Preparing for Options and Fixed Income Cost Basis Reporting

Guest Blogger: George Michaels, CEO of G2 FinTech

Brokers and custodians have an extra year to report to investors the adjusted cost basis for options and fixed income instruments. Originally, this third phase of the cost basis reporting rules was set to include fixed income and options products purchased as of January 1, 2013. Now, reporting can wait to include instruments bought as of January 1, 2014.

This extension gives firms more time to prepare by working with vendors and/or creating in-house solutions. More time is only one part of the equation. This complex undertaking requires a smart, comprehensive plan grounded in the harsh realities inherent in buying and/or building software to solve business problems. These systems should also handle the cost basis for debt and options transactions. However, if firms do not have an effective system in place, more work lies ahead, especially when calculating cost basis for fixed income and options instruments.

G2 FinTech has come up with a list of 10 key issues firms need to confront for compliance.

The Good, The Bad and The Ugly: 10 Key Considerations to Prep for Options and Fixed Income Cost Basis Reporting

1. Asset class inventory (Operations)

Create a checklist and verify which asset classes are held and traded by your firm and your clients.  You need to have a forward-looking approach and be ready for anything your front office expects to trade in the next 24 months.

2. GAP verification (Technology and Operations)

Analyze what the firm can already do – Examine what the firm has and what is needed and examine any gaps.  In some cases, both technology and operations teams need training in order to accurately understand the nuances of how cost basis integrates with the new instrument classes.  Does your ops team know that when you exercise a call option, the cost basis of the options needs to beadded to the strike price in order to calculate the correct cost basis of the newly acquired equities?

3. Technology upgrades (Technology)

If your firm trades either fixed income or options securities, you will likely find gaps in two major technology areas — data acquisition and data storage.

a. Data acquisition.  For options and fixed income, you need to access strange data elements in order to track their cost basis.  One example is pay-downs: a transaction wherein the loan underlying an asset-backed security is paid off early by the original borrower.  A typical case occurs when a mortgage holder sells their house or pre-pays a chunk of principal.  This causes the cost basis of the asset-backed security to decrease. How are you going to know this occurred unless you subscribe to a service that lets you know when this has happened?

b. Data storage.  What do you do with the avalanche of data your new-found vendor just dumped on you?  This data can consist of complex owner actions or include terms and conditions for the convertibility of a bond into the issuer’s common stock.  You need to put it somewhere and it should to be stored where your cost basis engine can find it and get to it quickly.

4. Operational changes (Operations)

As technology departments put new systems in place, firms will need to train their operations teams on how to use these new features and functions. You will likely need to design new business processes to deal with the day-to-day use of the new technology as well as business training for your operations staff.  Nowadays, the ops staff needs to know exactly how a convertible bond differs from a convertible preferred share and if they can affect the cost basis of the final shares acquired via a conversion transaction.

5. Procurement (Technology/Business side)

The cost basis rules pushed the burden of cost basis determination from the individual investor over to the large, faceless broker-dealer who cannot make technology purchases quickly. Instead they must deal with a procurement process that is often frustrating, time-consuming and downright dangerous. This process is concerned with business requirements and the best IT solution and can become highly political. Especially when the CFO’s best friend’s mother’s bridesmaid happens to be a sales rep for Software Vendor XXX.  There is a lot of money at stake so every vendor will descend on the hapless CFO.  This is all the more reason to get started soon.

6. Implementation (Technology)

You have decided what technology you needed and purchased it.  However, not every element of the problem can be solved with off-the-shelf software.  Clients do not want to receive separate 1099(b) forms for equities, fixed income and options.  You now need to build software to fill in the gaps and the CTO sings the chorus “My staff is overworked, under-paid and demoralized from the initiatives of the last few years; you want this done WHEN?”  In order to finish on time, the CTO demands a budget the size of the national debt of Italy, and the CEO counters with “revenues are down; so you need to get this done with an even smaller budget than last year.”  This will take some time to resolve.

When the fireworks are over, the IT guys get to work, and the CTO hires his grandmother’s gymnastics coach for $900/hour to supervise the project as a “consultant.”  Eventually, the functional spec finally gets to Archibald, the bald guy in the basement cubicle who actually knows how the IT systems work. He knocks out the work in a week or two.  Unfortunately, all the other steps take about 50 weeks.

7. Reports requirement analysis (Compliance)

The suffering from the prior steps serves no purpose unless the client can see the data that the cost basis regs require you to deliver.  You have a fancy website that delivers reports to your clients daily, but none of these reports include the all-important cost basis data points. You need to enhance your existing reports.  But which ones?  Which data fields need to be added?  From where do you get this data?

8. Implement the reporting changes (Technology)

The CCO hires his pet rock’s uncle’s cardiologist to examine the problem.  Three million dollars later, a functional spec gets to Archibald (the bald guy in the cubicle) who hacks out the new reports in 30 minutes and uploads the schema changes to the website.

9. Quality analysis / quality control / UAT (Technology and Compliance)

The CCO needs to make sure the CEO does not fire him if the data looks bad.  Since his pet rock’s uncle’s cardiologist is busy, he hires his golf caddy’s second-cousin to put together a very detailed document that promises the CEO that the data on Archibald’s reports are compliant with the EESA 2008.

10. Deployment and PR (All)

We won’t mention how the PR firm was selected by your firm to trumpet the news to the world, but can assure that the selection process was fair and in the best interests of the broker-dealer’s shareholders.  So the PR firm tells the world that the faceless broker-dealer is now in compliance with the CBL.  The CTO tells Archie to hit the switch.  The reports cut over, and the CCO’s consultant verifies the cutover is complete.

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