The potential impact of regulatory reform on financial firms’ business models has never been greater. Short selling, EMIR, CRD IV, MiFID and MAD revision are only a few of the new pieces of European legislation. Tackling each one in isolation could result in a disjointed approach that would prove to be very costly and inefficient. Instead financial firms need to look at the body of reform in a holistic fashion — understanding the purpose of each regulatory initiative and then identifying the interrelated aspects of the legislative process and their impact across the firm’s entire business model.
Although there are a myriad of regulations from different supervisors in different markets and regions, the overall intention behind them all is relatively consistent – to make the markets fair and orderly and to guard the interests of investors.
For example, OTC derivatives trading and the mandating of central clearing aims to bring more transparency to a formerly opaque market. Recent developments in areas like algorithmic and high-frequency trading are facing new regulations. Counterparty risk is being addressed, and all trading is moving toward a mandate to be covered in full by liquid collateral.
While the overall goals of various reforms are clear, it is easy to get lost in the details. More pages and new regulations appear on an almost daily basis. To come up with the right responses, the complexity must be peeled down.
From the perspective of national and supranational regulators in Europe, the expected roll out order will be:
- Licensing of the new roles of trade repositories and central counterparties (CCPs)
- Raising the bar on operational procedures, in terms of electronic capturing, timeliness and more frequent valuing and reconciling.
- Receiving data through data repositories to improve post-trade transparency and give insight to regulators on where to set priorities in regulating.
- Analyze and decide which OTC instruments should be regulated within CCP models.
- Implement new capital and liquidity standards, including incentives for CCP trading and disincentives for bilaterally cleared OTC trading.
- Implement CCP models, including clearing funds, margining and collateral, to mitigate systemic risks.
- Move CCP-eligible instruments towards trading platforms, including licensing of new platform types, to create more pre-trade transparency and to avoid market abuse.
The first task for regulators is to collect information on the OTC market itself in order to see how much standardization is possible – for example, the size of participants’ portfolios and how they are concentrated and valued. This is the reason why the regulators’ initial short-term focus lies on trade information and reporting.
Of course, this means there are implications for financial firms. How well do they know their trade data inventory? Where are the order, trade and position data stored and how reliable are they? Is the company’s database based on the same company-wide definitions or are there many local dialects in combination with many local replicated or slightly adjusted data collections? Is there a single source of truth?
Financial firms need a blueprint for regulatory change in order to navigate the changes successfully and to remain competitive in the “new world of central clearing.” There are three key steps to establishing a regulatory blueprint.
Stage 1: Getting your house in order
Various firms have rightly started to improve their enterprise data management practices both internally (via architectural changes to enable real-time calculations and aggregation) as well as at the trade data repository level — the interface between regulated firms and their regulators – where data fragmentation and a lack of standardization have been evident.
At the same time, regulators expect that the operational processes around trade confirmations, portfolio valuation, reconciliation, compression and dispute resolution will be improved and executed on a more regular basis.
Stage 2: Reporting, collecting and analyzing data
Once firms have improved their data management processes and established the necessary infrastructure, a daily exchange of OTC trading and portfolio information via the data repositories can flow freely. This data can then be analyzed and will help form the basis of a more transparent market where the direction of certain asset classes to CCP structures will be fact-based.
Stage 3: Introducing new workflows, connectivity & support functions for trade processing
In this stage, firms need to be ready to switch to a CCP workflow, create connectivity into the CCP infrastructures and at the same time (if you are a credit institution) start implementing the CRD IV agenda, the European response to the Basel III recommendations.
In the new CCP world, collateral will also play a pivotal role. Having a clear overview of your collateral inventory is important, but having the right mechanisms to transform illiquid or lesser-quality collateral into liquid collateral becomes vital. This will necessitate a change to traditional post-trade activities such as risk management, clearing, collateral and settlements into pre-trade activities. Only then can a firm make sure they are able to trade and are aware of trading decisions and consequences upfront.
Ultimately, all of the required changes to a firm’s business cannot be left only to the compliance, legal or audit departments. If a firm decides that it wants to stay in this business, it will need to make major structural changes – especially with technology – in order to meet the new regulatory challenges.