the paper argues. It adds that currently, weekends and holidays offer a pause in trading and allow market participants to reassess market conditions. This pause also has traditionally

provided regulators a time to manage defaults and crises. “Policymakers will need to assess how to work through these one-off challenges without that buffer,” the paper states. “The adoption of 24/7 trading will require regulators to adjust definitions and practices under which their markets operate. For example, timing for residual interest calculations is premised on regular closures of funding markets. Likewise, customer fund segregation reporting is premised on regular closures of futures market.

“A similar situation exists when it comes to contract specifications and market practices,” it continues. “For example, many futures and options contracts reference a “cash close” in the underlying market, which may need redefining or clarification, and legal certainty is needed for weekend settlement references and price limits. In the same vein, a thorough examination of error-trade windows and trade bust rules for market sessions on weekends and holidays will be required.”