Guest Commentary by David Field.
David Field is executive director of Rule Financial, a London-based advisory firm focusing on IT for the global marketspace. His specialty is clearing and collateral management, and he currently advises clients on regulatory changes such as EMIR, with its mandatory OTC clearing requirements.
Despite numerous delays to the introduction of mandatory reporting for over-the-counter (OTC) derivatives, the deadlines now finally appear to be on the horizon. Research conducted last year by Rule Financial showed buy side firms to be lagging considerably behind their sell side counterparts in their preparation for the Dodd-Frank reforms; one year on little has changed. A combination of the need to reduce operating costs and a relative lack of involvement in the drafting process are just two reasons why the buy side have thus far struggled to adapt and comply with the incoming regulation. Set to impact virtually every element of the derivative trade lifecycle, firms are tasked with considering a number of issues for timely compliance:
- The scale of reform; firms must ensure that regulatory governance is frequently reviewed and that the adequate programs are in place to manage any operational change required
- Understanding the changes required to address collateral segregation; the rules between Dodd-Frank and EMIR vary, with each holding a separate set of requirements
- Adjustments to operating models; some buy side firms are now having to re-visit their operating model for the processing of OTC derivatives in light of the imposition of new business conduct rules
- Efficient connectivity; some buy side 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
Another key factor is that whilst buy side firms have the option to delegate their reporting functions, they should be cognizant of the fact that the regulators will still hold them legally accountable for the accuracy of submitted reports. Firms will have to report new and historic trades to a central trade repository in the interests of ‘market transparency’, and those on the buy side cannot assume that the sell side will conduct these reports on their behalf. Buy side firms will therefore need to weigh up their reporting options. Whilst establishing a direct reporting function will involve significant capital costs, it may have lower operational costs in the long run.
The reduction of counterparty risk is the unifying principle between derivatives reform in the US and Europe. Under both Dodd-Frank and the European Market Infrastructure Regulation (EMIR) newly formed central counterparties (CCPs) will hold and clear eligible products between both the buy and sell side, reducing systemic risk as a result. However, the cost of supplying eligible collateral and having to post both initial and variation margin to the CCP could be significant, and it is thought that CCPs will call for higher margins than those needed for bilateral trades executed before the regulatory reforms.
A buy side firm connecting to multiple CCPs and clearing brokers will also face a significant technological challenge – not forgetting the extensive task of implementing the collateral solutions for each new connection made. The triparty model offers one possible solution to this, in which the collateral agent sits between the buy side firm and CCP, providing a collateral optimisation strategy and streamlining collateral management processes. This approach will especially benefit smaller players who lack sufficient collateral funds. Using a collateral agent will grant them access to larger pools of collateral for posting at the CCP.
Selecting the right CCP
Selection of a suitable CCP is one of the most important decisions a buy side firm will make in preparing to comply with new regulations governing derivatives trading. This decision will largely be based on the financial strength and security that the CCP can provide – notably the relationship it has with a central bank. Having a strong financial standing and appropriate connections can help to mitigate the consequences of a possible CCP default, which (although extremely unlikely) could be caused by a member failing. Carefully analysing a CCP’s admission requirements should therefore form an integral part of the buy side firm’s selection process.
For those wishing to use a clearing broker, these should also be reviewed for suitability and stability, as not only will they hold the firm’s initial margin but they will also help clear the firm’s trade in the years ahead. It is imperative that there is no repeat of instances where client funds come under risk, as was the case with MF Global.
What happens next?
The impending compliance deadlines may seem fluid, but the on-boarding of clients and the work required to meet the appropriate level of compliance is a time-consuming and lengthy task that should not be underestimated. For some buy side firms, the scope of the requirements is likely to necessitate a significant and fundamental change to their operating model, demanding a significant budget for program implementation. Therefore, exploring the appropriate options and compiling a checklist for compliance to encompass selection of clearing brokers and CCPs; the use of triparty agents for outsourcing elements of collateral management; and designing target operating models for process, controls and technology – is key.
With several rules already active and others fast approaching, the buy side must act now to prepare itself for regulatory reform on both sides of the Atlantic.