DerivSource’s Julia Schieffer spoke to Commerzbank’s Eric Bystrom about how post-trade outsourcing for OTC derivatives has evolved as a result of the regulatory overhaul in Europe.
Q. Relying on service providers to take on non-core functions is not a new concept. How has outsourcing of post-trade processes changed with new regulation for OTC derivatives under EMIR?
A. EMIR introduces new regulatory requirements that impact the OTC derivatives lifecycle from all aspects – execution, clearing, reporting, funding and capital and risk management. At the same time, the deployment of these new requirements is coming at a rapid pace, often with areas of the rules uncertain and still requiring clarification. The sheer scale and pace of the change makes it very difficult for many financial organisations that simply lack infrastructure, resources and in-house expertise to adjust post-trade processes in time to be EMIR compliant.
Given the significance of this change and the limited timeframes for client compliance, a big part of TradeCycle, our full-service offering in conjunction with Clearstream, is advisory services. Outsourcing providers like ourselves must keep up-to-date with all regulatory developments and have in-house experts who can help clients better understand the various obligations, how they impact them and then be able to help plan all the nexessary changes to ensure trading and processing is conducted in a manner which is regulatory compliant for clients.
Additionally, the level of control firms need over their trading and processing activities, including processes outsourced, is greater compared in the current market climate. This is directly related to the volume of regulatory change and obligations firms must meet but organisations are also keen to be able to have clear oversight of activities as needed to assist with key decision-making.
Q. Have the drivers for outsourcing changed as a result of new regulation?
A. Cost reduction is still the primary driver due to a need of firms to reduce their fixed overhead components of Operations and technology . Tradecycle offers a robust and reliable infrastructure in order to conduct all post-trade processing. Together with Clearstream the Trade Cycle offering leverages the broker offering of Commerzbank with the collateral management infrastructure of Clearstream delivering great economies of scale but also an enriched range of tools and services to chose from through one contact point.
Cost savings are achieved not just through our scale but also through the advisory services mentioned already. Improved risk management practices, such as improving funding options utilising credit valuation adjustment (CVA) and fund valuation adjustment (FVA) tools, is also a key benefit to outsourcing as these savings directly impact a firm’s P&L.
Q. Are organisations looking for full-service outsourcing rather than a more modular approach, which has been more common in recent years?
A. The market analysis and the feedback we have received from both clients and market practitioners widely is that many clients have followed a modular approach where they select different vendors or service providers who provide different solutions. However, many firms who follow this approach also face significant challenges with integration between system and maintenance of in-house processing. For example, an asset manager may choose a particular collateral management system which might not cover the full scope of their obligations in post-trade processing and under EMIR or be compatible with other systems or services used. This asset manager would then have to go to market, select another provider to support other functions not covered, but also spend valuable resources on building integration for this collateral management system. Therefore, the asset manager now faces a number of friction points, which now the operational team has to add to its list of projects – again taking up scarce time and valuable resources. This might be a ‘best of breed’ approach but those who opt to outsource multiple and fully integrated functions to a single service provider who can support all their end-to-end processing needs significantly benefit from gaining operational and processing efficiencies. They also benefit from having no gaps and full integration in the processing chain, which ultimately delivers further cost savings in the longer run.
Flexibility is more important now than ever before. There will certainly be cases where organisations have developed modules and capabilities in any one of the product offerings, which service providers naturally support. For firms who want to continue to run their own modules, service providers need to have flexibility to allow clients to cherry pick services based on their own unique needs and offer integration where selected to ensure there are no missing elements or gaps which could impact efficiency.
Q. What challenges related to regulatory change is hitting asset managers and mid-size banks the hardest?
A. One of the biggest challenges for many firms is managing the requirement to centrally clear under EMIR. Many firms are not large enough to support all the activities in house; they are grappling with a host of regulations, differering deadlines, the long lead times to onboard and a fairly lengthy onboarding process. The good news is that in creating TradeCycle we considered all aspects of the onboarding process and have made the onboarding process seamless, we have a consolidated onboarding package across all our products between Commerzbank and Clearstream.
Related to clearing, there is also the increase in demand for high quality collateral required to meet obligations – both initial and variation margin. Tied with greater margin requirements for bilateral trades too, this presents firms with a liquidity conundrum where they must find the right assets, and do so efficiently and quickly.
Together Commerzbank and Clearstream can provide the connectivity to clearinghouses via client clearing and efficient collateral management processes to support firms in meeting these two significant market changes.
Q. Collateral management is a big pain point for many financial organisations as they prepare for greater margin requirements for both bilateral and centrally cleared derivatives. Can you explain how firms are adjusting their processes accordingly and what a service provider offers compared to an in-house build or internal system?
A. Collateral management is an integral element of the OTC derivatives post-trade process and with new regulation margin calls are set to increase – both in frequency and in value, so it is absolutely crucial that collateral is managed efficiently to ensure the cheapest to deliver collateral is delivered and all obligations are met appropriately. If poorly managed, collateral management can negatively impact the P&L of an institution and the effectiveness of credit risk mitigation for the firm.
A dynamic and efficient collateral management operation, which is EMIR-ready is one, that combines various tools including use of sophisticated algorithms, to help firms clearly identify the cheapest assets to deliver. There are various elements to such a process including the identification of eligible forms of collateral to match up with obligations and careful consideration of the various funding costs associated with each asset they could pledge under the credit support annex (CSA). Also if our clients need to go to the marketplace to source different assets, or utilise collateral upgrade services for instance, we help advise them how to best complete this process.
Firms can of course build up infrastructure and resources to support these greater collateral management requirements however; those who have access to a custody banking service have the added benefit of depositing assets with a custody bank. Custodians have a direct overview of their portfolio, which means the asset servicer can advise them as to the most optimal asset and what they should be doing on a day to day basis as well as offer operational efficiencies through a streamlined operation. Through TradeCycle, for instance, Clearstream, as a market infrastructure provider is able to deliver those assets to the location where the client needs to fulfill their obligation whilst Commerzbank provides the intelligence and advice for collateral efficiency. The two offerings are combined to for the benefit of clients who seek truly comprehensive collateral management support service.
There are increased requirements for margin under both bilateral and CCP cleared derivatives workflow so the need to source the cheapest to deliver is the same for both cleared and uncleared workflow. And custodians, will have visibility of the client’s asset pools and can therefore better assist the client in making the most efficient use of the assets they already have. For example, a typical scenario is we have clients which have an asset pool eligible for LCH.Clearnet or Eurex or any of the other CCPs, our offering is to provide a menu of different products to assist them in upgrading their asset pool to eligible collateral and posting that to any of the obligations they may have.
Q. What about trade reporting under EMIR? Do you see demand for delegated reporting services from possible clients?
A. Yes, the obligation, which went live in February this year, was the obligation to report transactions to an authorised trade repository, and we offer this through the tradecycle offering. It is a delegated reporting service and we have access to a client’s trading positions and their collateral postings allowing us to seamlessly report those transactions on a daily basis to the trade repositories. Further, there are additional reporting requirements which are expected to come into effect in August. Our Tradecycle offering will also be compliant and ready to report these changes for our clients.
Q. On the clearing front, you offer clearing connectivity services through Commerzbank. Do you recommend clients utilise other brokers too?
A. There is a real and sometimes significant advantage in having more than one OTC clearer and a back up facility should one of your service providers’ fail. For prudentially regulated entities it directly impacts how your capital requirements are calculated, not only having one service provider for clearing but thinking of having one or two clearing brokers that can offer you a back-up facility.
This is a trend we are seeing and we are in conversations with our clients about it; it will enable them to feel comfortable in the knowledge they are able to port transactions to a back up facility should one of the service providers fail. And I think service providers need to support this clear need to have multiple brokers and continue to offer advice for the entire lifecycle of a trade. There is risk in only supporting specific post-trade processes in isolation. Firms need support and more importantly, to understand how the new trade lifecycle needs to look and operate to comply with all the EMIR requirements from clearing to collateral and risk management.
