In a Q&A, Deloitte’s Ricardo Martinez explains the methodology and prioritization program used to assist sell-side clients in preparing for the changes proposed under the Dodd-Frank Act’s Title VII including the pushout rule, central clearing, use of SEFs and reporting to SDRs.
Q. How many financial institutions are actively being proactive in reviewing the impact of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act on their business models and operations? What can they start focusing on now?
Only a minority of financial institutions are being proactive. A number of them are taking a ‘wait and see’ approach where they will wait until the rules come out before they think about the business implications. This is where scenario modeling can be very useful for firms because even if it doesn’t mean a firm can take action now, at least it will have already gone through all the potential scenarios.
Firms should realize that change is inevitable so its important to have some idea of what the implications could be on the business model and business activities including operations and technology.
Many individuals trying to be proactive may only be looking at one silo – operations, technology, for instance, however, this silo-approach to scenario planning is not going to take a firm very far. If the different departments are not communicating and coordinating efforts, it is unlikely they will be able to come up with a consistent and realistic set of scenarios. The consequence of lack of coordination is that each area or department could be working towards a different operating model and they will be unable to agree on what the unified business model should look like and will therefore not be able to react quickly when the rules come out.
And for this reason, I think the mandate to look at scenario analysis really needs to come from the top because it is essential that there is a consistent view of the world that allows all departments to go through the scenario planning and think of the functions impacted including business, operations, and risk management on a holistic basis.
Q. Can you describe the methodology you use to help clients define and implement a strategy for complying with the new requirements under Title VII of the Dodd-Frank Act?
The methodology used starts with working out the priorities. Based on the interpretations of the legislation made by a client’s legal team, we work with a client to prioritize the rules by reviewing what proportion of their trades and business activities will be impacted. Once we have reviewed the impact the rules will have on the operations, business activities and technology, we can determine what actions should be taken now to start preparing and reacting to those new rules. With this prioritization framework, we can determine what rules and consequent changes need to be addressed immediately and which ones can wait for the rules to be finalized.
For example, standardized trades will trade via swap execution facilities (SEFs) and will be cleared via a central counterparty (CCP). Once we help the client determine what proportion of their business or existing book is subject to central clearing, we determine how the client needs to change their operations to enable straight-through processing and make sure they can connect to the clearinghouses. This includes reviewing all the technology elements that they need to bring in place to make sure they can process those derivatives in this new execution venue, via a clearinghouse and also report those positions to the new swap data repositories (SDRs).
The prioritization process will be very different for financial institutions, even seemingly similar institutions. For example, the impact criteria used to establish the priorities in the first place will review the potential revenue impact, liquidity and capital requirements and what the impacts are on functional areas – risk , operations and technology. The effect on these various areas will vary greatly from firm to firm.
There is also a business objective component to this methodology that means we cannot do this analysis in a vacuum. We take the client through a number of workshops to ensure we capture the level of subjectivity on what the impact could be. And once this is achieved, we can then take the client through the prioritization process and exercises.
Once we have prioritized the rules with the client, we then translate this into a roadmap for execution of the various changes to support the move into the next stage, what we call the mobilization phase. In this stage, we often help clients in managing the projects and drill down into the subset of actions to be taken to change business activities, processes and technology to support the roadmap and greater plan.
Focusing on derivatives and Title VII, the priority of firm’s preparation plans tend to concentrate on central clearing, margin requirements and pushout rules. In terms of the impact on an organization, the focus isn’t so much on the ability to react now given some of the new rules are not likely to be enforced for some time, and therefore firms feel they have time to react. However, the rules will have a huge impact on a firm’s business model, activities and operations in the long run so some are proactively reviewing the required changes so they are ready when the rules are finalized.
Q. Let’s drill down into some of the new regulatory changes and how you recommend firms can start responding to the new rules and market changes.
Central Clearing of OTC derivatives
The expectation for the percentage of the market that will be centrally cleared has varied drastically for the last couple of months. Statistics vary between 30 to 80 percent. The last report I saw produced by estimated about 60 percent, which is in the middle of diverging expectations.
The first task at hand is to analyze what proportion of their existing broker business could be potentially standardized and therefore centrally cleared.
If the proportion of the flow trades, these trades being the trades that become standardized, is high enough to drive the business towards becoming a business with higher volumes, and low margin, a firm will have to adjust it’s business model and the operational infrastructure and technology to support this change. A firm will have to change its operations and technology to ensure it can support the increase in trade volumes and the business side needs to prepare for the potential loss in revenue of non-standardized trades, as they move to a high-volume business.
When looking specifically at operational changes to support central clearing many firms have considered parallel processes to managing standardized and non-standardized trades, but this means the processing of some instruments, such as credit derivatives, will require a firm to differentiate between trades that need to be centrally cleared and those that do not. A financial institution can have a process that separates trades to the appropriate clearing process or they can have different processes for standardized and non-standardized. We have worked with clients to assess the advantages and disadvantages of both methods and determine which model is suitable based on the firm’s existing technology.
Many sell-side institutions are also focused on establishing connectivity to clearinghouses by becoming a Futures Commission Merchant (FCM) and offering client clearing services.
Becoming an FCM, which means the firm will act as a conduit for all of its client’s central clearing requirements, is a strategic business decision for many firms and will require the firm to change its processes and infrastructure to provide this connective to clearinghouses and supporting services. For FCMs, the ability to onboard new clients quickly and align their operations with the new client clearing service seamlessly will be a key competitive advantage for FCMs and the operational processes. The services offered are going to be key differentiator in providing those types of services as an FCM.
Pushout rule
Firstly, the pushout rule, or often called the Lincoln rule, refers to a section of the Dodd-Frank Act that prohibits federal assistance, including access to the Federal Reserve’s discount window and FDIC deposit insurance to swap entities in attempt to curb systemic risk and avoid future bailouts. Firms can push certain derivatives activities out to separate entitles (separately capitalized affiliates) to maintain its eligibility for federal assistance.
We advise our clients to look at the potential implications and variables that will help them determine how to react to the rule. Most of the large dealers have a number of options for pushing out the transactions, which can be creating a new entity, using an existing regulated broker/dealer or a new entity in North America or internationally, for instance.
We go through all the different scenarios and then we look at the pros and cons across the various dimensions. And dimensions could be, for example, what the implications to clients are, or what the capital level requirements of creating new entities. We also look at operations and technology impact on existing infrastructure to support multiple entities.
By flagging the advantages and disadvantages of each dimension, the client will be able to easily choose the best scenario and respond to the rules quickly when they are finalized. In short, a firm doesn’t need to wait for the rules to be finalized and deadlines published to go through this scenario analysis exercise.
SEFs
This scenario analysis methodology also applies to managing execution via SEFs. We have seen firms trying to establish SEF platforms based on existing trading platforms so these financial institutions must assess how this venue will work – via a Central Limit Order Book or Request For Quote process, which process is best and how the platform will compare to those offered by competitors.
Due to the high number of financial institutions looking to establish SEFs, it is reasonable to expect some consolidation in the future, so users of SEFs will need to choose those platforms likely to last the test of time. A firm doesn’t want to create connectivity to a SEF that will have low liquidity or will not exist in a few years time.
Q. What are the constants that firms can rely on when preparing for regulatory reform?
There are things that can be done irrespective of the rule-making process because they know some changes, like central clearing are coming, and there are some basic principles that firms can follow now to prepare, such as flexibility.
Specifically, financial institutions know they will have to send transaction information externally in the future to support execution via SEFs and reporting to SDRs, so firms can start to think about those steps that can make the technology environment more flexible. And reference data is one item that comes high on the list of what firms can work on now irrespective of the rule-making process, and reference data happens to be the one item that is slow to change.
If firms analyze issues with reference data they can start addressing these now, and it will be easier for them to be nimble and connect to SEFs and SDR and CCPs when they come into place.
Specifically, even though the definition of the legal entity identifiers (LEIs) and who will create the LEI at the industry-utility level is not finalized, a firm knows it will have a new data requirement to meet and can therefore start analyzing its own internal systems and mapping processes across all legal entitles so whenever LEI is mandated and published by the industry utility, the firm can accommodate quickly and efficiently. Compliance with all comes down to flexibility and allowing that additional information to be added and shared across internal systems.
Enabling the LEI is a multi-million dollar effort for most financial institutions. In many cases, firms knew that reference data needed to be enhanced they just couldn’t justify the expense. So in a way, LEI is becoming a catalyst for that justification of the expense because not only is it going to benefit the institution, it’s actually mandated.
Q. What advice would you give firms beginning this process now?
I think at the end of the day this could be a competitive opportunity for a lot of firms – change that can be difficult to manage but its also an opportunity to enhance processes, like reference data, that can really differentiate firms or create a competitive advantage in the future.
