The final countdown to compliance is well and truly underway, as was demonstrated by the recent authorisation of the first trade repositories under the European Market Infrastructure Regulation (EMIR) by the European Securities and Markets Authority (ESMA).
The final countdown to compliance is well and truly underway, as was demonstrated by the recent authorisation of the first trade repositories under the European Market Infrastructure Regulation (EMIR) by the European Securities and Markets Authority (ESMA).
Following years of drafting and consultation with industry participants, we are now beginning to witness the implementation of new regulations governing OTC derivatives trading on both sides of the Atlantic.
The US Dodd-Frank Act and EMIR impact every element of the derivative trade lifecycle, and firms should have already invested heavily in robust compliance initiatives if they are to ensure that they will be fully compliant within the appropriate timeframes.
However, a combination of the need to reduce operating costs and a lack of involvement in the drafting process has left the buy side struggling to adapt and comply. This is in sharp contrast to their sell-side counterparts, which have been bracing themselves for incoming regulations for some time.
Both Dodd-Frank and EMIR influence execution, confirmation, clearing, margining, and reporting, but there are many differences in their exact scope and requirements. Extraterritorial issues between regulations further complicate the compliance landscape. Institutions will need to ensure they are fully aware of jurisdictional regulations and that they capitalise on any opportunities for interoperability.
There is also Basel III to consider, which measures overall risk exposures more stringently, and forces banks to set aside additional risk-free capital in their reserves. This will impact sell-side institutions, their business model, and the choice of which asset classes they participate in—all of which could have a significant impact on the buy side, requiring them to open new relationships in order to access markets.
Other concerns plaguing the buy side include:
New trade reporting responsibilities: it cannot be assumed that sell-side firms will perform trade reporting, and buy-side firms must keep sight of the fact that they are still legally responsible for trade reporting, even if they have delegated the function.
The scale of regulatory reform being imposed: in order to remain competitive, firms must ensure that regulatory governance is regularly reviewed and that adequate programmes are in place to manage any operational change that is required.
Understanding the changes that are required to address collateral segregation: the rules vary between Dodd-Frank and EMIR.
Effects on operating models: some firms are revisiting their operating model for the processing of OTC derivatives in light of the imposition of business conduct rules under Dodd-Frank and EMIR.
Efficient connectivity: many firms have yet to understand and implement the required connectivity solutions for new OTC services (affirmation, trade reporting, etc), all of which require proper planning, implementation and testing.
Trade reporting
ESMA’s authorisation of the first trade repositories under EMIR means that firms falling under its jurisdiction now have a solid deadline for the
implementation of their trade reporting solutions. Any organisation that is not fully compliant with EMIR’s trade reporting requirements by 12 February 2014 risks falling foul of the regulators.
Under Dodd-Frank, buy-side institutions do not play a role in the submission to the trade repository, but they are required to verify the accuracy of reports submitted. Under both regulations, a buy-side institution has an obligation to either submit or to verify the trade details submitted to the trade repository.
This will require a control framework capable of expanding as data-sets fragment further, in an environment where the organisation has to reconcile submissions at multiple trade repositories.
EMIR requires a wider range of trade details to be reported than Dodd-Frank, some of which may not be available through common trade execution standards. This means that institutions must find a way to enrich or modify any reporting message sent to a trade repository on their behalf. As this must be completed within a specified timeline, institutions will need to assess the need for any infrastructure build and investment.
For transactions that are not eligible for central clearing, buy-side institutions should be aware of the reforms governing bilateral confirmation that will be phased in. These are being introduced in order to mitigate the risk of un-cleared transactions and will impose different requirements across asset classes. This again emphasises the need for straight-through-processing in all elements of the trade lifecycle environment, and may require an institution to assess their ability to meet these requirements.
Institutions will also be required to perform periodic portfolio reconciliations for non-centrally cleared transactions. The requirements here are determined by the portfolio size but impose another level of operational complexity, which institutions need to be aware of and prepared for.
The cost of collateral
The cornerstone of OTC derivative reform on both sides of the Atlantic is the creation of central counterparties (CCPs) and the mandatory clearing of eligible products, designed to mitigate counterparty risk. While central clearing reduces counterparty credit risk, initial and variation margin (often cash) will have to be posted at the CCP.
For the buy side, the cost of supplying what a CCP considers ‘high-grade’ collateral may come at a price.
The increased cost of posting eligible collateral and the lost opportunities that will occur as a result of funds being tied up at a CCP are amongst the anticipated challenges. In the short-term, CCP requirements may drive margin requirements higher than bilateral agreements, and calculations may shift to a daily and intraday basis.
It is estimated that over two thirds of current bilateral trade volumes will be cleared through a CCP in the future, splitting the market between the cleared and non-cleared products. The need for technology to process both cleared and non-cleared products may concern buy-side participants who fear an increase in operational processing and risk as a result.
Institutions can gain support from triparty structures. For instance, it can be helpful to use independent collateral agents and systems that efficiently underpin ongoing collateral re-allocation and intraday substitutions based on collateral values.
Triparty agents reduce operational risk and complexity, help manage counterparty exposure, and provide clients with a wide array of solutions to transform and optimise collateral. However, choosing the right clearing agent can be challenging.
CCP/clearing broker selection
The CCP mechanism, its financial strength, and the selection of a clearing broker/s are all crucial considerations for the buy side. If there is no direct relationship with the CCP then the clearing broker assumes the credit risk and acts as the intermediary.
Buy-side firms must familiarise themselves with the options available, as the collateral taker (the CCP) sets the parameters for the collateral it will accept from the collateral provider (the buy- side firm). Clearing brokers should also be reviewed for suitability and stability, as they will not only hold the firm’s initial margin, but also help to clear the firm’s trade in the years ahead. It is imperative that there is no repeat of the MF Global case where client funds were put at risk.
With the cost of margining increasing, risky, long-term bespoke swaps will become uneconomical, encouraging the trading of more ‘vanilla’ products. Indeed, it could potentially lead buy side firms to use the futures market to mimic their swaps trades given its lower margin costs and less stringent regulatory requirements. However, with the imperfect hedging provided by futures contracts, many question whether the tailored nature of swaps will actually transcend the regulatory reforms.
The authorisation of the first trade repositories under EMIR marks the beginning of the final phase of derivatives reform. Prior to this, numerous delays had lured firms into a false sense of security, which led to the mass adoption of a hesitant and gradual approach to the implementation of compliance initiatives. Now that the compliance countdown has been initiated, firms can no longer afford to have such a laid back attitude.
Conforming to the demands of the regulators is, however, no small feat. The work required to meet the correct level of compliance is substantial and should not be underestimated. The on-boarding of clients and the accompanying processes all take considerable preparation and time.
The updating of documentation and implementation of new infrastructures will also require significant investment. For organisations that intend to remain in the derivatives market, any unintended consequences of the reform should also be considered. This is particularly pertinent for monitoring the operational risk profile of derivatives trading.
Buy-side firms need to act fast if they are to beat the countdown and be fully compliant before time runs out and their bottom line is negatively impacted.
