Capital Markets

vice president, SunGard’s capital markets business

Is CVA the Poster Child for Regulatory Corrective Action?

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This blog post originally appeared in GARP.

Now that the global regulators are in full swing of finalizing the rules that are expected to substantially change the way the financial markets operate, we are left with a growing list of disparate requirements. That is, rules promulgated by certain jurisdictions that differ from other jurisdictions, as well as rules imposed by various governing bodies of the same jurisdiction that differ from each other.

In defense of the requirements gaps, regulators assert that since processes, participation, and market cultures vary, the rules will inherently follow suit.

However, in real terms, the disparity is likely to inspire regulatory arbitrage. Regulatory arbitrage exists in circumstances where any marginal distinction creates a seemingly risk-free advantage or opportunity. Here, trading firms, banks, as well as commercial hedgers may change their strategy and move transactions to jurisdictions that provide risk-free advantages, including favorable regulatory treatment, a safe haven from onerous processing, or reduced costs.

One issue of concern is the mandate to analyze credit valuation adjustment (CVA). CVA is a calculated value representing the possibility of a counterparty’s default. Simply, CVA is variable value, usually calculated daily, representing a counterparty’s credit risk profile.

The CVA requirement is part of the Basel Accord, and is intended to provide a basis for the real- or near real-time monitoring of counter party credit risk. Significantly, because Basel is an advisory directive and each jurisdiction may, and generally does, implement it differently, Congress has introduced a bill to address the potential negative effects of Basel on the U.S. economy by possibly mandating the discovery of articulable jurisdictional CVA differences.

To this end, and to address the looming reality of regulatory arbitrage, on May 7, 2013, the Financial Competitive Act, H.R. 1341, was sent to the U.S. House of Representatives for consideration. The bill, if passed, will require the Financial Stability Oversight Council (FSOC) to generally measure the regulatory implementation differences between the United States and other jurisdictions.

Specifically, this proposed legislation calls for a comprehensive study on the possible or likely effects posed by any differences, including the method and manner, between the U.S. and other jurisdictions in their implementation of CVA.

The statutory language also calls for a competitive forecast analysis, including the impact on end users of derivatives. For instance, the bill requires consideration of all input variables, assumptions and capital costs concluding with an analysis of extent to which differences in the CVA capital requirement could move derivatives trading to other jurisdictions.

In addition, the analysis must explore the interaction between differing CVA capital requirements and margin rules.

Now that we have approached the crossroads of defined regulatory differences, bills, such as the Financial Competitive Act, H.R. 1341, will attempt to close gaps that regulators assert are inherent in the rule-making process. Generally, legislation that purports to seek clarification or other corrective measures should not, on its face, be construed by market participants to lessen the regulatory burden; rather, the sole intent is to force more seamless harmonization.

However, in this instance, the express language of H.R. 1341 calls for recommendations by the FSOC concerning any corrective measures necessary to minimize the negative effects on U.S. financial institutions, derivatives markets, and end users.

For instance, under Basel within the European Union (EU), a directive known as the Capital Requirements Directive IV (CRD IV) exempts EU registered swap dealers from certain capital requirements — specifically CVA — when doing business with non-financial end users. Here, CRD IV provides an express advantage and will necessarily result in the type exploitation or burden that H.R. 1341 is intended to prevent.

For example, Rep. David Scott (D-GA), a co-sponsor of H.R. 1341 said that “certainty and uniformity are needed on the calculation of the derivatives credit valuation adjustment as it relates to Basel III capital requirements.” Ranking Member Maxine Waters (D-Cal), a supporter of H.R. 1341, observed that regulators must ensure the uniformity of CVA and that the calculation does not put U.S. financial institutions at a disadvantage.

As a result, the U.S. securities industry supports H.R. 1341 as part of an effort to promote consistent international standards.

This is true because previously the industry has raised concerns that securities-based derivatives transactions may be subject to different capital requirements under U.S. CVA rules. This could distort the transaction pricing while contributing to liquidity compression, as U.S. transactions would not receive the CRD IV exemption.

The Financial Competitive Act, H.R. 1341, and its narrow focus on CVA is one of many likely extra-territorial legislative gap fillers. It is likely that the U.S. Congress will proffer additional correction bills that seek to close, or at least limit, the gaps that could invite regulatory arbitrage.

senior manager, SunGard Global Services

The New World of Agile Development: The Whole is Greater than the Sum of Its Parts

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In the U.S., the baseball season is in full swing. Baseball fans everywhere have surely witnessed greatness as individual players often strive to win for their teams more than for themselves. In fact, in the case of many great athletes who have never won championships, some might argue that those players were more invested in themselves than the team. When it comes to today’s financial markets, like in baseball, a successful firm – or team – needs to understand the old adage “the whole is greater than the sum of its parts.”

In particular, financial firms today should focus on the team vs. individual concept with regard to agile software development methodology.

At the very heart of this emerging technology development methodology is the concept of collaboration. Collaboration extends from the end client through the engineers creating or updating the solution. The beauty of agile development is the promotion of breaking down the walls that divide the various stakeholders — clients, business analysts, developers, testers, etc. – by bringing all of them together often.

Traditional software development methodologies such as Waterfall created silos of roles and responsibilities that were guided by a project manager. Collaboration was always facilitated through the project manager, and was generally not encouraged across the enterprise.  The whole here was not often greater than the sum of its parts, as collaboration and interaction were stunted, and individuals were not allowed or encouraged to function as a team.

Introduce agile development. Break down the silos! Clients, facilitators/project managers, business analysts, engineers, and testers all come together as a united “well-oiled machine” that promotes collaboration to build the best possible software and operational solutions.

Sounds great, but how? Communication between all stakeholders occurs regularly, usually every day. Constant feedback and daily software iterations are shared across the team to allow the agility and flexibility to embrace changes and “tweaks” until the client is thoroughly satisfied. This is about a team-focused approach, where communication and collaboration allow the team to “win the championship.”

To take this a step further, let’s look at how agile development could relate to the world of post-trade processing. If we just look at the post-trade world, we understand that processing a trade requires so many core functions – purchase and sales, clearance and settlement, customer and general ledger processing, etc. – that agile development may not intuitively feel like the right solution.

Sometimes, the more complex the solution, the more likely that agile development may not be right for the project. However, there are many opportunities in the post-trade space, such as Dodd-Frank, or technological innovation (e.g. mobile or tablet integration) – that agile development may be the perfect option. At the end of the day, agile is a flexible and a results-oriented methodology, and should be considered for all kinds of post-trade software projects today.

To gain competitive advantages and achieve growth, teamwork and collaboration are the right ingredients for success. Whether in the context of post-trade processing software development or the World Series of baseball, winners recognize that “the whole is greater than the sum of its parts.”

vice president, SunGard’s capital markets business

Market Participants, Not Regulators, Are Inspiring Next-Gen Post-Trade Processing

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This blog post was originally published on TabbFORUM.

Over the past few years, the financial markets have undergone significant infrastructure realignment caused in part by global regulatory responses to the most recent financial crisis. For market participants, this has led to a frenzy of internal collaboration for the purpose of process reconfiguration – specifically for post-trade processing.

Although changing regulations continue to inspire enhancements of post-trade servicing for the benefit of a streamlined workflow, the genuine compelling push concerning post-trade harmonization is industry-driven innovation and its response to liquidity deficiency and settlement risk concerns – many of which are cross-border relevant.

Common to all post-trade processes is an engine that powers the connectivity between the front and back office for the purpose of pre-trade monitoring and requisite disclosures, which inherently supports and links to the confirmation, settlement, record-keeping and accounting processes. Further, regardless of asset class or market segment application, a commonplace for post-trade processing in this new regulatory inspired paradigm is the challenge of complex dependencies and relationships. As a result of myriad processing applications for instruments such as derivatives, equities, and bonds, it is expected that straight-through automation will cross-pollinate to multiple market segments.

To this end, today’s post-trade processing race anticipates innovative automation evolving at an incremental pace, with distinct priorities and first movers likely emerging as the global best practice setters. Convincingly, the tri-party repo segment is a first-mover and already has substantively addressed liquidity and settlement issues. This is true because in 2011, the repo market successfully implemented a mandatory three-way trade confirmation between dealers, cash investors, and clearing banks.

From a direct collateral perspective, which remains a contentious issue for non-cleared swaps, the clearing banks have automated a substitution capability that allows for collateral within a tri-party repo transaction to be removed or reallocated and used for other purposes, subject to adequate collateral substitution. This functionality is relevant to non-rehypothecated collateral assets that are present on a tri-party repo platform. This type of bank-inspired process optimization is indicative of replicable best practices that are expected to benefit other market segments.

This market-led innovation is also broadly consistent with the European Commission’s explicit directive to increase transparency of collateral movements, as preferential to any substantive modification to securities law. Because Europe has traditionally experienced a “greater disparity and a lack of harmonization,” specifically within the context of post-trade processing, market-directed sourcing of post-trade best practices inherently contributes to a totality of safer and more transparent markets. For example, European regulators recognize that the current demand for high-quality collateral may necessarily be answered by collaborative market-inspired post-trade solutions.

In fact, EU legislation has coined the term “shared functions” to explicitly encourage collaborative market-inspired innovation, or alternatively, the sharing of best practices among sources. For instance, central securities depositories (CSDs) are currently harmonizing the book-entry process to accommodate legal uncertainties surrounding cross-border holdings and transfers without needing to modify any definitions of securities ownership. Concurrently, and possibly a competing interest to CSDs, the Target 2 Securities (T2S) platform is intended to create a “pan-European domestic” market for securities settlement with a clear objective of aligning, or in some cases consolidating, the cross-border settlement process.

It is clear that this innovative landscape is fluid and evolving rapidly. In support, regulators in Europe and the U.S. have expressly provided substantial deference to financial market utilities across market segments to implement transferrable best practices.

For instance, on May 16, 2013, the U.S. Commodities Futures Trading Commission (CFTC) voted to allow designated contract markets (DCMs) and swap execution facilities (SEFs) to unilaterally determine the “made available to trade” (MAT) criteria that effectively determines which swaps are required to be cleared. This simply means that, at least from a listing perspective, independent innovation by DCMs and SEFs will actually and substantively influence the course of performance for the global swaps marketplace. For instance, MAT determinations by SEFs will likely influence any swap transactions being moved to other jurisdictions with favorable treatment or requirements.

It is likely that market-driven innovation concerning post-trade activities such as collateral allocation, reconciliation, confirmation, settlement, record-keeping and accounting process across multiple market segments will gap-fill ambiguity and any lack of express enumeration by regulators. This is generally consistent in the EU and U.S. It is this market-inspired urgency that continues to be a major catalyst for seamless escalation of cross-border post-trade best practices.

Regardless of the method and inspiration of change, and whether the innovation originates from securities lending, post-trade derivatives, or collateral hubs, a new paradigm is inevitable and will certainly affect market participants across multiple segments, triggering fundamental and structural change in business models.

Above all, market-inspired innovation can preempt uncertainty and reasonably provide relief to overly burdensome regulations.

vice president, SunGard’s capital markets business

Is SEF Aggregation the Next Big Thing?

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This blog post originally appeared on DerivSource.

A significant event occurred on May 16, 2013. The U.S. Commodities Futures Trading Commission (CFTC) voted to allow swap execution facilities (SEFs) to unilaterally determine the “made available to trade” (MAT) criteria; which effectively determines which swaps are required to be cleared. This simply means that SEFs, as well as their post-trade service providers, will substantively influence the course of performance for the global swaps marketplace.

The general rule is that all swap transactions that are subject to the trade execution mandate must be executed on a designated contract market (DCM) or a SEF. However, concerning rules, it is often the exceptions that are most valuable when developing the next-generation business models for our customers.

The final SEF rules seem to be consistent with Congress’s mandate to shift the swaps market from a bilateral one to more of a public exchange-style market, with a greater number of participants having access to pre-execution data.

As a result, it is a certainty that market-driven, technology-based business models will emerge, or alternatively, migrate to support SEFs, and their customers, through services such as portfolio compression, risk mitigation, and most significantly, swap aggregation.

The question then becomes, which requirements, if any, will be placed onto technology service providers?

It is undisputed that in light of the CFTC’s final rule, the time has ripened to provide automation supporting the SEF listing, connectivity and processing race. For instance, SEFs are now incentivized to find reasons to list instruments and declare them, “made available to trade.” This so-called “race to the bottom” will likely result in mass SEF consolidation, but before that, we will embark on one of the greatest shifts of market-inspired transparency aggregation in history. Yes, the next big thing.

Therefore, independent service vendors (ISVs) should diligently map their respective offerings in accordance with the market demand for this “next big thing” together with the intricate details of the new bright-line rules.

For example, the CFTC deems that transparency aggregation, market depth, or analytical services provided by an ISV that defer any transaction execution to an independent execution source will not constitute a need for the ISV to register as a SEF. This is true because the ISV is simply providing market visibility or other decision-support functions — while refraining from the actual swap execution.

Conversely, to the extent that an ISV provides integrated execution capability, registration, as well as other related requirements, may, depending on the facts and circumstances, apply.

Additionally, swap support services such as portfolio compression are viewed similarly. Here, the CFTC allows portfolio compression as a netting mechanism, thus reducing a counterparty’s trade count and outstanding gross notional value. The result is a compression exercise that has the potential to alleviate, or at least provide, a viable alternative to collateral scarcity or portfolio margining efficiency — which incidentally remains a significant challenge to many market participants.

In accordance with CFTC guidance, depending on the methodology used, portfolio compression may wholly terminate or change the notional value of some or all of the transacted swaps. The result is a netting that consolidates trades and notional values which is valuable because the compression directly impacts optimization schedules as it relates to risk analysis, margin, and any applicable risk charges. Therefore, depending on the methodology used, no reliance on any external source is necessary to achieve risk and margin optimization.

Note however, that the actual swap execution remains the bright-line test. So to the extent an ISV offers portfolio compression services that supports multi-SEF transparency aggregation, market depth, or analytical services — without providing execution capability — SEF registration is avoided.

Another example is the automation in support of directly managing market, credit and other relevant exposures. Also known as risk mitigation techniques, they are incidentally an integral component of the European Markets Infrastructure Regulation (EMIR). In this case, the focus is on the redistribution of a market participant’s risk elements, without conducting an actual netting calculation. For example, a participants’ ability to identify elements of risk in a portfolio would likely exist in the front office, and the firm would reasonably seek to calibrate pre-execution what-if scenarios or volatility hypotheticals for all points along the maturity or credit curve. This service, as described, may be delegated to an ISV providing risk mitigation services.

It is important to note that the purpose of the SEF rules has been articulated, and the resulting message invites ISVs to embark on the next big thing. Specifically, swap processing services such as transparency aggregation, market visibility, or analytics such as portfolio compression or risk mitigation techniques. Each component is an integral part of a successfully functioning swaps market.

The “next big thing” never comes without its challenges. From a delivery perspective, in this post-SEF environment, it is important to be mindful of separating execution capabilities from a processing services offering – which is the bright-line distinction between leveraging facility execution and being an execution facility.

vice president, risk solutions, SunGard's capital markets business

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Battle of the (Super) Risk Managers: Iron Man vs. Batman

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This blog post was originally published by GARP.

This May saw the third installment of Marvel’s Iron Man film franchise. Amid the new movie buzz, it is striking that the super hero world offers a surprisingly unique way to explore different approaches to risk management. By comparing two competing superheroes and their infinite powers, we can ask ourselves, who would make the most effective risk manager – LA resident Tony Stark or Gotham’s own Bruce Wayne?

At a glance, the two characters are very similar. They both inherited large corporations and enormous wealth, have an obsessive interest in technology which they utilize to control high end crime and they have a number of stakeholders to address both as civilians and heroes.

Despite these similarities, they do have significant differences, particularly in their approaches to risk management. It is these differences that map so well to the different approaches that financial institutions can take to their own internal risk management functions.

First, let’s review how a financial trading firm approaches risk management. As regulators began to appreciate the extent to which derivatives in particular could cause large, unexpected losses (extreme tail events), the role of the risk management department became one of data collection and reporting to regulators. The sheer amount of data collection, analysis and reporting would often mean that this was the only operationally efficient task that the risk team could reasonably accomplish. The unintended consequence of that approach was that ‘risk’ was increasingly seen as taken care of by the risk department, and the sole driver of the trading function was profit.

Not surprisingly, this raised concerns at the executive and board level, and in turn led to the rise of the Chief Risk Officer (CRO), whose main function is to re-culturalize risk internally, and ensure that risk is front and center in the minds of:

  • Risk takers – traders/portfolio managers/dealers/salesmen
  • Operational staffers – back office and operational risk management
  • Risk appetite decision makers – C-suite, typically CEO or CFO
  • Risk consumers – shareholders, regulators and bond holders

The most effective CRO is a high-profile executive who is as much an evangelist for risk awareness as a quant or an operational expert.

In the DC comic universe, and particularly in its dystopian version of New York, Gotham, Batman’s Bruce Wayne is clearly an advocate for big data collection and analysis and risk control from behind the scenes. His tactics have included CCTV and microphone monitoring the whole city to search for and locate voice and face pattern matches to trace his villains. Known as ‘The Dark Knight,’ his choice of a bat motif was driven by Bruce’s desire to combat the criminal classes after hours. Batman cares little for moral judgment but instead focuses on a line that cannot be crossed in terms of actual activity. He does not evangelize, he does not reveal his identity but he does constantly monitor and control.

There is little doubt that Bruce Wayne would make a good regulator, and indeed a good head of risk limits, but would he be a good fit for the increasingly popular CRO role?

While Bruce Wayne owns the Gotham night, Iron Man’s Tony Stark prefers the spotlight. From sponsoring and starring in a New York-based expo (Iron Man 2), to making public statements of intent (Iron Man 3), Tony glamourizes being on the right side of the law. That said, Iron Man is no slouch when it comes to actually dealing with issues as they arise. The key to understanding Stark’s approach to risk management is recognizing his desire to stay technically ahead of the game, while constantly being active in the game itself.

There is an interesting nod towards the fact that the character is an allegory for modern risk management. This is evident in the first Iron Man film, when Tony’s desire for Stark Industries to internalize his moral beliefs and risk appetite was made a specific feature when the board became unhappy at his decision to withdraw weaponry as a core profit line. Batman, by contrast, uses Wayne Enterprise’s R&D department to build his technology while keeping its very existence a secret.

Clearly, Iron Man would be very comfortable in a CRO role, designing a risk appetite for his firm and working publicly and diligently to ensure that the firm understood, communicated and acted in accordance with that appetite. There is, though, a concern over whether he would pay as much attention to the far less glamorous regulatory reporting requirements of his organization.

The style of the risk and compliance can create its own issues as well as solutions. In various high profile cases, we can see that understanding how risk and compliance monitoring is run in an organization allows for rogue traders to game that system. The main ways in which risk compliance is circumvented tend to be:

  • Using bad data that creates issues within the system, allowing ‘out of compliance’ trades to slip by undetected
  • Designing trades that may break future limits but are within current constraints. This creates highly volatile and risky tails, but is often undetected at the risk percentiles more routinely monitored

This has direct similarities to the way in which Iron Man and Batman partially create their own anti-heroes. In Batman’s case, his obsessive sense of order and data analysis lends itself to a villain such as the Joker, who is deliberately chaotic in order to disrupt and prevent that analysis. With Iron Man, his willingness to engage, and his lack of data analysis tend to invite villains who rely on equal technology but better strategy.

Today’s risk management function faces some tough choices around determining the right approach. It is certainly true that the regulators need their reporting, but it is equally true that the firm needs a recognizable and credible risk profile and ethos which is understood by risk takers, consumers and managers alike. That is, after all, the prime reason for a financial institution to exist, to take calculated risks in pursuit of risk-adjusted profits.

To ignore or forget this is to lose, in many ways, the identity of the firm itself. So, knowing what we know about these superheroes, who would make the better CRO — the high profile Tony Stark or big data collector Bruce Wayne?

 

vice president, post-trade derivatives, SunGard’s capital markets business

Will the Futurization of Swaps Transform the Clearing Industry?

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This blog post originally appeared on FTF News.

The dictionary defines the word “swap” as to change or interchange, to move, and even “to thrash,” a computer term meaning to move data into and out of the core rather than perform the useful computation. Regardless of which definition one chooses, each fits today’s evolving derivative marketplace quite well, as regulations have moved swaps on to the clearing stage.

The futures commission merchant (FCM) model that serves futures customers is being disrupted as it proves to be less profitable due to a low interest rate environment. At the same time, the traditional servicers of over-the-counter (OTC) swaps are also facing challenges of their own with increased costs and lower expected volumes in OTC swaps. Is the futurization of swaps the answer that could turn the tide for both? Could it help to transform the industry, increase volumes, provide a useful alternative contract to the buy-side, and invigorate the FCM business model?

Turning an OTC contract into a listed or “futurized” swap contract offers both benefits and drawbacks. The main drawback is the loss of flexibility to customize swaps on an individual basis. However, the key benefits include a less expensive margin treatment and greater efficiency, as well as a wider audience of firms to provide clearing of these contracts.

Futures contracts are more “standardized” — that is, more defined up front and more liquid – and exist in a more defined world of interconnected systems that is well understood by regulators and market participants alike.

Very different by nature

While listed and cleared OTC derivatives are converging in the new world of central clearing, their paths to this new environment are quite different.  Ironically, the first futures contracts most likely started out as OTC transactions between two counterparties who recognized the mutual advantage of exchanging the price risk on a commodity.  Fast-forward a few hundred years, and these same types of transactions are traded electronically on open exchanges, centrally cleared and highly regulated.

By comparison, OTC derivatives, specifically credit default swaps and interest rate swaps, are much newer to the financial ecosystem.  Far greater in complexity, the arrival of OTC derivatives has been faster and had a much deeper impact on the financial industry than traditional listed derivatives.

Because these contracts are highly customized with no real limits on their size, it is difficult to understand the full impact of a major counterparty default. The results of this limitation are well known: Dodd-Frank, central clearing, and a new world in which listed and OTC derivatives would be cleared alongside one another.

Although OTC and listed derivatives now live in the same clearinghouse, they are very different. Listed derivatives transactions are based on standardized, highly liquid exchange-defined products with predefined specifications that are traded in an open exchange. On the other hand, each OTC derivative transaction is bespoke and unique like a special brewed tea, with special features transacted in an exclusive deal between two counterparties.

OTC clearing requires a five-day VaR for initial margin, while futures use a one-two-day SPAN margin. Because the latter is better understood and more standardized, the amount charged for initial margin is less than that for OTC clearing. Placing the clearing of an OTC derivative into the futures category, as in the case of interest rate swaps, could reduce margin requirements. Potentially, any firm that is an FCM that already trades futures can offer these futurized swaps to new or existing clients. Futurization could increase the number of FCMs offering these products at lower prices, which could produce happier customers and increased competition.

Ongoing change:  are we ready?

Should the interest rate swap futures products attract large volumes, the cost of capital requirements to trade these futures that resemble interest rate swaps could become significantly lower than that of the equivalent cleared interest rate swaps. If early examples are followed by other exchanges that introduce new futures products designed to bring similar economic benefits as equivalent OTC derivative contracts, but with lower capital requirements and subject to fewer regulations, this could lead to the migration of OTCD business to the futures world.

It will be interesting to see if the CFTC takes action over the coming months to try to level the playing field between economically equivalent futures and swaps with respect to block trade sizes, margin and other requirements.

head of post-trade securities, SunGard's capital markets business

Self-Clearing vs. Outsourced Clearing in the Securities Markets: Which Approach is Better?

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This article originally appeared on TabbFORUM.

As financial services companies focus their attention on controlling costs, acquiring new business and leveraging their global presence, many are reviewing their existing operations and service-support infrastructures to enhance cost savings, efficiencies and service differentiation.

Traditionally, players that had a track record in a domestic market were used to self-clearing and had direct membership with central securities depositories (CSDs). But when a firm wants to become a multi-market player, it is faced with many challenges in terms of infrastructure, relationships and regulations.

As a result, many firms are considering business process outsourcing (BPO) or full outsourcing arrangements in order to enter new markets quickly. For example, a firm who self-clears in London may opt to outsource clearing for its New York operation. BPO helps to alleviate the firm’s responsibility and resources required for settlement. Also becoming common is a hybrid model, which offers elements of both self-clearing and outsourcing.

Key Decision Factors

In the securities industry, participants with legacy in-house infrastructures with all the associated maintenance and staff costs are considering BPO to help reduce dependency on those systems that can hold them back from entering new markets or asset classes. But making the choice between self-clearing, outsourced clearing and settlement, or a hybrid model in the securities markets is not a simple one.

Self-clearing incurs relatively high fixed costs in terms of memberships, capital for collateral, staff, management time and compliance, while outsourcing tends to have low fixed but higher, transaction-driven variable costs. With volumes on the decline, variable costs can be more attractive, while a fixed cost structure is better in times of when high volumes are expected. The industry is seeing a slightly stronger level of confidence in the markets; two years ago, the focus was on stability, whereas now firms are willing to review changes to their offerings that would emphasize innovation.

For small- to medium-sized retail brokers in the U.S., where the market is well developed, outsourced clearing makes sense in terms of both economics and client service. A retail firm can make significant gains by aligning itself with a large clearing broker that exudes strength and confidence to end clients. Conversely, institutional firms face greater complexity in the decision to self-clear or outsource.

For institutional firms, client service in the settlement process starts to become a differentiator and product details become more critical, particularly for firms trying to offer a combination of more sophisticated, detailed products. This level of client service can be difficult to control if the firm is working with an outsourced clearer and even more challenging if on an international scale.

The Middle-Office Question

While a lot of the settlement processes reside in the back office, a number of BPO providers are looking to extend their reach up the customer value chain and into the middle office. This would involve maintaining direct relationships with a firm’s clients through service level agreements (SLAs). However, many firms prefer to retain control of the client relationships and middle-office processes. Although there are many advantages on a strictly economic basis, there is a fear of loss of control, especially in the institutional space.

Outsourced settlement has a number of benefits in terms of greater agility to trade in new markets, for instance. However, some firms considering BPO are concerned about the lack of control over the process, a lack of transparency, and the potential cost reductions they can realistically expect to achieve as a result.

Some organizations are finding that BPO is not really delivering the staff cost savings they were hoping for, because they still need to communicate with clients and monitor the process to keep a certain level of control. However, the perceived risks could be greatly reduced or even eliminated if the firm was able to shift business from one supplier to another, and consolidate information for the customer.

A transaction management tool could provide firms with the control they demand by keeping all of their data in one place, while maintaining the transparency and information with their outsourcing providers. If a firm’s client has executed business in France with one clearing provider and business in Asia with another provider, a middle-office transaction management tool could show the firm all of its clients’ business across the markets in which they are active.

From the broker’s perspective, staying on top of reducing and controlling costs is paramount, but in the near term, outsourcing decisions also will be driven by new market opportunities and the need to acquire and retain customers by differentiating themselves from their peers.

vice president, SunGard’s capital markets business

How Much Power Did the CFTC Give to SEFs and DCMs?

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A version of this blog post originally appeared in FOW.

As additional final rules are promulgated throughout the globe, an emerging trend for financial market regulators is to transfer, allocate and defer significant implementation discretion to financial market utilities and other relevant transaction infrastructures.

For instance, on May 16, 2013, in a landmark ruling decided in a public forum, the U.S. Commodities Futures Trading Commission (CFTC) voted, by a margin of 3-2, to implement, among other rules, the final “made available to trade” (MAT) rule.

The MAT rule fundamentally changes the swaps market by instituting the method and manner by which specific products required to be executed and cleared are identified.

This changes the swaps market because the CFTC, in its final rule, has effectively transferred, allocated and deferred significant power to swap execution facilities (SEFs) and designated contract markets (DCMs), (collectively, “facilities”) to unilaterally bind the entire swaps market to mandatory participation.

This binding effect is accomplished through a self-certification and designation process, which is based exclusively on independent factors deemed relevant by the facilities. Once the determination is made that a swap qualifies as MAT, all swap transactions must be executed on a facility, unless a narrowly construed exemption applies.

Concurrent with the final rule, the CFTC has effectively relinquished most, and arguably all, of its authority to oversee the facilities’ independent determinations. This is because the facilities’ self-certification to inform market participants of MAT swaps is deemed enforceable in all instances, unless inconsistent with the Commodity Exchange Act (CEA) or a preexisting regulation.

This strict standard essentially eliminates the CFTC’s ability to filter, restrict, or otherwise prevent abuses by facilities that attempt to impose marginally liquid swaps onto the market, or alternatively, pursue a strategy of over-inclusivity.

Beyond an express requirement that each facility must have order book capability, facilities have broad discretion to dictate the execution format of MAT swaps. This point is significant in that it dispels any expectation that facilities must necessarily have an advanced electronic processing capability. Also, voice brokerage remains a viable execution method.

Critics of the final MAT rule might contend that the CFTC has an obligation to maintain oversight authority over any facility-imposed mandatory trading determination. However it cannot because the final rule has effectively relinquished any meaningful discretionary oversight beyond a facility determination that is inconsistent with the CEA, or in contravention to a relevant CFTC regulation.

This simply means that, at least from a MAT determination perspective, independent innovation by facilities will actually and substantively influence the course of performance for the global swaps marketplace. This is the case because it is yet to be determined whether swap transactions will migrate to other jurisdictions with favorable treatment.

During the open forum, there was significant debate concerning ancillary issues such as the thresholds that would determine large notional value swap transactions, also commonly known as although marginally distinct from block trades. Although contentious, the block trade final rule at least provides for a well-articulated reservation of authority.

This all simply means that unlike the MAT rule, where any authority is illusory, the CFTC may revisit, reanalyze and/or modify the final “block” rule to align any abuses and to ensure a proper market synthesis.

head of product management, Protegent, SunGard’s global trading business

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When Is Compliance a Competitive Advantage?

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This blog post originally appeared on Wall Street & Technology.

Like many things in life, our interpretation of a subject varies based on the experience through which we approach it. If you ask a compliance officer whether compliance is a competitive advantage, he might well respond that keeping his firm’s name out of the headlines for compliance failures certainly helps keep business from getting derailed. But does good compliance really give a firm a revenue advantage against their competition?

In the world of compliance, a job well done is often a thankless one. After all, when compliance operations are running effectively, no one is the wiser. However, when things don’t run well and it all goes bad, everyone shifts into crisis mode and the compliance department gets a lot of unwanted attention.

So how can one say good compliance actually provides a competitive advantage when the sign of a good compliance shop is to operate virtually unnoticed? Two things are clear.

First, performing compliance is not optional. It’s like a tax; any shop wanting to compete in the fast-paced world of financial services must fulfill their obligations to the regulators and demonstrate they are equipped to operate in accordance with the law. Additionally, how does one compete for clients and to increase revenue on a function that for most markets is a minimum expectation? It would be analogous to selling an automobile without brakes. A firm can’t get into the business without compliance, and even if it somehow did, customers wouldn’t do business with this kind of firm. Some firms may choose to market their compliance culture as an advantage but fulfilling minimum expectations isn’t likely to be the source of new or significantly increased revenue streams.

Second, compliance professionals are not only willing, but eager, to share information. To the compliance manager, the competition isn’t necessarily the other firm down the street; it’s the regulator performing sweeps and audits which affect each firm equally. This perspective causes compliance officers to share information and best practices on how to prepare and mitigate their risks against common challenges. Sharing allows them to operate compliance as effectively and efficiently as possible with the least amount of interruption from auditors and regulatory inquiries. Sharing is a win-win for compliance professionals and results in best practices which ensure firms fulfill their obligations to protect the investing public. Sharing helps firms keep their name out of the headlines so they can avoid public relations and financial crises, and also helps compliance professionals to be more prepared when a regulator gives notice of an impending audit.

The reality is that compliance has been seen as a cost center for financial firms. How then can compliance really be a competitive advantage? The answer lies in the two commodities most valued by all businesses: time and resources.

Under The Radar
The compliance professional’s job is to spend their career performing an unassuming duty, which in the best possible scenario means flying under everyone’s radar, keeping the firm out of the headlines and the regulator’s crosshairs by proactively tracking down and addressing potential risks before they become issues.

As new regulations mount and operational budgets become tighter, the compliance officer (like the rest of us) is expected to do more with less. Automation is the only reprieve. Additional employees aren’t always the answer because they are expensive and not as scalable. Smartly architected solutions can position a firm to increase both its compliance efficiency and effectiveness. Done correctly, these investments can yield increased ROI by dramatically increasing the capacity of the compliance department, increasing the transparency compliance has to the firm’s business, and removing the need to hire an army of analysts. In most cases, existing resources can be repurposed or expanded to take on new tasks. For example, in the time it takes to manually sample a few random transactions or customer accounts for issues, an automated solution can systematically review every single transaction and account within the firm and flag those items on which the reviewer’s time should be spent. Instead of looking for risks, reviewers can more effectively mitigate risk by addressing them.

By now, most firms have some form of compliance automation, but in many cases it is limited. The problem is in reviewing and selecting a point solution to address each compliance task where automation can and should be leveraged. Between the time needed to implement and test the solutions, resources required to revise policies and procedures, and effort spent in training and supporting the compliance users, the commitment in man hours is tremendous and can eat up a significant portion of the proposed ROI.

One must also consider the time it takes to interpret the results of multiple point solutions and determine how the result of one solution affects another. In some cases it means integrating multiple point solutions to paint an overall risk picture of the firm, which is no small task. The result is often vendor consolidation where firms seek strategic partnerships with fewer vendors to maximize their economies of scale for greater benefits.

Good compliance is about identifying trends that can lead to future issues, then taking action to mitigate those risks. It is the unknown issues that keep compliance professionals awake at night. Identifying unknown issues requires greater transparency across a firm’s organizational data with an integrated workflow so managers can efficiently document and assign issues then follow their resolution progress.

Holistic automation is the next step for the compliance department. The combination and integration of the applications compliance managers rely on with the necessary reporting and workflow capabilities consists of more than what a point solution can offer and is the crux of the compliance technology platform. Integration for transparency, detection, documentation, and resolution must work seamlessly across multiple solutions. This is not easily found without expensive custom development, and it is usually unsustainable to keep multiple point solutions current with ongoing maintenance and upgrades.

The compliance needs of today’s — and tomorrow’s — sophisticated financial services firms are complex and broad. Compliance solutions specializing in their respective areas are critical, but making sure they work together is the key to success — and the biggest challenge. Without this, the advantages gained by automating with various point solutions are essentially erased because the mountain of information produced becomes unmanageable.

Platform solutions which incorporate the key components required by today’s compliance office are where compliance technology budgets will be — and must be — directed. There have been enough regulatory mishaps over the past few years that compliance professionals don’t have to work quite as hard nowadays to get the attention of senior management. Corner offices are listening, but what they listen for is how their compliance technology budgets can go further and do more to maximize the limited resources compliance teams have while being more creative about how to proactively uncover and address potential regulatory and compliance risks.

senior vice president, Astec Analytics, SunGard’s capital markets business

The Language of Liquidity: LCR, HQLA, LOLR

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This blog post was taken from the Astec Analytics Securities Lending Focus for May 2013.

Trading venues require a number of different characteristics to function properly no matter what product or service is traded. “Liquidity” is an oft-quoted characteristic when describing an efficient market.

Market “liquidity” is where a given asset can be sold without causing a significant movement in the price and with minimum loss of value – otherwise defined as exhibiting equilibrium between buyers and sellers where a scarcity of either can lead to deflated or inflated prices, respectively. Just ask anyone looking to buy a house in London.

But what has this got to do with securities lending? A great deal in fact.

To many, securities lending is synonymous with short selling whereas, in fact, it has much to do with obtaining collateral for other trades/uses, market-making and providing market liquidity as well. Having a ready supply of assets to satisfy purchase orders without tipping the market, or a ready market for your excess securities when selling out can dampen the volatile effects of scarce supply or demand. I have previously touched on the effects on market volatility when securities lending is diminished; I have also explored the potentially catastrophic impacts of the proposed Financial Transaction Tax covered in the Securities Lending Focus. This month, I wish to look at the wider capital and liquidity requirements coming into play from impending regulations such as the Liquidity Coverage Ratio (LCR).

Banks under the LCR have to hold sufficient “high-quality liquid assets” (HQLA) to cover 30 days of outflows, with those HQLA reserves often being held as high-quality government bonds and some highly-rated corporate debt, much of which, of course, is sourced through the securities lending market. The need to gather ever greater volumes of HQLA for these purposes is seen as one of the new trades that will continue to support revenues in the securities lending market – known by some as the “collateral transformation trade.”

However, there is a fine balance to be made here and one which I fear the regulators are struggling with. A number of influences may be constraining the supply of HQLA in the market; this has already prompted a loosening of the definition of such assets, as well as a bolstering of the support from central banks as “lenders of last resort” (LOLR).

Striking a balance here seems virtually impossible – if you make LOLR too easy to qualify for and too abundant, then the banks will not consider the need to gather sufficient HQLA too seriously as the central bank would be there to catch them if they fall. Make it too expensive and make the LCR requirements too harsh, and market liquidity would dry up when banks and the wider economy really do need it.

The Australian market in particular has taken an interesting position in a “committed liquidity facility” – essentially where a bank can rent a portion of the central bank’s balance sheet in advance. This brings a cost to using LOLR which in turn will focus the bank in question’s strategy on avoiding using LOLR with prudent collateral management. But everything has a price, and it will be a challenge for the Australian authorities to pick the right level. Some would argue, of course, that there can be no right level, as you cannot “buck the market,” no matter who you are.