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The Paper Chase - Implications of a tough approach to trade transparency

Published in Automated Trader Magazine Issue 33 Q2 2014

The US had paved the way with the start of swaps market reporting as called for under Dodd-Frank. Yet even with the benefit of that experience, the introduction of OTC derivatives reporting in Europe is proving to be a formidable test for trading firms and for the regulators themselves. Rochelle Toplensky reports.

Ian Salmon

Ian Salmon

"We know clients, big tier one clients, who are analysing their trade transaction flows through their front office right now and there are literally thousands of different types of flow, just within one asset class."

If financial firms once harbored hopes that the US experience of introducing over the counter (OTC) derivatives reporting would ease the burden for reporting in Europe, they probably don't any more. European regulators have shown fierce determination to stick to the timelines and scope of the European Market Infrastructure Regulation (EMIR). And though the OTC reporting objectives and rules are similar, the differences are substantial enough to require completely new systems and processes that have some in the industry scrambling.

"We know clients, big tier one clients, who are analysing their trade transaction flows through their front office right now and there are literally thousands of different types of flow, just within one asset class," said Ian Salmon of ITRS, a provider of application, process and business monitoring. "And they are having to look across those to work out which things need to be reported on behalf of whom, and then resolve where they are going to report them and how. Those challenges aren't to be underestimated."

In an effort to increase transparency and decrease risk, EMIR has required European companies to report their OTC and exchanged-traded derivative transactions from 12 February 2014. Since that date, European companies have been sending a mountain of complex data to the European regulator.

Matthew Coupe, Director Regulation and Market Structure at software provider NICE Actimize, said regulators themselves are going to have to use the same level of technology that trading firms do.

"The regulators have got a massive challenge," Coupe said. "The data they are going to get is going to be massively useful, but they are going to have tons of it. They are going to have a haystack, and require intelligent analytics, and advanced technology that trading houses use for trading to find the needles."

Christian Voigt

Christian Voigt

"It is in everybody's interest that the regulators in the end have the right tools available to allow them to monitor the market in a sensible fashion."

Initial data quality has been poor.

"In the first few weeks after go live, the matching rates were no greater than 30% to 40% and 60% to 70% were orphaned trades that did not have another side to pair to," said Mahesh Muthu, Associate Principal at eClerx, a provider of knowledge and business processing.

Unlike equity markets, the OTC derivative market has very few industry standards and is therefore a complicated market with a range of processes and systems.

"The market is in need of standards," said Michael Sits, head of business consulting for SunGard, a provider of software and IT to global financial services. "There is always a difficulty when moving from a legacy system where firms probably use their own process to the market standard.

Everyone wants to have an easy transition... It will take some years before there is enough clarity on the various standards to really make it to electronification of the OTC market."

Data problems still persist in US reporting, which started in early 2013. Commissioner Scott O'Malia of the US Commodity Futures Trading Commission (CFTC)
said in March, "The (reported swap transaction) data is extraordinarily difficult to use and the Commission is not utilising this data effectively, or as it was intended."

Assuming the initial data quality issues are addressed, the reporting of standardised derivatives could become routine. But the more complex derivatives will always be a challenge to report.

"It's great for the vanilla (trades) and people have implemented it... However, when we are trying to put
 the same criteria around some really complex, paper based derivative contract, it's a complete nightmare and people are failing," Coupe said.

The same but different

"What's happening globally is coming from the G20 initiative... although everybody is focusing on the same outcome, there are different approaches and timelines being used," SunGard's Sits said.

Rules for reporting OTC contracts were developed concurrently in the US and Europe, although they came into effect at different times; so while US implementation happened earlier, it did not alter the European rules.

Regulators had the critical task of taking the legislated principles from EMIR and Dodd Frank and developing detailed regulatory technical standards. However, there
is always room for interpretation and EMIR's frequently asked questions have provided further detailed guidance on implementation.

"It is in everybody's interest that the regulators in the end have the right tools available to allow them to monitor
the market in a sensible fashion," said Dr Christian Voigt, Senior Regulatory Adviser at trading technology provider Fidessa. Even in the US, despite the criticism of figures such as O'Malia, Voigt said a good deal of the data collected after more than a year of reporting is new and has never been collected before.

"The question is, is that the right kind of data so that policy makers and legislators can carefully monitor the market and make sensible decisions? I think at the moment it is still too early to judge, because we have to see how the rest of the market will develop."

The differences: must be reported

In the US, the CFTC required one of the counterparties to an OTC swap to report transaction information to an approved trade repository.

Matthew Coupe

Matthew Coupe

"They are going to have a haystack, and require intelligent analytics, and advanced technology that trading houses use for trading to find the needles."

In Europe, the European Securities and Market Authority (ESMA) surprised the industry by requiring
a much broader set of reporting.
 Both counterparties must report transactions to an ESMA-approved trade repository for all OTC and exchange-traded derivatives. Thus, they require two-sided reporting across a much wider range of derivatives.

"They (the companies) were all 
a little bit surprised that the regulators decided to do many things at the same time, sort of a big bang. So that created quite some unpreparedness," Sits said.

"The people now understand that the regulators are serious, so some have started rather late with onboarding towards trade repositories, meaning that the solutions they have chosen are not always well thought-through solutions. Sometimes they are a little bit more technical, just to get something started and then they start thinking about what to do next."

Two-sided reporting has created substantial challenges. First, the trade repository must match the two sides of the trade, requiring coordination between counterparty systems; specifically the two must agree a unique trade identifier.

In theory generating a UTI to match trades is simple, said Tony Sarkis, Director, Account Management EMEA for AxiomSL, a regulatory reporting and risk management solutions provider. "In application you've got an enormous infrastructure here, an enormous market here that doesn't trade like that," Sarkis said.

Mismatched UTIs are a key source of data quality issues in current European data.

More fundamentally, two-sided reporting has meant many corporate counterparties needed to start reporting data, something previously managed by their brokers. Although they can delegate responsibility to brokers, they remain ultimately responsible for reporting and many have been scrambling to develop systems.

"Some people thought that they were able to outsource this to their brokers and banks, but they may have missed the small print, because there it said that you are allowed to delegate this responsibility but the legal responsibility remains with the one owning the trade," Sits said.

Industry experts question the utility of dual-side reporting, which adds complexity with little obvious benefit in the near term. Eventually, two- sided reporting could help regulators identify counterparties who value trades differently, when they start reporting trade values, as required from 12 August 2014 under level two of EMIR. However, in the near term, it simply adds complexity.

The Differences: Regulatory flexibility

Another fundamental difference between the US and Europe is that the CFTC has the ability to issue
 a no-action-order that essentially delays the application of a particular regulation on a particular market segment. However, ESMA has no similar power and must make requests to the European Commission to delay regulation.

ESMA has written two letters requesting delays. The first, written in February 2014, requested a delay in EMIR implementation so that a clear definition of a derivative could be agreed. Though the European Commission agreed with the need for a clear definition, no delay was granted.

Jonathan Faull, Director-General of Internal Market and Services, wrote: "I agree with the important need for clarity and consistency in this regard and can inform you that DG MARKT will urgently assess the options for action to ensure consistent application of the legislation."

The second letter, sent 8 May 2014, requested an eight- to 15-month delay in frontloading clearing requirements until the regulatory technical standards for clearing obligation come into force. No response had been published at the time of writing.

US implementation

The US experience has still failed
 to produce usable data though it covers fewer derivative products and requires only single-side reporting. Commissioner O'Malia has been forthright about data quality issues and the CFTC formed a team to "identify and fix" the data problems. Based on the data team's work, the CFTC recently put out for comment approximately 70 questions addressing several swap data reporting issues.

Mahesh Muthu

Mahesh Muthu

"In the first few weeks after go live, the matching rates were no greater than 30% to 40% and 60% to 70% were orphaned trades that did not have another side to pair to."

Some global banks have been able to leverage some of their US reporting experience in their approach to reporting in Europe. Best practices can be reapplied for techniques to improve data quality and streamline reporting and the knowledge that substantial compliance and IT staff is required to implement.

However, Mutha of eClerx said: "For a bank that's moving from US to UK, potentially there may be some components of core elements that could be reused but, I think it is largely a different exercise."

European implementation

Europe's reporting implementation has faced challenges with some smaller banks, buy-side institutions and corporates caught under-prepared. "There was also a level of wishful thinking, that some people thought this storm of regulatory change would probably calm down over time," Sits said. "People now understand that there will be very little calm around this storm in the near future."

Michael Sits

Michael Sits

"People now understand that there will be very little calm around this storm in the near future."

Europe is still in the early stages of reporting derivatives data. Regulators are in a honeymoon period as they build their capability. "(The) response in Europe has been one where regulators have taken a firm stance on timing. They've made it clear
 that they want these procedures to 
be implemented. But I think they recognise that the industry is not
 quite there yet. It's not quite ready,
 so therefore their attitude to it is one of watch and brief, until such time as they believe that the industry should be prepared, in which case they will begin to get tougher," Salmon of ITRS said.

The regulations are extremely complex and guidelines are likely to evolve as the industry and regulators grapple with the practical realities of implementation.

"With every regulation written, it's never going to be perfect. There will always be loopholes. If anyone says there aren't loopholes they are crazy. And so it needs to have constant improvement and one of the best things is from a European perspective, ESMA has had the ability to write technical standards and update the regulation as they see fit," Coupe of NICE Actimize said.

Key risks

Key risks to the implementation of the trade repository data are data quality issues, extra-territorial conflicts and ESMA resourcing.

Fidessa's Voigt said, "It is very important (for effective regulation) that this is aggregatable and consistent."

Inconsistent processes to generate UTIs and missing legal entity identifiers are creating substantial data quality issues, yielding less than 50% trade matching rate in early data.

Sarkis from AxiomSL said the UTI concept will be brilliant when it will be possible to get the process done at trade inception, when markets are all centrally cleared. "But, in practical terms, it is a pretty significant hurdle."

Tony Sarkis

Tony Sarkis

"In application you've got an enormous infrastructure here, an enormous market here that doesn't trade like that."

Data quality issues can be addressed with the appropriate time and resource. However, actors are dealing with tight budgets and multiple regulatory changes, so if the regulator is too tolerant of errors some observers say there is a risk that improving data quality will not be prioritised, compromising effective market oversight.

Muthu of eClerx suggested tying the trade repository information into 
an operational process to increase motivation to sort the problems out; one example might be using repository data to trigger cash flow settlements.

He said, "Unless the banks have
 some other objective or the regulators actually start scrutinising the information, the question is, when are the banks going to feel the pressure 
to really clean up the information? Because there is a lot of data quality issues."

Discrepancies between rules in different countries could undermine the reporting process. If regulators create duplicate or conflicting requirements, global companies could struggle to comply with all relevant regulation. Footnote 88 in the CFTC regulations is a recent example of
an extra-territorial conflict. The rule required any exchange that has a US person trading on it to register with the US authorities as a swap exchange facility. This extension of US regulatory powers to other nations created confusion, fragmentation, varying prices for the same derivatives in different locations and a drop in liquidity, observers said.

Another risk to effective implementation of reporting: insufficient staff levels at the regulators. ESMA Director Steven Maijoor has called for more resources, particularly related to data issues, and has highlighted the need for reform to its funding system.

Voigt said ESMA funding and staffing were potential issues, but he was confident they will be resolved.

The new reporting requirements
for derivatives represent a work in progress, with much still to be done to ensure they produce useful data. Time is precious for the compliance teams, particularly as a host of additional regulations appear on the horizon; central clearing party requirements, EMIR level 2 valuation reporting and MiFID II legislation are all on the way.

Voigt, however, is optimistic for the industry.

"I view regulation as a two-sided coin. On the one side, regulation
can drive up costs because it makes compliance harder. On the other side, I can see that regulation can create new opportunities. If you consider the impact of MiFID I, we now have increased competition between exchanges with a number of new trading platforms introduced to the European market. These are all new businesses (that) were able to benefit from new regulation."