Kevin Thorogood, Global Head of Capital Markets at Thunderhead.com talks to DerivSource about the challenges firms face as they transform over-the-counter-derivatives (OTC) trade documentation to comply with new regulatory requirements. He addresses the problems posed by adjusting workflow and infrastructure models as well as the importance of sound relationship documentation and legal processes.
Q. Why is it crucial that financial institutions tackle inefficiencies in trade documentation processing now? Why is automation of this operational area important?
A. Part 23 of the new Commodity Futures Trading Commission (CFTC) and regulations published by the European Securities & Markets Association (ESMA) sets out rules on confirmation, execution and dispatch time frames as part of the G20 commitments. This is a warm up for T+2 for rates and credit and T+3 in equities and commodities, all of which have to be implemented by Q1 2013. They are going to T+1 and T+2 for all asset classes in 2014 and when you look at the benchmark surveys equities is the one that concerns many of the institutions the most. Currently tier 1 banks cover the execution of equities for the paper-based population in T+6 1/2, they are the group which have to be T+3 by Q1 2013.To meet these new execution times, firms will have to double their efficiency to halve execution times through a combination of automation and in the short term by using more full-time staff. Taking on more staff will however not be sustainable in the long term because of cost and availability.
Q. How will new regulation impact trade documentation?
A. A larger proportion of confirmations will have to be automated as a minimum to meet the new regulations. Term sheets are in effect becoming a full confirmation to an execution and many firms are looking at ways to manage that process. It is not just about the economics on a term sheet, upon request pre-trade term-sheets should contain all terms of the transaction except those agreed at trade execution. In effect there is a move towards improving and becoming more efficient with automated term sheets, which will then move into an executed confirmation. It is becoming less of a back-office function and moving up to front and middle office execution. Before trades get executed in the “new world” they will also have to have relationship documentation executed pre trade as part of the new regulations. The impact will be on the operational and legal side as firms will need to become more efficient and effective on relationship documentation as well.
Q. Are there any non-regulatory drivers, which are important?
A. Minimising legal and operational risk between the time of trade and execution of the confirmation is critical. They have their own reasons internally to try to streamline and improve that process to make sure they reduce the legal operational risk when they trade more complex products. Every bank I talk to also wants to reduce cost; Thunderhead.com can help to take the manual effort out of raising confirmations and help reduce risk by automating the process.
Q. Why is the current trade documentation process problematic for many firms?
A. I have watched and observed many of the banks draft and execute some of the more structured confirmations; it is quite a laborious, manual and high cost process. The banks generate first drafts, which then go through internal review and multiple iterations and versions, before being sent externally to counterparts.
Many counterparties insist on a ‘paper’ process or want PDFs emailed which are then subjected to the counterparty legal review process. It is a very time consuming, laborious, high-risk strategy and it is easy to make mistakes. We have seen economic data accidentally deleted out of the documents due to the manual process and also multiple levels of legal checks.
If there is a way of streamlining that negotiation and collaboration process between an institution and their buy-side counterparts in a secure platform, then metrics could be produced around that negotiation process in order to learn and become more efficient. Becoming more efficient and executing faster reduces the period of risk where there may be contention around critical provisions such as calculation agent, termination provisions and corporate action notices. If any of these issues occur in the interim period prior to execution then this is a major risk factor on existing trades.
Q. Due to pre trade requirements is it important for banks to have a greater understanding of relationship documentation?
A. Yes absolutely, banks and institutions want to have a much faster access and better understanding of the provisions within their relationship documentation. If a disruptive event happens in the market, for instance when a bank gets downgraded, they want to know immediately which contracts are effected to assess the impact on collateral, pricing and risk positions. To achieve this they have to change the way in which relationship documentation is negotiated to ensure that all documentation is maintained in both human and machine readable formats and that a “single source of the truth” is always preserved.
They also have to go through an education exercise and support their clients to ensure they are aware of what the new trade processing landscape looks like and how to accurately capture the trade data in the first place – a big issue with many of the banks is poor data. When we speak to banks they want to streamline, improve data capture and improve relationship documentation, changing the structure so they can achieve point of execution in the front office.
Q. Are relationship management and more efficient legal processes part of the overall solution?
A. Clients are now seeing relationship management as part of the overall solution i.e. how can we improve relationship documentation to execute faster, more efficiently, and in a format in which we can search information very quickly. Legal operations must therefore become more efficient and look at new ways to provide more transparency and control around the negotiation process. The legal industry is a critical part of the solution and must be ready to embrace change to meet the new regulatory changes coming into force.
The buy-side also has to be on board and become more efficient when negotiating the paper population with dealers. All market participants have to help to meet the new regulations.
Q. What are the main challenges firms face as they adjust processes to meet new regulatory and market structure requirements?
A. Firms must ensure that they have the appropriate resources to deal with the immediate regulatory requirements, whilst at the same prioritize resources to fast track strategic automation initiatives to be sustainable in the longer term – all this in a time of unprecedented change. It is a pretty tough market for them out there, you have to put together a process were you can become compliant and also invest to make sure that you have a strategic model for the long term. Balancing compliance and strategy is essential to ensure cost efficiencies and risk reduction.
Q. Can you get a high level of automation with minimal effort?
A. Technology is readily available to help meet many of the regulatory initiatives but as we all know it can be a time consuming and challenging process to deliver successful IT projects. One of the barriers to using technology is that you have to go through an acquisition process for hardware, capital purchasing of software and maintenance/upgrades of software which can become quite expensive. This for us has been one of the key drivers for launching Thunderhead.com as a service (SaaS), to enable simple and fast deployment and significantly lower cost of ownership. In addition, SaaS opens up new capabilities and enhanced responsiveness in an uncertain regulatory environment.
Q. Is there an average time frame to get set up on Thunderhead.com?
A. If you have a product with decent quality data in your front/middle/back office then passing that data into the Thunderhead.com service to get an automated document can be done in days, not weeks or months. We also provide services through partners such as Sapient who can help with the rapid adoption of this type of service.
Q. What advice would you give financial institutions about to embark on this change?
A. They need to know how to become compliant quickly within the current regulatory framework and have a strategic blueprint in the long term. A target operating model will allow firms to adapt and have a more agile infrastructure that will help enable them to remain compliant going forward.
To help with this we have started to populate the Thunderhead.com service with templates as many of the buy-side and dealers want to be able to use fairly standard templates quickly with some changes for their own key requirements as this gives them a competitive advantage. For example with some standard products in the equities or interest rate swap market we can stand up about 90% of what is required in a standard template.
