Market Matters | FICC Market Structure: What’s All the Buzz Around T+1?

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MERIDY CLEARY: Hi, I'm Meridy Cleary. As many of you may know, our team is uniquely positioned. We produce content on the drivers of liquidity in the market today, and how policy technology and microstructural dynamics are influencing how market participants interact. A key theme on our radar right now is the move to T + 1 Settlement in the US and Canada for security trades. This is set to be implemented next May. In today's podcast, we'll lay out some of the market structure implications of shortening the settlement cycle, and what this might mean in terms of cross-border transactions, and the potential knock-on impacts. To do this, I'm joined by the Global Head of FICC Market Structure at JP Morgan, Kate Finlayson. Hi Kate.

KATE FINLAYSON: Hi Meridy. Thanks for that intro. It's great to be here.

MERIDY CLEARY: Kate, while some of our listeners may have seen the headlines of the move to T+1, I think it would be useful to get a little bit of a background. How did we get here?

KATE FINLAYSON: Sure, maybe if we take a quick step back. In trading, the settlement cycle is the amount of time between the trade date, T, and the settlement date. In other words, when buying or selling securities, there's a cutoff date when the trade must be one, confirmed, two, any allocations made, and three, affirmations completed. At the moment most economies around the world follow the T+2 settlement cycle, meaning the majority of routine security trades settle two business days after the trade date. Over the past few decades, regulators have looked to shorten the settlement cycle, which is intended to protect investors by reducing systemic and counterparty risk.

MERIDY CLEARY: Yeah, and for background, the US led the move from T+3 to T+2 in 2017. Regulators in Europe led the move to T+2 in 2014. So similar to the move now, we're not seeing this global alignment.

KATE FINLAYSON: Right. The US is leading the charge this time, driven in part by the so-called meme stock volatility in January 2021, which demonstrated vulnerabilities in the securities market that T+1 settlement would lessen. On February 15, the SEC adopted amendments and new rules to shorten the standard settlement cycle for most securities transactions, which will go into effect on May 28, 2024.

And the Canadian Capital Markets Association also released a formal announcement confirming May 27, 2024. This is one day earlier than the US given, of course, the US Memorial Day holiday. The scope is quite broad and encompasses largely the same products as the previous move from T+3 to T+2 for both the US and Canada. So, this includes equities, fixed income securities, that's across corporate, government, and convertible bonds, and it also includes unit trusts, mutual funds, ETF's, ADR's, and options. On the primary market side, debt and equity offerings are not required to settle T+1. And while derivatives such as security-based swaps are not scoped in, it is anticipated that the market will recognize the new settlement cycle to avoid mismatches in settlement between derivatives and instruments used to hedge.

MERIDY CLEARY: Yeah, that scope is quite broad. As you mentioned, this shift is driven by the desire to leverage the benefits associated with the accelerated settlement. The SEC Chair Gary Gensler said that it would reduce the amount of margin that counterparties need to place with the clearinghouses, thereby lowering risks, and freeing up liquidity elsewhere in the market. Kate, taking into account some of these potential benefits, what are the knock-on impacts of T+1?

KATE FINLAYSON: Well, at a high level, the shortening of time frames means that confirmations, allocations, and trade affirmations will effectively have to take place on trade date in order for settlement to occur on time. And while the benefits you mentioned there Meridy, are definitely important to market risk as a whole, halving the settlement cycle in such a short time period could lead to extensive operational hurdles, due diligence, and new deadlines for the submission of data across the globe.

In terms of industry impact the effects could be felt by a range of market participants. Think issuers, asset managers, broker dealers, custodians, transfer agents, exchangers, clearing firms, just to name a few.

MERIDY CLEARY: And now there's just one year until T+1 goes live. Market participants, and some of the ones that you just mentioned, will need to analyze and test the operational and technological changes to be able to meet this deadline. This will inevitably be an uplift and the shorter settlement time frame means that there's not so much time for firms to identify any discrepancies. It will mean more reliance on for example, straight through processing to avoid a spike in settlement failures. And Kate, another concern is funding.

KATE FINLAYSON: Absolutely. Market participants often rely on the spot effects market to fund securities transactions that settle in US dollars. And typically, settlement for spot effects transactions is done on a T+2 basis. Unless this also moves to T+1, which may take a long time, it may result in some settlement issues. T+1 could increase the risk that transaction funding dependent on effects may not occur on time. This so-called FX fail could require additional funding and lead to further costs and inefficiencies. It's also likely that the move to T+1 will create or extend a funding gap between UK and European funds, which settle on a T+2 or T+3 basis and their underlying assets, if those funds hold US or Canadian securities.

MERIDY CLEARY: And as you say Kate, effects spot transactions are typically settled T+2. There are some exceptions to the rule, but for the most part, deliverable currencies can settle T+1.

KATE FINLAYSON: Correct. For example, the currency paired dollar CAD has T+1 spot date. For the currency pairs where your spot date is T+2, T+1 settlement can be easily achieved with the use of an FX swap. However, there are dependencies and some exceptions to this. For example, if the currency has a less liquid funding market. And of course, you have currency pairs that cannot settle T+1. This is where the pre-funding element will be needed. And the end client will need to assess and manage the impact based on their own funding needs.

MERIDY CLEARY: And I suppose the time zone element is quite an important one. If trades are executed later in US markets, this could impact liquidity.

KATE FINLAYSON: The bottom line is that this move will not only impact North American clients, but global clients trading US and Canadian securities. If you're a non-US Canadian based investor, and need to ensure that you settle T+1, it's important to clarify that certain matching and settlement platforms do have cut off times, which may also need to be considered. This time zone impact, and when or where trade is executed, could involve a reshuffling of staff or operating hours. Some firms may consider moving certain functions to the West Coast for example, to allow for more time for trade processing.

MERIDY CLEARY: Taking a step back there are some other considerations. For example, T+1 could impact stock lending and corporate actions. It also might call into question the impact on repo, and whether it would require the supply of lending instruments to be more liquid. And this could also play out in ETF markets since many ETFs and conventional funds contain underlying securities from several jurisdictions. Not only could it augment or highlight cross-border settlement complexities, but it could also impact the create and redeem process.

KATE FINLAYSON: Yes. And taking all of this together, there becomes a reliance on market middlemen, i.e. T+1 could mean even more of a reliance on third parties across custodians, market infrastructure, vendors. This all involves a significant amount of coordination and not a huge amount of time to do so.

And if we'd look at the Asia-Pacific region for example, it could arguably be hardest hit given that time zone difference, and also some restrictions to APAC post trade coverage, and the fact that APAC markets do not permit overdrafts. And in terms of the prefunding element, the window for funding cross-border trades will be narrowed in a T+1 settlement cycle, which could mean that foreign investors might have to incur additional costs to prefund based on estimates instead of confirmed trades on T.

Market participants investing in the US or Canada, once T+1 takes place would therefore have to look at making settlement more efficient, and look at a range of options, possibly expanding settlement operation hours, or setting up night desks to accommodate the settlement processes such as trade instructions and resolving pre trade problems.

MERIDY CLEARY: You mentioned APAC. In January of this year, T+1 went live in India. India is currently the second largest market after China to reduce settlement from T+2. So obviously very significant. Of course, in India's case the rule only covers execution and not settlement, and the settlement obligations sit with the asset custodian. This transition was done in phases, beginning in 2022 with the least liquid securities, before moving on to the more listed securities in the final phase. Although overall this transition in India has been relatively smooth, there are still time zone considerations that we've been mentioning that could impact operations. And Kate, since this time around the transition is not in unison globally, how do you think things will progress from an EU and UK perspective?

KATE FINLAYSON: Well, I mean arguably the US and Canada's transition could put some pressure on European regulators to follow suit. The UK government has put together a dedicated task force on the implications of T+1 and has recently confirmed that a report will be released at the end of this year with an official recommendation. It will be interesting to see how different the elements are addressed, and how aligned this will be with North American transition when it comes to the individual process flow, reconciliation, documentation, and so on.

The EU is a slightly different story. The previous transition from T+3 to T+2 in 2014 was in the context of the Central Securities Depositories Regulation, CSDR. CSDR aims to harmonize both the timing and conduct of security settlement in Europe, as well as the rules governing central security depositories, CSD's, which operate settlement infrastructures. And currently, CSDR is being looked at with regard to these T+1 dynamics, and both the Settlement Efficiency Task Force and the Cross Association Task Force are currently fleshing out the pros and cons of this transition.

MERIDY CLEARY: Yeah, and while the US has one currency, one market, and regulators focus on just one jurisdiction, the EU has a lot more to consider obviously, taking into account what a shortened cycle could mean for the 14 currencies and 31 CSD's operating in the Union. Moving too quickly to a T+1 could maybe lead to an increased number of settlement fails, which will incur cash penalties under CSDR rules, as well as having capital impacts under Basel III requirements. OK, so, putting T+1 to one side, there is also this view that markets might shift to a T+0 settlement environment. I think we can both agree that that would be a fundamental change in the overall settlement infrastructure, not to mention post-trade processing.

KATE FINLAYSON: Well, of course. And this is where blockchain technology and instantaneous or atomic settlement comes into play. At JP Morgan, we've seen this happen in a range of markets, including intraday repo transactions. And it certainly helped facilitate settlement and a host of other benefits. There are so many considerations when it comes to T+0, market readiness for a start. Some may argue that blockchain technology is not needed for same day settlement. And there of course are considerations regarding what instantaneous settlement would mean in terms of any netting benefits. Given all the dependencies on market readiness, one would hope that this would be carefully thought out, and rolled out in a measured way. One thing is for sure, it would require the whole industry to work together.

MERIDY CLEARY: Well, thanks Kate, so much for today. I think this was a great discussion.

KATE FINLAYSON: Of course. Thanks Meridy.

MERIDY CLEARY: And I think a year might seem like a long time to people for T+1, but we have to remember the transition from T+3 to T+2 took the industry 30 months. So clearly a lot to consider here. As more developments play out, our team will be sure to keep you updated in our reports and our other content mediums. To our listeners, please stay tuned for more FICC Market Structure episodes. Thanks for listening.

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Market Matters | FICC Market Structure: Uncovering Key Trends in EM Swamps

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Meridy: Hi, this is Meridy Cleary from the FICC Market Structure and Liquidity Strategy team here at J.P. Morgan. Today, we're going to delve into the world of emerging markets to talk through some of the key features, drivers, and dynamics of these markets. I'm joined by Avi Berkowitz, who is the head of EMEA, Emerging Market Interest Rate Derivatives Trading. Hi, Avi.

Avi Berkowitz: Hey, Meridy. Good morning.

Meridy: As the largest derivatives asset class, Interest Rate Swaps, or IRS, play a key role in the global financial ecosystem. Usually, these products involve the exchange of a floating rate for a fixed rate and vice versa. IRS can take many different forms. In periods of uncertain rate movements, like we're experiencing right now, IRS helped mitigate some of the ongoing uncertainty. Avi, the growth in emerging market IRS trading activity has been quite something. A combination of new access channels to these markets, technological advances, and policy initiatives have contributed to this increase. From your perspective, what are some of the explanations of this growth?

Avi: Over the past decade or two, we have seen volumes and trading activity increase in EM interest rate swaps. This trend has picked up considerably in the last couple of years. If you look into the new data released from the BIS in November, an OTC derivative activity, we can see there has been a general pickup in volumes across EM IRS markets since 2019. Most notably, Czech, Poland, and Korea notionals have essentially doubled since pre-COVID.

Meridy: That's interesting. Why do you think that is?

Avi: I would say this general growth comes down to two key things. Firstly, we are seeing more active central banks in EM. Some EM central banks held rates at or close to zero for a while, but since COVID, have suddenly become more active, which has increased demand and overall trading. We are seeing this in Czech and Poland markets, for example, where more active central bank policy has been driving trading. This explains the rise in average daily volume. EM central banks have been more active compared to their G10 peers, both by hiking first. Now some have started to ease already ahead of their G10 peers.

Brazil, Chile, Hungary, and Poland, for example, have started cutting rates already. This has driven an increase in short end trading. Most EM traders express their short end views using FRAs. These are essentially three month interest rate swaps. Unlike in euro or dollar, there are no liquid short dated interest rate futures. FRAs are used to express short dated views in EM. Second, a trend we have seen is an increase in relative value trading by hedge funds and real money clients. It used to be the case that clients use EM IRS mostly for directional trading. Now, clients are trading liquid emerging markets similar to how they trade G10 really by using IRS for relative value trading.

Meridy: As markets adapt to new technologies, a key market structure trend that we've observed is the electronification of markets. EM IRS trading has also followed this trend. Avi, from your seat, what are some of the factors contributing to this?

Avi: One of the main drivers of this is that banks are offering more electronic liquidity in EM. Another notable trend is the growth in systematic trading within emerging markets. These market participants, which deploy a range of automation strategies, are increasingly making up a larger portion of the overall trading landscape. These accounts mainly trade based on models, meaning it's low touch trading, making them well suited to electronic trading.

Meridy: Another observation that we have seen is the general increase in the sizes being traded electronically. While we'd expect the concentration of trading to be in the smaller tickets, we're actually seeing this shift.

Avi: Yes. Up until recently, I would say the typical average DV1 in E was less than 5k. We are now, however, seeing significantly more being traded in the 5 to 10k DV1 bucket and even 10 to 15k buckets. We expect this trend to continue towards the 20 to 30k bucket. What does that mean? It tells us there's increasingly more comfort and confidence in trading EM IRS electronically.

Meridy: Agreed. We're also seeing changes in the protocols being used in these markets, right?

Avi: For sure. We have noticed an increase in demand by clients for RFM or requests for market where the client asks for a two-way price. This means that clients can trade electronically and do not have to show their trading direction. Another development is that compression trading is being increasingly used in EM IRS. This is known as list trading. It allows a client to trade on a PV or Present Value as opposed to a rate. Whereas through voice execution, clients would typically go through a two-step process. In other words, first enter into a new trade to hedge the existing risk, then ask for a PV calculation to unwind the old trade. On E, this can be done in one step via list rates. The client would ask for a compression price priced as a present value.

Meridy: Something else that we've been looking out for is the global transition from live [unintelligible 00:05:36], which has led to a shift in IRS trading. Looking ahead, emerging markets will have their own transition to risk-free rates or RFRs in the coming years, which could definitely help drive EM IRS popularity even further.

Avi: Yes. One of the struggles felt by emerging market participants was the difficulty in finding a stable benchmark or fixing rate. Now, we are seeing some emerging markets either currently transitioning or planning to transition into RFRs, which will likely spur more trading opportunities. We're already seeing global clearinghouses going live with some new rates, and we expect Mexico and Israel to go live with their new RFR rates next year. For emerging markets that did not have a reliable libel fixing, the move to RFRs can increase trading even further. A good example of this is Turkey. Now with the Turkish Lira overnight reference rate, also called the TLREF, we have seen an increase in client interest to trade Turkey, given a more reliable fixing rate to express interest rate views.

Meridy: Thanks, Avi. There are certainly a number of elements here at play. Thank you so much for your time today.

Avi: Thank you. Pleasure.

Meridy: To our listeners, please stay tuned for more FICC Market Structure episodes on Making Sense. We recently released a report for clients on some of these EM IRS dynamics. Should you have any questions, please reach out to your J.P. Morgan sales representative. Have a great day.

Female Speaker: Thanks for listening to Market Matters. If you've enjoyed this conversation, we hope you'll review, rate and subscribe to J.P. Morgan's Making Sense to stay on top of the latest industry news and trends. Available on Apple Podcasts, Spotify, Google Podcasts, and YouTube. The views expressed in this podcast may not necessarily reflect the views of JPMorgan Chase & Co. and it's affiliates, Together J.P Morgan, and do not constitute research or recommendation advice or an offer or a solicitation to by or sell any security or financial instrument.

They're not issued by J.P Morgan's research department but are solicitation under CFTC Rule 1.71. Reference products and services in this podcast may not be suitable for you and may not be available in all jurisdictions. J.P. Morgan may make markets and trade as principal in securities and other asset classes and financial products that may have been discussed. The FICC market structure publications, or to one, newsletters, mentioned in this podcast are available for J.P. Morgan clients. Please contact your J.P. Morgan sales representative should you wish to receive these. For additional disclaimers and regulatory disclosures, please visit www.jpmorgan.com/disclosures. Copyright 2023 J.P. Morgan Chase and Company. All rights reserved.

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Market Matters | FICC Market Structure: Top of Mind Themes for Q4

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Meridy Cleary: Hi, this is Meridy Cleary from the FICC Market Structure and Liquidity Strategy Team. We've had a particularly eventful three-quarters of 2023, so in this episode, we'll take stock of the most important topics on our radar and highlight some of the global developments that you should look out for in the run-up to year-end. To do this, I'm joined by my colleagues, Kate Finlayson in London, and Leland Price in New York. Hey, guys.

Kate Finlayson: Hi, Meridy.

Leland Price: Hey, guys. Great to be here.

Meridy: Kate, there's been quite a bit of noise around basis trades recently. This is where a trader buys treasuries and sells the associated treasury futures contract and vice versa. Maybe you could cover what the backdrop is there and what policy action we're tracking.

Kate: Yes, sure. Well we’ve been monitoring proposals relating to non-bank financial intermediation sector for some time now. So far, many of the proposals have been keenly orientated towards money market fund and open-end fund reform, and in fact, the liquidity risk management of these funds in particular. When it comes to hedge funds within this non-bank financial intermediate sector, we have seen attempts by US regulators to enhance oversight and transparency. For example, the SEC recently made amendments to Form PF with the aim of gaining visibility into hedge fund exposures.

The SEC has also proposed a change to the definition of a dealer and proposed or finalised various other private fund advisor reforms. However, there haven't been any recent detailed global policymaker recommendations on proposals relating to hedge fund leverage.

Meridy: And the most recent development is a progress report issued by the Financial Stability Board. Right, Kate?

Kate: Exactly. It highlights the elevation of non-bank synthetic leverage over the historical average, primarily driven by a group of hedge funds with very high levels of borrowing. So the report also raises the difficulty in accurately assessing the leveraged treasury market exposures for these large funds who typically spread their borrowing across several different prime brokers. The FSB also states that the concentration of hedge fund lending among a few prime brokers could amplify any shocks to the financial system. This focus on leverage was also reflected in the Fed's notes published on September 8, which stated that financial stability risks are facilitated by low or zero haircuts on treasury repo borrowing.

The note supports the idea that elevated exposures are concentrated among the 50 largest funds. And alongside this, repo borrowing is trending up as a result of the re-emergence of the treasury cash futures basis trade. I think it's worth highlighting the mention of a minimum haircut floor. The Fed estimates that implementing a 200 basis point haircut floor on repo borrowing would require funds to hold $12.4 billion in additional capital, resulting in a reduction in effective leverage. Of course, the Fed does acknowledge that this move would negatively impact hedge funds' return on equity on their relative value trades financed by US treasury repo.

Pricing spreads in hedge fund trades would have to double in order to remain profitable. Look, clearly more to come on this topic. On the FSB front, we could hear more in the coming months about its book of work at plans to roll out over the next year on leverage.

Meridy: Thanks, Kate. That's really interesting. Another topic that has been on the top of our agenda the last two quarters, in particular, is around Basel III implementation, meaning the rules to enhance regulatory capital requirements that align with the final set of Basel III standards, which were issued in 2017 by the BCBS or the Basel Community on Banking Supervision. Lee, in July of this year, US agencies released a couple updates within the so-called Basel III endgame. It sounds a little bit suspenseful.

Leland: That's right. As you mentioned, the Federal Reserve, FDIC, and OCC recently put forward two notices of proposed rulemaking related to Basel III. One of the important aspects of these proposals is that they change the calculation of risk-weighted assets or RWA. Specifically, the proposal would replace internal models-based capital requirements for credit and operational risk with new risk-sensitive standardized requirements. This is being referred to as the expanded risk-based approach. The new rules would also apply capital standards to a broader set of banking organizations.

Putting organizations with over $100 billion in total assets would now be required to calculate regulatory capital in a consistent manner. For the largest, systemically important banks, which are also known as

G-SIBs, the joint agency has issued a Notice of Proposed Rulemaking, or NPR, to change that methodology for calculating the risk-based capital surcharge. It seeks to measure on an average basis over the full year, the indicators that currently are measured as of year end.

Meridy: I think it's worth stressing that the NPRs are not final rules, right?

Leland: 100%. From the information that has been provided and set out in the G-SIB surcharge in the Basel III endgame, it is clear that there will be a significant rise in the amount of capital that US G-SIBs need to set aside. While these proposals are quite complex and maybe something for a report instead of a chat on this podcast, as the capital requirements increase, the cost of capital could ultimately mean increased costs associated with execution and liquidity. Now, the comment period on these two NPRs is open until November 30th. Given the significance of the impact, it seems like a great opportunity for market participants to opine and provide their views.

Meridy: Thanks, Lee. Another topic that we've been covering is India's inclusion in J.P. Morgan's Emerging Market Bond Index, which is due to start from June 28th, 2024. Kate, this has been a long-awaited development. What do you think this could mean for India's fixed-income markets, but also for foreign investors?

Kate: Yes. In fact, this update has actually been years in the making. India has been on the positive index watch list for nearly three years, and the inclusion into the index is absolutely significant. Even though India's bond market is one of the largest in emerging markets in APAC, foreign holdings currently comprise around only 2%. Our research team expects foreign bond inflows of between $20 to $25 billion as a result of the inclusion, phased in over 10 months. The announcement was off the back of India's Fully Accessible Route program, which was launched in 2020 and enables foreigners to invest in specified government bonds without quotas. Actually, Korea also remains on the watch list for inclusion, albeit into the FTSE World Government Bond Index. The Korean government has announced various initiatives to facilitate foreign investment into its capital markets. This includes removing capital gains taxes on government bonds and loosening restrictions on FX markets. Foreign investor engagement in these different markets and the various access routes will continue to be a keen focus for us.

Meridy: Thanks, Kate. Switching gears a little bit, the move to T+1 settlement in the US and Canada in May next year has been a hot topic within the industry, as firms seek to understand what the shortened settlement time could mean for their operations and market liquidity. We published a podcast on this channel a few months ago, but to our new listeners, this move will require equities, corporate bonds, mutual funds, ETFs, convertible bonds, ADRs, and others to essentially complete trade confirmations, allocations, and affirmations on trade date or T.

Since this was announced, industry testing is ongoing as market participants prepare for the new rules to kick in next May. Firms that do not currently have a US presence may look to move employees. Others may look at pre-funding trades when it comes to executing and settling a short-dated FX transaction and so on. From an EMEA perspective, the UK government has put in place a task force to explore the potential for faster settlement of financial trades. In Europe, regulators are looking to see how T+1 could be rolled out. Given the market fragmentation there, with multiple currencies and countries to consider, it's certainly no small task.

This roadmap sits within the CSDR refit, or for those of you who aren't familiar, this is the Central Securities Depositories Regulation. You may recall that the European Parliament and Council reached an agreement on a compromise tax for CSDR refit in June of this year. Overall, from an industry perspective, it's important that we focus on coordination, both at an intra and international level.

Kate: Yes, and actually just to hop in there from an APAC perspective, as we know, India made the move to T+1, which was completed for equity markets in January 2023. That scope is not as broad for fixed-income securities. The FX component is one of the key dynamics in this move to T+1 for APAC market participants as well. To prepare for the move, the industry is anticipating that demand for trading US dollar currency may accumulate during two distinct time periods. One, the existing end of day in EMEA, and then two, around the close of business US time, so 9:00, 10:00 PM London time.

In both cases, the demand could spike during peak hours when firms try to trade FX in the market to seek next-day settlement. As you mentioned, Meridy, the firms may decide to move FX functions to the US where FX instructions can be sent during conventional working hours. I think in this period of preparation, broadly speaking, firms will need to engage with custodians to understand deadlines to access CLS if it is used and gross bilateral settlement of FX.

Leland: I'll just jump back in here to draw our attention back to Europe. One topic that we'd like to discuss is the EU's open strategic autonomy, which continues to be an important topic with respect to trading, clearing, and settlement on the continent. Now, the overall goal of the initiative is to reduce perceived over-reliance on non-EU firms and improve market infrastructure to service EU clients. A big topic of conversation is the proposed active account requirement by the European Commission. Kate, I wonder if you can offer some thoughts on that topic.

Kate: Yes, you're absolutely right. This forms part of the second major revision to the European market infrastructure regulation or EMEA 2.0. This would require all market participants subject to the clearing requirement to hold active accounts at EU CCPs for clearing at least a portion of in-scope derivatives. Importantly, what qualifies as an active account is still being debated, so there's more to come on that. While the aim is to encourage clearing in the EU and improve the attractiveness of EU CCPs, there are split views on this proposal, with some arguing to do away with the requirement as it could hamper competition and raise costs. Others are calling for more qualitative rules instead, taking a less stringent approach versus those who are in favour of the rule, ie. supporting the quantitative approach. Overall, it's important to ensure that any significant requirement doesn't hamper the competitiveness of EU firms and overall costs of end investors.

Meridy: Team, we've covered a lot of ground today.

Kate: Yes, we have.

Leland: Definitely.

Meridy: I think one more topic I'd like to discuss very briefly is just around transparency developments. Obviously, in the UK and EU, they're separately looking to develop consolidated tapes for different asset classes. Looking ahead, we're also expecting an FCA consultation in Q4 on bonds and derivatives transparency. This is hugely relevant as these rules govern when a trade is made public, which could potentially be revised. Thank you, Kate and Lee, very much for your time today.

Kate: Thanks, Meridy.

Leland: Thanks, guys.

Meridy: To our listeners, please stay tuned for more FICC Market Structure liquidity strategy episodes on J.P. Morgan's Making Sense channel. I hope you have a great day.

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Market Matters | FICC Market Structure: What’s Driving Emissions Trading

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Meridy Cleary: Hi, this is Meridy Cleary from the FICC Market Structure Team at JPMorgan. In this episode of Market Matters, we're going to focus on the development of international carbon markets. These markets aim to reduce greenhouse gas emissions by facilitating trades between those who are looking to reduce emissions, compensate for emissions, and those looking for opportunities as part of the carbon transition. Over the past few years, emissions trading has garnered the attention of a broad range of policymakers and market participants, which makes it a fascinating market. With me to discuss these drivers and dynamics, I'm joined by my colleague in trading, Jose Cubria, who's leading JPMorgan's carbon trading activity. Hi, Jose.

Jose Cubria: Hey, Meridy, it's great to be here with you. Thanks for having me.

Meridy: Yes, of course. It's great to have you here. In July, as you know, the FICC Market Structure Team published a report on emissions trading given the market structural dynamics in this market. When it comes to the trading of emissions, we outlined in the report that there are broadly two types of markets; the compliance or mandatory markets, and then the voluntary markets or VCM. Before delving into these, I think it would be useful to take a step back. Jose, how has carbon trading fundamentally functioned? I wondered if you could run us through how it works from your seat.

Jose: Sure. At a high level, carbon markets work just like any other commodity markets, supply and demand are the fundamental price drivers and other factors such as regulation or legislation play important roles. Certain carbon instruments can be traded bilaterally or on exchanges such as the Chicago Mercantile Exchange, CME, and the Intercontinental Exchange or ICE. Carbon derivatives have become an increasingly important tool in helping market participants meet emissions targets. These instruments can range from swaps to forwards, options, futures, et cetera. Carbon derivative products, for example, emissions allowance futures are physically delivered, meaning that contracts held to [unintelligible 00:01:59] result in physical delivery. Of course, there are nuances to each carbon market, and we can get into those a bit more later.

Meridy: You mentioned carbon allowances there, which often get confused when compared to other products. What is the difference between carbon offsets and carbon allowances?

Jose: Offsets and allowances are the two main types of tradable carbon instruments, but they do often get confused for each other. I think it's really important to highlight that even though both are measured in metric tons, they represent fundamentally different things. A carbon allowance is a permit to emit 1 ton of carbon dioxide. Allowances are issued or created by regulators. Polluters covered by cap and trade schemes must purchase allowances against their carbon footprint. There's no inherent value to a carbon allowance beyond the mandatory purchase under a cap and trade. In other words, the allowance itself doesn't represent anything. Auctioning continues to be the primary means of introducing allowances into the market, and participants are also able to trade allowances on a secondary market. Carbon offsets, which are also called carbon credits exist because of an activity that actually mitigates carbon emissions. In other words, carbon offsetting is a reduction or removal of emissions from the atmosphere. Each carbon offset represents 1 metric ton of carbon that was avoided, meaning it didn't get released into the atmosphere, or 1 metric ton of carbon that was removed, meaning it was pulled out of the atmosphere. In either case, the carbon offset rewards the entity that captured or removed the carbon, and the ultimate buyer of the carbon offset can claim the environmental impact of that mitigation.

Meridy: Okay, thanks. I think these terms can easily be confused, thanks for clearing that up. If we first focus on compliance carbon markets, which I mentioned earlier, these markets are regulated by national, regional, and international carbon reduction regimes. Here, the trading of emissions is done on an ETS or an emissions trading system, which create an economic incentive for industries to reduce emissions.

Jose: Yes, exactly. Under an ETS, regulated entities buy or receive emissions allowances. ETSs are cap and trade systems, which as the name suggests, have two main functions. The first is to put a limit on carbon emissions, and that's the cap. The second is to put a price on carbon emissions, and that's the trade. Once the ETS is in place, the entities covered by the scheme, by allowances, and they can do that on the primary market, typically via auctions, or on the secondary market, that would be through exchanges or from intermediaries. That trading activity is what sets the market price for an allowance, and that gives polluters a way of calculating the cost of their emissions. They can then use the price signal to decide whether it's cheaper for them to buy allowances or to change the way they do their business to pollute less. The main drivers in the EU ETS are of course supply and demand. The supply of allowances is determined by the cap or the desired limit of pollution, and regulators can and often do, respond to various signals, financial or political, to change how and when supply is put into or taken out of the market.

Meridy: The EU developed the first ETS in 2005. Now in its fourth phase, the EU has been focusing on a lot of reforms to its Fit for 55 with the EU ETS within this.

Jose: Yes, the EU ETS serves as the EU's primary policy to reduce greenhouse gas emissions, and it's probably the most complex cap and trade because of the breadth of industries and countries it covers. The inputs on the demand side include everything from weather to the price of coal or the price of natural gas, to interest rates and more. There's also a significant investor or speculative element to the market, which is great for liquidity and price discovery, but that also brings other types of risks and trade flows to the market. As I mentioned earlier, demand for EUAs or EU allowances traded on the ETS, is driven by the entities who must buy allowances, and those can be energy generators, industrial polluters, et cetera. JPMorgan's trading desk participates in the EU ETS, and we offer a variety of products and risk management solutions to our clients. We have trading capabilities on exchanges as well as bilaterally, and we also now offer EUAs on our single dealer platform. Going back to your question though, EU policymakers have been looking to expand the scope of the ETS. For example, legislation was adopted this year to scope in emissions from the maritime sector starting in 2024, and it was announced that a separate ETS will be established for certain fuels used in buildings, road transport and industry.

Meridy: Yes, this year was a busy one for the EU ETS in terms of reforms. On top of the increased scope of coverage, the EU has announced that it will phase out the free allocation under the EU ETS, which will take place in parallel with the phasing in of CBAM between 2026 to 2034.

Jose: Yes, we hear the term CBAM a lot in my world. CBAM is the EU's Carbon Border Adjustment Mechanism. It's essentially a tool that will aim to put a fair price on the carbon emitted during the production of carbon-intensive goods entering the EU and encouraging cleaner industrial production in non-EU countries. The CBAM aims to help ensure that the carbon price of imports is equivalent to the carbon price of domestic production. In terms of timeframes, the CBAM will enter into application in its transitional phase later this year on October 1st with the first reporting period for importers ending on January 31st, 2024. When fully phased in, CBAM intends to capture more than 50% of the emissions in ETS-covered sectors. To your point, the gradual phasing in of the CBAM is aligned with the phase-out of the allocation of free allowances under the cap and trade. In April of this year, actually, the EU parliament adopted a package of reforms that will phase out free allocations for the industry from 2026 through 2034.

Meridy: While the EU ETS launched in 2005, as I mentioned before, post-Brexit, the UK created its own ETS, which went live in 2021 to replace its participation on the EU cap and trade. What have been some of the dynamics, according to your counterparts in EMEA? Are there significant divergences from the trading of UK allowances versus EU allowances?

Jose: Well, the clearest sign that the UK scheme is significantly different from the EU ETS is that EUAs are currently worth somewhere between one and a half to two times as much as UKAs. This is a market change from much of last year when UKAs were trading at a premium to EUAs.

Meridy: Interesting. Why is that?

Jose: Well, the short explanation for the price reversal in UKAs, and for the difference in UK and EU pricing in general, is in the fundamentals, I think specifically in UKA supply. The UK recently announced that we'll inject more than 50 million UKAs into the market between 2024 and 2027, and that additional supply is weighing on prices. The UK also said it will increase the number of free allowances it gives out to certain high-emitting sectors, and that's another bearish price driver. There's nothing permanent in the current price divergence between the UAs and UKAs of course. Numerous factors can and will influence pricing going forward, and those could be supply-demand balances, it could be macro-economic trends, regulation, politics, et cetera.

Meridy: Unlike the carbon compliance market in the UK, for example, compliance carbon markets in the US take a different shape. There isn't currently a nationwide ETS in the States. Jose, with you based there, what's the structure and history of the US compliance carbon market? It's clearly a little bit more fragmented.

Jose: It is. For most of the last decade, there have been two cap and trade schemes in North America. The first is the WCI, which stands for Western Climate Initiative, and that currently has California and Quebec as members. Then there's the Regional Greenhouse Gas Initiative, which we commonly call RGGI, and that has about a dozen member states in the Northeast and Mid-Atlantic US. Earlier this year, the state of Washington launched its own ETS and the state of Massachusetts has a cap and trade specific to power generators in the state. That programme supplements the state's participation in RGGI, but the Massachusetts market is not open to non-compliance entities. Various other states in the US are at least discussing or considering launching their own ETS, or maybe joining an existing scheme, but I don't think any of those are on the cusp of launching yet.

Meridy: Yes. Over the last decade, these markets have developed quite a bit. The most obvious change is the price in both RGGI and California, which is multiple times higher than they were just a few years ago. How have these evolved in the time you've been trading in these markets?

Jose: A large part of the price increase in both markets, and I think especially in California, is that the programme is designed for prices to increase over time with annual increases to the auction price floor, to the price containment reserve, and to the price ceiling. Both programmes also undertake periodic reviews every few years, and those processes typically lead to important changes to the market design and to market supply. Historically, every programme review has led to a tighter supply-demand balance and higher prices. It's worth highlighting that both California and RGGI are undergoing their reviews as we speak. The other major change we've seen in these markets is that there's increased interest from investors and speculators, and that mirrors what we first saw in Europe a few years ago. The California-Quebec programme and RGGI are both significantly smaller than the EU ETS, but they're still big enough and liquid enough to attract participants outside of the usual compliance entities, trading shops, and financial intermediaries such as JPMorgan.

Meridy: Yes. Both of these main programmes currently have multiple members, right?

Jose: Yes, that's right. RGGI has 11 or 12 states, and that number is an approximation because things are still in motion. For example, Pennsylvania's technically a RGGI member, and they have been since the start of the year, but that participation is on hold and tied up in the state courts. Another member state, Virginia, is currently in RGGI, but planning to exit at the end of 2023, although that too is stuck in the courts. The WCI has California and Quebec as current members, and Ontario was also a part of the programme for a short time. The programme's design explicitly lays out the steps for further linkages. The State of Washington's recently launched programme was designed to closely mirror California's with an eye towards an eventual linkage in a few years. The joint California-Quebec ETS is quite a bit bigger than RGGI, and I'd say it's also the most dynamic and liquid of the two. JPMorgan's trading desk participates in both. Similar to my point on the EU ETS in RGGI and in California and Quebec, we offer risk management solutions on exchanges as well as bilaterally.

Meridy: Of course, carbon trading has taken off across the globe, not just in EMEA and North America. For example, China's ETS, which started operating in 2021, is now estimated to be the world's largest in terms of covered emissions. How do these compliance markets in the US that we were speaking about differ from, for example, China's ETS?

Jose: Well, cap and trade schemes are definitely on the rise globally. As you say, APAC is a key region to watch. China's ETS is operational, although the sectors covered and the types of entities allowed to participate in it are still evolving. The same would go for compliance schemes in South Korea, in Australia, and elsewhere in the region. The one constant in carbon trading I think has changed. I'm confident that over the next few years, there will be more markets. As emissions trading continues to develop globally, we at JPMorgan are working to expand our trading capabilities across these markets.

Meridy: Okay. We spent a good chunk of time on the compliance carbon markets, but of course, we should briefly touch on the second major type of emissions trading market, which is the voluntary carbon market or VCM. Since these markets currently lack a centralised regulatory framework or structure, it means that it's a little bit hard to estimate the actual size. Because of this, there have been concerns that this lack of transparency and oversight provides a downside to the market. At the same time, the driving force behind the rise of VCM is that they open the door to new investors looking to opt into this global carbon transition.

Jose: The VCM has actually existed for over a decade now, but it still feels nascent compared to the cap and trade markets we've been discussing. I think that's because the market was essentially dormant for most of the 2010s, but it's definitely roared back to life in the last handful of years. The renewed interest I think, has brought with it massive changes and significant growth, but also a lot of criticism. That all adds up to an extremely dynamic and ever-evolving market.

Meridy: What types of participants does it attract? I imagine there are several barriers to entry.

Jose: On the demand side, the short answer is that almost literally every company in the world is a potential buyer of carbon offsets. Anyone with a carbon footprint and with a commitment to clean up its act could look to carbon credits as one way to offset its emissions. The supply side has historically been made up of smaller boutique and specialist carbon credit developers, but I think that's also starting to change as bigger and more capitalised entities enter the project development realm. As with any other global commodity, there's no shortage of secondary market participants looking to get involved in trading carbon offsets, including financial intermediaries like JPMorgan.

Meridy: Thank you, Jose, so much for your time today. We've covered a lot of ground here. Thanks so much for being here.

Jose: Thanks for having me, Meridy.

Meridy: We'll be sure to keep our listeners and our clients up to date with any major developments in the carbon markets. If you're interested in further learning about how JPMorgan participates in these markets, please feel free to reach out to your JPMorgan sales representative. To our listeners, please stay tuned for more FICC Market Structure features on Making Sense. I hope you have a great day.

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