Following the collapse of Lehman Brothers and the near-failure of AIG, financial authorities in the USA, Europe and Asia are planning overhauls of the regulatory framework surrounding the OTC derivative markets.
Proposals put forward by the US Treasury include having standardised OTC contracts cleared by central counterparties (CCPs), moving such contracts to regulated exchanges, and compulsory reporting of all derivatives transactions, both standardised and customised, to a trade repository.
The European Commission has made it clear that it, too, intends to encourage greater standardisation to facilitate centralised clearing and, ultimately, exchange trading of OTC contracts. Asian authorities are planning similar moves.
The authorities are still discussing the details of forthcoming regulations. One of the most important concepts in their proposals is the need to standardise product definitions – something that is itself subject to continued debate.
Indeed, no full definition of what constitutes a standardised contract has been set out, although Mary Schapiro, chairman of the US Securities and Exchange Commission, has said: “There should be a presumption that if an instrument is accepted for clearing by a fully regulated clearing house, then it should be required to be cleared.”
Despite some lack of clarity around certain aspects of the financial authorities’ plans, the general direction regulation looks set to take is clear. It is also increasingly apparent that banks will need to enhance their IT systems and rethink business processes to cope with these changes.
Dealers face upgrades – or worse
Among the most significant challenges faced by financial firms will be the requirement to feed standardised contracts directly to a CCP, via MarkitWire, for clearing.
Introducing CCP clearing will make it necessary to post and receive margin on trades, obliging companies to review their banking and collateral systems. Firms will also need to interact with a trade compression service.
Most affected by these moves will be dealers that are not yet already members of a clearing house, as they will have to implement an interface with a centralised clearing service.
Other firms – dealers’ corporate clients – will also have to make changes. However, these will be less onerous as their access to the CCP will be indirect, via a third party clearing member.
So what practical impact are the proposed measures likely to have for banks and their IT departments? This will largely depend on banks’ current IT set-up, the type of systems in use and, in particular, whether these are software packages supplied by specialist vendors or proprietary systems developed in-house.
Where vendor platforms are employed, such as Murex, Calypso, Summit, Reuters and so on, upgrades are likely to be necessary. Indeed, for firms that have long relied on older installations, it may be necessary to put off any further delay and to press on with deploying vendors’ latest offerings.
For banks using custom technology, even more significant changes may be needed. Take, for example, companies with their own proprietary pricing routines. As these are likely to prove insufficient or raise questions when reconciling marks with the central counterparty, they will have to be replaced with new technology.
In such cases, the most practical solution will be to use market-standard valuations, which are most easily archived by substituting proprietary analytics with off-the-shelf pricing libraries from specialist firms such as FinCAD, Numerix or Pricing Partners.
Nevertheless, even though this is the most straightforward way to tackle this challenge, introducing the kind of new technology described above still has non-trivial implications in terms of time and cost.
Standardising trade capture
If banks are to connect successfully to a CCP, they will need to rethink the way they book transactions in their trading systems. For example, whether using vendor or proprietary software, a bank will need a common trade capture platform that can funnel all relevant transactions into MarkitWire.
For companies using several different trade capture systems in various locations this poses a dilemma. A number of responses are possible – for example, a firm could establish one trade capture platform as a master system, or create an intermediate tool to aggregate all the trades before sending them on to MarkitWire.
Time to clean up
Firms will also have to eliminate some workarounds, very commonly used in the past, to facilitate connection with the CCP. Certain workarounds, developed to counteract the shortcomings of banks’ own IT systems, could stymie the trade matching process within MarkitWire.
Take, for example, one common workaround: booking an exotic derivative as a combination of simpler vanilla products. To avoid the difficulty of representing a complex transaction in existing IT systems, a trade is broken up into two simpler components (for example, a callable swap is booked as a vanilla swap and a swaption).
While this may be a useful expedient for bank staff – it does generate the proper cash flows and valuation – there are serious implications when it comes to feeding contracts to a central clearer. If single trades are not represented as such, but are broken down into components, they no longer correspond with counterparty trade records, meaning that a match cannot be readily achieved.
Other workarounds will have to be weeded out, too. Consider, for example, the practice of booking swaps as multiple legs. In future, banks will need to make quite certain that trade legs are readily identifiable to a particular confirm, so that deals can easily be reassembled as a single trade and fed to MarkitWire.
Companies will need to reconsider other aspects too – for instance, they must make sure floating rate indices correspond to standard conventions. Should the correct conventions not be used, MarkitWire will be unable to pair up transactions with the relevant counterparty trades.
Finally, companies will have to implement globally used trade and legal entity identifiers: failure to do so will undermine MarkitWire’s ability to successfully match the company’s trades to those of its counterparties.
Naturally, eliminating these widely used workarounds will not be easy. A good deal of work will be needed to adapt proprietary technology, and vendor platforms will have to be upgraded.
Feeding time
Having laid the foundations for connection to MarkitWire, banks will need to create feeds into and out of the service. Where proprietary technology is used, these pipelines will have to be built from scratch. Vendor platforms may well provide an electronic feed which just has to be switched on.
A tool for reviewing the MarkitWire interface will also be necessary. Operated either automatically or manually, this will allow a bank to approve trades before their release for central clearing.
On top of this, firms will need to ensure that the margin on trades can be posted, recorded and tracked. Interfaces to the TriOptima compression service will have to be implemented, enabling trades to be merged for administrative purposes.
Beware the regulatory upgrade
Finally, as regulators have made clear, all transactions, including both standard and non-standard or customised trades, will have to be reported to a central data warehouse.
At present, financial authorities appear set to require only basic information such as trade identifiers, the names of counterparties and limited information about positions, for example, notional or mark-to-market.
In the future, it is not unreasonable to suppose that these requirements could be extended to encompass other information such as trade details.
For the time being, banks need only modify their systems so as to be able to contribute data to the trade warehouse. Should more details be required, companies will be obliged to standardise their representation of more sophisticated products.
This will, in turn, necessitate extensive alterations to their IT systems, including mapping to FpML, and will entail both extra work and expense. Furthermore, as the ability to correctly model exotics across institutions is an arena in which much groundbreaking work is still being undertaken, it is an emerging – and therefore challenging – area for regulators and market participants alike.
Get ready for work
Regulators across the globe look set to impose new rules on the OTC derivative market. In response, financial organisations will need to focus on standardising products and, in particular, to set up systems to feed these contracts to the MarkitWire service.
This is likely to involve considerable time, effort and cost, as well as forcing companies to do away with workarounds currently in use.
Firms will also be required to submit details of OTC contracts – both standard and non-standard transactions – to trade warehouses. At present, this is a fairly straightforward task, but if regulators want to see complete economic details relating to exotics, not simply more work, but a whole new level of complexity, will result.
Kevin Samborn is a director in Sapient’s trading and risk management practice, working on valuation initiatives for clients. He previously worked at Numerix, a pricing analytics software company, specialising in structured notes and their hedges.