OTC Derivatives Regulatory Reform -

Has a new reality emerged for OTC Derivatives Market?

The emergence of a combination of regulations such as the Dodd-Frank Act, the European Markets Infrastructure
Regulation (EMIR), MiFID 2 and Basel III will significantly impact the way the OTC Derivatives Market operates in the
future.
Notwithstanding some of the finer details of the regulatory provisions, which are yet to be firmly defined, or the fact that there are some key
differences between the US and European regulations, the broad intent behind these regulatory reforms in the Over-The- Counter (OTC)
Derivatives market converges on the following key areas:
Increased transparency by enforcing the electronic execution of OTC derivative contracts on an Exchange or a Swap Execution Facility (SEF)
Reduction of systemic risk in the market, by ensuring the mandatory clearing of standardized contracts by a Central Counterparty (CCP)
Higher visibility and control over the notional exposure in OTC Derivatives through mandatory reporting of all cleared and non-cleared
contracts to a Swap Data Repository (SDR)
Adequate collateralization of risk exposure, by way of initial and variation margins, and the posting of highly liquid securities or cash as
collateral
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We believe that the industry will operate and interact in radically different ways in this post-regulatory world. These regulations will
drastically change the business models of both swap dealers and buy-side clients. Many new entities like the SEFs, CCP and SDRs have been
introduced to the OTC derivatives trade life cycle process. This will necessitate higher efficiency in areas like, near-real-time reporting of
trades, submission of trades for clearing post execution, shorter durations for posting allocations, and operating in an Exchange-like world,
supporting new trading models such as Central Limit Order Book (CLOB) etc.
Swap dealers may be required to manage their CCP exposure limits in the capacity of either a self-clearing member or a Futures Clearing
Merchant (FCM). Buy-side clients will have to manage their exposures and post adequate collateral with an FCM, through whom they may
clear on the CCP. In addition, the need to maintain adequate initial margin for clearing trade on a T+0 basis and to segregate client collateral,
applies a strong emphasis on the efficient management of collateral across bilateral and CCP cleared trades.
Some of todays business processes may become less relevant in the post-regulatory world. For instance, the use of affirmation/confirmation
platforms may decline, particularly for contracts executed on electronic venues. With CCPs providing intermediation, and FCMs providing
credit enhancements for buy-side clients, swap dealers will not have to worry much about the client/counterparty credit checking process for
CCP cleared trades.
All the above changes will create greater operational and system complexity. Applications will have to be reengineered sizably to support
the new business models.
In this article, we look at some of the key areas of impact as well as the technology investments required for Swap dealers and FCM clearing
members to become compliant with these regulations.
The new face of OTC Derivatives trading
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Electronic Execution on SEFs
Clearing on multiple CCPs
Margin and Collateral Management
Trade Reporting and Record Keeping
We foresee a major transformation of the front office functions which will involve significant investments in e-commerce technology. Some
of the key areas of focus will be:
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Setting up connectivity to several SEFs for trading in different asset classes
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Real-time price streaming and response management for different trading models Request for Quotes (RFQ), CLOB orders etc.
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Integrated trader desktop tools for aggregating quotes and order details across different venues in real-time
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End-to-end straight-through processing for CCP cleared trades
Swap dealers and FCMs must reengineer their technology infrastructure considerably, to support CCP clearing on multiple clearing houses,
while bilaterally clearing a portion of the swap contracts that are not clearing-eligible. Mandatory clearing adds complexity to the OTC trade
life cycle process. Select key challenges that must be addressed are:
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The growing importance of real-time pre-trade credit checks, as trade executed on SEFs may otherwise not be accepted for clearing by the
clients FCMs. This requires SEFs to access clearing members to confirm credit lines prior to trade execution
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Trade will be accepted by the clearing house for clearing, based on the collateral posted by clearing members at the time of trade
execution. This necessitates real-time routing of trades to the CCP to confirm clearing acceptance
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The multiple clearing members associated with the trades with allocations add an additional layer of complexity to the trade acceptance
process
CCP clearing increases the focus on capital requirements, and will require significant changes to margin and collateral management
functions, especially cross-product margining, collateral optimization and other arrangements. Major enhancements will be required in the
following areas:
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New initial margin requirements will call for real-time/intra-day calculations and posting of collateral for CCP cleared trades
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Risk management is going to involve higher complexity because it will cater to a environment in which both OTC cleared and non-cleared
derivatives contracts will co-exist
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Information management will be required to keep track of positions and collateral obligations across different CCPs on a near real-time
basis
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Centralization of collateral management will help collateral optimization, which in turn will become an essential tool for the efficient
funding of margin calls
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Collateral management systems will have to factor in the new constraints such as stringent collateral eligibility requirements and
segregation of client collateral
Market participants will see an overall increase in regulatory reporting, with both US and European regulators mandating the reporting of a
number of data points relating to cleared and non-cleared swap transactions into the trade repository or SDR. Swap dealers will have to
develop a strong information and data architecture to:
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Collate data from various sources
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Report on a near real-time basis to the data repositories and regulatory bodies
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Support new reference data requirements such as the emerging data standardization related to Legal Entity Identifier (LEI), Product
Classification, Trade Identifier etc.
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Maintain audit trail details
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Keep records of transactions for the stipulated time period
It is clear that the Dodd-Frank Act and the European regulations are going to fundamentally alter the OTC derivatives market. These
regulations will change the compliance landscape, and as a consequence new business models will emerge.
The impact on derivatives technology will be pervasive. With the new industry infrastructure being created, the existing systems and
operational models will need to be repurposed. Market participants need to take a long-term view that looks beyond the regulatory
compliance. They need to seize this opportunity to transform their derivatives business landscape so that it can yield much more than just
regulatory compliance. There is a real opportunity to make their business model more responsive to customer needs, offer new and better
services, improve operational efficiencies through automation, and to enhance risk management capabilities. These opportunities for
improvement will help market participants to retain their competitiveness in the new business environment.
Getting ready for the new reality
About the Author
Prema Aiyer is the head of the Capital Markets Consulting group within TCS' Global Consulting Practice. She has over 20 years of consulting
experience in the financial services industry. She brings global markets expertise across the capital markets value chain, having successfully
led and executed many consulting engagements for leading capital market customers globally.
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