Looking ahead to 2023, Lynn Strongin Dodds explores how risk, ongoing regulatory change and digitalisation initiatives will be the focus for the derivatives and post-trade industry.
As 2022 demonstrates, predicting the future is never an easy thing. As the year dawned, industry pundits expected inflation to be transitory and growth sluggish but not stalled. No one predicted a Russian invasion in Ukraine, soaring energy prices, record inflation and interest rates and recessions. This is not even mentioning the political upheaval in the UK which saw three prime ministers in three months. The latest Rishi Sunak is hoping to undo the damage of his predecessor Liz Truss and her controversial mini budget which upended markets. The jury is out as to whether he will be able to restore calm.
Views also differ on how far south markets may go in 2023, but all agree that higher inflation and tighter monetary policy will continue to be hallmarks of activity. Rate rises and economic slowdowns may be underestimated but so too will the lasting impact on IT budgets, strategies and staffing levels at buy and sell side firms.
Key risks – market, credit and liquidity all top agenda
There have been several studies outlining the major risks for next year but Bloomberg’s study sums it up by pointing to market, credit, and liquidity risks as topping the agenda.
The survey, which polled over 200 senior risk executives during Bloomberg events on Managing Risk in a New Era of Uncertainty, found the order of risks was as follows, – market was named by 39%, credit, 31% and liquidity. 24%.
For the UK, the month of September in 2022 illustrates the possible effects of market turbulence when market movements prompted sudden spikes in margin calls which largely impacted the UK pension funds.
Stuart Smith, co-head of business development at Acadia says:
“In the wake of the UK Mini-budget in September of 2022 there were large market moves which prompted significant margin calls. Acadia observed this through the increase in VM calls over that period. Comparing the 2 weeks before the budget and two weeks after Acadia observed a 200% increase in GBP margin calls, with the highest day being a 350% increase.”
The causes of these moves and the pro-cyclical nature caused by the use of UK Gilts both posting collateral and in determining the interest rates being hedged have been well discussed. On the contrary any solutions are still at the early stages of discussion. One thing appears to be clear that non-bank participants require more stringent stress testing (Market, Credit, Liquidity and Operational). Particularly on the Operational side it is likely that many firms will need to bolster their capabilities in sourcing collateral, particularly in times of market stress.
The wider impact of the period of market stress will be part of the financial make-up for a prolonged period of time. When the stress period enters the calibration period for Market or Credit risk models it will impact both firms internal risk calculations and industry risk calibrations such as ISDA SIMM. These impacts will in general reduce the risk appetite for firms in Sterling.”
Geopolitical risk too
Meanwhile geopolitical risks and high inflation were prominent and have risen on DTCC’s annual Systematic Risk Barometer Study.
Breaking it down, the report found that 68% cited geopolitical risks and trade tensions as main threats, up from 49% last year. In addition, 61% were worried about inflation compared to 34% last year, while cyber fell down the danger chart at 47% from 59% last year. It said this was driven by the growing sophistication of threat actors, the proliferation of new technology adoption and an increasingly interconnected marketplace.
“The dramatic increase in concerns around geopolitical risks & trade tensions, inflation and U.S. Economic Slowdown reinforce how quickly the threat landscape evolves and the importance of regularly monitoring the external environment to gain intelligence into potential shocks to market stability,” said Michael Leibrock, chief systemic risk officer at DTCC. “As a result, firms must continually review their risk management practices and procedures, conduct scenario planning exercises and ensure their operating structure is nimble to protect themselves and the broader industry.”
Regulatory change continues
There is always a constant barrage of regulation coming through the pipes but next year all eyes will be on the progress of the CFTC Rewrite and EMIR Refit. As Chris Childs, managing director, head of Repository & Derivatives Services at DTCC and chief executive officer & president, DTCC Deriv/SERV LLC says, “Next year will mark a significant milestone as regulatory regimes across the globe continue to implement new trade reporting rules that drive greater harmonisation across markets. With a wave of regulatory deadlines in 2023/24 – from EMIR Refit in the EU and UK, the JFSA Rewrite in Japan, and phase-two of the CFTC’s Rewrite in North America – firms must take advantage of the time remaining to ensure they understand the changes as well as identify and test the operational updates necessary to ensure preparedness. Ultimately, these revised rules will bring enhanced levels of transparency and risk mitigation to the global derivatives market, as originally envisioned by the G20.”
CFTC Rewrite
The US Commodity Futures Trading Commission (CFTC) has become the first regulator to amend its swap data reporting framework to incorporate harmonised critical data elements developed by the Committee on Payments and Market Infrastructures and the International Organisation of Securities Commissions (CPMI – IOSCO), with the initial round of changes coming into effect on December 5.
The first phase of CFTC’s Rewrite was originally due to come into effect in May 2022 but was delayed until December 5 to give market participants time to change to their system. The second stage of changes are due to follow in late 2023.
“This rewrite is a clear marker that the journey towards the holy grail the industry needs for global harmonisation of regulatory reporting is underway. The regulators are now focusing on data quality, validations, and reconciliation to improve accuracy of submissions and looking at best practices from other regimes and jurisdictions, “ says Phil Flood, regulatory expert at Gresham Technologies.
He adds, “It’s likely given the age of Dodd Frank that existing swap data reporting solutions either in-house or legacy vendor will carry considerable technical debt which makes the challenge to migrate that much harder. Migration paths to support the rewrites for regulations that were first enforced after the financial crisis could be complex and costly.”
Market participants may think they have time to prepare as the Emir Refit does not go live until 29 April 2024. However, if past experience is anything to go by, firms should be laying the foundation now to update their technical standards and its addition of new fields, submission format and approach to lifecycle reporting. (See recent commentary from Duco on challenging the assumptions for how to tackle regulatory rewrites including both the CFTC Rewrite and EMIR Refit.)
Industry Initiatives – ISDA Launches DRR
In response to these regulatory changes, the International Swaps and Derivatives Association launched the digital regulatory reporting initiative or DRR . The aim is to improve the accuracy and consistency of what is reported to regulators by giving firms access to a collective interpretation of the CFTC amendments developed by an industry working group. The DRR leverages the Common Domain Model to transform a mutualised interpretation of the CFTC rule amendments into code, thereby reducing the inconsistencies that can emerge when each firm independently implements its own interpretation of the rules.
ISDA will continue in a test environment next year to develop new functionality and adapt the framework for forthcoming data reporting rule changes in Europe and Asia-Pacific. The trade group estimates that approximately 70% of the coded CFTC rules can be transferred directly to the DRR that is being developed for Europe, while 90% of the combined coded US and European rules could be applied for rule changes in Asia-Pacific.
Leo Labeis, ceo at REGnosys, comments, “In 2023 we are likely to see more testing and implementation of DRR. This is because whilst the CFTC Rewrite dominated industry discussion last year, this was just the first of a number of amendments to global reporting requirements that lie ahead. These include changes to the EMIR as well as updates to several Asia-Pacific reporting regimes.
He adds, “As DRR implementation grows, so will application of the Common Domain Model (CDM): the machine-executable data model underpinning DRR. We expect regulated institutions to leverage the CDM not just for their regulatory reporting, but across multiple stages of the post-trade cycle, such as collateral management and settlement.”
Digitalisation business cases and progress in focus
Digitalisation will continue to be a theme next year and beyond. As Jennifer Peve, managing director, head of Strategy and Business Development, DTCC, notes, “We anticipate the drive towards adoption of digital assets and DLT-based solutions will continue to prevail in the coming year as firms evaluate business cases where the technology can deliver new value. At the same time, the definition and intersections of traditional finance (TradFi), centralised finance (CeFi), and decentralised finance (DeFi) will remain important topics.
As the industry develops in these areas, we must ensure the requisite infrastructure, underpinned by robust technology, delivers the same high levels of safety, resiliency and dependability across markets. For this reason, as the adoption of novel technologies accelerates, regulated financial market infrastructures (FMIs) will have an important intermediary role to play, ensuring robust risk management capabilities remain a key focus in our financial system.”
In a recent DerivSource podcast, Martin O’Connell, solutions architect at HQLAᵡ, explained how DLT is already in use in the securities financing and collateral management space by addressing collateral mobility. Listen now to hear more about how this works, what benefits it delivers and what he believes will be the focus for 2023). DLT though will not be the panacea to all processes, according to a recent report from Acuiti and ION – DLT in Derivatives: Crypto innovation, traditional technology and the market of tomorrow.
Areas that will benefit the most are trade settlement, trade reconciliation and custody. Moreover, near real-time settlement and risk management, which are features of native crypto derivatives market structure, would be incorporated into traditional markets. By contrast, certain functions of native crypto market structure, such as auto-deleveraging of positions and sell-side disintermediation of finance, would not become part of mainstream structures.
“The two worlds of crypto-native and traditional finance are currently largely bifurcated owing to a lack of regulatory clarity which prevents significant intermediation from traditional sell-side firms,” says Will Mitting, founder of Acuiti.
He adds, that “this has forced native markets to innovate and develop new processes and workflows. While some of these innovations, such as harnessing the revolutionary potential of DLT, are likely to become key elements of market structure in traditional finance, the coming together of the two worlds will also see many elements of traditional market structure incorporated into native markets.
This report explores how the development of regulatory frameworks for trading digital assets and adopting new workflows and market structure will bring the two market structures together to create new and common processes.” (https://www.acuiti.io/dlt-and-the-derivatives-market-structure-of-tomorrow/ )
Technology innovation will also come in non-DLT strategies and that’s where could APIs and no-code strategies come in. In a recent podcast, Torstone Technology’s CEO, Brian Collings, discussed how firms can improve their post-trade operations processing, support new market initiatives (such a shortened settlement cycle) and digital assets, without upending legacy systems that still have life in them.
