Some of the most notable articles on DerivSource this year looked at the role of derivatives in the transition to net zero, the benefits of an integrated risk management approach, collateral optimisation, digital regulatory reporting, challenges around the coming wave of global regulatory updates and the need for firms to integrate back and middle office operations. See below for brief summaries and links to these articles. Of course, there is much more to explore in our industry analysis and opinion from the last year (check out topic tabs on homepage for quick deep dives into digital, collateral management, regulation and more) and check out our podcast – Living the Trade Lifecycle. Happy Holidays from DerivSource and all the best for 2023!
Derivatives and Net Zero Transition: Striking a Balance Between Risk, Impact and Influence
DerivSource reporter Lynn Strongin-Dodds spoke with Keith Guthrie, deputy chief investment officer at Cardano and a member of its Sustainability Steering Committee about the role for derivatives in supporting the transition towards net zero.
“Regulators have largely ignored both derivatives and hedge funds and the use of shorting as part of the thinking that goes into a sustainable portfolio. What we are trying to do is to develop a framework where we can measure emissions and create the right kind of pressures and incentives for companies to actually decarbonise,” Guthrie said.
There are three tiers of influence investment firms can use: providing new capital to a business through debt or equity; voting and engaging with management around ESG issues; and impacting outcomes for companies through buying and selling shares. Pushing prices up or down with long or short positions is an indirect form of influence.
“Derivatives, unlike equities do not have voting rights nor can they be used for engagement. However, they do have an indirect influence because they can impact the pricing of the underlying equity through market arbitrage… In general, derivatives can be used to either maximise climate influence or manage financial risk or both. One strategy is to go long assets held in physical form to actively engage and vote and go short companies that are high emitters that are unlikely to transition,” Guthrie said.
However, firms should note that shorting those firms does not physically take carbon out of the atmosphere and portfolios with low or zero net carbon financial risk should not be misrepresented as having low real economy emissions or as automatically being aligned with a net zero economy by 2050—this would be greenwashing.
Optimising Risk Management: The Why, How’s and Role of Data in an Integrated Approach
DerivSource spoke with Donal Gallagher, Co-Head of the Quantitative Services Division at Acadia about the benefits of an integrated risk management approach.
“New standard measures of risk are driving the optimisation of initial margin (IM) and capital across the industry. For example, the International Swaps and Derivatives Association’s (ISDA) Standard Initial Margin Model (SIMM), the Basel III’s Standard Approach to Credit Counterparty Risk (SA-CCR), and Fundamental Review of the Trading Book (FRTB) all provide a standard target variable for IM, credit and market risk respectively, making it in everyone’s interest to collaborate and optimise their positions. Optimisation means taking redundant risk out of the system, not just within the organisation but across the industry,” Gallagher said.
Legacy systems (especially at firms that have grown through acquisitions), and data silos are the biggest obstacles to an integrated risk management approach. Pulling together data in a standardised format for multiple purposes is a major challenge, but one that regulators are pushing firms to solve.
A large firm with a complex web of different systems and processes needs to define the data standard or data dictionary, select a model (for example, the ISDA Common Domain Model), after which it becomes a regular, albeit complex, IT project. “A couple of firms have mastered this and have one standard representation of the balance sheet that then flows through all the processes of the organization,” Gallagher said.
“Acadia either provides just the data standard to firms that want to do the computations themselves or runs the whole project for firms that prefer to hand over the raw data and outsource the rest. Leveraging a central infrastructure frees up a lot of time and resources because firms no longer need to do so much of the work in-house. It also enables firms to access services that they could not otherwise, such as new network optimisation services,” Gallagher says.
EMIR Refit: 3 Key Challenges and How to Overcome Them
In a DerivSource commentary, Hugh Daly, head of Capital Markets Data & Regulatory Solutions at Broadridge, explored the most prominent obstacles firms face as they work to comply with upcoming regulatory rewrites, and shared the strategies firms can use to address these efficiently.
Regulatory divergence and staggered deadlines for global regulatory rewrites complicate firms’ regulatory strategies. The European Securities and Markets Authority’s (ESMA) version of the European Market Infrastructure Regulation (EMIR) Refit is expected to go live in the first half of 2024, with the UK’s Financial Conduct Authority (FCA) version following shortly after. “The small time-lag will mean that firms will simultaneously have to report all the additional fields, validations, actions, and event type sequences and the new schema related to the ESMA version, while the FCA still uses the legacy schema and rules. It will be complex to manage this for the three months or so when the two regimes are bifurcated,” Daly said.
Complicating matters further, ESMA and the FCA require different versions of XML schema, and the CFTC rewrites will differ from other regulators when it comes to requirements around Unique Transaction Identifiers (UTIs) and Unique Product Identifiers (UPIs).
EMIR refit will bring data challenges, with the number of reportable fields growing from 129-203. Pre-go-live trades will need to be updated with the additional data elements. Reconciliations will come under pressure and breaks will have to be rectified within 7 days. Valuations will also have to be reconciled in a future update.
“In the Asia-Pacific markets, the Australian Securities and Investments Commission (ASIC), the Hong Kong Monetary Authority (HKMA), the Monetary Authority of Singapore (MAS) and the Japanese Financial Services Agency (JFSA) also have rewrites between now and 2024. It is like a perfect storm of regulatory change all coming together from now until mid-2024,” Daly said.
Firms need to start preparing as soon as possible and to break down silos to take a consolidated approach.
Future-proofing Post-Trade: How to Get the Middle and Back Office Talking
Brian Collings, CEO of Torstone Technology, discussed the important of post-trade processing integration and the role of data in achieving a seamless end-to-end operation.
Regulatory change, including the move to T+1 settlement, the introduction of fines for settlement failures and rising demand for real-time cryptocurrency and digital asset trading, are driving firms to change the pace of back-office operations by integrating the back and middle office.
Obstacles include historic underfunding of these areas, entrenched silos along asset class and geographic lines and a lack of adaptable, cloud-based, real-time technology.
“Recent high volatility, for example driven by the pandemic and the Russia-Ukraine war, has meant some firms have seen much higher daily volumes. Where systems are not cloud based or real time, they run into capacity issues, and it puts a lot of pressure on the legacy systems to be able to deal with sudden high volumes. Whereas cloud-based, on-demand environments can handle changing volumes more straightforwardly as there is flexibility in scaling up processing power,” Collings said.
Overhauling the back office is a multiyear, even decades-long endeavour, but firms can see quicker wins by modernizing the middle office. “Consolidating the information in the middle office rather than the back office enables firms to have more of a back-to-front flow of information so they can either present information directly to the front office or carry out analysis on it. For example, firms could use artificial intelligence to perform analysis across all client activity to see what is causing settlement failures and P&L impact, or to review client patterns of profitability,” Collings said.
Cloud-based systems, application programming interfaces (APIs) and standards such as FIX moving to the middle office are all key enablers of this transformation. The back to front information flow enables more real-time views of positions and risk but it also helps firms deal with changing customer demands.
“In the last two years demand for cryptocurrency and digital assets trading have gone up and pushed traditional firms to broaden their offerings in this area. Moving from a legacy to a more modern real-time environment means the systems are more flexible so firms can add new asset classes according to client demand” Collings noted.
Digital Regulatory Reporting: Everything You Need to Know
Leo Labeis, CEO at REGnosys penned an explainer of the Digital Regulatory Reporting initiative, which aims to mutualise the cost of interpreting and implementing reporting rules.
“Over the last decade, regulatory compliance has been a dominant theme for financial institutions. Regulatory reporting has proved increasingly difficult due to the sheer volume of data requirements embedded in often conflicting and ambiguous rules, resulting in fragmented approaches globally. Upcoming changes to trade reporting regulations across the G20, starting with this year’s CFTC Rewrite, offer firms the chance to adopt a more strategic approach to regulatory data management. DRR emerges as a key driving force behind a new collaborative approach, enabling regulated entities to build and automatically execute a single, open-source interpretation of the amended reporting rules,” Labeis wrote.
Trends shaping the implementation of DDR include the move to standardization, the transition to “integrated” reporting, the prioritization of data quality, the embedding of reporting into data strategies and wider deployment of maturing technologies, such as cloud and the blockchain.
Firms should have a cohesive data management strategy, prioritise long-term investment and ensure traceability of data in order to be able to automate exceptions and data reconciliation.
“DRR enables collaboration in regulatory reporting, allowing firms to mutualise their implementation costs by building machine-executable rules in an open-source environment. It delivers strength in numbers, through a peer review process that produces the industry’s best-practice interpretation of each specific rule. For financial institutions, looming regulatory deadlines present a timely opportunity to review their regulatory operations. The adoption of technology-driven solutions will be key in helping firms adapt to these changes and prepare for future updates more effectively,” Labeis wrote.
Collateral Optimisation Goes Cross-Asset and Supports Alpha Generation
In a Q&A, WeMatch’s UK CEO and co-founder, David Raccat, explored how a cross-asset collateral management strategy and optimisation tools can support collateral trading activities and help a firm future-proof its collateral operations.
“The collateral management operations for many financial services firms are complicated. Internally firms have multiple silos or pockets of collateral to manage; they are also dealing with the costs of capital optimisation, optimisation of resources, asset allocation, and margin compression as well as various regulatory changes, especially Uncleared Margin Reform (UMR) and Basel III and IV. The combination of these elements is pushing financial institutions to optimise collateral allocation,” Raccat said.
“If firms do not manage collateral efficiently, they will end up with high collateral costs, which will impact the firm’s bottom line. They could end up in a stress situation needing to borrow collateral at a very high cost. This needs to be anticipated, formatted, and framed. Collateral management is becoming a front-office expertise, driven by both cost-saving and revenue-generating mandates,” he said.
“Integrating collateral trading so it becomes more like a collateral treasury function puts a bank in a better competitive position because any disjunction or segregation between collateral pockets can create immediate friction or costs within the bank. However, depending on the size of the bank, integrating collateral operations across assets and geographies to create a single collateral treasury book can be very complex. Fixed income and equities just do not run under the same system, for example. Some banks turn to external solutions such as WeMatch to facilitate internal workflows, internal communications, internal matching, or smart allocation of collateral between multiple buckets within the same institution. Some banks prefer a plug-and-play solution rather than transforming their infrastructure in-house,” Raccat said.
