OTC TRADE DOCUMENTATION: a revolution awaits
Until the third quarter of 2012, trade confirmations had existed on the periphery of the regulatory change agenda. Previously, the Over-the-Counter (OTC) derivative industry had been fully focused on meeting regulatory obligations in relation to swaps clearing and reporting. This all changed in a matter of weeks as the Commodity Futures Trading Commission (CFTC) in the US and the European Securities and Markets Authority (ESMA) both published final rules detailing their future requirements for this area of the market2 3. In this article, Nick Fry outlines what is being mandated by the regulators; why compliance is going to be such a challenge; how the different participants are likely to be impacted; and what the future holds for this diminishing, yet currently substantial, section of the industry.
Regulatory pressure to improve the OTC trade documentation process is not new. For several years, regulators, led by the Federal Reserve Bank of New York, have been pushing the industry to become more standardized and automated. Leading dealers have previously signed a number of letters to the Fed committing themselves to certain targets, and these have been instrumental in significantly decreasing operational risk in many asset classes, most notably credit derivatives.
Now, however, the stakes have been raised. The financial crisis and the subsequent commitments from the G20 group of nations to bring control to the complex and disparate OTC market have bred a different outlook from global regulators. Goals that were considered a fantasy by participants only months ago are now expectations; practices that have been the norm for decades have been questioned and destined for transformation.
The most noticeable theme that can be drawn from both sets of legislation is that the regulators are targeting an environment where there is little-to-no downstream operational risk attached to unexecuted trade documentation. This is a major step-change from the current state, and as the following sections detail, it will pose fundamental challenges to all client types and all departments dealing with non-cleared OTC derivative transactions.
There are two key directives in both the CFTC and ESMA regulations around OTC trade confirmations: timeliness and recordkeeping.
The primary component of both sets of rules centers around the timeliness of confirmation execution, with the ultimate goal of both regulators that all OTC trade confirmations should be executed by the first business day following the trade date—except for deals transacted with non-financial services firms who do not regularly trade in derivative products. This is a change of focus, since previously there have been no specific industry commitments around execution timeliness for the entire confirmation population (the Fed commitments only focused on execution timeliness for electronically confirmed trades).
Regulators have acknowledged that the industry will need time to adjust to this new reality. They also recognize that certain asset classes have much more work to do toward meeting these targets than others (e.g., equity vs. credit). As a result, they have both decreed a rolling schedule for compliance over the next two years based on asset class and client type, as detailed in Figure 1.
The ESMA regulation around confirmation timeliness is simpler yet more stringent than that of the CFTC. Under the CFTC rules, Swap Dealers (SDs) and Major Swap Participants (MSPs) are the only parties subject to the mandatory requirements of confirmation execution timeliness. The rules governing trades facing non-SDs and non-MSPs only decree that policies and procedures should be in place to achieve execution by certain timeframes but fall short of mandating execution versus these types of clients. Instead, the rules require SDs and MSPs to dispatch confirmations within target timeframes. ESMA, on the other hand, simply orders firms to execute confirmations by specific timeframes, discounting the need for policy around confirmation dispatch.
The other key area of focus of both regulatory bodies is recordkeeping and reporting. The CFTC regulations demand that market participants retain details of the time of dispatch or receipt of i) the sent confirmation and ii) the executed confirmation, and that these details be made available on request to auditors and regulators. The ESMA Technical Standards require firms to report to the regulator on a monthly basis the number of unconfirmed OTC derivative transactions that have been outstanding for more than five business days.
The CFTC regulations also stipulate additional obligations. There is a requirement for SDs and MSPs to generate and dispatch pre-trade acknowledgements upon request by the respective counterparty. These acknowledgements go beyond the typical term sheets seen in the market today and are required to include all legal and economic terms, except any terms agreed upon at trade execution (e.g., strike price).
The State of Play
So how far is the industry from achieving these goals? The metrics in the ISDA Operations Benchmarking Survey (IOBS) from May 2012 indicate that the market will have to change dramatically in order to comply. The IOBS data suggests that all firms struggle to have less than one business days’ worth of OTC trade confirmation volume unexecuted.
This is particularly the case for the asset classes where paper confirmations are still common (e.g., equity). Indeed, the survey states that for most asset classes there are still instances when confirmations are outstanding over 30 days old.
The only metrics around confirmation timeliness in the IOBS are related to dispatch—not execution. However, these statistics can be used as another indicator of the market’s readiness to comply.
The survey also details the percentage of confirmations sent by a certain time per asset class for both electronic and non-electronic confirmations. The data for electronic confirmations demonstrates that the vast majority of documents processed via this method are dispatched by T+1 (equities is by far the lowest at just over 80%, whereas other asset classes are in excess of 90%). However, the cumulative percentages of confirmations sent by a given day for the paper population, as shown in Figure 2, are far more concerning.
- Only commodities could manage to dispatch their entire paper population by T+5
- All asset classes are failing badly when compared to the initial CFTC targets for dispatching paper confirmations for trades with a non-SD/non-MSP
When this data is reviewed against the average percentage of paper confirmations for each asset class, the scope of the challenge is clear.
The Initial Impacts
It is clear that the impact of these rules will be felt far and wide across business divisions and market participants. Different participants will be affected in different ways. For the sell side, the impacts are primarily process and technology changes; the buy side will need to embrace automation; and intermediaries will need to help drive and facilitate industry change.
Sell Side – Front Office
Front-office personnel in investment banks will be affected in numerous ways as firms react to the regulations. The initial action for most, particularly sales staff, will be to educate their clients. While the regulations are widely acknowledged and understood on the sell side, the same cannot be said of the smaller buy-side firms, many of which trade OTC derivatives only sporadically. Therefore, the sales organization has a key responsibility to ensure their clients are fully aware of the rules and their impact in order to help meet compliance deadlines.
Another functional area in which the front office will be under pressure to make necessary changes is trade capture. In order for firms to have any chance of meeting the aggressive targets around confirmation execution, it is imperative that trade capture is done in both a timely and accurate fashion. Given the onset of real-time transaction reporting, this may have already improved; nevertheless, these new regulations drive home the importance of creating new process efficiencies.
With regard to the CFTC rules, there is also the potential requirement for pre-trade acknowledgements containing full legal terms which will change how the front office communicates with its clients. With the exception of the highly structured business, most OTC transactions are pre-confirmed by the dissemination of a term sheet, which merely details the core economics of the trade. The new CFTC rule potentially changes that requirement, resulting in an increased reliance on legal, credit and/or operations personnel to produce these pre-trade acknowledgements instead.
Sell Side – Operations
The division that initially will be most affected is operations. In order for firms to cope with the new targets, they will need to provide tactical and strategic solutions to the problem:
- Tactical – Add additional manpower to ensure confirmations are dispatched T+0 and returned within the relevant timeframe
- Strategic – Invest heavily in further template standardization across the industry, as well as technological solutions (market-wide and in-house), in order to reduce the reliance on extra headcount
The additional headcount required in the short term to meet the new targets is likely to be substantial. Firms today fail to dispatch the majority of paper confirmations on T+0, let alone fully execute them. (The IOBS states that Currency Options perform best out of the asset classes at less than 20% being dispatched on trade date).
It is imperative that in asset classes with significant paper volume, most notably equities, there is a concerted drive by the industry to standardize further product templates in order to facilitate electronic matching and automation. The industry must also find technological answers to the paper problem. Many firms are still reliant on manual processing and must embrace enhancements to their own systems infrastructure. Firms, such as Thunderhead.com, have proposed inventive solutions to this issue which are likely to be explored further.
There would also be an expectation on buy-side firms, such as asset managers and hedge funds, to be willing and able to meet the new regulatory timeframes. In Europe, such firms also have to comply and, while in the US they are not directly affected, they will be expected to help sell-side firms to comply. As a result, these firms will also require significant changes to the way they currently operate.
First, the buy side can expect increased pressure from the sell side to utilize electronic matching platforms for electronically eligible trades. As the IOBS states, between 10-20% of electronically eligible volume is still confirmed via paper. This is primarily due to either clients not wanting to change their process to incorporate firms, like MarkitSERV or ICE eConfirm, or banks not having the resources to onboard clients who trade sporadically. Either way, there will be a focus from the sell side to eliminate this “missed opportunity” percentage as electronic matching is seen as key to meeting regulatory targets.
Additionally, there is likely to be increased pressure on buy-side firms from the sell side to agree upon confirmation templates prior to trading. This could take the form of Master Confirmation Agreements (MCAs) which detail industry standards for a particular product to reduce the size of the trade confirmation and facilitate electronic matching. This is in lieu of long-form, bespoke confirmations.
Finally, there will be increased pressure from the sell side to agree to execute confirmations once the transaction has been completed. This will inevitably mean that buy-side firms, or their operational administrators (e.g., State Street, JP Morgan WSS, Northern Trust), will be forced to enhance their business processes and probably increase their headcount to handle the new demands from the sell side.
While market participants conducting OTC transactions are primarily affected by these rules, there are a number of players who will also be under extreme pressure to deliver.
The performance of the International Swaps and Derivatives Association (ISDA) will be placed under the microscope as the market looks to standardize more products. The lack of adoption of the 2011 ISDA Equity Derivative Definitions has been a barrier to reaching agreement on new product standards in this asset class. As such, ISDA has to find a way to marry the requirement for rapid template standardization with a return on investment for this initiative.
The industry acknowledges that electronic matching platforms are the most effective way to achieve timely confirmation execution for non-cleared trades. However, in most asset classes there is only one vendor that has critical mass (e.g., MarkitSERV), and, as a result, there is a huge dependency on that vendor to deliver new templates onto its platform when they are standardized.
In the medium-to-long term, a revolution awaits the bilateral OTC market.
Historically, the industry has primarily traded first and agreed upon legal documentation post-trade. While participants will continue with this approach in the short term, going forward, it will have to change as compliance targets in 2014 move toward T+1 execution. This reduced timeline is simply not conducive to post-trade negotiation. Therefore, firms will be forced to evolve the target operating model to move confirmation negotiation to be a pre-trade function in order to comply.
The impacts are likely to be dramatic. The pre-trade term sheet and the official legal confirmation will most likely become the same document. The front-to-back processes and technical infrastructure will have to be reviewed and enhanced in order to facilitate the pre-trade negotiation process. Confirmation teams (or elements of them) will most likely move from being a post-trade operations function to support sales desks.
The biggest impact, though, will be on the front office. In essence, firms will have to ensure that all legal terms and conditions are agreed upon prior to trading. Therefore, unless clients have already pre-approved the template, there may be a lag between agreeing to trade and actually executing the trade while the legal terms are agreed. This is a significant change to the current process. Firms that can minimize this lag will potentially have a competitive advantage over their peers. For some firms, the change may inhibit them from offering bilateral OTCs as a service because the incurred pre-trade cost and associated risk that the transaction might not occur may be prohibitive.
While bilateral OTC transactions will reduce in number over time with the onset of central counterparty clearing, the expectation is that volumes will remain significant for a number of years and that there will always be a proportion of the market that will be non-cleared. As a result, the new regulations around confirmation timeliness should be of immediate concern to all participants.
In recent years, OTC documentation has not been a traditional area for industry investment. For firms to have any chance of regulatory compliance, this will have to change. These rules will also see the end of the OTC confirmation process as we know it—another radical step in the industry’s move towards a more transparent, efficient and ultimately safer market.
is a Director with over 20 years of experience in the capital markets industry, including investment banking operations and financial services consulting. He has extensive derivatives subject matter expertise and deep knowledge of the documentation domain. Nick also has firsthand experience in legal entity migrations and novations.