Despite the changing market dynamics, regulation continues to be one of the constants. It seems that implementing a set of rules is only the beginning. Often in the wake are a number of revisions, updates and reviews that industry participants have to contend with. Below is the list of some of the main revisions working their way through the financial system. Read on also for insight into the opportunities these regulations present financial institutions and including SA-CCR, LIBOR, UMR, CSDR, CFTC Re-write and EMIR Refit.
The Standardised Approach for measuring Counterparty Credit Risk (SA-CCR), was finalised in 2014 but has taken several years to phase in. The regulation has been in place in Switzerland as of January 2020 and in the UK and US at the start of this year. Other European countries were expected to follow but this has been delayed to 2023 due to the COVID-19 pandemic.
The SA-CCR provides the framework for assessing capital requirements relating to counterparty risk for banks with derivatives exposures. It replaces the existing non-internal model approaches – the Current Exposure Method (CEM) and the Standardised Method (SM) – and is designed to be a more risk-sensitive framework for measuring capital exposures relating to derivatives trades.
Not everyone has been happy with the rules. In April, the International Swaps and Derivatives Association (ISDA), Institute of International Finance (IIF) and Global Financial Markets Association (GFMA) submitted a joint letter asking the Basel Committee on Banking Supervision (BCNS) to revise the SA-CCR standards.
They argued that the regulation does not adequately reflect structural changes in the derivatives market and the overall regulatory framework. “It is becoming evident as firms implement SA-CCR that the framework as written needs to be revisited given the timing of the finalised rule as it does not adequately reflect structural changes in the derivatives market and the overall regulatory framework since the standard was finalised,” ISDA said in a statement announcing the letter.
In this statement ISDA added, “In light of market developments that have occurred in recent years the industry believes a holistic and consistent review of SA-CCR across all jurisdictions is justified in order to minimise the risk of market fragmentation and to recalibrate SA-CCR to a sufficiently risk-sensitive level.”
The industry groups note that supervisors also share concerns about the design and calibration of SA-CCR, in some cases proposing modifications for local implementation that are unrelated to their local specificities – which could lead to inconsistent transposition into regional and national laws.
The letter notes that there has been a significant increase in collateralisation via Initial Margin (IM) under uncleared margin rules (UMR), which should be properly accounted for as a key risk mitigant in the SA-CCR standard.
The current SA-CCR framework also does not provide guidance on an exposure calculation across Securities Finance Transactions (SFTs) and derivatives in a standardised framework, in light of the introduction of a new ISDA master netting agreement for such transactions.
Erik Petri, Business Manager at triBalance, OSTTRA on SA-CCR
“Enough time has passed for the major market participants to understand the high-level implications of the regulatory change, with the focus largely shifting from gross to net exposures. Firms are in the process of developing their capability to calculate, consolidate and monitor SA-CCR exposures and while they are at different stages most are now in a much better position to assess and analyse different business activities. These improvements will also allow banks to manage exposures using vendor solutions more efficiently. We have seen the number of clients that multilaterally optimise SA-CCR almost triple in the first half of this year and we expect this evolution to continue into the back end of the year.
Banks that actively manage their bilateral exposures with interbank counterparties and clients will benefit from lower capital costs under SA-CCR. The size of capital buffers is based on risk, meaning that trading activity will not necessarily translate into a higher capital exposure. Using vendor solutions to multilaterally optimise the SA-CCR exposures in the interdealer market, will help banks reduce their net exposures, and as a result reduce the capital costs. Additionally, it will also help them to serve their clients more effectively since, if they can redistribute risk to allow for larger degree of netting under SA-CCR, the banks can hedge more cost-efficiently.”
The Central Securities Depositories Regulation (CSDR) introduces new measures for the authorisation and supervision of EU Central Security Depositories (CSDs) as well as creates a common set of prudential, organisational, and conduct of business standards at a European level. A large part of the regulation is designed to support the Target2Securities (T2S) system by implementing a securities settlement discipline regime (SDR). This harmonises operational aspects of securities settlement, including the provision of shorter settlement periods; mandatory buy-ins; and cash penalties, to prevent and address settlement fails.
The CSDR remains a work in progress with shifting implementation timelines. This is particularly the case with the SDR, which has a number of measures including reducing settlement fails by ensuring that all transaction details are provided to facilitate settlement. It also aims to incentivise timely settlement by cash penalty fines and buy-ins which has proved controversial. Calls for delaying the mandatory buy in regime increased during Covid-19 pandemic over concerns about the challenges they would face in implementing the mandatory buy-in regime on the scheduled date.
This culminated in a letter calling for a delay. It was written by an alliance of 14 trade bodies including International Capital Markets Association (ICMA), the International Securities Lending Association (ISLA), the Association for Financial Markets Europe (AFME), ISDA and the European Fund and Asset Management (EFMA).
Last November, the European Securities Market Authority (ESMA) postponed the mandatory buy-in regime past the 1 February 2022 go live date. However, this year, the European regulator went a step further and suspended the mandatory buy-in regime for three years. (https://www.esma.europa.eu/press-news/esma-news/esma-publishes-technical-standards-suspend-csdr-buy-in-regime.)
Rui Ferriera, Product Owner – Settlements at Torstone Technology
“While the full effects of the CSDR regime are still yet to be fully realised, especially with the 3-year delay to the mandatory buy-in rules, there are certainly issues around settlement fails and Securities Settlement Instruction (SSI) management that continue to pose problems for the industry. Firms need to take a proactive approach to actively analyse their internal processes and workflows across the front- and back-office to identify settlement failure issues.
Reactively, firms must understand that all market participants under the CSDR regime are subject to penalties processing, so the functionality or processes required to capture, monitor, and reconcile or even to dispute such penalties need to be in place. The regulation presents an opportunity for firms to streamline and evolve their front to back processes and controls, and to think about their in-house solutions or even alternative providers that can help in this process.”
EMIR Refit is designed to amend and simplify the European Market Infrastructure Regulation (EMIR). While it was originally expected to be a small-scale exercise, it has introduced major changes, particularly regarding reporting standardisation on the ISO 20022 standard and a significant increase in reporting fields from 129 to over 200.
EMIR Refit will also necessitate more granular reporting and an entirely new obligation to notify the national competent authority of any failures during the reporting process. The aim it to better align EU derivatives reporting with global standards and improve the quality of data that regulators use to supervise financial markets.
On June 10, the European Commission adopted the regulatory technical standards (RTS) and implemented technical standards (ITS) on reporting, data quality and data registration of trade repositories.
The European Parliament and Council now have a three-month scrutiny period to raise objections, with the option of an additional three months. The EC has committed to an 18-month implementation date from when the Refit is approved and while there is no concrete deadline, estimates are that the Refits are likely to have a compliance date in the second half of next year with reporting coming into force in the first half of 2024.
Expectations are that the Refit will increase sell-side and investment firms’ reporting requirements to a level where submitting new data fields and new combinations of actions and events could cause significant delays and run the risk of fines, according to a recent study from Acuiti’s new report, ‘EMIR Refit: Navigating the mandatory changes’, sponsored by Broadridge Financial Solutions. (https://www.acuiti.io/emir-refit-regs-raise-risk-of-fines).
The study found that it will strain resources, and that both budget and staffing issues will challenge some firms’ capacity to comply. Another issue is the lack of clarity in terms of how the new framework will impact companies’ reporting processes. This increases the risk of errors, which adds to teams’ burdens when they have to explain breaks to regulators.
The increase in data fields and fields for mandatory matching is also seen as making reconciliation a major issue. Firms are also expecting Unique Transaction Identifier (UTI) implementation to be complicated, with pairing and sharing highlighted as a particular pain point. Ambiguity on how to interpret some new fields, such as for lifecycle events, is heightening the risk of breaks between counterparties.
By contrast, the Broadridge/Acuiti report notes that integrating ISO 20022 is expected to be a relatively smooth part of the EMIR Refit due their experience with backloading during Securities Financing Transactions (SFT) Regulation.
*Stay tuned for a deep dive into EMIR Refit coming soon from DerivSource
A sixth and final phase of the Uncleared Margin Rules (UMR) will come into force this September, with almost 800 companies globally to be in scope of the rule, more than double those in phase five, according to ISDA estimates.
Unlike previous phases of the UMR, this final phase is mostly affecting fund management and similar firms – including pension and mutual funds and smaller insurance companies. These are firms that hold more than $8bn in average notional value in uncleared derivatives contracts. If the initial margin of those contracts exceeds $50m, the firm will need to post collateral with a custodian bank.
Firms only have two months to prepare and if they are unable to calculate their margins or do not have the proper custodial paperwork and accounts in place, they could effectively stop trading. Both sides of the transaction will need to calculate their margin requirements. If one side believes the threshold will be breached, it could prevent unprepared firms from trading with that counterparty.
In its Dear Chief Risk Officer letter, the Bank of England’s Prudential Regulation Authority (PRA) highlighted the problems regarding the Standardised Initial Margin Methodology (SIMM) model governance and firms’ capabilities to identify and remediate model underperformance.
In its conclusions, the PRA found that the existing margin governance process, in which firms rely primarily on the ISDA governance for SIMM updates and for negotiating add ons for model underperformance, may result in under-margining for some counterparties — a position where margin levels are inadequate to cover risks at a 99% confidence level as required by the regulations.
This letter pinpointed hedge funds, which comprise a chunk of the phase 6 cohort – as possibly having risk profiles that differ significantly from those especially large broker dealers to which SIMM has been applied to date. This is “why it is even more critical that SIMM model governance can enable firms to promptly identify and remediate model underperformance,” says the letter.
John Pucciarelli, Head of Industry & Regulatory Strategy, Acadia
“It is of the utmost importance that firms trading non-cleared derivatives take the proper steps so that they can keep trading on September 1 when Phase 6 kicks in, and ensure that they either have appropriate monitoring in place if they expect to be under threshold or are operationally ready to exchange Reg IM from 1st September.
Critical to monitoring margin and managing risk, all firms subject to UMR should invest in pre-trade analytics. Having this service and capability available meets a critical business need and helps firms stay competitive by offsetting their operational readiness until it is clear that they would exceed the $50 million maximum Reg IM threshold. Additionally, understanding the impact of your firm’s initial margin costs will help enable your firm to keep the cost of trading down and potentially make strategies more capital efficient.
As the industry prepares for the last phase of UMR and firms continue in their compliance journey with EMIR, SA-CCR and other regulations, it has rewarded those who have invested in optimisation and been smarter in the ways in which they select collateral and more efficiently consider best execution and funding costs. With regulators standardising the approach for margining collateral, firms have been empowered to go back and look across the entire trade cycle and apply new pre- and post-trade technology to optimize operations.
For firms that have already been complying with rules from previous UMR phases, they are able to employ a whole new set of innovations and services to make it easier to manage and validate collateral. As the industry has become more standardised by new regulations, the benefits for firms to stand out is happening for those who are able to reduce costs and apply a more integrated approach to their back-office strategy.”
The start of the year was also the demise of the London Interbank Offered Rate (LIBOR), for new derivatives and loans. as of 1 of January 2021. The bulk of contracts such as mortgages, credit cards and business loans pegged to LIBOR, which was compiled across five currencies, have been phased out. This covered all euro, Swiss franc and Japanese yen tenors, the overnight/spot next, 1-week, 2-month and 12-month sterling; and the 1-week and 2-month US dollar settings.
The use of US dollar LIBOR in new contracts was banned from the end of 2021, with limited exceptions, and the remaining five US dollar LIBOR settings will continue to be calculated using panel bank submissions until mid-2023. The US has another year – until 30 June 2023- to gets its LIBOR house in order – but the US Alternative Reference Rates Committee (ARRC) selected the Secured Overnight Financial Rate (SOFR) to replace US dollar LIBOR, although other new reference rates have also been launched.
Progress is being made with the adoption of SOFR reaching over half the US dollar derivatives market as the use of risk-free rates also reached an all-time high, according to a recent blog from Chris Barnes at derivatives analytics provider Clarus Financial Technology.
Meanwhile, in the UK, the Financial Conduct Authority (FCA) has launched a consultation on the end for both synthetic sterling LIBOR and the future for synthetic dollar rate. Respondents have until 24 August to reply.
The FCA introduced these synthetic rates as temporary solution to allow for firms with tough legacy contracts to repaper to reference replacement rates such as Sonia.
If all goes to the FCA’s plan, publication of these synthetic rates will end on 31 December.
Didier Loiseau, Global Head of Trading and Financial Engineering, Murex
“This transition away from LIBOR has not been a one-off switch, but a long and complex journey that poses operational, analytical, and legal considerations for financial institutions—first for sterling, yen, and Swiss Franc LIBOR, and now for USD. While the deadline for moving away from legacy USD LIBOR contracts is still a year out, one crucial difference this time compared to December 2021 is in the volume of products linked to the legacy benchmark. The result means that market participants still have a lot to do, in developed markets as well as emerging financial centres. Take LATAM and Southeast Asian region, for example. Banks in these regions had very little exposure to sterling, yen, and CHF LIBOR products, but have a much greater percentage of USD LIBOR linked products in their portfolios meaning many firms will be dealing with the Libor transition without the experience of 2021 and the other three legacy rates. While there has been good progress, firms must ensure their systems can cover transition of LIBOR instruments, and trading of all new RFR instruments, including subtleties of the different risk-free rates and how these will apply to different products, to reduce operational risk as we approach the deadline.”
The CFTC Re-write represents the largest regulatory reporting change since CFTC reporting requirements began in 2012, according to the Bloomberg white paper.
As expected, the US regulator gave industry participants more time to prepare. They welcomed the delay in the trade reporting rules rewrite to 5 December 2022 from May as well as the six-month extension to implement the Unique Product Identifier (UPIs) and ISO20022 messaging to Q4 2023.
The CFTC rewrite, among other things, streamlines the requirements for reporting new swaps as well as defines and adopts swap data elements that harmonise with international technical guidance. It also reduces reporting burdens for swap dealers (SD) and major swap participants (MSP). Other changes include the introduction of collateral reporting for SDs, verification and reconciliation requirements and submission timing changes of T+1 and T+2.
Despite the reprieve, firms will have their work cut out for them especially in terms of reviewing current systems, processes and technical/product solutions.
Alan McIntyre, Senior Regulatory Reporting Specialist, Kaizen Reporting
“What’s next? That’s easy. More, more and more. First and definitely foremost, the CFTC will expect firms to invest diligent efforts into the verification, correction and notification process. The regulatory intent here is clear. They want to see more accurate data that is continually trending towards better quality. The CFTC Re-write has been a long time in the making and is heavily focused on data quality.
Next is ISO20022 messaging, which is expected in late 2023. The CFTC is adopting ISO 20022 messages as the only format firms can use for submitting swap data to the Swap Data Repositories (SDRs). The rationale is that these XML schemas remove ambiguity around how to populate fields and come with baked in validations thereby increasing data quality at the SDR front door.
Next is the adoption of Unique Product Identifier (UPI), also expected towards the end of 2023. The UPI is being adopted by many G20 derivative reporting regimes but the CFTC is on track to be the first to implement. The UPI is a global taxonomy to accurately describe the various product attributes of OTC derivatives. The aim being to remove the ambiguity that is found in current methods for describing OTC derivatives and prevent the conflicting or inconsistent data that is often submitted currently.
The final ‘more item’ is more of a wildcard but I hope that the CFTC will issue further guidance around how to accurately report certain aspects of swap reporting based on a combination of the topics that continue to prove contentious (much discussed ‘Packages’ for example) and also based on the issues that will inevitably arise when reporting commences.
The much discussed ‘Verification & Notification’ requirements mandate the opportunity to build, invest in and operate much better controls. These controls should not only help firms identify and remediate reporting errors, but properly implemented, they will also allow firms to better understand where reporting issues are occurring and learn important lessons and hence mitigate against future issues.
Efforts to improve the completeness and accuracy of reported data means that firms will have higher quality data that can be trusted and utilised for various purposes, such as analysing collateral margin data and pricing data from public price dissemination. For this reason, reporters can look at the swap data they are collating and the data they are reporting as a useful internal and public resource, rather than just a burden to produce.
The CFTC Re-write is the first major G20 regime to adopt global harmonisation components such as Critical Data Elements (CDE). The implementation can serve as a baseline for understanding and meeting other upcoming reporting rewrites for regimes such as EMIR, ASIC, MAS, HKMA etc. Many of the revised reporting regimes have common components such as reporting CDE, collateral margins and reporting packages etc. A good example is UPI which needs to be adopted across many systems and not just the reporting engine. Leveraging the process and lessons learned here will help firms with a wider reporting footprint tackle future reporting changes.
The final opportunity is that the move to prescriptive rules and more guidance from the regulators gives the opportunity to thoroughly review and improve the full reporting flow against clearer requirements to ensure front to back alignment.”
*This article is one of many of the current DerivSource regulation editorial series.