How are financial institutions adapting execution and post-trade processes whilst the market structure and regulatory framework is in evolution? JR Lowry, a senior vice president in State Street Corporation’s Global Service, explains how organizations are establishing connectivity to SEFs, preparing for the cost structure changes of CCP clearing and adjusting processes to support real-time reporting
Q. How can firms select from / establish connectivity to the multiple execution facilities (SEFs and OTFs) that are expected to launch to support the electronic execution of some OTC derivatives in an operationally efficient manner? What are the challenges firms face and possible solutions?
A. Regulations for swap execution facilities (SEFs) and registration time periods are still pending. However, multiple participants have announced their intent to enter the market. We believe different trading models will emerge that will determine client selection. Whereas in the current market, execution partners are selected on the basis of credit extension, liquidity, market guidance and a bundling of services, electronic platforms will bring fundamentally different participants into the execution mix. Buy-side firms will have the option of trading directly through a SEF, working through a “SEF aggregator” or continuing to work through their executing broker. In any case, once the execution mandates take effect, execution itself will need to take place on a SEF. SEF selection will be based on product coverage, technology, trading style availability, and liquidity which are core elements in seeking to achieve best execution. We believe some participants will offer multiple instruments and/or trading styles while others will specialize in a niche approach. While we anticipate 15 to 20 SEFS to start, this number will decrease to a smaller number of end winners. At State Street, we are focusing on a multi-execution style SEF platform to fit diverse client needs, combined with a set of workflow and analytics tools to help improve process efficiency and decision-making.
Q. How can firms establish connectivity to FCMs?
A. Buy-side clients are currently in the process of selecting Futures Commission Merchants (FCMs) for their OTC derivatives that are moving to the centrally cleared environment. With the bifurcation of execution and clearing, the selection criteria are different in the emerging new world. Buy-side clearing is new and fundamentally different than the traditional broker-to-broker clearing, which was established to net exposures to other brokers. Buy-side FCM selection should be driven by the FCM’s business model, financial stability and credit rating, product and clearinghouse coverage, and technology infrastructure. While early conversations with clients were around the central counterparty (CCP) default waterfalls, recent events have proven that while CCPs mutualize risk at the FCM level, clients still have exposure to the FCMs they select. Dodd Frank’s mandate for fair and open access of the clearing houses enables a new provider model that addresses the importance of neutrality and credit risk in the market place. As a financially strong buy-side aligned partner, State Street is focusing on expanding our current FCM futures platform to include OTC clearing solutions for our institutional clients. This new cleared model leverages our core custody competencies around settlement, cash and collateral movements, messaging and reconciliations.
Q. How do you foresee the cost structure changing in the centrally cleared model?
A. In the new market, the bundling of clearing and execution services will be replaced by an unbundled pricing model with greater price transparency for individual service components. We anticipate that spreads will narrow over time as execution prices become available on SEFs and as “one-to-many” trading replaces “one-to-one” trading. The new market participants, including SEFs, FCMs, CCPs and swap data repositories (SDRs), will have associated costs. However, the greatest cost in the new environment will likely be around the margining of trades. The regulated margin requirements for both bilateral and cleared transactions will likely be higher than most collateral requirements in today’s credit support annexes (CSAs). Margining will also require daily processing and reconciliations as well as more rigorous infrastructure, straining the operations of those who have only rudimentary capabilities. The restriction of acceptable collateral will likely further enhance cost pressures and may lead some firms to pursue collateral upgrade capabilities to meet their trading needs.
There will also be cost requirements for the operational upgrades required for technology systems in order to handle the processing of these transactions. With increased volumes of collateral, spreadsheet managed solutions will no longer suffice. With the complexity of moving to the new cleared model, we are seeing additional interest in outsourced solutions.
Q. How will firms adjust reporting and data collection processes to support new needs for more ‘real-time’ reporting?
A. Reporting requirements are also still being finalized. SEFs and CCPs will likely report the majority of trade information to SDRs . For uncleared, non-electronically executed trades, the executing broker is likely to assume the reporting requirements. Industry participants must be aware of reporting requirements and must take the proper steps to ensure compliance.
Beyond regulatory reporting itself, one of the interesting consequences of additional market transparency will be the availability of data for enhanced reporting and analytics. From pre-trade analytic capabilities to the ability to compare and contrast execution pricing, data availability will further transform the derivatives markets.
Q. Are there any opportunities for the market participants to improve their workflow to support new market changes? For instance, is there a silver lining to making all these changes from an operational efficiency or transparency perspective?
A. There will indeed be opportunities to reduce operational risk as well as provide synergies across services. State Street is providing a full end-to-end solution, DerivOneSM, including electronic execution, clearing, investment operations servicing, collateral management, valuation, and reporting and analytics. Within this solution there are advantages to combining services, from a single point of contact for issue resolution to operational synergies including streamlined collateral movements and payments and increased straight-through processing (STP). Clients can customize solutions, taking components based on their individual needs. Synergy advantages are gained when multiple components are taken together. Clearing in particular involves many of the same services already provided by asset servicers/custodians, enabling some of these end-to-end advantages. At a market level, the new regulatory regime will drive significant change, but it should help reduce and mutualize risk and provide transparency previously unavailable.
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