Operational risk part and parcel of OTC regulatory response, say Fiserv’s Simon Garwood and Andy Mellor
Simon Garwood, Investment Services at Fiserv and Andy Mellor, Risk and Compliance, say that those considering a response to OTC regulations must also address operational risk issues.
Both Dodd Frank and the European Market Infrastructure Regulation (EMIR) are principally aimed at reducing the risk associated with the OTC derivatives market. The global financial crisis highlighted the risk that OTC derivatives pose to the wider economy. To address this, policy makers have implemented changes to the way that OTC derivatives are traded and cleared with stricter controls to improve the transparency and risk associated with the industry. For regulators, the challenge has been to balance this trend, while preserving the benefits that OTC derivatives provide to global capital markets, including improving liquidity and reduced market transaction costs.
Although EMIR came into force on 16 August 2012, the European Commission is yet to finalise the 20 sets of technical standards that are necessary for full implementation of the regulations. Approval of those standards is expected in 2013, and if approved, the part of the regulation associated with operational risk management of non-cleared OTC derivatives has a targeted timeline of mid-2013. Additionally, some European firms may also be required to add functionality to clear certain asset classes as mandated by Dodd Frank if they have clients based in the US.
The introduction of Central Counterparties (CCPs) is a hugely important aspect of Dodd Frank and EMIR. The CCPs will be responsible for clearing trades, collecting and maintaining margin, overseeing delivery and trade settlement, and reporting trade data. The goal of the CCP model is to minimise the impact that would arise if one counterparty failed to make the required payment when it is due. Central clearing mitigates counterparty credit and operational risk by managing a transaction after order matching and before settlement. The CCP would take on that risk as a centralised party, protecting the trading parties from risk associated with late payments.
Whether the CCPs will reduce risk as they are intended to is still an area of debate in the market. Some argue that this model could instead concentrate risk, leading to systemic consequences if a CCP was to become stressed and collapse. CCPs must therefore be effectively regulated and have strict risk management procedures in place to prevent this. Connectivity to multiple CCPs will be required to support the regulations and local jurisdiction. In addition, trading across multiple asset classes requires different CCPs for each, introducing further complexity.
A consequence of these regulations is the additional burden it will place on operations departments of financial institutions that trade OTC derivatives. Both Dodd Frank and EMIR will require increased portfolio reconciliation frequency. Additionally, CCPs will effectively become a new party in the trading process and the flows of information to and from them will need to be reconciled using the existing operational risk controls. Firms will need to implement these changes, whilst ensuring that existing financial controls and operational reconciliation processes remain as stringent as ever.
CCPs require that collateral is posted for every OTC contract cleared. This will drive an increasing focus on collateral management processes as some trades may require highly liquid collateral like cash to be posted, whereas bonds may suffice for others. Effective reconciliation of posted collateral against requirements will help to ensure this process runs as smoothly as possible.
Firms should consider automation of these complex tasks. Through automated controls, an organisation will be able to implement consistent and repeatable reconciliation processes that will scale up to the increased frequency demanded by regulators. Automation also removes error-prone and costly manual reconciliation processes, enabling staff to shift their focus to activities that add value.
The lack of clarity around these regulations is problematic for both financial institutions and technology providers. Despite that there are no concrete dates for implementation of the CCP components of EMIR and Dodd-Frank, firms should be looking to their technology providers to prepare their systems. As a result, platform providers are in a situation where they have to develop functionality that can account for all possible outcomes.
It is clear that firms will need to have strict financial controls in place to manage the implementation of these regulations. Financial institutions must take a holistic view of their trading infrastructure in order to capitalise on the changes mandated by these regulations. An automated back-office can not only overcome cost burdens, but also optimise process efficiency and risk management.
(Andy Mellor, Risk and Compliance, Fiserv)