OTC DERIVATIVES: the data management challenge, risks and opportunities
Even as regulators struggle to harmonize significant inconsistency in rules across jurisdictions, they are now shifting from rulemaking to enforcement. To avoid the risk of noncompliance, trading firms are beginning to invest in data management as a discipline within their organizations. As internal architectures are reshaped, costs will likely increase in the short term. However, the return on investment is potentially exponential. In this article, Paul Gibson and Matthew Rodgers discuss how poor data management practices and a fundamental lack of standardization still pose a risk in the over-the-counter (OTC) derivatives markets. But as businesses work toward providing regulators with the ability to effectively monitor systemic risk, they may also be opening up new business opportunities for themselves.
LACK OF HARMONIZATION AND EXPECTED ENFORCEMENT OF RULES
In 2009, leaders from the Group of 20 developed nations (G-20) agreed on a series of commitments to reform OTC derivative markets with the aim of improving transparency, mitigating systemic risk and preventing market abuse in order to restrain the excesses leading up to the financial crisis. Explicitly calling out reckless behavior by capital market participants, they committed to put in place the checks and balances needed to prevent excessive risk taking and hold firms accountable for the risks they take. Despite the tough stance taken then, many inside and outside the industry feel little progress has been made with regard to the majority of these commitments. In fact, at the 2015 ISDA AGM, it was reported that only 15 percent of the 2009 Pittsburg agreements have been implemented.
One exception is the headway that has been made in reporting OTC derivative contracts to trade repositories (TRs). Most national regulators now have rules in place that require this but, notwithstanding the presence of the rules, regulators are becoming increasingly frustrated with their inability to understand the data being reported to them and the impact this has on their capacity to monitor systemic risk. In efforts to improve the situation, the European Securities Markets Authority (ESMA) has increased the pressure with their level 1 and level 2 validations. Furthermore, over the past 18 months, the Commodity Futures Trading Commission (CFTC) has begun to levy fines due to the lack of or inaccurate reporting.* Although participants may argue that the number of different and sometimes contradictory regulatory requirements actually contributes to the problem rather than helping to solve it, regulators are likely to continue moving into a period of enforcement. Participants have dedicated considerable time and resources to begin the process of bringing
transparency to the OTC derivatives market, but unless they are able to report all of their eligible trades in a timely, accurate and complete manner, they face significant risks. In order to resolve this situation, trading organizations must invest in the operational processes to support their complex business models. Otherwise, the effort which has been put into this period of change will be rewarded with yet more fines.
HOW HAS THE LACK OF REGULATORY HARMONIZATION AND INDUSTRY STANDARDIZATION IMPACTED FIRMS?
Until progress has been made in harmonizing the inconsistent rules and creating common standards across the global markets, participants will continue to be pulled in various directions to address G-20 commitments. With budget constraints and the changing economy increasingly weighing on investment banks’ balance sheets, this poses a significant risk to market participants.
Eventually, the industry can, and will, create a more seamless transparent landscape for regulators and participants—but it won’t be easy. And, as the business of banking and investing changes, it is likely that this period will usher in a new set of winners and losers. While firms can point to the lack of global alignment of requirements as an impediment to transparency, it is not a valid excuse for failing to meet regulatory mandates or falling short from an operational risk and controls perspective. In short, it will not save participants from the potential for fines. Furthermore, unless firms invest in the business models required to accurately collect and disseminate the data required, they could also fall behind when it comes to new business opportunities.
The main choice firms make when deciding on a reporting model is to choose between a central internal hub with one connection to a TR or a solution that has multiple connections from one organization to the same or multiple TRs. While many agree that a centralized internal hub is the superior model, establishing one is extremely challenging for many organizations. In a recent Sapient Global Markets’ survey taken at the ISDA AGM in Montreal, the majority of firms (about 72 percent) said they are using their own in-house solutions to satisfy their regulatory reporting requirement.2 Additionally, the survey highlighted how the majority of firms are still working with a decentralized internal model. In fact, as seen in Figure 1, there are often
a number of different reporting models scattered throughout a firm’s internal infrastructure. This is partly due to the bifurcated nature of most institutions’ systems by geographical location, regulatory obligation and strategy, as well as a lack of standardization, clarity and direction on harmonization from regulators.
There are many advantages to working toward a central internal hub. A single central location for all reporting decision making logic, suppression rules and enrichment provides an organization with consistent management information along with a robust proof to regulatory scrutiny for the completeness, accuracy and timeliness of their reporting. Combined with the cost-saving opportunities for leveraging third-party providers, this area of financial market infrastructure offers many opportunities for performance improvement. When taking into account more than the G-20 OTC commitments and looking at the legacy reporting frameworks, such as MiFID, Trace, Blue Sheets, ACT and FINRA as well as upcoming requirements like SEC and MiFID II, the number of different reporting frameworks currently in place at each firm is likely to be extremely high.
Most participants struggle with data integrity issues across business lines and functions, but the speed required for implementation programs and the nascent nature of the practice of data management within the investment banking industry has meant that rather than simply being a characteristic, poor data-management practices tend to define OTC derivative reporting frameworks. With operations budgets normally first in line to be scrutinized and cut, compliance monitoring and reporting requires constant justification. These budget constraints and gaps in proper oversight and governance impact the quality of the architecture which is implemented; it is not unusual to see firms making do with solutions which rely on manual reconciliations a year, or even two, after the deadline is met. In many cases, firms have disjointed systems that are growing increasingly expensive to maintain and update as firms have to keep multiple systems up to date with the everchanging rules of each regulation. Historically, due to industry pressure, TRs have interpreted the rules and requirements in different ways and have allowed firms to submit loosely validated data—contributing to the data quality issues at the TR level. These data quality issues, coupled with the maintenance of the regulatory rules engine, add to the rising cost of maintaining or upgrading the technology firms are currently using.
Figure 1: Two main approaches have been identified as most prevalent in trade reporting: a central internal hub, or a solution with multiple connections to TRs.
Complying with upcoming G-20 regulations following American and European derivative regulations while managing ongoing updates to existing rules is causing firms to be in a state of almost perpetual scramble, facing tight timelines for implementation every quarter. Simply keeping pace with regulatory requirements requires large numbers of support staff and ongoing maintenance, which is adding dollars to the bottom line that firms will never be able to recoup unless they are building scalable, flexible solutions. Spreads and credit are so tight in today’s financial markets that firms are unable to pass regulatory costs on to their customers or shareholders without an adverse impact to their reputation or product offerings.***
More institutions are coming under regulatory scrutiny and will need to establish proper checks and balances to survive the ever-changing regulatory landscape. This is likely to lead firms to reevaluate their strategic solution for regulatory reporting and ideally tie into broader requirements, such as Basel Committee on Banking Services (BCBS), for an effective solution. Many firms have acknowledged that they were materially non-compliant with the rules associated with some—or all—of the G-20 regulations implemented to date due to data architecture, IT limitations, accuracy and reporting integrity. For these participants, time is running out. Governing bodies are growing less tolerant when firms heavily rely on manual processes and “work arounds.”
WHAT CAN FIRMS DO?
In 2013, BCBS and IOSCO identified 14 principles under four headings intended to assist firms in creating a harmonized structure for effective risk data aggregation and risk reporting.4 While there are many ways to ensure high-quality data, this approach indicates the direction regulators are looking for firms to take as they move toward the necessary standards required for compliance. The firm-wide understanding of these types of frameworks is critical in order for participants to implement a workable approach to data governance and day-to-day management and stewardship that are ideally globally streamlined. The principles are grouped into the four themes outlined in Figure 2, which presents the proposed framework developed by the BCBS on how firms can aggregate those principles into a harmonized governance model. By looking to follow a model based on these principles, firms will have greater access into their data and a better understanding of where the issues lie, while moving toward a global harmonization with other institutions.
Figure 2: Four principles representing the BCBS proposed framework for achieving a harmonized data governance model.
PRACTICAL NEXT STEPS
Since the financial crisis in 2007, data has remained fractured. It still lacks structured oversight and accuracy and is often maintained in silos throughout the enterprise. Having bad data that is not harmonized causes gaps, leading to various internal and external control breakdowns. The majority of a firm’s data is simply not actionable. What’s more, many firms still struggle to adequately review their positions or provide transparency to external data consumers in a timely fashion and are unable satisfy the necessary requirements for proper oversight. While the 2013 BCBS/IOSCO Risk Mitigation paper highlights a structure participants could aim for, the majority are a very long way off from such a formalized approach. Despite the lack of regulatory harmonization and global data standards, regulators are still planning to levy fines.*****
Firms need to become smarter about their trade reporting. This starts with adopting a culture where data matters, ensuring initiatives such as those coming out of BCBS/IOSCO are well understood, and engaging in the significant progress being made at the TR and industry association level, such as the DTCC and ISDA. In the absence of leadership from national regulators, these organizations are taking the calls from the industry and supranational bodies for harmonization upon themselves. The methodology for agreeing upon a cross-asset/jurisdiction approach to streamline and harmonize reported data in order to achieve a consistent framework by classifying data elements for maximum completeness, validity and accuracy is gaining significant traction. Industry working associations are taking the approach to guide members and participants in a more streamlined way. Two significant examples currently in place are the proposal from DTCC for global data standardization6 and the ISDA EMIR Review Consultation working group, which is focused on single-sided reporting for EMIR and harmonizing collateral calls, margin and liquidity to establish more consistent models across the globe. It is the mindset of and action by market participants, such as ISDA and DTCC, which will eventually lead to a global standard for transaction reporting.7
As these initiatives progress, all market participants should begin assessing their infrastructures and operating models for inefficiencies stemming from either the lines of business or from technology and infrastructure. This analysis should include data capture, front-to-back flow analysis, level of headcount, organizational structure as well as how technology functions across asset classes. Future-state definition should take into account current industry practices to promote and support the definition of the target process. Being able to leverage industry working groups, while seeking various solutions both internally and externally, will allow firms to expedite any immediate needs that fall out during the assessment of a firm’s reporting infrastructure.
Another challenge is putting the right governance in place to ensure people own the data and see it as a valuable commodity in its own right on an ongoing basis. Establishing the necessary processes with robust controls and procedures, will help alleviate compliance concerns related to data quality and harmonization. Once this is achieved, firms will be able to use the data for a variety of purposes, including analytics, management reporting, compliance oversight and more. In fact, regulatory reporting may well be the basis by which many firms are coerced into achieving a level of data-quality maturity fit for their businesses. The regulatory requirement for firms to report all of their OTC data gives them the mandate to put these standards in place—but it may actually be the catalyst pushing the larger investment banking organizations toward business models that are actually sustainable going forward. In the short term, the investment required is not insignificant; but this is expected to drive down the cost of compliance in the long term and provide opportunities in risk management and asset servicing, with greater access to more reliable data.
is a Business Consultant currently based in New York. Specializing in new business and regulatory drivers, Paul has extensive experience in how these are impacting the capital markets industry. His current focus as a program manager of a top market infrastructure provider’s data quality initiative was the result of an engagement to advise on its products and services strategy, helping to identify strategic growth areas and facilitate the board’s decision on further investment. His previous client was a top European investment bank, focusing on the impacts of regulatory reform on the bank’s execution, clearing and reporting workflows, designing solutions, and planning implementation to facilitate eventual compliance and more efficient operating models.
is a Business Consultant based in New York. Matthew has an extensive background in sell-side banking, where his experience has been pivotal around OTC derivative trading and regulations. His expertise has carried over to various other regulations within the OTC regulatory space for Dodd Frank, Canadian regulations, ESMA, ASIC, MAS, JFSA and HKMA. His current
engagement entails regulatory reporting globally along with advising on upcoming regulations within the derivatives and cash space for a tier 1 investment bank. His broad understanding of the “front to back” business flow is beneficial in advising clients on strategic decisions needed for compliance within the OTC space.
1. U.S. Commodity Futures Trading Commission, “CFTC Orders ICE Futures U.S., Inc. to Pay a $3 Million Civil Monetary Penalty for Recurring Data Reporting Violations”
2. Sapient Global Markets, “Sapient Global Markets Survey Reveals Escalating Trade Reporting Costs and Concerns over Maintaining Compliance”
3. MarketsMedia, “Trade reporting costs on the rise,” July 9, 2015
4. Bank for International Settlements, “Principles for effective risk data aggregation and risk reporting – final document issued by the Basel Committee”
5. U.S. Commodity Futures Trading Commission, “CFTC Orders ICE Futures U.S., Inc. to Pay a $3 Million Civil Monetary Penalty for Recurring Data Reporting Violations”
6. DTCC, “DTCC Issues Proposal to CPMI IOSCO for Global Data Harmonization,” June 2015
7. Committee on Payments and Market Infrastructures, “Harmonisation of key OTC derivatives data elements (other than UTI and UPI) – first batch,” September 2015