As pressures for timely reporting of OTC transactions mount on both sides of the pond, Ian Salmon of ITRS Group explores the challenges that this presents, while explaining why the sell-side requires a fresh approach to avoid heavy fines and reputational damage….
Hindsight is a wonderful thing. Having met the Dodd-Frank deadline for reporting trades to a data repository, most banks in Europe initially felt that the 12th February deadline for Emir compliance presented little problem. Fast forward a few months and that first flush of optimism feels wildly misplaced. Mention Emir to a compliance officer now and you are likely to be met with black scowls and a rapid change of subject. Somewhere along the line, Emir turned out to be a lot more challenging than was first anticipated.
What hindsight tells us with astonishing clarity is that the differences between Emir and Dodd-Frank were always going to create difficulties. The two regulations have different specifications for timing of reporting and the inclusion of collateral reporting. More significantly, where Dodd-Frank Title VII looks at mandating transaction reporting solely for OTC instruments, Emir includes both OTC and exchange-traded derivative products.
Most importantly of all, the two regulations differ when it comes to which entity reports a trade. Under Dodd-Frank, the dealer takes responsibility for reporting a transaction. Under Emir, both parties to the trade are accountable. Emir also specifies several additional data fields to Dodd-Frank, including information that is specific to each counterparty.
To achieve compliance with Emir, each counterparty needs to apply a unique trader reference identifier to each trade at the same stage of the workflow. How to ensure all identifiers match so that both counterparties have the same reference at a point at the same time is – often quite literally – the six million dollar question.
To make things even more interesting, Emir allows one counterparty to delegate transaction reporting to the other. They can even arrange for a third party to do the necessary reporting. Given that workflow surrounding derivatives trading can often resemble a game of pass the parcel, this only adds new layers of complexity both when trying to ascribe a unique identifier to the trade and when trying to assign responsibility for its reporting.
With brokers giving up electronic flow to fellow brokers to execute on their behalf, the relationship between the reporting entity and clearer is much more convoluted. Each of the intermediaries in the way represents a break point in the workflow, and the potential for reporting responsibility to fall between a gap. Banks that undertake reporting on their clients’ behalf need to ensure they have the means to source customer-related data in order to report it. No wonder that Emir is discussed only through much gritted teeth.
Principles and prescriptions
The specifics of transaction reporting aside, what this highlights once again is the difficulties associated with trying to create a model for OTC and derivatives trading that is based on equities workflow. In effect, the regulators are trying to deliver an identical end result from very different materials.
By very definition, OTC transactions are not standardised. Futures and options have less centralised markets, different platforms and different flow for different instruments. There’s no consistent and verifiable data streams. Even within a single institution there is unlikely to be a single infrastructure to handle every OTC transaction. The likelihood of two separate counterparties having identical infrastructure and workflow is even less likely.
That’s a very different proposition to the equities world, which although fragmented and complex, still retains a more straightforward and linear workflow. A standardised infrastructure is in place, which makes it much easier to deliver consistent results.
For many, the situation brings back painful memories of the early days of MiFID, with its lengthy consultative and often quite disorientating process. This is perhaps the biggest difference between Dodd-Frank and Emir, and is symptomatic of the broader difference between prescriptive and principles-based regulation. It also has the most implications for Asian markets as the regulatory trend moves inevitably eastward.
So where Emir is the liberal parent asking a teenager to decide whether they should stay out late or come home early, Dodd-Frank is the parent that demands they be home by ten. Interestingly, when ESMA was introduced in Europe it implemented a bunch of quite short, sharp regulations and applied them quickly to market participants. The approach was close to that taken in the US: this is what you have to do, this is when you have to do it, and this is what happens when you fail to comply.
The problem with Emir is that the market infrastructure is not in place for them to do that. They have effectively asked brokers to be home by ten, but can’t enforce it because there is no train service until half-past. Both regulator and regulated are caught in a stand-off, trying to work out how to progress without the necessary infrastructure in place.
Facing the future
Nonetheless, there will be a point where the regulator will enforce the transaction reporting requirements, and there are ways in which brokers can prepare now to avoid fines and reputational damage later. The principles-based approach gives brokers plenty of opportunity to develop their own proposals and plans for dealing with the problem. Mapping their own workflows across their disparate systems the in front-, middle- and back-office and then creating a landscape of transactions enables them to identify potential break points or gaps where data can slip.
This is the kind of information that can be used to engage with the regulators. It is far more about using specialist reconciliation tools to monitor infrastructure and applications, and using business intelligence to analyse potential improvements, rather than re-building platforms for interest rate swaps or installing monolithic derivatives platforms.
Increasingly, the solution is a light-touch layer of software that sits above and across all existing infrastructure and looks at the completeness of these flows – what gets traded and what gets reported, and flags up any discrepancies. It is far easier for intelligent software to spot that thirty incoming trades have only produced twenty reports than it is for a compliance officer to do the same – and it is the only way to ensure that thirty thousand trades produce thirty thousand reports.
The added advantage of course is that it protects brokers from whatever final demands the regulator makes. But there is more to it than that. To date, buy-sides have outsourced their reporting process to their brokers, and if banks didn’t report on behalf of their counterparties, buy-sides may have chosen to take their business elsewhere. That has always required a level of trust. But now the regulators are demanding a standard of proof that the buy-side – as well as the sell-side – has acted responsibility. This subtle, but important shift, places buy-sides under greater scrutiny: we are certain to see regulators asking some very probing questions in the future.
For smart brokers, it’s yet another tool to be used to demonstrate absolute compliance with the complex network of regulations that now encircle the world’s capital markets. It is another way of demonstrating value. Interestingly, after the transformative effect of the technology arms race, it is compliance standards (as well as the speed of the algo or quality of the DMA) that is now attracting clients.