Tuesday, 21 February 2017
Last updated 3 days ago
Jul 8 2014 | 10:48am ET
The surge in derivatives regulation is among the most complex challenges facing the financial services industry today. The United States, the European Union, and half a dozen other nations are in various phases of implementing rules that govern the clearing, reporting, and reconciliation of derivative instruments. Regulatory regimes are similar in character but divergent in the particulars, creating a complex web of obligations that have investors, managers, and administrators working to understand their obligations and how to address them.
Northern Trust’s Joshua Satten recently spoke with FINalternatives to share insights into the challenges presented by new regulation and explore how the industry is responding.
How complex are derivatives regulations and how much do they change from country to country?
Derivatives regulations vary greatly, but we can group them into four buckets: First, a move towards central clearing; second, electronic execution requirements for OTC swaps; third, risk mitigation requirements, mainly through portfolio reconciliation; and fourth, requirements to disclose activity to a trade repository.
One point of note is that the U.S. and Europe have taken very different approaches in terms of how they are bringing standardisation and transparency to the marketplace. The U.S. focused first on centralised clearing, whereas Europe’s initial focus has been more on the trade reporting requirement. This adds to the challenge when managers are subject to both regimes.
A second key difference is that the U.S.’s trade reporting requirement, now live, is centred on major swap participants – the large broker/dealers and banks. They are responsible for reporting in a one-sided model: counterparties are not required to report. Conversely, in Europe we see two-sided reporting where both parties to the trade are expected to report.
One other interesting difference is that that most regimes focus on OTC derivatives – swaps and foreign exchange. However, the European Market Infrastructure Regulation’s (EMIR’s) rules include exchange-traded derivatives, such as listed options and listed futures, which makes the European regime more holistic – and more complex.
The end result is that whilst the types of rules are similar, the implementation of the rules – in terms of timing, format, etc. – are quite diverse. It makes compliance more complicated, and creates a need for managers to have robust legal and operational support.
Is anything being done to create more consistency?
There are some efforts at aligning/rationalising the different regimes. In particular there is an OTC Derivatives Regulators Group (ODRG) comprised of regulators within the G20 which are working on implementing the different rules for their respective nations. A good example of efforts to create consistency is the standardisation of trade identifiers. For the regulations to function properly, each trade must have an identifier. Right now, each regime has its own conventions, but there are efforts at reconciling the regimes so we have a globally recognised standard, kind of like an ISIN, but at the trade level.
We are also seeing a move towards cross-jurisdictional recognition and the idea of equivalency among the various regimes. In other words, regulators are looking for ways to say “if you’re compliant with derivatives regulation in your home country, we’ll consider you compliant here.” For example, Europe recently approved five Asian countries, saying that if they were a member of a compliant European domicile nation that would count for the others.
From a hedge fund manager’s perspective, is it expensive to comply? What kind of burden do these regulations place on your average hedge fund manager?
Complexity and preparation are more significant issues than expense. Firms like Northern Trust and others are devising services to help lessen the operational challenges in cost efficient ways. The greater challenge is preparing our clients for the future: to see what they are doing today and help them understand what their obligations will be as new regulations take effect or the manager expands into new markets.
The other challenge is how regulation impacts strategy: when you are look at hedge funds historically, they have always been known for opportunistic trading – capitalising on investments quickly in response to market behaviour. In the future, they will also need to address legal and operational requirements in any country or counterparty they intend to trade with.
What are the biggest issues in terms of dealing with central clearing? And what are we seeing on the electronic execution side?
With central clearing, what we have is a range of different clearing houses which all offer different products, and most of them are domicile/regime-specific. So the regulators are standardising swap execution, but they are standardising it a little differently in each market. This creates a plethora of operational changes – everything from trade capture to lifecycle event processing to collateral management – and those changes need to be able to adapt to the specifics of each market where the manager is executing/clearing OTC trades.
Have we learned any lessons in the months since EMIR began to take effect?
We have learned many lessons. We have learned that there is an immense amount of data out there. We have learned that we need to work collaboratively to make the system work. This includes regulators working with the industry as well as industry participants working with each other to make sure we are addressing these issues in an effective manner.
Interestingly, what we have seen with the advent of EMIR is that much more remains to be done to achieve full compliance across every participant subject to the rules. The regulators and the industry are working together to achieve this.
Any other lessons?
I think another major lesson is the systemically important players in the market need to be invited to the table and to give their views. An open forum for participants and regulators helps bring challenges and issues to light, so that we can ensure that we are helping them in the most fruitful way possible.
Are these regulations making investors safer? Who is benefiting?
We’re not in a position to comment on whether investors are safer, but when you consider that these regulations are meant to bring transparency and increased liquidity to the market, I think you can say that regulators have more insight into market activity. So, in that sense the rules are creating more transparency into systemic risk. They are also making sure that everyone has equalised responsibility.
Do you have any advice for small hedge fund managers who are going to be facing these regulations? How should they go about educating themselves?
First, you should engage a good law firm to determine your obligations and which regimes you fall under. Second, you want to work with a financial services firm that can offer you broad operational and regulatory compliance capabilities. Choosing the right partners can free you to focus on investment strategy and attracting capital while still meeting your regulatory obligations.
Finally, when managers contemplate their service providers, regulatory capabilities should be part of the assessment criteria. At Northern Trust, we have added regulatory reporting to our existing suite of middle office, fund administration, safekeeping, and analytical services. We strive to be what I affectionately call “the ultimate middle man,” supporting needs across products, markets, and regulatory regimes. We encourage clients and prospects to incorporate regulatory capabilities into their selection criteria and due diligence.