Clearing the Decks with London Gold Forwards

This article is written by Mike Greenacre at Autilla and discusses the multi-faceted factors influencing a
decision to centrally clear LGF1 trades. Here we outline approaches for those firms considering the
various trading and clearing alternatives2 now becoming available in the market. We review the
implications of the regulatory reforms, and present a case for moving the trading process into a CCP
model supported by an electronic execution facility. While the regulatory rules to clear physical
commodity forwards has not been universally mandated, many firms, financial and non-financial traders
are having to consider how they manage trade flows to meet new reporting requirements. It is proposed
here that adopting these facilities will support the overall solution necessary for meeting compliance,
capital efficiencies and streamlining the reporting, clearing and error reconciliation process within the
new regulatory framework.

Introduction
Unprecedented changes are underway throughout the global trading markets. Participants are digesting
new regulations from market authorities and adjusting trading activity to accommodate structural
reforms. Reform without clarity has riddled the process. An unprecedented amount of acrimonious
legislation has unleashed far-reaching regulatory mandates. A vast array of complex rules will either
directly or indirectly affect all users of all OTC markets. Every marketplace will be impacted, each
differently and to varying degrees. Some have greater certainty of final rules, while others, such as
precious metals remain divided and uncertain.
In response, participants are reviewing and even implementing new processes to comply with expected
regulations. When change is required, firms have found it necessary to spend significant time and
resources to come into compliance. Many prefer to first review alternative solutions prior to undergoing
such high expenditures that fundamentally restructure legacy businesses.
At present, physically settled precious metal transactions have fallen between the regulatory cracks. At
the heart of this issue is whether gold forwards are considered commercial contracts, derivatives or
something entirely. This distinction determines how a firms trades are captured under the regulations.

LGFs is the colloquial term used here to encapsulate spot and forward transactions in gold and silver that settle
physically into good London delivery basis the LBMA definitions.
2

This article considers regulatory reform issues and their impact on the specific market case for clearing physically
delivered precious metal forwards (LGFs). While we provide this note to users, it does remain the responsibility of
the individual institution to solicit independent legal and compliance advice in determining how to manage their
business within the dictates and guidelines of market reforms.

Clearing the Decks with London Gold Forwards

Pending regulatory clarification, we encourage firms to consider the impact imposed under various
alternatives rulings and determine how best to manage their book in the run up to regulatory certainty.
Without going into the necessary detail of all the rules, the primary impact behind the reform initiatives
reside within four key features that are implicit across all the affected markets:

CCP clearing of trades

Reporting of transactions to Swap Data Repositories

Execution on organized trading venues

Collateral posting

These four factors represent the primary features within the extensive package of regulatory reforms
and will be our focus. But there are multiple secondary and tertiary features embedded within the
regulatory initiatives that also need understanding. The rules are complex and cover greater details than
what we can fully discuss here. The Dodd-Frank Act extents to 849 pages with an additional 9,000 pages
of regulations and its only two-thirds complete with room to expand.

Futurization of OTC Metal Markets

Derivative market reform has become one of the key elements of the post 2008 financial crisis. Market
authorities have called for unprecedented action that has led to sweeping changes across global
markets. These reforms have extended into markets, participants and instruments that had no direct
relationship with the financial crisis. Reform is impacting not only the financial institutions but all
nonfinancial companies (NFC) involved in managing market risk. Now, after three years of extensive
proposals, the rules are coming to completion and we are seeing greater clarity in how markets will be
formulated going forward.

The G20 issued its communiqu in 2009 that all standardized OTC derivatives should be
traded on exchanges or electronic platforms, where appropriate, and cleared through central
counterparties by end-2012. OTC derivatives should be reported to trade repositories. Noncentrally cleared contracts should be subject to higher capital requirements.
The consequences of this simple statement by the G20 have been enormous. OTC markets were
established as global, nearly borderless markets governed by flexible legal and commercial terms. Now

Clearing the Decks with London Gold Forwards

these reforms are being driven by legislation being taken forward by multiple national market
authorities.3 Separate and conflicting national interests have added further complications to reforming
markets, and while all regulators have the common objective of the G20 statement; distinct rules and
laws will increase market fragmentation, complexity and, of course add incremental costs to all. Traders
are responding in different ways and ultimately these actions will impact how markets functions,
especially with regards to price discovery, collateral posting, risk management and trade reporting.
What is unknown is how a particular markets liquidity will eventually be impacted by the reforms.
Further bad news; it has been seen within the energy markets that reaction to regulatory reform has
already altered participants interaction with certain instruments. A shift away from OTC swaps and into
futures has taken place by a substantial number of participants who were previously using OTC markets
to manage risk. The rationale here was based on a cost benefit analysis between similar products that
favored futures contracts in light of new regulations. Many NFC traders did not want to incur the higher
costs and increased regulatory reporting requirements necessary to continue swaps trading. Change
happened quickly. In addition, the ongoing regulatory uncertainty prevailing within the OTC swap
market was another factor to shift risk into futures contracts.

These types of risk management discussions will become commonplace across markets as rules remain
vague and indiscernible. One might say that increasing the burden on OTC trading is a visible objective
of the market authorities. This encourages more activity to migrate to listed futures exchanges
andcould force many more participants into futures and completely leave the OTC market. Some OTC
markets will become undistinguishable from where they were prior in terms of liquidity and
participation.

The term, futurization of the swap market is now widely debated and used as a preferred market for
many commodities. Will this type of futurization have the same impact on the LGF market and what are
the key factors that should be considered? One point is certain, participants are opting for clarity,
certainty and efficiency within a known set of market-based parameters.

While all G20 nations and other countries will be impacted by these reforms, market authorities in the EU and US
are leading the way in crafting regulations. These agencies include the national and regional regulatory bodies of
IOSCO, FCA, ESMA, CFTC and SEC.

Clearing the Decks with London Gold Forwards

Summary of the Impact of Regulatory Reform on Commodity Trading

In broad terms, the regulatory reforms being introduced within the commodity markets mean that all
traders will operate under a far tighter framework of compliance than ever before. These rules will
determine how prices are formulated. Market authorities tend to favor, a one size fits all approach
and are attempting to bring commodity trading closer to how equity markets are regulated. In addition,
market authorities have gained enhanced powers to impose fines and penalties when firms and
individuals fall outside these boundaries. Hence, all participants are increasing their awareness of these
regulations and adapting new trading practices to ensure compliance.
Practices impacted by regulatory reform can be broadly established into four main categories:
1. Regulatory Encroachment into Markets
Demarcation of the lines of regulatory oversight has been fundamentally redrawn. Previous regimes had
acknowledged and separated rules between OTC markets, physical contracts and exchange based
instruments. Proposed reforms are seeking to encapsulate commodity trading under a single regulatory
umbrella; hence encouraging a single market for all participants and instruments, but one with
exceptionally more complicated rules. This adds complexity and in the near term creates more
ambiguity regarding reform.
Regulatory treatment of the LGF traded contract is complex since it does not comply with the explicit
definition of an OTC derivative, hence it can be interpreted as a physical commodity forward or a swap
instrument. In addition, financial firms are the most active participants trading the LGF instruments and
these companies come under the new derivative regulations. This uncertainty is further complicated by
having nonconforming rules across the major trading jurisdictions which fail to address the uniqueness
of precious metals. All this issues contribute to the ongoing uncertainty on how to treat LGF instruments
in the new regulatory environment.
Also, market authorities have generally segmented commodity instruments into separate categories and
view spot, forward and option contracts as distinctly different types from one another, therefore
creating further regulatory reporting complexity within these markets.
2. Impact on Market Liquidity

Clearing the Decks with London Gold Forwards

It is rightly said that the proposed regulatory reforms have not addressed the economic and commercial
concerns of market participants. In the post financial crisis period, concerns from the Banks were not
high on the regulators concern list. At risk is market formation if fragmentation occurs. The finer details
of regulatory rules will eventually determine the efficiency of these markets. Hopefully, to help avoid
the negative consequences of a long drawn out regulatory process, some firms would be inclined to
proactively engage in setting market standards to help shepherd the process along for establishing a wellrun marketplace.
3. A Clearing Obligation for OTC Derivatives
This obligation is at the core of the regulatory reform, especially when the trade involves two financial
institutions. EU and U.S. rules are complementary in requiring all eligible derivative contracts between
certain counterparties to be cleared through a CCP. A register of eligible derivative contracts will
eventually be made available on the European Securities and Markets Authority's (ESMAs) website. The
Commodity Futures Trading Commission (CFTC) has initiated a rule labeled, Make a Swap Available to
Trade (MATT) under Section 2(h)(8) of the Commodity Exchange Act (CEA) which gives a registered
Swap Execution facility (SEF) the ability to determine which instruments are mandated for clearing. Once
an instrument is deemed MATT, then all further transactions are subject to clearing. It remains
uncertain how certain physically settled commodity contracts traded between financial firms will be
handled.

While futures must be publicly reported, swaps are now being subject to fairly onerous reporting rules
that resemble a ticker tape, according to the CFTC. How much different this process ultimately will be
from futures reporting is unclear, but it initially appears that swaps will be subject to a different and
possibly even more stringent reporting regime. Also, regarding swap block trades, there is a delay
allowed in reporting time, but non-blocked swaps must be reported as soon as practical.
4. Capital Requirements for Un-cleared and Cleared Derivatives
Together with the implementation of the clearing obligation, commodity contracts on the books of
banks and outside the scope of clearing will also be subject to mandatory margining and collateral
posting. In addition to these mandates, banks holding commodity contracts will incur increased Basle III
capital adequacy measures now being formulated by the BIS. Individual firms will need to assess how
clearing LGFs will impact the accounting treatment under their own cost benefit framework to
determine where to maintain their trade positions.

Clearing the Decks with London Gold Forwards

With respect to margin, a market participant is required to post significantly more margin to enter into a
swap transaction on a SEF as compared to an economically similar (if not identical) future on a DCM.
5.

Increased Transparency for all Derivative Contracts

Both the EU and U.S. have market transparency as a primary reform objective. This obligation requires
all derivative contracts entered into by financial firms to be reported in a trade repository and be
subjected to pre and post trade transparency. Reporting practices between cleared and un-cleared
markets will become less distinct as many firms implement similar enterprise-wide procedures across
trading markets. Commonality of operational procedures will encourage the LGF market to adopt
practices mandated within the regulatory reform measures of the derivative market.
Lastly, there is an anti-competition issue to consider. For the most part, futures exchanges have
theirown captive clearing houses. Thus, clearing is part of a vertical model that has made futures
exchanges valuable utilities (oligopolies). Open interest (OI) of a specified instrument resides at a
single clearinghouse, which creates a fundamental different to how cash equities can be traded. OI is
protected from commingling by rules of the clearinghouse. A captive clearinghouse of a futures
exchange can decide to do business (or not) with whomever it pleases. While its not uncommon for a
clearinghouse to agree to clear another futures exchanges non-competitive product, the clearinghouse
is not required to do so. The open interest of the other exchanges contracts is kept in a separate pool
within the clearinghouse. It would be expected that clearinghouses will follow these same procedures
for when they clear swaps and other non futures products.

In the newly developed SEF and MTF world where multiple trading platforms will transact on identical
instruments, it has been mandated that clearing houses must accept for clearing other competitors
swap products, as long as it passes certain criteria as established by the risk committee of the clearing
house, etc. So, theoretically, LCH could have a SEF/MTF that goes to CME clearing and ask that one of its
swap contracts be cleared at CME and CME cannot decline (absent a legitimate reason and not
wanting to do business with LCH is not legitimate). What is the effect of this factor, then? While the
rules mandate that a clearing house cannot deny a SEF/MTF access to clearing, the practical reality is
that multiple SEFs/MTFs will end up clearing identical instruments on different clearing facilities.

Clearing the Decks with London Gold Forwards

Dealing with Regulatory Uncertainty

Evolving regulatory reform will continue to create uncertainty in coming months and even years. This
will impact pricing and liquidity of the LGF market. Central to this issue are rules that might classify
precious metal forwards as swap instruments which would mandate them for electronic trading and
submission to CCP facilities. Instruments that are mandated for clearing will no longer be available to
trade as bilateral interbank products, hence becoming subject to wider risk management practices
defined by market authorities. If and when instruments are classified as swaps, additional rules would
be pervasive and extend into the granular details on how Banks manage price formation and liquidity
risk. These rules would have a transformational impact on the LBMA forward metal market which
currently trades within the UK as wholesale products under the NIPS code overseen by the Bank of
England4.
Therefore, the associated risks that these rules could bring to the market are significant enough for all
participants to take precautionary steps in this product. Across all OTC products, the Banks are
reforming trading practices. Regardless of whether LGF contracts are classified as swaps, its apparent
that traditional bilateral trading practices are falling out of favor with all the global market authorities5.
This further elevates the risk in OTC markets and for those institutions who continue bilateral trading.
The authorities are increasing investigations on how wholesale markets operate, with particular
attention on commodity markets. This can be seen with recent and ongoing probes into the benchmark
setting practices within the power, gas and crude oil markets. These can result in very damaging
outcomes, as seen by the LIBOR price fixing scandal.
Ongoing events have (or should) heighten participants concern about the potential threat that
regulatory reform can bring. The downside risks of noncompliance are significant. Not only with the
change in market formation that authorities can impose, but with financial costs related to potential
fines and with reputational damage that comes with a loss of business revenue if a firms market
practices are determined to be abusive or anti-competitive. Risk of regulatory reform is that when
market authorities investigate markets and sense improprieties, they impose new practices on the
constituents. These new rules rarely come with commercial benefits to the more active participants.
Typically, the active and large volume market participants are most impacted by reform measures.
4 www.bankofengland.co.uk. The Non-Investment Product Code for Principals in the Wholesale Market.
5

Markets in Financial Instruments Directive (MiFID), Annex 1, Section C, Financial Instruments

Clearing the Decks with London Gold Forwards

This creates a difficult scenario for the LGF market to operate. The market has not received clarity
regarding regulatory reform, therefore participants will need to determine for themselves as to the
appropriate level of measures to implement. The risk of market fragmentation is high if participants
determine to implement competing practices.

EU and US Swap Regulation Reform Comparison

Of critical concern are the EU and the US legislation which aims to fulfill the G20 commitments. The
impact comes from two separate sets of rule makings that should be unified, but remain apart causing
further complications. Title VII of the Dodd-Frank Act in the U.S., and the E.U.s pending EMIR/MiFiD II
proposals are the primary sources. These Acts are not for the faint-hearted, both entail thousands of
pages of rules that stipulate how participants and markets are to act in the new paradigm. In addition,
market authorities have gained new and robust regulatory powers to impose fines and penalties when
rules are not followed. Most participants no longer debate what the intent of these byzantine rules was
meant to be, but instead now seek to adjust business practices to comply with the substantial reforms
that these rules bring.
There is a significant commonality of approaches between EMIR and the Dodd-Frank Act (DFA) in
relation to the regulation of markets, but there are also some significant differences. We summarize the
way in which the two regimes treat different categories of counterparty and highlight certain other
major differences between EMIR and the DFA in relation to OTC derivatives regulation.
However, both EMIR and the DFA require the adoption of extensive implementing rules and technical
standards before they can become fully effective and these will significantly affect how the two regimes
operate. While the US regulators have now adopted many of the rules required, a number of key points
are not yet settled and the EU consultation process on implementing measures under EMIR is still in
progress.
The DFA addresses issues relating to the execution of OTC derivative contracts on electronic trading
platforms, post-trade transparency and position limits for commodity derivatives. The EU is addressing
these same issues (and others relating to trading and transparency) in the proposals to replace the
existing Markets in Financial Instruments Directive (MiFID) with a restated Directive (MiFID 2) and a
companion EU Regulation (MiFIR). This legislation is only likely to be adopted by the end of 2013.

Clearing the Decks with London Gold Forwards

The EU clearing regime is potentially less burdensome for end-users. In the US, the clearing obligation
falls on everyone who trades an eligible contract, with a narrow exemption when non-financial entities
enter into certain hedging transactions. In the EU, the clearing obligation only applies to transactions
between financial counterparties, non-financial counterparties whose positions (excluding certain
hedges) exceed a specified clearing threshold and certain non-EU entities.
Both the EU and U.S. regimes include a broad requirement on counterparties to report all derivatives
transactions to trade repositories and to keep records of transactions. Both the EU and U.S. regimes
envisage that there will be mandatory margin rules for uncleared derivatives transactions; but both EU
and US regulators have paused progress on these rules pending the outcome of the BCBS-IOSCO
consultation.
While both regimes envisage registration and conduct of business rules for dealers (the EU already had
rules under MiFID), the U.S. regime also extends registration, business conduct, margin and other risk
mitigation rules and capital requirements to "major swap participants" as well. EMIR applies some
obligations even more broadly: some risk mitigation rules (e.g. on confirmations, reconciliation,
compression and dispute resolution) apply to all financial and non-financial counterparties and
obligations to carry out daily valuations and exchange collateral apply to all financial counterparties and
non-financial counterparties over the clearing threshold.
Both regimes seek to allow cross-border clearing by allowing the recognition/exemption of nondomestic CCPs. They are less flexible in relation to cross-border provision of trade repository services,
with the US requiring compliance with full US requirements and the EU making recognition of non-EU
repositories conditional on conclusion of a treaty.
To attempt and simplify the overall regulatory framework, we include below a diagram showing the
potential trade flow of a LGF transaction as it progresses through the regulatory maze.

Clearing the Decks with London Gold Forwards

10

Trade Flow Process for London Gold Forwards

Contract

counterparts

Market Authority

UK
BOE
NIPS

EU ESMA
EMIR
MiFiDII

US CFTC
DFA

Depository

Exceptions

Arguments in favor of trading LGF contracts on organized trading venues

To clear or not to clear has been a topic within the LBMA trading community for several years. At its
start, the desire for clearing was focused on mitigating forward credit exposure during the 2008 financial
crisis. The crisis had severely impacted the interbank bullion lending arrangements. At this same time,
anomalies with LIBOR further disrupted participants ability to apply this benchmark for setting accurate
precious metal forward prices. Today the immediate urgency for credit risk mitigation has receded, but
external pressure from regulatory authorities to amend and change market practices impacting
interbank trading persist. Participants trading LGF contracts now need to address these market practices
and determine how best to accommodate regulatory reform.
This push for change is not specific or targeted at precious metals, but captures the entire interbank
derivative markets. Extensive reform measures have ensnarled LGF contracts. Most difficult is the
abstruseness regarding the scope and coverage of conflicting national regulations, which create the
uncertainty over the impact on LGF instruments.

Clearing the Decks with London Gold Forwards

11

To place this in context, precious metal forwards are not typically categorized as OTC swaps since they
deal with a physical delivery at maturity6. But due to the reflexive response by market authorities to
quickly legislate and write rules, these contracts are being captured within the larger umbrella of
regulatory reform. One solution is to jump fully into a regulated market contract environment (as a
futures contract or RIE classification in UK) such as that explained earlier on how the energy market
opted to deal with this matter, but we believe that other more viable options are still available for the
LGF market. We propose that LGF transactions remain swaps instruments and voluntarily trade within
the new regulatory parameters as cleared contracts.

Derivative regulatory reform is highly concentrated on the interbank market. Final and
proposed rules intend to capture all aspects of this activity. This is where a considerable
amount of the LBMA trading, liquidity and pricing occurs; it is only sensible to expect that it
will come under greater scrutiny by market authorities.

Finding the Optimal Solution

While clarity of final reforms remains evasive, the direction of change is known. Today, there are several
core issues that the LGF market can fold into its daily trading practices. Of these practices, the two most
critical involve trading on and organized trading venue and to submit LGF contracts to CCP facilities.
Both these practices are now available to banks.
The overriding objective is to bring interbank trading practices into alignment with the functionality now
being implemented for swaps. We think that full interoperability between futures, swaps and forwards
is not achievable. Not only are the instruments different, but also the participants are not the same.
These are different instruments that cant be governed by identical rules or market structures. They
have separate contract specifications and unique trading practices that require different market
structures to support efficient market formation.

CFTC interpretation of a commercial commodity contract. In sum, the CFTC is interpreting the term commercial in the
context of the Brent Interpretation in the same way it has done since 1990: related to the business of a producer, processor,
fabricator, refiner or merchandiser. While a market participant need not be solely engaged in commercial activity to be a
commercial market participant within the meaning of the Brent Interpretation under this interpretation, the business activity
in which it makes or takes delivery must be commercial activity for it to be a commercial market participant. A hedge funds
investment activity is not commercial activity within the CFTCs longstanding view of the Brent Interpretation. Statutory
Interpretation Concerning Forward Transactions, 55 FR 39188 (Sep. 25, 1990) (Brent Interpretation)

Clearing the Decks with London Gold Forwards

12

Therefore, for participants trading LGF contracts, only certain core practices can be applied that
correspond with the more far reaching regulatory reform practices being introduced to OTC swap
markets. These can be classified into several categories which include:

Transparent price discovery on an organized trading venue (OTV)

Mitigation of bilateral credit risk by routing trades to CCP facilities

Reporting of price information through 3rd parties

CCP facilities have now been established for LGF contracts by the major clearinghouses (CME and LCH) for
several years and would fulfill the clearing mandate outlined by the EU and US regulatory

authorities,

yet contract specifications remain applicable for the LGF contract. For specific clearing terms and
structures, please see the relevant CCP websites for details.
The second aspect of these core practices involved price discovery and trade matching via OTV
platforms. These services have been and continue to be provided by the Interdealer Brokers (IDB) to
source liquidity and discover prices. Reform has meant that many of the traditional ad-hoc voice
brokering practices used by IDBs will now be subject to stricter regulations, of which the most critical
one is the use and registration of electronic execution platforms. Within the US market, the CFTC has
mandated that swaps are traded on Swap Execution Facilities (SEFs) which adhere to rigid market
practices involving the number of participants, price reporting and trade disclosure rules. While within
the EU, ESMA has proposed a slighter wider selection of trading venues that include MTFs and OTFs
(Multilateral Trading and Organized Trading Facilities).
In summary, each of these trading platforms offers alternatives for the LGF market. MTFs and SEFs are
mandated responses aimed at OTC swaps and the regulatory requirements to bring swaps into
compliance. OTFs are less product specific marketplaces and have been established to manage trading
of market instruments that are not explicitly regulated as OTC swaps7.
Some firms are now using these platforms, without taking a decision to turn LGF contracts into swaps or
acknowledging any formal regulatory rule interpretation. For the LGF market to maintain pricing
efficiency and liquidity, it will require more participants to adopt CCP clearing and routing trades via
OTVs. This type of self-reform is a pro-active approach to avoiding potential further investigation and
lower the probability of harsher regulatory reforms being forced upon them.
7

The Council of European Union, EMIR 7743/2/13REV 2

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The following check-list provides firms with an itinerary of actions steps leading up to clearing OTC
swaps. These issues are organized in four sections - (i) pre-clear review, (ii) operational, (iii) funding and
(iv) counterpart risk assessment.

Pre-clearing

Operational

Funding

Counterparty
Risk

Impact
Review regulatory
status

Action
Identify applicable rules that govern product and your trading activity
Determine what additional processes and procedures are needed to conform with regulatory rules
Adjust or implement trading and processing practices when deemed necessary

Review accounting
treatment and bank
capital requirements

Consider the accounting treatment of forward positions when adding a clearing component
Consider what, if any changes will impact the level of banks capital adequacy under BIS guidelines
Consult with internal and external audit, compliance and legal advisors

Data Management

Transform trade data into primary economic terms for mapping of raw statistics for depositories
Obtain end of day settlement prices from reliable sources

Connect to OTV
(SEF,MTF,OTF)

Select CCP facility

Build a technical connection to OTV platforms (SEFs, MTFs, OTFs), or enter into a broker
relationship
Register within the appropriate market category, completing the legal documentation
Review the operational model and process for execution
Select clearing venue; select a single or use multiple CCP
Remember, trades can still be executed on a bilateral basis as well (block trade size)
Execution of documentation and collateral terms for cleared OTCs with selective clearing firm(s)

Report trades to
Swap Data
Repositories (SDR)

Connect directly to a SDR directly or indirectly via OTV, depending on regulatory regimes
Define the internal distribution of data to relevant departments within your firm
Adapt back office, accounting and collateral infrastructure and organization

End-of-Day product
valuation

Reconcile end of day CCP prices, using internal valuation process and independent sources
Use pricing at the portfolio level to validate P/L and variation margin calculation at clearing firm

Collateral
management set-up

Review the CCPs and clearing firms terms for posting collateral
Ensure firms funding facilities are capable of meeting reporting qualifications

Reporting convention
& market disclosure

Identify trade data reporting formats required by CCPs and SDRs

Enquire with CCP and SDR as to level of public release of trade data

Selection of clearing
firm and CCP

Check quality and operational expertise of relationship

Negotiate fees and cost structure with clearing firm(s)
Comprehend CCP risk policy for margining (intraday margining and credit limits)

Clearer selection,
collateral
optimization and
transformation

Select more than one clearing firms to allow efficient migration of portfolio to another firm in
event of credit downgrade or default
Seek clearing firms who can work with custodians and help manage/transform collateral
Work with a collateral agent to achieve maximum collateral optimization

Collateral protection

Define the best collateral segregation structures that are allowed within the CCP
Understand the CCPs risk waterfall in event of default

Counterparty risk
measurement

Apply risk processes to firms entire portfolio to determine how bifurcation between cleared and
non-cleared trades impact risk and funding
Determine any margin offsets available within CCP that can be applied to LGF trades

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How Technology can ease the Burden of Implementing New Market Regulations
Complying with the principle pieces of legislation and subsequent rule making requires all firms involved
in exchange-traded and over-the-counter derivatives to be able to capture the primary economic terms
(PET) associated with their trades and report the raw statistics to trade repositories for the purpose of
ensuring public transparency and accountability. Mapping of this data is a sizeable task due to the
commonality and granularity standards needed by the repositories to maintain quality and accuracy
across such diverse markets. To fulfill these objectives, the task will require new standards of trade data
management.

How firms will comply with these requirements is now a pressing matter and involves:

Real time reporting of trade details to swap data repositories.

Monitor individual and group portfolios against the clearing threshold, with the demand to clear
swap contracts if the threshold is exceeded.

Manage and report gross notional valuations of swap positions against market prices.

Mitigate risks through timely confirmations and trade reconciliation.

Implications
Complying with this legislation will be complex, burdensome and pervasive. Nearly all firms will need to
expand their data operations to encompass the new reporting structure, regardless of how complete
their legacy management has been.

First, all derivative contracts must be reported to a qualified trade repository (SDR), whether they are
cleared or uncleared. This means that daily reporting procedures must be in place to ensure proper
notification on all contracts in a timely and efficient manner. Most standardized derivative contracts
executed between financial firms will be required to be cleared through CCPs.

In the case of non-financial counterparties, only companies that exceed a clearing threshold will be
required to have their contracts centrally cleared. This will result in each NFC having to monitor and
report its own notional level of derivative exposure to the repositories, especially if a NFC seeks to
remain below the clearing threshold and outside further regulations.

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Second, this reporting division necessarily means that non-financial counterparties dealing in derivative
contracts must employ some measure of active mapping of their traded position against this threshold
to preserve the clearing exemptions and avoid the potential burden of the clearing requirement.
Collateral calculations will also be an issue since cleared and uncleared swaps of identical risk will have
different margin requirements.

Risk mitigation on any cleared or uncleared swap contract requires all counterparties to post collateral
and take and pay margins, while Banks will also have to manage capital adequacy levels under BIS
standards. NFC parties will have to set up facilities within their treasury operations to handle this
process. Access to highly liquid collateral, such as cash, gold or government bonds will be necessary. As a
result, traders will have to forecast daily funding needs and adapt a collateral management strategy to
match their portfolio trade volume.

How Reforms Affect the Marketplace

The consequence of these reforms will fundamentally change the way companies engage in the market
and report trading activity. Three major considerations are on the table for entities affected by the
legislation.

1. How will you handle the required transaction reporting?

There may be no simple answer to this question. Mandated activity must be reported to trading
repositories on a regular basis, with records kept for regulatory access on request. With EMIR, the
legislation affects all derivative contracts, including those in most physical commodities (final rules
remain to be formulated). The CFTC has carved out exceptions for companies commercially involved in
certain commodity transactions. In both these jurisdictions, financial trading firms, especially Banks are
less likely to escape the reporting requirements.

The complexity of the recordkeeping, the need to store data securely and the speed and accuracy with
which the data must be submitted suggests enhanced electronic reporting as the only viable solution.
Affected companies should begin implementing effective systems capable of:

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Identifying how to report different transactions to particular repositories, along with the raw trade
statistics found in the PET data.

Connecting securely to the appropriate trade repositories, either directly or through 3rd party
services.

Creating and transmitting the required files on a daily basis.

Non-registration of counterparts and incomplete data transmission could cause a severe impediment to
doing business for firms not equipped to handle the requirements within appropriate deadlines.

2. How will you manage trades under the new CCP clearing restrictions?
The requirements state that standard derivative contracts must be centrally cleared. It is expected that
market authorities will soon begin to list out which instruments fall into the category of standard
derivative contracts. Furthermore, non-cleared derivatives, if counterpart and activity is large enough,
will require reporting to repositories as well as additional capital held for collateral posting. Assessing
which contracts are subject to the clearing mandate adds to the complexity of the operational
management of derivative contracts, not to mention concerns over any funding sources necessary to
post or receive collateral. Considering that all standard and sufficiently liquid derivatives must be traded
on an exchange or electronic trading platform, it is prudent not to delay this level of connectivity.
Systems should be equipped to:

Monitor and manage collateral requirements

Assess your daily funding needs across different CCPs and uncleared positions

Manage derivative positions in relation to trade, pricing, valuation and collateral thresholds.

The complexity of these requirements may suggest that a single platform collecting transactions and
data across multiple sites with an automated solution is the best means of organizing compliance and
reconciling trade data.

3. How will you effectively reconcile your trades with the approved authorities?
Given that all market participants must now be registered with national regulatory authorities, the
question of connectivity, security and timeliness will necessarily shape your process and technology
decisions. Most market authorities require confirmation of all contracts reported within one business

Clearing the Decks with London Gold Forwards

17

day, with reconciliation performed daily, weekly or quarterly depending on the level of transactional
activity of each counterpart. These requirements will put additional strain on your data systems. In
response, many firms have to construct a reconciliation system that allows:

Integrate trade, post-trade and collateral engines with appropriate trade repositories

Provide internal reporting of how trade formation was reached for insider information compliance

Resolve trade disputes in a timely manner.

The fact is these additional regulatory reporting requirements will add to an already complex web of
data management issues facing many firms. The added risks, of course, are the out of compliance
penalties and fines which the market authorities can implement when firms fail to follow regulations.
With many of the reforms now law or coming into effect by 2014, the time to investigate and determine
a workable solution is now.

In Summary, Firms will see Benefits when Putting Trades in Clearinghouses

As the clock nears midnight on imposing new regulations governing execution, reporting, clearing,
tracking and managing commodity derivatives, firms are implementing new technology solutions to
handle these tasks. A fundamental and imposing requirement is the reporting element of all cleared and
uncleared trades to repositories.
Presently, the LGF market has choices as to where it transacts. It is not suggested here or encouraged to
classify LGF contracts as OTC swaps that would have their activity mandated under proposed swap
regulations. However, our view is that the regulatory reforms are far too evasive and overbearing to
ignore and that the LGF market would benefit its participants to comply with the spirit of the new
regulatory reform rather than risk becoming subjected to the full weight of the directives.
Overall, banks, financial firms and NFCs are being subjected to greater regulatory supervision, this will
certainly continue in the near term. Transparent views of real-time positions, trades and transactions
across clearing venues will become commonplace. For many large and sophisticated trading operations
it will be seen as more efficient and less susceptible to running afoul of the complex rules to place all of
their swap activity onto trading platforms and into clearing facilities.