The OTC derivatives reform is opening up the industry to new operational risks, primarily due to the sheer magnitude of the system and process changes needed to be accomplished in a relatively compressed timeframe. Rule Financial’s Ciaran Henry explores the operational challenges associated with the Dodd-Frank compliance marathon now underway and offers insight into the complexities of processing trades in a new post-trade workflow including the challenges in trade reporting and data management.
Not in 30 years has the OTC derivatives landscape faced such sweeping changes.
In 1981, the first interest rate swap was executed between Salomon Brothers and the World Bank. Six years on and the market had exploded to a total notional value of $856.6 billion (as reported by ISDA) and by 2010, notionals outstanding stood at a staggering $415 trillion. The rise of credit default swaps was even faster – from the first trades initiated by JP Morgan in the mid ’90s, to notional value of $30trillion by end-2010, according to the Bank for International Settlements.
As volumes and product complexity grew, the early paper-based market transitioned onto mainframe technology, then to workstations and PCs and eventually to today’s more robust, integrated, risk management and settlement systems. While that sounds like a lot of change – and it was – it pales in comparison to the change implications arising from Dodd-Frank Wall Street Reform and Consumer Protection Act and its related legislation around the world. What we now refer to as infrastructure – the systems, pipes and processes that support the OTC derivatives landscape – will change radically to adapt to a new, electronically executed and centrally cleared model. And it is important that financial institutions fully understand the scope and level of complexity of the operational changes required including challenges in data management, trade reporting and how a trade workflow will look like in this newly reformed marketplace.
The true complexity of Dodd-Frank compliance
New research by Rule Financial found that approximately 85% of OTC trading system components and functions in place at market participants will be touched in some way by the requirements of Dodd-Frank’s Title VII and the Volcker Rule. To understand some of this impact, we can look at something as simple-sounding as reporting, where many of the challenges and complexity come to light.
Under Dodd-Frank, the requirement to report trading activity falls on the majority of entities including derivatives clearing organizations (DCOs), designated contract markets (DCMs), swap execution facilities (SEFs), swap dealers (SDs), major swap participants (MSPs), and non-SD/MSP counterparties. The reporting must start at the moment of execution, with a real-time notification of primary economic trade details, and continue daily through the trade lifecycle, with data retention for a further 5 years.
Sounds simple enough, right? Not quite.
There are many variables and considerations which are not clear cut in managing this complex challenge, for example:
• Timeliness – the concept of real-time, at-trade reporting is new to the derivatives world. The majority of systems designed for regulatory reporting are located in back-offices, operating overnight batch processes. Now, the already complex front-end trading blotters will need to have new functionality
• Product-awareness – with both the SEC and CFTC in the mix, any reporting solution needs to know what kind of swap is being traded and apply the rules appropriate to each regulator. At the moment, these requirements are not identical
• Notional – Title VII has the concept of ‘block’ or unusually large trades. Regulators will define block trades by analyzing historical trading data and deriving thresholds, above which, a certain notional size will qualify as a block trade and public dissemination will be delayed. The challenge is, since the CFTC requires the dealer to identify its block trades and flag them as such, any solution needs to be aware of the notional value and block thresholds.
• Counterparty status – depending on whether the other side is a dealer or ‘end-user’, certain data may have to be ‘masked’ to protect the privacy of the counterparty, or for legal reasons
• Scope – it’s not just the centrally cleared and executed trades that fall under these rules, it’s also applicable to OTC bilateral transactions. Every conceivable combination of transaction type and execution/clearing model has to be examined for its reporting obligations to be met.
Visualizing the above results in a flowchart like this:
The big data mega trend
Complexity isn’t the only issue however, data volumes will be large and continue to grow over time. This surge in data will challenge not only dealers, but also central entities such as swap data repositories (SDRs) and DCOs who will be receiving and retaining data from multiple market participants. The scale of this challenge has given rise to the ‘big data’ megatrend – where data moves from conventional product silo-driven databases to very large-scale data warehouses and appliances that combine hardware and software to improve processing power.
Of course there will be benefits to having all of this data in one place. Dealers can use business intelligence tools and analytics to examine their trading activity for areas of concentrated risk or potential opportunities. One example would be for dealers to develop and back-test algorithmic trading strategies which can be implemented in the execution flow and for their clients.
Having a more complete view of positions and how they are performing across asset classes will inform the process of collateral optimization and margining. The real-time data can be used to develop and implement control and surveillance functions within the flow of the trading activity, as opposed to offline and after the fact.
Still, getting there won’t be easy. Implementing technology changes needed to comply with Dodd-Frank is a complex and risky endeavor, with a significant cost element, which can run into millions of dollars, depending on the scale of the business and the level of flexibility of incumbent legacy systems. And we have only looked at reporting here.
Navigating the OTC derivatives reform
When one adds in the changes required to systems supporting the other impacted functions (such as collateral management, margin and risk, messaging and connectivity to execution and clearing venues, legal documentation, limits management) it becomes apparent that the scope and scale of the work required is a very high-risk undertaking.
Reform impact on the OTC Derivatives logical application architecture
Navigating through the OTC derivatives reform will only be safely accomplished with a detailed knowledge of the many rules and requirements and a thorough understanding of both current and future state derivatives infrastructure, as well as a relatively deep pocket.
Many rules have already been delayed, and there are a few market participants who believe that political challenges to Dodd-Frank in an election year could weaken or even repeal the legislation. This view is not widely-held though and even those doubters who have accepted that Title VII, in particular, is not going away anytime soon, have begun to mobilize around executing the changes to the new centrally cleared, electronically executed market model – albeit at a slower pace.
Risks of taking a ‘wait and see’ approach
There are substantial risks to waiting too long and being caught in catch up mode.
If the prediction of anywhere between a 5x and 20x increase in the number of trades turns out to be accurate, firms who haven’t streamlined and automated their trading processes could be leapfrogged by early adopters armed with the technology and process improvements to gain market share.
Those lagging behind in integrating their data across product silos will be disadvantaged on the client and prime services side of the business, in competing with clearing services, cross-margining and optimizing use of client collateral.
A finite talent pool
It is a fact that the talent pool of people with the right product skills and real-world experience implementing large-scale change in a complex product space is not infinite. There is a real risk of supply shortfall as the industry as a whole mobilizes to execute and compete in the new world. Technology resources are already much in demand, even in today’s down economy.
In my mind, there are several main pointers that all financial institutions should keep in mind in preparing for the onslaught of new regulation that will impact post-trade processing. Here are my pointers:
• Don’t underestimate the magnitude of the overhaul to comply with OTC reforms – use dedicated resources, people who have day jobs will not be able to do this work in their spare time
• Hedge your bets with the two regulators – build to the lowest common denominator
• Don’t reinvent the wheel – leverage knowledge and technology from the equities market as a blueprint for the future state of OTC derivatives
• Sometimes you just can’t make a square peg fit in a round hole – consider all options, including wholesale replacements to large changes of derivatives infrastructure
• Lastly, if you are in ‘wait and see’ mode, get out of ‘wait and see’ mode(!) – you should at least begin planning and analysis.