CROSSINGS. Edition Eleven Fall The Sapient Journal of Trading and Risk Management. CROSSINGS: The Sapient Journal of Trading & Risk Management 1

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1 CROSSINGS The Sapient Journal of Trading and Risk Management Edition Eleven Fall 2014 CROSSINGS: The Sapient Journal of Trading & Risk Management 1

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3 TABLE OF CONTENTS Introduction by Chip Register THE HIGH PRICE OF NON-STANDARD COMMUNICATION: firms reduce costs, errors and risk for OTC cleared derivatives reporting and communications by adopting new clearing connectivity standard by Phil Matricardi and Adam Kott CALCULATING THE CLEARING THRESHOLD: challenges for non-financial counterparties in the european union by Mahima Gupta and Shashin Mishra SINGLE DEALER PLATFORMS: are their days numbered? by Sean O Donnell and Matt Hopgood MULTIPLE PRIME UTILITY: the key to transforming the fund manager/prime broker relationship by Sudhanshu Bahadur, Vishal Bakshi and Valcony Sun THE NOVATION CHALLENGE: how to ensure a successful outcome by Nick Fry and Mark Thompson CROSS-ASSET UNIVERSAL PRODUCT IDENTIFIER: is this the solution the industry is looking for? by Peter Meechan, Jim Bennett and Pauline Tykochinsky MIFID II: harmonization mandates new business models in the OTC space by Paul Gibson, Kimon Mikroulis and Cian Ó Braonáin REMIT: bringing physical commodity trading into the regulatory spotlight by David Wardley and Owen LaFave Pursued by a bear: implications of banks leaving the traded energy markets by Ujjwal Deb, Rashed Haq and Lukasz Hassa CHANGING PARADIGMS IN COMMODITY MARKETS: what are price reporting agencies doing to remain on top of their game? by Leor Jivotovsky and Jeffrey Wang CROSSINGS: The Sapient Journal of Trading & Risk Management 3

4 INTRODUCTION new challenges drive renewed interest in market utilities In the last five years, the financial services and energy industries have been inundated with change mainly due to government levied regulatory reform, the challenges inherent in the proliferation of data, and innovations in industrial, financial and consumer technology. While busily confronting the realities of such disruption, firms within both industries are also recognizing the need to rethink their traditional business models to ensure future success. This transformation requires firms to search for new ways to differentiate their offerings while commoditizing the processes that either fail to offer competitive advantage or require decoupling due to regulatory requirements. As companies undergo such analysis, we re witnessing a renewed interest in industrialization for those activities that do not add to the bottom line especially those deemed nonproprietary, high-cost, high-scale and low-risk. This is especially true as firms consider how to increase efficiencies, reduce costs and, ultimately, improve returns in an environment of shrinking margins and dwindling demand for fee-based services. While embracing the utility model requires competing firms to play nicely together in the same sandbox, the benefits realized by leveraging utilities to manage standard processes promise to be significant. By utilizing technology and automation to create new efficiencies and standardizing access to common intellectual property, company resources both people and dollars can be better allocated to impactful initiatives with the potential to drive innovation and enable business transformation. The key to success lies in active participation and a sound governance model. This issue of CROSSINGS includes articles in which we explore the possibilities of a utility model and discuss the advantages of industry participants joining forces to solve business challenges. For example, Phil Matricardi and Adam Kott discuss how firms and the industry itself could benefit from the creation of a utility to help translate and streamline derivative reporting and communication. Likewise, Peter Meechan, Jim Bennett and Pauline Tykochinsky ponder whether the industry is ready to come together to create universal product identifiers (UPIs) and, if so, what that might look like. 4

5 The road ahead is not an easy one. Market participants that have long competed against each other may find it difficult to work together. But it s not impossible. In fact, I believe it is a sign of the times and a smart step for the industry as a whole. As the capital and commodity market ecosystem continues to face new requirements, all firms must find ways to become more efficient and more effectively focus resources where they matter most. Industry utilities are one way to make that happen. Best Regards, Chip Register Executive Vice President of Sapient Corporation Managing Director of Sapient Global Markets CROSSINGS: The Sapient Journal of Trading & Risk Management 5

6 THE HIGH PRICE OF NON-STANDARD COMMUNICATION: firms reduce costs, errors and risk for OTC cleared derivatives reporting and communications by adopting new clearing connectivity standard Now that some of the dust has settled following the implementation of several regulatory initiatives, such as Dodd-Frank, MiFID II/MiFIR, and European Market Infrastructure Regulation (EMIR), many financial institutions are grappling with how to deal with the impact these initiatives have had on their derivatives business. In this article, Phil Matricardi and Adam Kott discuss why firms are adopting the new ISDA Clearing Connectivity Standard (CCS), introduced two years ago, for derivatives reporting and communication and why an industry utility for data transformation is a necessary next step. Overview New regulatory requirements, combined with the increasing volume of cleared derivative trades, number of new players, and expansion of new offerings from existing players have added more complexity and expense to managing derivatives. As a result, firms those interested in remaining competitive and protecting revenues have begun to critically evaluate their operating models, processes and technology and look for ways to be more efficient and cut unnecessary costs. One area ripe for improvement is derivatives reporting and communication. Particularly as the industry comes to terms with mandatory clearing, the lack of a formal standard for formatting and transmitting margin and position data is a significant hurdle to achieving efficient and cost-effective connectivity between market participants. Currently, data between asset managers, clearing brokers, custodians and service providers is transmitted in a variety of formats. Custodians, for example, routinely receive a wide range of account-related information, such as fees, trade positions, netted positions, terminated trades and collateral from clearing brokers. Due to a lack of formal standards for formatting this type of data, most clearing brokers supply information to their customers in different electronic formats; these formats have been developed over time to suit their own operational needs and based on their own proprietary software or heavily modified commercial software. 6

7 The New Reality of Non-Standard Data Formats Up until new regulations went into effect and firms began to look for ways to decrease costs, use of proprietary data formats was considered a competitive advantage. Clearing brokers are often required to comply with their clients proprietary file formats. If a client wants to work with a new clearing broker, that broker may have to build a new set of reports a process that can be expensive and time consuming to the broker. In fact, brokers have related that their clients negotiate format with them in the same way that they negotiate fees, and that compliance with custom formats is a constant and expensive burden. Pushing back on clients by insisting that they use the International Swaps and Derivatives Association (ISDA) standard set of CCS reports is a key reason why clearing brokers support the initiative. On the other side, such propriety data formats cause custodians to spend considerable time and effort manipulating the data into a consistent format that their systems and operations teams can consume. As the volume of cleared derivatives trading multiplies and custodians are forced to spend more resources reformatting non-standardized data, costs are increasing along with instances of manual errors and, subsequently, operational risk. The reality is that the use of proprietary data formats is a costly and inefficient business practice, and clearly an area of competitive disadvantage. Firms Embrace the Use of a Standard Format for Clearing Reports In 2012, the ISDA Clearing Connectivity Standard (CCS), a standardized connectivity format, was introduced to the clearing broker community for transmitting cleared over-the-counter (OTC) derivative-related information. Specifically, CCS standardizes all of the message elements that should be universally present in margin statements, such as fields, headers and descriptions. The standard currently covers cleared IRS, CDS, and NDF trade, position, margin and collateral data for LCH, CME and ICE products. The CCS format can also be applied to varying timing and/or frequencies for complete or partial feeds based on the needs of the various parties. The format is currently specified as a series of CSV files, and made available as a free, downloadable Excel document from the ISDA website. When the ISDA CCS Steering Committee deems it appropriate, the CCS format will transition from CSV to FpML. In fact, according to the ISDA 2011 operations benchmarking survey, roughly 10% of trade records contain errors across interest rate, credit, equity, currency and commodity derivatives. The survey also attributes 50% of trade capture errors to the front office. 1 These errors range from counterparty name to legal agreement date, and plague all the commonly traded derivatives. Such errors can only be caught and corrected by reconciling positions and trading activity across counterparties, which is a very expensive process if each position at each broker has to be translated manually to match the client s preferred format. CROSSINGS: The Sapient Journal of Trading & Risk Management 7

8 Report Information ACCOUNT SUMMARY POSITION & TRADE DETAILS Figure 1. High-Level Overview of Sections Covered by the Clearing Connectivity Standard DAILY ACTIVITY COLLATERAL CASH SETTLEMENT UPCOMING CASH FLOWS X X X X X X Account Details X X X X X X References X X X Description X X X IRS Description X X CDS Description X X NDF Description X X Collateral Description MTM X X Initial Margin (Clearing House) Initial Margin (Clearing Broker) Variation Margin (Clearing Broker) Product Lifecycle Cash Flows Combined Margin Upcoming Cash Flows Settlement V1.01 Expansion X X X X X X X X X X X X Today, CCS is recognized as the industry standard by ISDA and many of the largest OTC derivatives clearing brokers including Bank of America Merrill Lynch, Barclays, J.P. Morgan, and UBS. In addition to CCS being a significant step towards achieving efficient and cost-effective connectivity between market participants, members of the Futures Commission Merchant (FCM) community are embracing its use to: Reduce errors and risk. By moving to a standard format, firms greatly reduce the need to spend time interpreting and reconciling data from different formats, or having to manually enter data from reports into their own systems, putting the data at risk for human error. Improve communication. Currently, when counterparties, or clearing brokers, service providers and custodian banks call to report or resolve an issue, they spend a considerable amount of time describing the content and defining the data. This process of break identification is streamlined by adhering to CCS. 8

9 Meet client demands. Derivatives customers, notably large asset managers, have already begun approaching their clearing brokers to request compliance with CCS. Reallocate resources. As margin reconciliation becomes standardized and automated, operations staff can be reallocated to more capital-efficient processes. Pass along savings. The automation of margin standardization and reconciliation may allow clearing brokers, custodians and service providers to pass savings on to their clients, who in turn can use this newly freed capital to engage in more swap transactions. Improve client onboarding. End users who wish to receive CCS reports can do so quickly and efficiently, eliminating the need to negotiate numerous custom reports required by their clearing brokers, custodians and service providers. Gain a holistic view of client swap information. By using a standard format, custodians and service providers can see a complete view of their clients swap data across all clearing brokers, including margin balances and requirements, collateral holdings, and upcoming cash flows. Likewise, end users can easily view their information across clearing brokers, custodians and service providers. Furthermore, as more firms adopt CCS, its use will strengthen an industry mandate, creating added pressure for those firms that delay complying with the standard. It is highly likely that, in the future, clearing brokers who do not adopt CCS may have increased costs passed on to their clients from custodians who are no longer willing to absorb the high cost of translating non-standardized data. Market Asking for More CCS Coverage and Automation Today, 26 firms have joined the ISDA CCS Steering Committee to continue defining the standard, and 17 firms are testing or producing one or more standardized CCS reports. Committee members are already asking to expand CCS s scope beyond cleared OTC into listed futures and options to facilitate cross-product margining and netting. CCS currently allows for this at the account level, and discussions are underway to make enhancements to existing reports to include more granular futures and options information. Additionally, members have asked for the creation of a parallel set of standardized reports focused exclusively on futures and options products. With industry-wide adoption of the new standard a future reality, the creation of a market utility that automates the translation and normalization of cleared product data is a clear next step for the industry. Such a utility would remove the burden of having to modify existing systems and reports for firms that do not have (or do not wish to spend) the resources to do so. Additionally, despite regulatory needs and the industry s cry for standardization, some firms may continue to use their proprietary formats. An industry utility would relieve custodians and service providers of the time-consuming and costly task of translating these reports. Non-standard data would be passed through the utility, which would translate and transform it into a CCS report and deliver it to the report recipient. Such a utility would also support data transparency requirements and enable straight-through processing. CROSSINGS: The Sapient Journal of Trading & Risk Management 9

10 Current state of otc communication Clearing House Clearing House Clearing House Clearing House Clearing Broker Clearing Broker Clearing Broker Clearing Broker Custodian/ Service Provider Custodian/ Service Provider Custodian/ Service Provider Custodian/ Service Provider End User End User End User End User future state of otc communication Clearing House Clearing House Clearing House Clearing House Clearing Broker Clearing Broker Clearing Broker Clearing Broker End User End User Industry Utility Data Transformation Reconciliation End User End User Custodian/ Service Provider Custodian/ Service Provider Custodian/ Service Provider Custodian/ Service Provider Figure 2. How a Market Utility Could Streamline Derivatives Reporting and Communication 10

11 CONCLUSION The derivatives market has already undergone major changes in the last few years and more changes are likely to come if they can help firms dramatically reduce costs or increase profits. Identifying areas where efficiencies can be gained and expenses can be cut is now a necessity for market participants that wish to remain competitive and protect revenues. The industry has begun to address the issues of nonstandardized data formats for derivatives reporting and communication with the development of the CCS. With the market-wide need to remove the cost and burden of complying with non-standardized reports and bring speed and efficiency to derivatives reporting and communication, the creation of an industry utility only seems like a matter of time. Resources 1. ISDA, ISDA Operations Benchmarking Survey 2011, research/surveys/operations-benchmarkingsurveys/ (July 2014) THE AUTHORS Phil Matricardi is based in New York and manages the Clearing Connectivity Standard for the communication of cleared OTC derivatives data on behalf of ISDA. Phil brings an in-depth knowledge of the swap market and derivative economics, as well as theory, modeling and computation. pmatricardi@sapient.com Adam Kott Adam Kott is a Senior Associate Business Consultant based in New York. In the past, Adam has provided business analysis and project management skills to help an international broker-dealer become compliant with Dodd-Frank swap data reporting regulations. He is currently helping to manage the industry-recognized Clearing Connectivity Standard initiative and build out Sapient Global Markets solutions offering. akott@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 11

12 CALCULATING THE CLEARING THRESHOLD: challenges for non-financial counterparties in the european union While EMIR mandates clearing and reporting requirements on over-the-counter (OTC) derivatives for Financial Counterparties (FCs), it exempts Non-Financial Counterparties (NFCs) from parts of reporting and clearing requirements only until their positions in proprietary trades remain within a pre-defined clearing threshold (defined for each asset class by ESMA). In order to avoid the infrastructure and process costs for the increased EMIR reporting and risk management responsibilities, every NFC has to closely monitor its vulnerability to breach the mandated clearing threshold. For many, however, this is no small task. In this article, Mahima Gupta and Shashin Mishra review the challenges involved for all participants and the next steps for the industry as well as regulators needed to maintain the integrity of the clearing threshold rule. CALCULATING THE CLEARING THRESHOLD: CHALLENGES FOR THE EU NFCs & REGULATORS In the aftermath of the 2008 global crisis, the G20 summit acknowledged the need for better management and oversight of financial market players across geographies. The European Market Infrastructure Regulation (EMIR) was introduced to monitor and reduce systemic risk in the European Union s (EU) financial ecosystem. While it mandates clearing and reporting requirements on over-the-counter (OTC) derivatives for Financial Counterparties (FCs), it exempts Non-Financial Counterparties (NFCs) from parts of reporting and clearing requirements because they trade in derivatives mainly for hedging purposes in order to mitigate the risks from their core businesses. However, this exemption applies only until the gross nominal notional for their uncleared positions in proprietary trades remains within a pre-defined threshold, or clearing threshold, as defined for each asset class by the European Securities and Markets Authority (ESMA). Once this clearing threshold is breached for any asset class, the NFC is then classified as NFC+. Under this designation, the firm faces increased reporting (transaction, valuation and collateral) and clearing mandates along with risk management procedures (e.g., internal marking-to-market of OTC trades), until it falls back within the threshold for all asset classes. 12

13 ASSET CLASS Credit derivative contracts Equity derivative contracts Interest rate derivative contracts Foreign exchange derivative contracts Commodity derivative contracts and others VALUE OF THE CLEARING THRESHOLDS EUR 1 billion EUR 1 billion EUR 3 billion EUR 3 billion EUR 3 billion Figure 1. Value of the clearing thresholds, in gross notional value, for different asset classes As a result, every NFC has to closely monitor its vulnerability to breach the mandated clearing threshold, in order to avoid the infrastructure and process costs associated with increased EMIR reporting and risk management responsibilities. While the clearing threshold for each asset class appears to be an easy target to benchmark against, the mere calculation of one s own OTC positions can be challenging due to the lack of industry consensus or standards and lack of appropriate guidance from regulators. Key challenges involved in calculating the gross nominal notional are analyzed below. IDENTIFICATION OF A HEDGE TRADE VERSUS A PROPRIETARY TRADE According to ESMA s rules, the clearing threshold must be monitored against the gross notional value of proprietary trades, excluding the hedge transactions from calculations. The idea is to collate and monitor the risk amassed by speculative trading, in addition to that incurred by business as usual (BAU). A hedge trade can be classified as offsetting risk from a particular business trade or a portfolio. Trades by a single legal entity can also be considered eligible hedge trades to mitigate the risk at a group level for all associated entities, termed as a macro hedge. For example, an energy producer may enter hedge trades on a macro or portfolio basis to mitigate the risks associated with fuel requirements, CO2 emission allowances, etc., on behalf of its group s upstream oil and gas business. The hedging may also be done to optimize market conditions, keep the firm active in the derivatives markets, avoid becoming vulnerable to biased pricing and/or contribute to the liquidity of relatively illiquid markets. Thus, when looked at individually, it is difficult to establish the intent of a derivative transaction as risk reducing or a hedge. The criteria to qualify as a hedge transaction, being subjective in most cases, cannot be standardized and configured in trade booking or processing systems so as to mark a trade hedge or proprietary. Sorting through deals manually in order to assess their categorization is cost and effort intensive without the guarantee of accuracy. NFCs can use a value at risk (VaR) method to confirm that the aggregated effect of their derivative portfolio is risk reducing. But, this can amount to placing any loss-making speculative position under the hedge category, given that the notional value of the propriety portfolio has to be calculated as gross. The benefits of remaining an NFC clearly outweigh the costs of upgrading to NFC+ or more, adding to the lure of justifying non-candidate trades to the hedge category. Keeping the regulatory aspect aside, being able to segregate speculative trades from the BAU and hedge trades will help any firm assess and manage their trading risk and operations much more efficiently. Even if implemented at the behest of ESMA, both FCs and NFCs should strive to achieve this as and when the challenges are resolved by the industry and/or by employing one or more of these interim approaches: CROSSINGS: The Sapient Journal of Trading & Risk Management 13

14 Maintaining the hedged positions at a portfolio or macro level. This is much easier than explaining it at a transaction level, and it is more efficient to manage the risk within the hedge positions at a portfolio level. However, this can provide a qualified mask for proprietary trading as the intent is not recorded. Regulators will have a tough time verifying and segregating real hedge trades from the grouped and masked ones. Conversely, it will be difficult for market participants to justify the hedge trades and portfolios, if challenged. Identifying the hedging trades. This should be relatively easy for the firms whose treasury performs the hedging function (in addition to financing activities) for their commercial activity risk. Here, the positions taken by the treasury can comfortably be termed hedging activity and any proprietary position is easily segregated, since it mainly requires a separate mandate or string of sign-offs. Assigning the task of risk management to a single entity within the group. This will help gain hedging efficiency as well as make the identification easier than if hedging was to be done by each individual entity for itself. However, if the hedging and business entities fall out of sync, there could be a situation where the hedged position remains while the initiating proprietary/business position may have already matured, leading to reverse market risk. Segregating hedge trading desks from the proprietary trading desks. This helps to keep a resolute yet independent tab on the two activities. The risk here is similar to the above approach. CALCULATION OF THE NOTIONAL VALUE OF TRANSACTIONS volumes for multi-legged trades such as swaption straddle. Some swap execution facilities (SEFs) are said to be counting both the receiver and payer legs of a swaption straddle and report double the volumes as compared to SEFs who are counting only a single leg in a transaction. It is left to the potential SEF user to determine whether the SEF is double counting or not. Similar issues will be faced by the market participants while calculating the notional values of such trades in their books. Currently, regulators are not offering guidelines on how they will monitor this calculation methodology but, until that is achieved, the implementation can be done to benefit the business or reporting interests of the implementing entity. Similarly, for a strip of options, should firms consider all legs for the notional value calculation or the active and eligible leg at that point in time? In other words, should the notional be calculated as per {notional per fixing} or {notional x number of fixings}? Should the notional be calculated on a commodity physical leg using the market rate for the underlying commodity or the strike rate? These are some questions that risk management professionals have been deliberating without agreeing upon an industry-wide approach. Without a standard approach, market participants will develop custom implementations to suit their profile and needs, which the regulators will find difficult to corroborate or benchmark amongst the reporting entities. Until the time a firm guideline is released by regulators or an industry body such as ISDA, participants have only two alternatives to continue to practice their present notional calculation methodology or to revisit all such contracts and alter their notional calculations to optimize their regulatory profile. There are many structured products already under debate across the industry for their notional value calculation methodology, with no resolution as of yet. A key example is the market split on reporting 14

15 Firms that are revisiting their contracts should consider the following: Revisiting would require extensive analysis to first gauge the benefits that such an alteration exercise may gain. If this does not designate them as an NFC, in the foreseeable future, they may be better off not embarking on this journey. Review of the notional calculations methodology should be viewed in conjunction with the impact on other parameters, such as net PnL or risk calculations on such structures. It would impact both commercial risk and hedge portfolios because the notional value calculation methodology must be the same for each of them. Hence, firms should take a long-term view of the kind of structures to be booked under each category. Firms that continue with their existing practice should consider the following: Participants can assert that they continued with their BAU practice and did not alter their methodology or were not influenced by regulatory needs and earn credibility with regulators. It would also save the company any operational and infrastructure costs that would have been used for an alternative implementation. However, following the approach of continuing as-is may not result in the most optimal regulatory profile. APPLYING THE NETTING RULES While netting is allowed at the counterparty level for Clearing Threshold calculations under EMIR, certain non- EU jurisdictions, such as Qatar, do not acknowledge Credit Support Annex (CSA) and, thus, do not allow netting. In such scenarios, BASEL reporting of credit risk positions against those counterparties will be out of sync with the notional value of positions reporting for EMIR. The application of netting rules can also cause risk management conflicts within the financial entity. If senior management cannot gauge the correct representation to work with, they may need to enhance their risk systems in order to mine and report the same position data but reflect for different regulators to monitor and manage. COUNTING THE INTER-AFFILIATE TRADES The Clearing Threshold calculation requirements include inter-affiliate trades. However, since the threshold is determined on a group level instead of being calculated separately for each legal entity within the group, there are calls from industry standard groups, such as ISDA and SIFMA, to change the requirements. Intra group transactions are not a good indicator of the overall systemic risk and hence should not be used for the group level gross notional calculation. CROSSINGS: The Sapient Journal of Trading & Risk Management 15

16 CLEARED FUTURE CONTRACTS ON NON-EU EXCHANGES ARE CATEGORIZED AS OTC BY ESMA According to ESMA guidelines, any exchange-traded derivatives contract executed on a non-eu exchange that is not recognized as equivalent to a European regulated market is defined as an OTC derivative. This means that such trades would add to the notional value for Clearing Threshold calculations. Since the Clearing Threshold limit for each asset class is already deemed conservative by industry participants, it further increases the potential for breaching the threshold limit. As a consequence, firms trading on non-eu exchanges are at greater risk of crossing the Clearing Threshold and becoming NFC+. They will have to then report these trades as OTC for EMIR along with the valuation and collateral information. Plus, they will have to adhere to the central clearing mandate under EMIR. The resulting influence on the geographic distribution of exchange-traded derivatives (ETD) trading is already making an impact. Firms are moving away from energy ETDs on US exchanges as demonstrated by the reported significant drop (up to 22% in monthly volumes) in CME s energy futures volumes, immediately after ESMA s clarification in August The volumes dropped even further and continued to do so until June In comparison, volumes traded at ICE Futures Europe, where the futures executed do not count towards the NFC+ calculation, have risen over the same period and to almost the same extent as the drop in CME s business. 1 The whole cross-border situation presents a challenge to reporting firms as well as exchanges, not to mention the liquidity impact it would have on certain geographies. Ideally, and as per the G20 commitment, regulators are meant to work together to increase efficiencies, reduce duplication in reporting and improve risk management. While it has not been called out anywhere, the tacit expectation from the participants was to have reporting obligations along with some adjustments to their business mix and mandates. Still, very few would have anticipated a resulting geographic shift in businesses and a consequence of cannibalization of each other s markets. CONCLUSION ESMA guidance on the Clearing Threshold calculation for moving from NFC to NFC+ status is still too complicated and ambiguous. Not only is there a lack of guidance from regulators, industry consensus is also missing. Until there is clear guidance, affected industry participants should come together as a working group to agree upon some guidelines which will help them avoid future implementation costs. Market participants too would need to be agile in adapting to the changing business mandates and market scenarios while striving to maintain an optimal and sustainable long-term regulatory risk profile. And even without EMIR requirements, any financial firm would benefit from being able to differentiate between a proprietary and hedge trade. The issues that are covered in this article not only indicate an impending implementation challenge for the reporting market participants, they also highlight the roadblocks facing regulators as they try to enforce a standardized reporting approach. Unfortunately, existing gaps and ambiguity in implementation specifics can be manipulated by the reporting entities to stay below the reporting and risk management radar which defeats the very purpose of correctly identifying and monitoring systemic risk in the financial markets. 16

17 Resources EFET. (n.d.). EFET feedback on the macro-portfolio approach Retrieved from Cms_Data/Contents/EFET/Folders/Documents/ MembersSection/OtherGrps/TFMarketSup/ PubPosPapers/~contents/BUL2RHPXHKFX358E/ EFET_Macro-Portfolio-Hedging_ pdf EMIR ATE. (n.d.). Clearing Threshold Calculations. Retrieved from items/clearing-threshold-calculations.html ESMA. (n.d.). Non-Financial Counterparties. Retrieved from ESMA Official Site: eu/page/non-financial-counterparties-0 FCA. (n.d.). Non-financial counterparties subject to EMIR. Retrieved from static/documents/factsheets/non-financialcounterparties-factsheet.pdf ISDA & SIFMA. (n.d.). ISDA & SIFMA comments to multiple agencies in response to draft rts on risk mitigation. Retrieved from comment-letters/2014/sifma-isda-submitscomments-to-multiple-agencies-in-response-todraft-rts-on-risk-mitigation-techniques-for-otcderivative-contracts-not-cleared-by-a-ccp Netherlands Authority For the Financial Markets. (n.d.). The main consequences and obligations for financial institutions. Retrieved from nl/en/professionals/regelgeving/european/emir/ gevolgen-financiele-instellingen.aspx THE AUTHORS Mahima Gupta is a Senior Manager with the Solutions team at Sapient Global Markets. She is involved in the product management of multiple solutions, including the Compliance Management & Reporting System (CMRS). She has over 11 years of experience in traded risk management, regulatory reporting and business consulting in the global capital markets. She is currently based in Gurgaon and is focused on various regulatory change initiatives unraveling in the US, Europe and APAC. mgupta4@sapient.com Shashin Mishra is a London-based Senior Manager with the Solutions team at Sapient Global Markets. Currently, he is the Product Manager for the Portfolio Reconciliation product and leads client services for the CMRS solutions in the UK and EU. Previously, Shashin has led CMRS solution implementations for supporting Dodd-Frank and EMIR requirements and has over 8 years of product management experience across industries. smishra2@sapient.com Risk.net. (n.d.). Tradition and Tullett Prebon draw fire in sef volumes flap. Retrieved from net/risk-magazine/news/ /tradition-andtullett-prebon-draw-fire-in-sef-volumes-flap References 1. Risk.net. (n.d.). ESMA derivatives definition hits cme futures volumes. Retrieved from risk-magazine/news/ /esma-derivativesdefinition-hits-cme-futures-volumes CROSSINGS: The Sapient Journal of Trading & Risk Management 17

18 SINGLE DEALER PLATFORMS: are their days numbered? While single dealer platforms (SDPs) have improved the experience presented to an institution s trading clients, they are not entirely fulfilling the core requirements in terms of openness or degrees of speciality. The needs of the institution and its clients are still too much at odds and this discord will drive the next revolution in client trading and information services. Sean O Donnell and Matt Hopgood discuss the next generation of these platforms and the implications to business and technology strategies. Over the last five years, the proliferation of single dealer platforms (SDPs) has increased dramatically from initial pioneering efforts by leading tier one investment banks to the mainstream delivery platform of choice for any large institution that is serious about consolidating its products and creating a brand for its services. SDPs have been proposed as the solution to unifying an institution s offerings, acting as a one-stop-shop for trading and market information. While the initial perception has been very positive in the market, the commoditization of SDPs (and therefore the need to stand out in a crowded marketplace), along with regulatory changes and gaps in client demand, have made this the right time to revisit the SDP value proposition. Like all product lifecycles, SDPs are a product of technology innovation, market forces (competition) and the demand for better services by clients, typically delivered in waves of evolutionary products. This is a similar pattern that we have today for trading and information systems. FIRST WAVE: SINGLE ASSET CLASS INFORMATION AND TRADING APPLICATIONS The convergence of the global recession in the early 1990s and the explosion in direct connectivity from clients to their financial institutions in the mid 1990s forever changed how clients would engage with their institutions. Clients were offered market data and simple trading capabilities through a single asset class application, starting mainly with equities and FX, followed by other asset classes. Clients benefited from these types of solutions through their self-service trading capabilities and improved pricing. The institution provided this lower and more competitive pricing in part by automating the role of its sales desks as well as other cost economies. As institutions grew their trading technology asset class by asset class (in effect creating silos), their clients were offered multiple applications that all looked and operated differently with no integration between them. 18

19 Largely supplied by a handful of specialist vendors or in-house development teams, these direct single asset class solutions were typically deployed on-site and typically focused on automating price discovery and trade execution workflows. While the applications were extremely lean, focused, beautifully supported the client engagement model and greatly reduced sales and operational costs, they provided very little auxiliary services or integration with the client s internal processes (risk reporting, settlement, internal workflows, etc.). But they were very much in line with the trend at the time of selecting best-of-breed services across multiple institutions. SECOND WAVE: MULTI DEALER PLATFORMS As single asset class platforms grew in numbers, external companies, such as Bloomberg, Thomson Reuters and others, started to aggregate price discovery services from multiple institutions (sourced from their single asset class platforms) and provided them to clients in one application; this was the birth of multi dealer platforms (MDPs). These MDPs served a number of purposes: They allowed clients access to wider pricing and trade execution through aggregation as they were now being serviced with multiple providers. They allowed certain client segments (Fund Managers in particular) to automate their businesses. For example, prior to this, clients needed to prove they had requested multiple prices and that they had sourced the best price at that time. MDPs extended the role of prime brokerage through the need for extensive credit relationships and technology plumbing for price and trade routing. MDPs still exist today and thrive in certain segments, though there has been a mixed response from institutions in supporting such entities because they offer price competition against the institution s native offerings. As such, best price is not typically offered by the institution through MDPs. Figure 1. Wave One: Single Asset Class CROSSINGS: The Sapient Journal of Trading & Risk Management 19

20 THIRD WAVE: SINGLE DEALER PLATFORMS With the proliferation of single asset class trading platforms and multi dealer platforms, clients were getting very confused. Several factors forced a new paradigm: 1) The emergence of dominant multi dealer platforms started to erode the trade flow to single asset class platforms. 2) The need increased for institutions to be more brand aware in how they serviced their clients and reduce the confusion of who was providing what. If trade volumes shifted en masse to MDPs, then the underlying institution risked minimizing its role to that of product manufacturing and pricing with the customer relationship becoming increasingly controlled by the MDP. 3) Clients were not happy using multiple applications that were not integrated and looked and operated differently from the same institution to run their businesses (as with single asset class platforms). Figure 2. Wave Two: Multi Dealer Platforms To address these issues, a new solution was required the single dealer platform. SDPs offered a single branded platform that provided access to all of the institution s products and services under one umbrella. While the services of most SDPs were initially accessed via the desktop, they are now offered via multiple channels including tablet and mobile. This central access point allows clients to research their business segment, trade their equity stocks and minimize their currency exposure all from one portal. But are the benefits of the SDP one-stop-shop approach equally shared between institution and client? 20

21 The institution benefits from a wholly controlled platform for brand engagement and client relationships; the opportunity to cross-sell and up-sell based on ease of provision and newly aggregated client analytics; and more importantly, a simplified and consolidated technology stack driving significant IT savings. While the benefits of SDPs for the institution are clear, clients still don t have aggregated access to the best services and products, coupled with the best prices and client knowledge insights. WHY IT S NOT WORKING While a segment of the market is satisfied with an SDP approach, there is a growing segment that is dissatisfied, stemming from the following factors: An institution may have a strong offering in FX on its SDP, but its equities services or derivatives products may not be the best in the marketplace; therefore, the client needs to have another solution on its desktop to provide that service. One of the key internal business drivers of moving to an SDP model for an institution was to align its internal siloed trading desks and technology, resulting in a more uniform clientfocused approach. The promise was that this would rationalize both internal sales and trading activities, enable cross selling and consolidate technology requirements and spend. While this has occurred to some degree, not all of these benefits have been realized. New regulatory programs, such as MiFID, Dodd- Frank and the introduction of swap execution facilities (SEFs), have all impacted the grey areas of price discovery and execution, thus negating the price differentiation an institution can offer through its SDP. The institution s overall agility in a certain vertical asset class development is reduced through the typical release cycle of a large, complex SDP platform. This occurs because all internal desks need to agree to the release schedule, align on requirements and plan common integration points. Figure 3. Wave Three: Single Dealer Platforms With the proliferation of SDPs, leading firms are looking for new ways to differentiate from the pack. When any product market matures, it experiences competitive convergence. Within the SDP space, increased functionality and product coverage are eroding as a way of product differentiation. Competitive convergence normally CROSSINGS: The Sapient Journal of Trading & Risk Management 21

22 precedes the next wave of innovation opportunities which drives new service engagement models and new commercial constructs. The expansion of services that include cloudbased, always-on, easy onboarding and a pay-asyou-play commercial framework reduces SDP stickiness. In the past, clients were forced to use their institutions platforms and put up with their inadequacies. With the popularity of easy-to-use services/switch services in the retail sector, client demands have changed; they will no longer put up with poor products. The mobile first/cloud first movement has led clients away from a view of everything on a desktop app all under a one-banner framework. The birth of the App Store is now infecting clients wants and needs by breaking up monolithic tasks into bite-sized apps that specialize in niche segments. This also holds true for trading and information services. Similar to the breakdown of Facebook s social media stranglehold by firms such as WhatsApp, Instagram, and Line, companies too are breaking down monopolistic SDP platforms. Today, clients are not really consolidating their trading through preferred single suppliers; they will always hunt for the best price, best service and most trusted supplier in any given market. Although trading institutions greatly benefit from SDPs, the client benefits are overstated. Ultimately, the client s need for best pricing and best research, all within a lean experience, is not being adequately met by having multiple SDPs. NEXT WAVE: THE MERGER OF SDP AND MDP Over the last twenty years (since the first single asset class platforms emerged), clients fundamental requirements have not changed. They have always asked for: A more efficient way to conduct their business (through multiple providers in most cases) Access to the best services and products in the market Confidence that they are being given the best prices and execution Satisfaction that they are dealing with an entity that knows them, their business, their market segment, regulations and competitors A single intuitive platform from both a user experience perspective and an integrated technology service (APIs) Some of these requirements have been fulfilled in the waves described above, but some are at odds with an institution s capacity and willingness to deliver. In an increasingly competitive marketplace, and with service aggregation popular in other market segments, clients are asking, Why not for us? The next wave of dealer platforms will likely involve a combination of SDP and MDP. Each will continue to exist in its own right, but clients want the best of both worlds and this is likely to happen in a number of ways. Leading banks will allow services and products from other institutions to be traded through their SDPs, effectively making them SDP/MDPs. Clients will build their own SDP/MDP solution though APIs; this is already happening with investment firms. And, independent firms will aggregate these services; this too is currently happening in similar sectors. The ultimate question is, Where does this leave the institution in terms of its ability to innovate, hold onto its clients and build brand loyalty? 22

23 The answer lies in where it can specialize, and if it can become a truly client-focused organization, with: A leaner set of client segments, rather than broad-sweeping categories Dedicated products and services focused on those client segments In-depth market research that will enable it to understand and more importantly predict client needs INSIGHT High High Low FI INSTITUTION NEEDS Wave3 SDP High Figure 4. The Next Wave? FUTURE WAVE DIRECTION Wave1 SAC Single vendor Low EXECUTION Multi vendor Wave2 MDP Wave? High CLIENT NEEDS THE AUTHORS Matt Hopgood is a Vice President based in London and co-leads Sapient s Visualization practice. Matt has a background in business and digital strategy, creative and commercial leadership, web/application support, user-centered design (UCD), information architecture and content management. Recently, Matt has worked on P&L apps for energy majors, collaboration tools for market data providers, collateral management for a central bank, risk, balance sheet substantiation and mobile strategy for investment banks. mhopgood@sapient.com Sean O Donnell is a Director of Technology based in London. Sean s background is in designing, building and running financial trading platforms, particularly in FX, CFDs, metals and some money markets for tier one, tier two and large broker clients. His technology experience is primarily in Java and open standard platforms, KDB+, UX, and highperformance/scale technologies deployed as cloud-based services. Over the last 10 years, Sean has worked in Product Management roles, bridging business and technology, and driving business development in Europe, North America and Asia. sodonnell@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 23

24 MULTIPLE PRIME UTILITY: the key to transforming the fund manager/prime broker relationship In response to the financial crisis, financial markets across the world are transforming themselves. One of the most significant changes happening today is in the Prime Broker/Fund Manager relationship a world in which Prime Brokers (PBs) provide a variety of services to Fund Managers. The Fund Manager s alpha generation bottom-line and the Prime Broker s services-based business model were both impacted by the turmoil in the financial markets, prompting a restructuring of the industry and a transformation of the industry s operating model. In this article, Sudhanshu Bahadur, Vishal Bakshi and Valcony Sun explore the changing business model of Fund Managers and Prime Brokers and the emergence of the multi-prime broker. They also analyze the nature of the challenges these firms face and suggest a transformation path for the next generation of Prime Brokers. EVOLVING THE PRIME BROKERAGE BUSINESS MODEL Prime Brokerage was once described as the largest but least noticed banking system in the world. It is the gateway between Fund Managers and the marketplace. The proliferation of Fund Managers in the last two decades of the 20th century led to phenomenal demand for PBs. They contribute greatly to their clients success and increase the profit margins for Investment Banks by providing custodial services, margin financing, securities lending, portfolio accounting, synthetic lending and other services. When large PBs offered a suite of services under one umbrella, Fund Managers could go to a single firm to get end-to-end services. This allowed them to focus their energies on managing their portfolio without being encumbered by non-alpha-generating operational functions. Having a single Prime Broker act as a custodian of their assets was risky as it meant that the Fund Managers were putting all their eggs in one basket. Meanwhile, PBs would rehypothecate these assets, often into pooled accounts, to lend them to other parties. The market turmoil of 2008, with the collapse of Bear Stearns and bankruptcy of Lehman Brothers, resulted in $65 billion in frozen Hedge Fund assets. 1 The legal battles that ensued to find the rightful owners resulted in huge losses for Fund Managers, and also to PBs as Funds withdrew their capital. To decrease the rehypothecation risk, Fund Managers demanded that their collateral be segregated from their Prime Broker accounts. Instead of having the collateral sit with another custodian, PBs stepped up and created a service called Prime Custody, where the Funds assets are held in a single but segregated and protected account. 24

25 Having suffered considerable loss as a result of the crisis, Fund Managers realized that keeping all assets under one custodian was a risky strategy and started looking at diversifying their risk by splitting the basket under multiple PBs. This also gave them the opportunity to utilize different partners for the different services that they offered, diversifying their asset portfolio mix and market reach. Fund Managers have now largely switched to this multiprime business model due to the flexibility it provides and the associated reduction in counterparty exposure it offers. While this model does provide the benefits of diversification, access to a wider product range and competitive pricing, it also brings with it a new set of operational challenges. SINGLE PRIME BROKERAGE MODEL Fund Manager 1 Fund Manager 2 Fund Manager 3 Prime Brokerage 1 Prime Brokerage 2 Prime Brokerage 3 Security Lending Security Lending Security Lending Operations Risk Management Operations Risk Management Operations Risk Management Margin Financing Capital Introduction Margin Financing Capital Introduction Margin Financing Capital Introduction Portfolio Accounting Portfolio Accounting Portfolio Accounting Reporting Compliance Reporting Compliance Reporting Compliance Other Other Other Figure 1. Single Prime Brokerage Model CROSSINGS: The Sapient Journal of Trading & Risk Management 25

26 CHALLENGES IN USING MULTI- PRIME BROKERS A number of factors drive a Fund Manager to adopt a multi-prime broker environment. As their investment managers continue to expand into strategies that promise high returns, they look for opportunities that provide access to new securities, geographies, mitigation of risk and competitive pricing. While a migration from a single-prime to multiprime model has benefited Fund Managers, it has also led to increased complexity in their operations. At the same time, PBs are faced with a much more demanding clientele that can use its diversified base for extracting better financial terms and operational considerations. This new paradigm is also presenting the following challenges: Administrative Issues From an administrative perspective, funds now have to manage multiple relationships, with each new relationship involving different products and services. Each of these new PB relationships offers a significantly different operational flow. This brings about the challenge of evaluating each relationship as it is formed, defining a new operating model for each and creating a new onboarding process. Counterparty Risk Because PBs range in size, product offering and complexity of service, they bring about different levels of associated risk. In the past, Funds were aligned with a single PB, and their exposure had been aligned to the PB s ability to continue operating in an efficient and financially viable fashion. With multiple PB relationships, Funds have to understand the counterparty risk associated with each one of them and build a strategy towards mitigating that risk. Trade Allocation From the middle-office perspective, with Funds positions sitting with multiple brokers, trade allocation across the primes becomes a challenge. Funds need to define more sophisticated trade allocation processes not only to achieve best execution and generate alpha, but also to mitigate risk. Reconciliation Numerous relationships, each with its own complexity, create error-prone processes. This leads to reconciliation breaks between the Fund and the PB. While each PB may support a reconciliation process, they will have a different methodology, and Funds need to reconcile with each to reduce breaks. Risk Management In the past, the Fund Manager had all its positions sitting with a single PB. Hence, it was able to rely on the risk reports produced by the PB. With positions straddling multiple PBs, Funds have had to invest in internal risk technologies to aggregate balances across PBs and calculate Value-at-Risk (VaR), greeks and other risk measures. Portfolio Accounting Portfolio Accounting is another function for which Funds have relied on the PB in the past. Once again, the dispersion of positions across PBs required Funds to bring this function in-house, increasing operational overhead and reducing profit margins. Integration One of the biggest challenges in establishing a new relationship between a Fund and a PB is the integration between them. It can take months (and sometimes over a year) for a PB to onboard and integrate a large Hedge Fund. The pain is felt on both sides as operations and technology teams struggle to cope with the different interfaces involved. With Fund Managers now seeking to integrate with multiple PBs, it has become an overwhelming task involving a huge cost and operational burden. 26

27 Reporting All major PBs spend a considerable amount of resources on technology that provides their clients with extensive sets of reports and extracts. These reports inform Fund Managers about their activity, positions, performance, collateral utilization, margin situation, risk assessment, rebates and fees incurred, etc. With multiple PBs providing these reports and extracts in custom formats, the Fund Manager is no longer getting a consolidated set of reports. Instead, they have to collect all data from multiple PBs, aggregate it and generate reports. Additional Documentation/Counterparty Monitoring Mounting regulatory oversight has increased the amount of documentation required to onboard a new prime. This is further complicated if the Fund is comprised of Employee Retirement Income Security Act (ERISA)/ pension money. New Anti-Money Laundering (AML)/Know Your Customer (KYC) practices need to be followed before adding another prime, which increases the complexity of relationship onboarding. MULTIPLE PRIME BROKERAGE MODEL Fund Manager 1 Fund Manager 2 Fund Manager 3 Interface Interface Interface Aggregate Reporting Portfolio Accounting Trade Allocation Risk Management Other Aggregate Reporting Portfolio Accounting Trade Allocation Risk Management Other Aggregate Reporting Portfolio Accounting Trade Allocation Risk Management Other Prime Brokerage 1 Prime Brokerage 2 Prime Brokerage 3 Security Lending Operations Risk Management Margin Financing Capital Introduction Portfolio Accounting Reporting Compliance Other Security Lending Operations Risk Management Margin Financing Capital Introduction Portfolio Accounting Reporting Compliance Other Security Lending Operations Risk Management Margin Financing Capital Introduction Portfolio Accounting Reporting Compliance Other Figure 2. Multiple Prime Brokerage Model CROSSINGS: The Sapient Journal of Trading & Risk Management 27

28 TRANSFORMATION PATH Fund Managers must reassess their operating models to identify opportunities for improving the efficiency and profitability of their current business, and conduct an assessment of their strengths to identify how to invest in innovation and capability building. In order to transition/onboard seamlessly to a new prime, it is often beneficial to leverage third-party services. Involving these services early during the PB integration can help Fund Managers overcome the challenges mentioned above and focus on core alpha generating efforts. Some critical areas of focus should include service provider selection and defining the Target Operating Model (TOM) to overcome operational inefficiencies. By defining a mature TOM, both PBs and Fund Managers will be able to transition to the nextgeneration business model and more effectively address the challenges of today s brokerage market. TARGET OPERATING MODEL A TOM is the idealized business vision of how an organization will operate. It includes the principles that will be used to guide the organization s behavior. Outputs typically include business processes, objectives and organization ownership. The objective of an operating model is to ensure business agility and scalability while minimizing operational risk. The processes defined within a TOM stand as the foundation for business use cases. As Fund Managers demand more transparency from their PBs and adjust their business models to diversify counterparty risk, PBs also face new operational challenges around middle/back-office functions as they try to accommodate clients needs and remain competitive. This has led to a reorganization of the business model and competitive landscape of the Prime Brokerage industry. In either case, reviewing the operating model is the key to flexibility, business agility, scalability and minimum operational risk which all contributes to future growth. As the operating structure becomes complex, one area requires increasing attention: operations and IT. This has been largely bypassed by Fund Managers who usually focus on other corporate and front-office functions. Efficiency in these areas was never aggressively pursued because they are considered business support functions rather than profit-generating functions. Recent years, however, have proved that this uneven focus is a costly lapse, strategically as well as financially. 28

29 BUSINESS STRATEGY FRAMEWORK 1 Business Strategy Business aspirations and guidelines to guide current and future-state thinking Specific outcomes that demonstrate the realization of the vision Vision & Strategy Business Objectives Core Principles 5 Business Standards Parameters and values that will influence the design and execution (legal entity structure, core values, culture, etc.) 2 3 Business Structure The framework through which the business will operate Business Infrastructure & Operations The fundamental activities and operating environment Technical Architecture Client Model (For who) Process Functional Model (What we do) Collaboration Model (How we interact) Benefit Model (Measurement) Governance Org. Structure Location Model 4 Implementation Change and Continuous Process Improvement Figure 3. Target Operating Models Fit into an Overall Framework of Business Strategy, Structure and Operations The key areas of focus in operating strategy in the multi-prime world include: 1. Effective Counterparty Risk and Collateral Management The counterparty risk in a single prime model is overbearing, a fact confirmed by the resulting turmoil following the fall of Lehman Brothers as Fund Managers lost their collateralized assets. In the multi-prime model, there is a need for stringent collateral administration and counterparty monitoring to efficiently manage collateral across various PBs. The focus areas to ensure effective collateral management processes include accurate valuation of assets, collateral allocation and optimization. 2. Standardized Trade Allocation Process The multi-prime broker model necessitates an approach for trade allocation across the primes. Depending upon the fund size, Fund Managers have to define an allocation methodology, such as static allocation that can be by Fund, by market or by strategy; dynamic allocation that distributes by security, at a pro-rata basis or arbitrarily; or opportunistic allocation by borrow availability or by executing broker. Each option has its pros and cons and the final approach may vary from Fund to Fund. Based upon resource availability, Fund Managers may opt to add staff or leverage outsourced organizations to assist with allocation. Having a structured and effective allocation process ensures that the output data can be sliced and diced in meaningful ways to suit data consumers needs. CROSSINGS: The Sapient Journal of Trading & Risk Management 29

30 3. Structured Reconciliation Process Along with the issue of having to deal with a larger number of brokers comes the challenge of maintaining accurate trade data. Standardized processes are required to manage cash and position reconciliation with multiple parties and to resolve exceptions/breaks in a timely manner. This requires an investment in processes and technologies that can reconcile and report, minimizing breaks between counterparties. 4. Aggregation When using a single PB, the entire Fund Manager s book is managed through a single counterparty, thus enabling easier access to positions, balances and risk reports. With multiple primes, one of the biggest challenges is to set up a process for the daily aggregation of data across multiple primes in order to track the entire portfolio risk, performance metrics, etc. This also requires consideration by Fund Managers to build infrastructures or outsource services to a third party. The infrastructure has to be efficient to consume inputs from numerous primes that may be using different systems and various protocols, such as flat-file, XML, SWIFT and FIX. It may also require customized integration with other existing systems within the Fund. The in-house option can be complex and involves significant cost, but it also offers complete control over the data and required reports. It has the added benefit of giving each Prime Broker access to only their portion of the portfolio. Additionally, there is a tradeoff in the form of risk distracting the fund from its central purpose of alpha generation. Other options that can be considered are hearsay reporting using a selected Prime Broker and using a Fund Administrator for aggregating and reporting across PBs. 5. Sound Data Architecture An operating strategy typically drives data aggregation requirements. If a fund is split between many PBs to acquire better financing and also to spread risk, it becomes necessary to aggregate data from multiple primes in order to generate consolidated reports. Hence, Fund Managers need to acquire technology to achieve the same level of service and transparency as a single prime environment. This requires the creation of a data architecture that allows for the consolidation of data ingested through various mechanisms (ESBs, queues, messages, files, etc.), collection into usable packages (ABOR, IBOR, etc.) and storage in an easily reportable format (data warehouses, dimensional data marts, etc.). By establishing a TOM that addresses these focus areas in the multi-prime world, Fund Managers and Asset Managers can increase their competitive advantage. Opportunities that could potentially set them apart include looking into fast-growing solutions and technology that enable the firm to move with the market, increase alpha, improve operational agility, reduce expenses and expand into innovative products. 30

31 INDEPENDENT MULTI-PRIME UTILITY In the future, PBs and Fund Managers will need to create an environment in which they can regain focus on their core competencies. In this environment, Fund Managers will be able to concentrate on generating alpha for their clients, without being burdened by aggregating positions and performing other middle- and back-office functions. The PBs will be able to focus on providing value-add services, such as Securities Lending, Margin Financing, Synthetic Lending, Repo Financing, Swaps, etc. A key element of this environment is a utility that would provide a seamless platform upon which to conduct various business transactions and related operations. It would mitigate the complexity of handling different systems, formats and associated protocols and enable the consolidation of backoffice functions that neither PBs nor Fund Managers are well-positioned to perform. An independent body hosted either by a collaboration of PBs and Fund Managers, or by a third party can act as an interface between the PBs and Fund Managers. This independent utility will be built upon an independently hosted infrastructure maintained by a third party. It will integrate with multiple PBs and provide a single interface to Fund Managers, enabling simple access to many PBs offering different services and market access. To access a new PB, the Hedge Fund will only need to subscribe to that PB, without having to go through the long onboarding and integration exercise that is required today. Intermediaries, like Hedge Fund Administrators (HFAs), Third-Party Administrators (TPAs) or even large PBs, might be well suited for the creation of such utilities, which will work on a feebased model and provide services to both Fund Managers and PBs. This utility could provide a number of benefits, including: 1. Integrating multiple Prime Brokers onto a single platform The utility will integrate with multiple PBs into their custom environment using the PB s protocols and interfaces, removing the integration burden from the Fund Manager. The complex operational processes currently part of onboarding a new Fund Manager into a Prime Broker, or vice versa, will be undertaken by the utility. When onboarding another PB, the utility will create interfaces to access the transactional, positional and other information from the PB and perform additional analytics on it. 2. Convenient access to multiple Prime Brokers for Fund Managers The utility will build a standard interface that Fund Managers will use to gain access to PBs. This model will require a one-time integration for the Fund Manager into the utility, after which the Fund Manager will gain access to all the PBs that the utility offers under its umbrella. Both PBs and Fund Managers will be able to avoid the burden of integrating multiple parties a process that brings no financial benefit to either. PBs will no longer have the burden of integration, while Fund Managers will have a single channel to a broad market of PBs. As this model matures, it will provide Fund Managers ease of portfolio movement from one Prime Broker to another, increasing their accessibility to the market. 3. Independently hosted technology The multi-prime utility will be an independent body that will host its solution on its own infrastructure. The utility will be responsible for maintaining that infrastructure and all operational processes involved, and will have clearly defined SLAs with both PBs and Fund Managers. It will utilize best-ofbreed technologies for performing data integration, portfolio accounting, risk management, data management and reporting functions. CROSSINGS: The Sapient Journal of Trading & Risk Management 31

32 4. Consolidated back-office functions across PBs The utility will take over the job of performing back-office functions from PBs and Fund Managers. With the availability of aggregated positions across multiple PBs, the utility will be best positioned to perform risk management, portfolio accounting, reporting, compliance and similar back-office functions. Fund Managers will receive consolidated data and reports, while the PBs will be able to focus on core operations instead of spending millions on non-value-add services. MULTIPLE PRIME UTILITY Fund Manager 1 Alpha Generation Investment Strategies Other Fund Manager 2 Alpha Generation Investment Strategies Other Fund Manager 3 Alpha Generation Investment Strategies Other Multi-Prime utility Interface Aggregation Reporting Portfolio Accounting Trade Allocation Risk Management Other Prime Brokerage 1 Security Lending Operations Margin Financing Capital Introduction Compliance Other Prime Brokerage 2 Security Lending Operations Margin Financing Capital Introduction Compliance Other Figure 4. Multiple Prime Utility 32

33 CONCLUSION The Fund Manager/Prime Broker relationship is continuing to evolve with the changing dynamics of the marketplace. While Fund Managers are looking at diversifying risk and increasing revenue, PBs are focused on improving their service offerings. Meanwhile, both parties are spending considerable resources on integrating with each other and performing back-office functions that neither is well positioned to perform. Both parties will be better served by investing those dollars to strategically address the new paradigm of a multi-prime marketplace, by creating a TOM that creates the right structures to overcome operational complexities in a more holistic and fungible fashion. This may involve the realignment of non-profit generating functions, consolidation of services, refocusing Operations and IT teams and the creation of technology solutions that enable seamless integration. In the long run, this will improve operational efficiencies, reduce integration expenses and help them regain focus on their core competencies. As the market becomes more competitive, a thirdparty multi-prime utility, offered by a Hedge Fund Administrator, third-party administrator or a large PB, that integrates with multiple PBs and provides single interfaces to Fund Managers, is a solution that could satisfy the evolving requirements of Fund Managers. Resources 1. Axel Pierron, New Basis for the Hedge Fund / Prime Broker Relationship, Celent, June 29, 2011, (August 13, 2014) THE AUTHORS Sudhanshu Bahadur leads the technology domain for Sapient Global Markets in Canada. He advises capital market firms in formulating, architecting and defining their solutions. Sudhanshu has 18 years of extensive experience focused mainly on applications and products in risk management, trading systems and data domains. Prior to Sapient, Sudhanshu led the Prime Brokerage Technology team in Toronto for Bank of America Merrill Lynch, building risk, trading, financing and business intelligence platforms. sbahadur@sapient.com Valcony Sun is a Toronto-based Business Consulting Associate, specializing in capital market initiatives. Since joining Sapient Global Markets, she has been involved in multiple strategic initiatives, such as assessing the current technology landscape of a leading Canadian Prime Brokerage to position it for future growth and defining the Target Operating Model of a major pension fund with a focus on the investment lifecycle. Valcony is currently helping a top Canadian investment bank to design and implement an entity data platform as part of a regulatory response initiative. vsun2@sapient.com Vishal Bakshi is a Senior Associate of Trading and Risk Management based in Toronto and has over 10 years of consulting experience within the financial services industry. He has worked on numerous transformation projects involving prime brokerage, regulatory compliance and wealth management (financial planning). Vishal is currently helping a top Canadian bank manage operational risk across its capital markets division. vbakshi1@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 33

34 THE NOVATION CHALLENGE: how to ensure a successful outcome Organizations within the financial markets are undergoing a period of incomparable change. The financial crisis has prompted a reevaluation of how risk is managed within firms, and as a result, many have been either forced to, or have elected to, fundamentally transform their business models. This has prompted an unprecedented amount of change in legal entity structures, often leading to large-scale migrations of trade portfolios. As firms migrate positions between legal entities, the need in the market for novation expertise is growing as never before to avoid reputational damage with counterparties, spiraling costs and increased operational risk. In this article, Nick Fry and Mark Thompson explore the main drivers behind this wave of novations, the key challenges firms have when faced with conducting this exercise and the guiding principles for a successful outcome. WHAT IS A NOVATION? A novation is defined as the act of legally replacing a party to an agreement with a new party. It is only valid with the consent of all parties to the original agreement: the remaining party must consent to the replacement of the transferor with the transferee. The transferee steps into each of the in-scope transactions in place of the transferor and assumes its obligations to the remaining party. A number of drivers can cause a firm to perform a novation of its externally facing position to another legal entity. Most are ultimately driven by regulatory change, but some have been projects that were the result of business transformation. THE KEY DRIVERS The first driver is a general theme among regulators for their own jurisdictions to be protected, meaning foreign banking organizations need to ensure that only risk originated in that country is held there. This could result in a stream of inter-entity novations, or risk transfers, as banks move risk to more appropriate jurisdictions. A specific example of this is the Dodd-Frank Act s enhanced prudential standards, the final rule of which was recently released. This states that foreign banks of a certain size must place all of their US assets under the control of a US Intermediate Holding Company (IHC). This can then be appropriately regulated by US authorities and be governed according to domestic legal, capital, liquidity and governance rules. This segregation of US assets and regulatory control over the new US parent entity have the clear intention of ringfencing the effects of foreign banks on the local capital markets. The intention is that after this is implemented a non-us bank in distress could no longer threaten the US capital markets. The timeline starts in January 2015 with submission of plans to the Federal Reserve and extends into It is clear that this regulation will create considerable work for any non-us bank with significant US operations. 34

35 The second driver is a little bit looser and broad based. It is the concept of jurisdictional or regulatory shopping the idea of placing assets and operations in the most favorable regulatory environment. With the uneven rate of worldwide regulatory change and the rolling out and enforcement of new regulations comes the prospect for banks to take advantage of the shifting landscape and move their main legal entity into the location that provides them with the most efficient capital, tax and legal rules. There are also some jurisdictions that adopt a more advantageous regulatory position than their global hub competition. In other words, banking operations in that country will always be more favorably treated. In a global banking environment where margins are tight and profits can prove scarce, or at the very least highly fought over, any improvement on margins or the bottom line could prove decisive in a competitive battle. Thirdly, there are specific regulations that force banks to change their structure to some extent by spinning off entities or closing them down completely. Whether it s the same entity but it now falls out of the legal structure of the original parent bank, or if the entity has been forced to close out completely, a novation project will be required to enact the policy decided upon by the bank s senior executives. One obvious example is the proprietary trading desks of banks. Under the Volcker rule in the United States, a bank is explicitly no longer allowed to risk its own capital in any trading activity. Some banks have decided to close their desks, while some have spun them off into hedge funds where they have further explicit rules about if and how they are allowed to retain any form of ownership in those funds. In either scenario, there is a likelihood that a novation exercise will occur. There are other drivers that are not directly the result of regulatory considerations. The traditional reason for bulk novations, company mergers and acquisitions is still as prevalent today as ever. Firms may also embark on a novation to fulfill a new business strategy around a particular market. Finally, there may also be non-regulatory drivers for firms to migrate to other legal entities to reduce capital or funding requirements. THE KEY CHALLENGES Novation projects are often complex affairs, involving multiple business units across each of the impacted institutions. As a result, the challenges involved in such large-scale projects are numerous. Engaging the counterparties The first challenge is counterparty engagement. In order to facilitate as smooth a novation process as possible, each counterparty will need to be bought into every step and be on board with the whole process. The challenge will differ dramatically depending on the type of counterparty involved. Large broker dealers will generally be familiar with the process; however, the challenges here are twofold. First, ensuring that the required resources are allocated can be difficult as competing requirements typically mean this can be a stretch for many counterparties. Resource mix Secondly, it s important to ensure that the novating firm s resource mix is optimal to mirror the globally distributed nature of these counterparties and therefore maximize the potential for engagement. For less sophisticated clients, the initial challenge is often successfully educating them on the reasons for the exercise and why it is happening, followed by ensuring the requisite tasks are carried out through to novation execution. Internal resourcing can also be an issue. Identifying the right number and mix of resources for each stage of the process is problematic, particularly when juggling the requirements of the bulk novation with business as usual (BAU). Plus, there are potential complications and resourcing impacts from performing the actual novation outside of market CROSSINGS: The Sapient Journal of Trading & Risk Management 35

36 hours (novations typically are processed over weekends, although we are seeing a trend towards midweek novations to limit this resourcing impact and as a function of process improvements). The role of intermediaries When firms undertake a novation exercise, there are multiple challenges linked to financial market intermediaries (FMIs). The landscape for over-thecounter (OTC) derivatives has changed dramatically since the financial crisis began, with swap execution facilities (SEFs), trade repositories, clearing houses, portfolio compression and portfolio reconciliation tools changing the way that these instruments are processed. This new industry landscape has complicated the novation process considerably. In the past, the only major difference in how OTC derivatives were processed was either via electronic matching platforms (e.g., DS Match) or via paper for confirmations. However in the new world, there is a multitude of possible process flows resulting from the various combinations of different industry systems and processing methods. Is trade execution via SEF or voice or electronic? Is a trade bilateral or cleared? Is a trade confirmed electronically or on paper? The landscape for over-the-counter (OTC) derivatives has changed dramatically since the financial crisis began, with swap execution facilities (SEFs), trade repositories, clearing houses, portfolio compression and portfolio reconciliation tools changing the way that these instruments are processed. This new industry landscape has complicated the novation process considerably. Understanding the process The initial challenge for firms is ensuring they have a deep understanding of these flows, the associated vendors and their capabilities, and how this translates into potential process or technology changes internally. This is absolutely paramount as some of these tools can dramatically simplify the novation process if used optimally. Similar to the challenge around counterparties, firms also have to ensure that FMIs have the resources available to process bulk novations if they are to be leveraged. Companies must also be cognizant of the fact that there can be a significant financial cost to being the initiator of a bulk novation via an industry platform. For example, novating parties often pay both the costs for their side and the counterparty s side when processing trades via MarkitWire. Internal and external coordination Coordination, both internally and externally, is a significant challenge. Often, the novation exercise is the final piece of the puzzle following internal risk migrations and such ready-to-trade activities as legal master agreement execution and internal and external system set-up. To address this challenge, a firm s planning must take into account these dependent projects while also ensuring that engagement with external parties is not compromised or delayed. Externally, the project planning needs to take into account not only the considerations of counterparties and FMIs, but also industry-wide events, such as quarterly credit rolls and equity expiry weekends, as there will be no appetite to novate on weekends where these events occur. Agreeing upon the portfolio to be novated Relying upon the in-scope products and counterparties, reconciliation of the novation portfolios can be an issue. Nowadays, large brokerdealers are directed to reconcile portfolios on a regular basis either via the traditional spreadsheet method or via tools such as TriResolve. Because 36

37 this process is not completed for all trade and counterparty types, the task to reconcile portfolios can still be resource-intensive and time-consuming. In addition, the plethora of new FMIs that have evolved in recent years often contains unconnected data records of the same transaction. It makes sense then for firms to use the novation exercise as an opportunity to ensure that these records are consistent. However, the challenge lies in ensuring that this worthwhile task is completed in the most efficient manner possible and without distracting from the main goal of the novation. PRINCIPLES FOR SUCCESS Firms must consider a number of critical success factors as part of a strategy to execute an effective mass novation. Strategy and Roadmap The key to any successful novation exercise is first devising an effective strategy and roadmap based on certain fundamental tenets: Effectively engaging impacted internal and external stakeholders with appropriate notice is a vital activity to clearly define and agree upon the scope; understand the associated trade/client populations, priorities and measures of success; develop an informed approach that is cognizant of constraints and considerate of opportunities; and create an escalation and decision-making mechanism as part of the communications and governance framework Creating a meaningful decomposition of the eligible trade population enables firms to make informed decisions around scheduling based on complexity and impact, factoring in product and client variables. This should lead to a clearly defined and controlled management of the novation portfolio data set, as trade data needs to be complemented with additional attributes to enable the effective planning and tracking of execution activities while preventing the need for manually intensive reconciliation processes Designing and agreeing upon a pragmatic and controlled approach supplemented by the requisite tools and interactions will provide an organization with a greater assurance of success Synthesizing the population decomposition and the project approach into a clear project plan that provides tangible milestones and an understanding of required resources will help firms more effectively transition into the later phases, with a clear understanding of a tracking and monitoring mechanism Mobilization and Readiness When preparing for novation execution, several elements are critical for success. Firms should establish a detailed and cohesive run-book for the novation, while maintaining regular dialog with clients and any impacted FMI providers. This is to ensure the successful establishment of the requisite environment within which to execute the migration. Best practices should be adhered to with regard to the development and testing of the approach including any related tools and processes. If portfolio reconciliations are already undertaken, they should also include a reconciliation of the target novation population throughout this period to ensure this data remains clean. At this point, there is the potential to augment the existing team and build this process out to cover the entities involved in the migration. This would help firms better understand the portfolio being novated and allow the project team to drive the streamlining of the portfolio. CROSSINGS: The Sapient Journal of Trading & Risk Management 37

38 MServ Trai SWIFT TriO DTCC ICE FMI BM S&T G15 Regional Bank Ops Trade Pop. IMs IT HFs Novating Party C/Parties CR Corps Fin HNWIs L&C Private Bank Figure 1. Balancing the Components (Internal, Counterparty and Intermediary) is Critical for Success Execution and Management Firms must also perform the required outreach to counterparties and FMIs, the coordination of migration schedules and the production of the necessary artefacts and evidence for this process. The team will also be responsible for client and internal dispute resolution and producing clear reporting and metrics (internal and external) to reflect progress and any risks or issues. In order to complete the execution effectively, firms should consider the following factors: Given that across all OTC asset classes the majority of trade confirmations are now processed via electronic matching platforms, it is imperative to manage the processing of the novation in each of these systems in a controlled and coordinated manner to avoid a multitude of post-novation reconciliation issues A thorough and complete understanding of the tools available for processing bulk novations within each of the systems managed by the FMIs is essential to ensure that efficiencies are realized during the execution phase Given the reliance on their platforms and solutions, effective management of FMIs is the key to a successful novation Agreeing upon a common set of industry-defined processes and recommended tools is desired (e.g., a standard toolkit to facilitate bulk novations) With regard to the processing of novation documentation, if the number of agreements to be processed is high, then it is worth considering automated generation tools, such as Thunderhead, to alleviate the load 38

39 Using standard agreements also improves turnaround times as clients struggle to understand bespoke documentation As for the team tasked with processing and chasing agreements, aligning novation agreement production closely with the client service team creates single accountability Using native language speakers to speak with clients where possible is a consideration when dealing with less sophisticated clients, such as small investors and corporates Locating teams where there is critical client mass is a prudent approach (e.g., if the counterparties are primarily large broker dealers who have outsourced their operations to India, it makes sense to situate the novation client service team in the same locale) As for metrics, turn-key reporting is a critical success factor. Teams should ensure client refusals are recorded and escalated accordingly CONCLUSION Just as the industry landscape for OTC derivatives has evolved over the past six years, so has the need for a far more sophisticated novation strategy. With so many factors now at play to complicate this exercise, it is absolutely vital that firms use a controlled approach. It should be developed with an understanding of how the target trade population connects with today s industry tools. This will help firms realize efficiencies by leveraging established market infrastructure, ensure counterparty satisfaction with the process and, ultimately, achieve risk management objectives in a timely and cost-effective manner. THE AUTHORS Nick Fry is a Director and leads Sapient Global Markets Trade Documentation practice out of London. Nick has worked for over 20 years in the capital markets industry, with a background in investment banking operations followed by financial services consulting. He has extensive derivatives subject matter expertise and deep knowledge of the documentation domain, and has first-hand experience of legal entity migrations and novations to draw on both from his time at Deutsche Bank and also with Sapient Global Markets. nfry@sapient.com Mark Thompson is a Manager based in London with over 10 years of industry experience in a variety of areas, including structured products trade review, product control and regulatory reporting. Underlying these roles is Mark s rigorous and practical approach to risk and control, operational risk management along with significant practical experience of the changing regulatory environment and updating processes and systems to match the latest requirements. mthompson4@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 39

40 CROSS-ASSET UNIVERSAL PRODUCT IDENTIFIER: is this the solution the industry is looking for? Covering the entire spectrum of asset classes and financial services, from loans and credit cards to derivatives and bond positions, a Universal Product Identifier (UPI) will enable a holistic approach to identifying all trades and positions, including capital calculations, reporting, clearing mandates and booking rules. While such an idea sounds great in theory, historical attempts at achieving global agreement have fallen short, even within a subsector of the industry. Peter Meechan, Jim Bennett and Pauline Tykochinsky examine the feasibility of universal product codes, ponder whether the industry is ready to come together to create them, and discuss what a potential solution might look like. During the past few years, firms have had to deal with a series of global regulatory changes, including the Dodd-Frank Wall Street Reform Act in the United States; along with European Market Infrastructure Regulation (EMIR), Markets in Financial Instruments Directive (MiFID) and Regulation (MiFIR) in Europe; and reporting and clearing requirements in Asia. These have resulted in numerous international regulatory bodies enforcing a series of new regulations for various jurisdictions, such as the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) (US), European Commission (EC) and European Securities and Markets Authority (ESMA) (Europe), Swiss Financial Market Supervisory Authority (FINMA) (Switzerland), Federal Financial Supervisory Authority (BaFin) (Germany), Financial Advisory Committee (FAC) (China), etc., to ensure transparency of trading activities and reduce systemic risk. A key area of change has been in the over-the-counter (OTC) derivatives space where new mandates that involved real-time trade reporting and mandatory clearing highlighted a major problem for all firms product identification. Many of the regulations are tied to individual product types. For example, some products need to be reported to the CFTC, whereas others need to be reported to the SEC; some products must be cleared with a central counterparty, whereas others can remain bilateral. The problem lies in the definition of the products. The nature of the OTC derivatives industry means that many products have evolved over time to become highly customized for individual client needs and there is little standardization across firms as to how a product is defined or named. What one firm calls product ABC, another may call DEF. Making matters worse is that the regulator may call the same product XYZ. Anyone who has worked on implementing the new Dodd-Frank rules will have experienced the difficulty of deciding which rules applied to which trades and positions and how such trades needed to be classified when reporting. 40

41 While the problem may have been brought to light by the implementation of rules for OTC derivatives, it also exists within a range of asset classes, including loans and mortgages. It is an issue that runs across asset classes for functions that need to include all of a firm s positions but treat them differently based upon product type. A key example of this is with capital treatment, whereby calculations need to be treated differently based upon product but aggregated across all of the firm s positions. IS THE UNIVERSAL PRODUCT IDENTIFIER THE ANSWER? The ideal solution to this problem would be a standardized way of referencing each product, based upon a set of differentiating attributes that are understood by both the industry and global regulators. Standardized identification exists today in other asset classes, such as the International Securities Identification Number (ISIN) for bonds, commercial paper (CP) and warrants. But, could such an identifier also work for areas that have historically resisted standardization and could disparate areas of the industry come together to utilize a single standard? There are many types of problems a Universal Product Identifier (UPI) could address. The complexity of the UPI could differ depending upon which use cases were included. Each type of market participant has a different level of interest in solving for each problem, so a consensus needs to be reached. Problems that have the most interest include: Mandate to clear and where to clear Do we need to clear and what are our CCP options? Mandate to execute via a SEF Do we have to offer this trade on a SEF? Mandate for collection of margin Do we have to collect/pay initial margin? Booking rules What system do we book this trade on and to what legal entity do we book it? Short sale Handling different levels of restrictions known as E-codes across various jurisdictions. Tax Consolidating several tax laws such as transaction tax, stamp duty, etc., across countries. Cost Basis Rule (CBR) Supporting long-term gain/loss reporting (IRS). The difference in each of these issues is the level of detail that needs to be attached to a UPI to determine the outcome. For example, the attributes required to determine if an OTC trade is CFTC or SEC reportable are different than the attributes required to determine if such a trade must be cleared. In other words, the UPI needs to be tied to a taxonomy. But questions remain. Does this taxonomy need to be completed prior to solving for each case? Can the same taxonomy structure be applied to all uses cases (just at a different level)? Or, does the structure need to flatten out? Figure 1 depicts the start of a possible hierarchy in which the number of layers required is dependent upon the use cases for which the hierarchy is to be utilized. Product/trade identification What do we call this when executing, reporting or booking? Capital calculation treatment How do we calculate capital for this position? QIS categorization How do we categorize this position during quantitative impact studies? Regulatory body and rules for trade reporting Where and how do we report this trade? CROSSINGS: The Sapient Journal of Trading & Risk Management 41

42 Product Hierarchy Loans OTC Derivatives Exchange-Traded Derivatives Mortgages... Commodities Equities Interest Rate Credit... IR Swap Exotic... Fixed Float Inflation... Ammortizing Figure 1. Sample Product Hierarchy Another challenge in categorizing some asset classes is the requirement for dynamic classification that is triggered by a recent security event. For example, some regulatory disclosures require a more granular classification of loan products driven not only by the initial contract agreement but also by certain subsequent life cycle events. These could include default on payments; some operational specifics in booking the product, such as held-to-maturity versus available-for-sale; operation loss events; and certain risk metrics, such as fair market value (FMV), etc. Similarly, commodities options require information about the last tradable date to assess exposure and capital requirements. With certain credit products (e.g., credit indexes), the regulatory treatment of the product changes based upon the number of names at time of execution. Therefore, a product traded one day could be reportable to the CFTC, and the same product traded a week later could be reportable to the SEC. One way to address this is to limit the hierarchy of the product to data points that are fixed and leave dynamic items to the transaction. This would make for a simplified product taxonomy, but adds an additional set of criteria to be used in regulatory determination. As such, it does not solve the entire problem. Key to deciding upon the use cases is to determine the scope across asset classes. For example, can a UPI provide solutions across OTC derivatives or across all areas? A cross-industry sector UPI would certainly help when calculating capital, but implementing such a solution across areas that already have their own IDs (e.g., securities) raises its own set of problems. 42

43 Solving across all asset classes is a lofty goal, but one that can be achieved. However, it is better to start with one area such as OTC derivatives which has the most diverse set of products and the most pressing need from a regulatory perspective and then expand to other areas. This means that when any solution is being designed, the end goal (one of true universal acceptance across asset classes) needs to be considered. This way, the solution can be extended rather than redesigned during each phase and some level of input would be required from all sectors at all stages of design and implementation. If a particular industry sector solves the problem in isolation, it will have a difficult time trying to force its design on an industry sector that already has some form of identifier. The final prerequisite is involvement from the regulators. It is pretty clear that most of the use cases revolve around the regulatory treatment of trades and positions. The UPI will only be effective if the regulators that decide upon the treatment are using the same taxonomy to make their determinations. Therefore, their endorsement is as critical as industry acceptance. What Would a Potential Solution Look Like? When it comes to UPI issuance, there are three basic ways that it can be handled. 1. UPIs are only issued by a centralized issuing entity. Product details (the defined set of attributes) are sent to the entity by either industry bodies (e.g., ISDA) and a new ID is published. This has the advantage of ensuring that there is no duplication of products but requires that a product taxonomy be fully defined prior to UPIs being issued. And, it means that either new products would be traded without a UPI or a method of assigning temporary UPIs must be defined. 2. UPIs are sold in batches to organizations that may create new products (e.g., swap dealers). The organization assigns the UPIs themselves and returns the assigned UPI with product attributes to the issuing organization for validation and distribution. This has the advantage of providing dealers with the ability to create on-the-fly custom products and trade them with a UPI. The disadvantage is that other firms could assign their own UPIs to identical products, causing product duplication. 3. Similar to option 2, UPIs are assigned by the dealers first trading the product. However, instead of a batch of numbers being purchased and later assigned, the numbers could be generated and assigned by the initiating dealers using an algorithm that ensures uniqueness. An example of this would be including a code that is unique to the dealer. Whichever method of implementation is chosen, the industry needs some form of market utility (or group of utilities) that would be responsible for distributing UPI information on behalf of the issuing entities. Figure 2 depicts how a centralized UPI utility (or series of utilities) could be used by the industry to generate UPIs and act as a UPI look-up service, working alongside the regulators. CROSSINGS: The Sapient Journal of Trading & Risk Management 43

44 Bank ABC A1. Bank purchases batch of UPIs from utility UPI Governance B1. Industry body shares information about standardized products with utility ISDA A2. Bank sends nonstandardized products with assigned UPIs to utility for validation C1. Bank sends product characteristics to utility for UPI lookup UPI Utility B2. Utility generates UPI and attaches to each standard product Bank DEF C2. Utility returns found UPI to bank along with regulatory rules D1. Product details with assigned UPIs sent to regulators for verification CFTC Figure 2. An Example of How a Centralized UPI Utility could be used to Generate and Manage UPIs Defining a new format for a universal code in one sector of the industry (e.g., OTC derivatives) and then trying to get another established sector to adopt it (e.g., securities), would be extremely difficult. However, there is little need to do this. There is no reason that each sector cannot maintain its own format and even generate and distribute its own identifiers, as long as each sector does the following: Has identifiers that do not match those used by a different sector Establishes an easy method of understanding which sector the identifier comes from by the format Provides a centralized report of all identifiers across all industry sectors In other words, organizations generating the identifiers need to work together. 44

45 UPI Funding Funding for a UPI utility or service would depend upon the method used to generate and distribute each UPI. If it is up to dealer firms to assign UPIs to products that they themselves create, then they could purchase blocks of blank UPIs, in a similar manner to how a grocery producer buys a block of UPCs (bar codes). However, if a centralized UPIgenerating organization creates and assigns all UPIs, then they would need to charge users of the service either a monthly fee or a transaction cost for retrieving UPI data. THE AUTHORS Peter Meechan is a Director of Business Consulting based in New York City. With over 20 years of cross-product, investment bank experience in business transformation, he has played leading roles in the development of several products, services and consortiums. Recently, Peter has been helping large investment banks implement changes required by regulatory reform and working with a range of industry participants to launch market utilities for client clearing and collateral management. pmeechan@sapient.com Conclusion A UPI has long been thought of as an unattainable goal within the OTC derivatives industry and other non-standardized industry sectors. However, as regulations increase in these areas and become more product specific, the benefits of a UPI become more apparent. A key focus of much of the recent regulatory reform has been on the standardization across asset classes. With the move towards electronic trading and growth of straight-through processing (STP), market utilities and clearing demand this. A UPI would not only provide a catalyst to standardization but standardization would itself benefit from the introduction of a UPI, producing a self-improving circle. For the UPI to be successful, industry leaders need to first agree upon the problems that are being solved and the regulators need to be on board. Jim Bennett is a senior executive based in New York City with more than 25 years of experience in capital markets, OTC and complex products. With a strong international background, Jim has helped firms navigate new regulations and adapt to changes in the global marketplace. jbennett@sapient.com Pauline Tykochinsky is a Senior Manager in Sapient Global Markets Data Management Practice. Based in New York City, Pauline has over 16 years of experience delivering highperformance enterprise solutions. In her current role, Pauline applies her in-depth knowledge of the trade lifecycle when advising global firms on data modeling, data architecture and data governance approaches and best practices. ptykochinsky@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 45

46 MIFID II: harmonization mandates new business models in the OTC space Regulatory initiatives, such as the Dodd-Frank Act and EMIR, have had a seismic impact on derivatives markets. The Financial Stability Board s seventh progress report on the implementation of OTC derivatives market reforms has highlighted crossborder consistency issues arising from different jurisdictions. The combined effect of these regulations through the mandated electronic trading and central clearing of standardized derivatives contracts has been the balkanization of the capital markets, causing pockets of liquidity and varying prices for the same contracts across jurisdictions. With the implementation of MiFID II/MiFIR on the horizon in Europe, the industry is anticipating a more level playing field between the US and the EU. Viewing regulatory initiatives in isolation is no longer an option, as it poses the risk of missing key inter-relationships and greater regulator cooperation, as well as potentially increasing the cost of compliance and failing to identify profitable business opportunities. Paul Gibson, Kimon Mikroulis and Cian Ó Braonáin discuss how firms can start thinking about their business models to exploit the synergies arising from the significant overlap across regulatory regimes. Holistic Response Needed Across Regulatory Regimes Where MiFID I tried to impose an EU harmonization framework for equities and prevent equity market abuse, MiFID II extends this framework to all asset classes and tries to foster competition among trading venues and financial institutions. MiFIR/MiFID II has been hailed by ESMA s chairman, Steven Maijoor, as the biggest overhaul of EU financial markets in more than a decade. It is poised to place stringent requirements on financial firms systems and risk controls, while shedding light on dark pools without curtailing liquidity, and bring crossasset EU-wide supervisory convergence. In conjunction with EMIR, it also aims to detect and mitigate the build-up of systemic risk. In this way, MiFIR/MiFID II can be viewed as the European Union s premier legislative tool for encouraging the expanded use of market infrastructure and adhering to the 2009 G20 commitments. Its scope encompasses transparency, investor protection, operational risk and third country access. These two perceived negatives market fragmentation and dark pools are addressed with MIFID II, which attempts to bring the positive effects of the equities space to non-share instruments traded over the counter (OTC) by professional investors and responds to the lessons learned from the 2008 financial crisis. 46

47 MiFID II/MiFIR OTC Derivative Trading Impact OTC market move to trading venues. Traditional OTC trading: in its current form to be only sustained for less liquid, more bespoke products. Competition: in trading and clearing markets is expected to increase due to the rules on open access for trading venues and CCPs. Firms: offering execution services need to re-evaluate their business models, as well as end-users reconsider their options for market access. Trading Venues OTFs: Introduced to move OTC trading to a multilateral environment for products not traded on MTFs, i.e non-equity instruments. 4 possible venues for trading: RMs, MTFs, OTFs and SIs or equivalent third country venues. Operators: Not permitted to execute trades on their own account; banks currently operating single dealer platforms for derivative instruments will need to: 1. Move their trading to a third-party OTF. 2. Create an OTF with a separate legal entity. 3. Apply for authorization as a Systematic Internalizer (SI). Products The trading obligation is applied to instruments based on a European Securities and Markets Authority (ESMA) two-pronged test. Clearing Eligibility and Liquidity: The instruments should be clearing-eligible according to EMIR and considered sufficiently liquid, a definition to be defined in ESMA technical standards. Top Down: The EU trading rule may differ from the US s bottom-up approach, where all clearing eligible swaps when offered by a SEF should only be traded on a SEF or a DCM. Next Steps Next Steps: with Q as the expected compliance date, there are many opportunities to take while ensuring compliance well in advance. From Swap Execution Facilities: Firms need to undertake a gap analysis of their current operational infrastructure against the new requirements of MiFID II/MiFIR and design a roadmap towards implementation. Business Models: Firms need to carefully consider potential changes to their business models and the provision of execution services. Due to the sweeping changes of MiFID II on competition and specific trading strategies, firms need to carefully consider potential changes to their business models and the provision of execution services. Figure 1. MiFID II/MiFIR OTC Derivative Trading Impact CROSSINGS: The Sapient Journal of Trading & Risk Management 47

48 Responding to an Integrated OTC and ETD Derivatives Market The post-reform landscape has wide-ranging implications for both the sell side and the end users of derivative transactions. The trading convention differences between exchange-traded and OTC derivatives are diminishing, as OTC derivatives are moving from a predominantly bilateral model to a more transparent cleared model. In light of the electronification of OTC markets and their convergence with exchange-traded derivatives (ETDs), a consolidation of ETD and OTC derivative infrastructures and trading behavior is likely, as they will be traded on similar exchanges and follow similar processes. Breakup of Vertical Integration Firms that up until now were offering OTC trading to clients via single dealer platforms will have a reduced execution-only stream of revenue. Under MiFID II/ MiFIR, they will need to migrate their trading to OTFs or apply for authorization as systematic internalizers (SIs). Operators of organized trading facilities (OTFs) will not be able to execute trades on their own account, meaning their business model will be feebased. Given that all of the SEFs registered with the US CFTC are not operated by an investment bank, firms that want to continue trading principal with clients will need to apply for authorization as an SI. This will require them to exceed specified thresholds in terms of the volumes they deal on a bilateral basis. Therefore, investment firms need to perform a cost-benefit analysis of each option: acting as an SI, operating an OTF under a separate legal entity or ceasing trading in these areas. Execution is expected to shift from dealers to third-party trading venues that will provide greater market transparency and increased instrument standardization, as well as broaden access for investors. Bid-ask spreads are expected to tighten and minimum margin requirements will increase on non-cleared derivatives. In addition, the clearing obligation will reduce bilateral exposures and concentrate counterparty risk in central clearing counterparties (CCPs). The consequence is that dealers will have to unbundle their services, as electronic execution and clearing are expected to be a smaller part of their value chain. The anticipated proliferation of trading venues, as already begun with SEFs in the US, means that end users will have more opportunity to choose trading venues based on offerings and costs. This is expected to foster competition and lower transaction costs. Pre-trade transparency is expected to enable more efficient price formation and reduce informational asymmetries between the buy side and the sell side. Product Rationalization The Joint Committee of European Banking Supervisors has published principles on product oversight and governance for both investment product manufacturers and distributors, while MiFID II has extensive rules for ensuring product suitability, requiring better client data analytics. Banks can rationalize their product portfolio by tailoring it to meet target customer needs. Carefully selecting the product mix that is provided in-house and the products provided on an agency-only basis can reduce costs and enable bespoke services when needed. Customer centricity predicated on a robust technology infrastructure that uses data analytics for better product design and customer relationship management can unlock value hidden in seemingly competing interests between regulatory, customer and investor demands. 48

49 A FOCUS ON COST EFFICIENCY As the OTC and ETD market infrastructures converge, derivatives dealers have the opportunity to reduce costs by developing partnerships with market infrastructure providers in order to meet common industry challenges and ensure common standards. A certain level of market collaboration can make strategic and economic sense, especially to alleviate resources devoted to routine back-office activities and free capacity for resources devoted to front-office revenue generation. Sharing costs with other partners can substantially improve the cost-to-income ratio, and greater industrialization of processes can streamline operations, decreasing reliance of subsidiaries on intra-group shared services. This is especially important for dealers who want to act as an agency business that captures volume, where scale is achieved to enable cost efficiencies to be passed on to customers. Banks must define their future market strategy. Early and conscious action can put an organization in good stead to reap the rewards of early positioning. A proactive approach also applied to compliance projects provides early movers with adequate time to develop robust solutions and ample time for testing changes. Developing a patchwork infrastructure that is barely fit for purpose can put banks at a steep disadvantage with competitors that have the right infrastructure to support their operating models. Haphazard approaches can also jeopardize the subsequent evolution to a stable business as usual process. This has been strongly underscored by the minimal impact on normal operations and benefits of this approach when offering services such as delegated reporting to clients. Business Model Considerations As dominant derivative players become constrained from entering clearing and trading venue markets in the same form as the past, it is imperative for firms to consider their business models, especially in light of the imminent single dealer platform push-out. As parts of the derivatives trading market are being transformed from a high-risk/high-return enterprise into more volume-driven businesses, some big players are struggling to increase revenue, while others are pushing ahead and embracing change. Existing and new market players will have to compete across three basic dimensions: price, customer service and differentiation. CROSSINGS: The Sapient Journal of Trading & Risk Management 49

50 Increased Capital Requirements: The Basel Committee has published a revised framework for the fundamental review of the trading book, imposing restrictions on the use of internal model-based approaches and a shift away from Value-at-Risk to Expected Shortfall. Heightened Supervisory Intensity: Supra-national authorities such as the ECB, have been expanding the scope of their responsibilities. Their banking supervision is expected to be more rigorous and stringent than national authorities. Resolvability and Removal of Implicit Government Support: The Bank Recovery and Resolution Directive (BRRD) adopted by the European Commission (EC) will put further funding pressure on banks. Capital providers to banks can no longer factor in the possibility of government support in the event of failure because of too big or too complex to fail. Structural Separation: The Volcker Rule in the US, and the European Commission s proposal of a Regulation on structural measures published in January 2014, effectively mandate the structural separation of retail and investment banking. This way, guaranteed deposits can no longer be used to subsidize risky activities in other banking divisions. Cultural Change and Conduct Risk: The OECD published a report on financial consumer protection in October 2013, and an update is to follow by the end of MiFID II s requirements on investor protection and client suitability also reinforce the importance of customer focus. The various misselling disasters, and other market abuses, such as the fixing of LIBOR, have cast a pall on the banking industry. Banks need to reorient their culture towards serving customer interests. Data Maturity and IT Infrastructure: Supervisors have been getting increasingly worried about the quality and accuracy of reported data. The Basel Committee on Banking Supervision (BCBS) published 14 principles on effective risk data aggregation and risk reporting, which was followed in December 2013 with a progress report. The report has highlighted the need to drastically improve data management capabilities. As banking increasingly becomes a technology business, better use of big data can have a multiplier effect. Risk Appetite and Governance: The Financial Stability Board (FSB) has published guidelines on how supervisors should assess risk culture within financial institutions. Defining an appropriate risk appetite framework can enable investors to understand the bank s risks better and adjust their expectations. Having a risk appetite framework in line with the business model can reduce the informational asymmetry with investors, who currently consider most banks as comparable with the same return expectations. Figure 2. Other Regulatory and Structural Trends Mandating Business and Operational Review 50

51 The three dimensions of emerging derivative models on which investment firms will fiercely compete and disruptions may be imminent are the depth of liquidity they can offer, the breadth of synergistic services they can cross-sell and the level of uniqueness or differentiation they can establish in their propositions. These three characteristics will need to be predicated on a robust operating model that can ensure sustainable operational effectiveness in order to build credibility and facilitate product take-up and client penetration in the market. These three strategies made popular by renowned management strategist Michael Porter can be combined with a common infrastructure model to create shared value. By focusing more on cooperation, otherwise infeasible cost efficiencies can be exploited, and flexibility in competitive strategy can be maintained for participants reducing exit/adjustments costs. Depth of Liquidity: The investment firm aspires to achieve economies of scale and establish cost leadership by attracting as much customer flow as possible and competing on price and breadth of venues. Breadth of Services: The investment firm aspires to achieve economies of scope by providing an end-to-end service that offers the maximum level of synergistic value-added services in order to meet the client s holistic needs and drive cross-selling. Niche Focus or Bespoke Customization: The investment firm aspires to differentiate its offering by focusing on specific products, client segments or geographies based on its strengths or relationships, in order to become a credible specialist provider, e.g., specializing in bespoke OTC products with higher margins. Depth of Liquidity Price Best Price C High Volume Multiple Trading Venues Niche Focus Product Choice Electronic Trading Venue Clearing House Smartorder Routing Breadth of Services Client, Product or Regional Focus (Balance Sheet Strength) Niche Bespoke Products Multiple CCPs Trade Repository Collateral Mgmnt. Client Choice Customer Service Figure 3. The Three Dimensions of Emerging Derivative Models CROSSINGS: The Sapient Journal of Trading & Risk Management 51

52 Operating Model Considerations Ensuring connectivity with key market infrastructures, such as CCPs, and electronic trading venues, such as SEFs and OTFs, will require extensible operational infrastructures and efficiencies. In the pre-trade space, reference counterparty data will need to be extended and cleansed in order to enable smooth client onboarding and compliance with Know your Client (KYC) regulations. Banks will need to select and onboard to electronic trading platforms, which will require the rationalization of existing platform connections that do not offer much benefits relative to costs. Trade execution will require effective order aggregation and smart routing in order to ensure best execution, while data analytics will play a role in ensuring collateral efficiency through CCP margin calculations based on real-time market prices. Trade capture, confirmation and clearing will require system rationalization across asset classes and products, especially given OTC and ETD convergence. A centralized cross-asset and product agnostic platform can reduce back-office costs by minimizing fragmentation and allowing better enterprisewide risk data aggregation and reporting. The level of automation needs to increase to capture efficiencies especially for products which currently lag in automation, such as bespoke products and commodity derivatives. In addition, exchange trading will initiate a shift from mark-to-model valuations to mark to market, increasing the importance of reliable market data feeds and group-wide clock synchronization. Clearing across assets and CCPs to provide netting and end-to-end service benefits will be the major selling point of one-stop-shop dealers focusing on synergistic derivatives-related capabilities in order to build economies of scope. The wider adoption of electronic trading of standardized OTC products in order to attain economies of scale in central clearing and trading can help incumbents with broad installed client bases. These firms will try to attract as much client flow as possible, by offering competitive transaction pricing and connectivity with the widest selection of trading venues and CCPs. With the possible emergence of buy-side market makers, an agency-based or sponsored access execution model will rely on processing efficiency to lower unit costs and enable competitive pricing, while aggregating sufficient volume of bids/offers and multiple liquidity providers. CONCLUSION To fully capture the opportunities emerging from financial reforms, market players need to evolve their strategies, reengineer their business models, delineate their differentiated capabilities and build partnerships in order to effectively deal with the fundamental power shift away from dealers. Players who strategically invest in building the required data analytics and increasing operational efficiencies through automation, system consolidation and industrialization, will develop robust technology infrastructures and risk frameworks. These capabilities will allow them to dominate, stay competitive in the new environment and rapidly capture share in the new market. 52

53 Resources 1. BCBS, Principles for effective risk data aggregation and risk reporting, January BCBS, Progress in adopting the principles for effective risk data aggregation and risk reporting, December BCBS, Fundamental review of the trading book: A revised market risk framework, October Bank of International Settlements (BIS), Authorities Access to trade repository data Consultative Report, April EC, EU Framework for bank recovery and resolution, June EC, EU proposal for a regulation on structural measures improving the resilience of EU credit institutions, January ESMA, Joint Position of the European Supervisory Authorities on Manufacturers Product Oversight & Governance processes, November FSB, Guidance on Supervisory Interaction with Financial Institutions on Risk Culture, April FSB, Principles for an Effective Risk Appetite Framework, November FSB, Seventh Progress Report on Implementation of OTC Derivatives Market Reforms, April International Swaps and Derivatives Association (ISDA), 2013 ISDA Operations Benchmarking Survey, April Organization for Economic Cooperation and Development (OECD), Update Report on the Work to Support the Implementation of the G20 High-Level Principles on Financial Consumer Protection, September Porter, M.E. & Kramer, M.R. Creating Shared Value, Harvard Business Review, Jan/Feb Steven Maijoor, ESMA Chairman, Keynote Speech, ICMA Annual General Meeting and Conference, June 2014 THE AUTHORS Paul Gibson is a Business Consultant based in London specializing in capital market initiatives. He is currently working at a top European investment bank focused on the impacts of regulatory reform on execution, clearing and reporting workflows. Prior to this, Paul spent time at a top market infrastructure provider, initiating a cross-asset industry project designed to facilitate the reporting of OTC derivatives to a global trade repository. pgibson@sapient.com Kimon Mikroulis is a Business Consultant based in London specializing in alternative investments, such as commodities, structured products and managed futures. He is currently engaged in OTC derivatives regulatory reform, working at a top European investment bank on cross-border regulatory reporting and system integration across products and asset classes. Kimon has experience across the capital and commodity markets, having previously worked at an oil major on trade documentation of physical oil contracts. kmikroulis2@sapient.com Cian Ó Braonáin is the global lead of Sapient Global Markets Regulatory Reporting practice providing guidance, insight, leadership and innovative solutions to the company s regulatory reporting and response project portfolio. Cian has over 14 years of experience as a lead business analyst, project manager and business strategist, developing methodologies and tools for solving the risks of regulatory impact and change. He has been involved in numerous regulatory reporting projects, many of which focus on pre-compliance date readiness activities, such as analysis, implementation and post-compliance assurance activities. cobraonain@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 53

54 REMIT: bringing physical commodity trading into the regulatory spotlight As far back as the 1986 Financial Services Act, regulators in the UK have had the authority to oversee activities related to commodity derivatives, but until recently, their presence was negligible. Despite the advent of the Financial Services and Markets Act in 2000 and a move from self to statutory legislation, the regulatory focus on commodities remained limited. The weight of rule-making was restricted to just two small handbooks one for energy market participants (EMPs) and one for oil market participants (OMPs). With the Regulation on Wholesale Energy Market Integrity and Transparency (REMIT), however, that is about to change. In this article, David Wardley and Owen LaFave discuss REMIT, its anticipated impact and what companies need to do to ready their organizations for compliance. For more than a quarter of a century, commodity market participants who did not hold a banking license flew largely under the regulatory radar. This has progressively changed during the last four or five years as a result of the financial crisis. Much of what has been enacted so far, such as Dodd-Frank and EMIR, has been targeted at the derivatives market. However, the next piece of legislation to go live throws a net over part of the physical commodity market. REMIT (EU) No 1227/2011 is concerned with ensuring that electricity and gas markets across the European Union (EU) are regulated in such a way that retail consumers and market participants can have confidence in the integrity and operation of the supply and demand in wholesale power and gas. It also mandates that prices be set in a fair and competitive manner ensuring an absence of market abuse. REMIT came into force on December 28, 2011 outlining three implementation strands: 1. The identification of insider trading 2. The provision of frameworks to prevent or deal with market abuse 3. Market transparency through the reporting of eligible trades to an approved repository The scope not only covers derivative contracts (which are already captured under EMIR as noted above), but also contracts related to the underlying physical commodity itself, in addition to the transportation and storage agreements that firms execute to deal with the custody of the commodity in question. 54

55 There is a final layer of complexity on the reporting side with the requirement to report orders to trade as well as the executed trades themselves. Given the low latency of market price change in the electronic information age, there is likely to be a large amount Enforcement & report back to ACER ACER Receive Data EU-wide screening of submitted data of data associated with entering, amending and cancelling pre-trade orders, which will be a challenge for market participants to capture. Compliance with all three strands will require a data NRA Decision and Enforcement ACER Access Data model comprising a specified field set for transaction reporting, plus some form of automated method of monitoring and creating alerts when this data suggests errant trader behavior. NRA determination of suspected breach NRA Informed and Review in Detail Suspected REMIT breach THE REGULATORY BODIES INVOLVED IN IMPLEMENTING AND ENFORCING REMIT Figure 1. REMIT Enforcement Model The responsibility for implementing REMIT has been assumed by the Association for the Cooperation of Energy Regulators (ACER), at the request of the Directorate-General for Energy (DG Energy). DG Energy is the European agency responsible for the Implementing Act, which defines the operation of REMIT as enacted by the European Parliament. Once the Implementing Acts are in place, the ownership of the registration and enforcement of market participants will be assumed by the National Regulatory Authorities (NRAs) who will in turn be coordinated at an EU level by ACER, completing the circle. ACER is then responsible for the analysis of submitted data. Initial alerts of any data breaches will be investigated by ACER with any further requirement for detailed investigation and/or enforcement passed to the relevant NRA. For the UK, the relevant NRA will be Ofgem, which is already actively regulating the distribution network and supplies of power and gas to retail customers. As the nominated NRA in the UK, Ofgem will now find itself overlapping with the Financial Conduct Authority (FCA), who will continue to own transparency and market behavior enforcement in the derivatives part of power and gas portfolios. As a result, firms under the influence of REMIT will also need to meet the requirements of yet another regulator. ACER is in the process of locking down its user manuals for market participants, potential regulatory reporting mechanisms (RRMs) and system operators. They are currently out for review and will be published along with the adoption of the implementing standards. ACER mandates that the onus for the delivery of data should fall on the various system operators: Transmission system operators (TSOs), storage system operators (SSOs) and LNG system operators (LSOs). These infrastructure providers are required to register as RRMs and will deliver reportable data to ACER s REMIT information system (ARIS), a designated repository. CROSSINGS: The Sapient Journal of Trading & Risk Management 55

56 REPORTING TRADES UNDER REMIT The ARIS architecture requires that all reporting be done via an RRM. (Trade repositories will register as RRMs, possibly under a lite program.) If market participants wish to report their own data, they will first have to complete the registration process to act as an RRM. There is a provision within REMIT for firms to use third-party RRMs to act on their behalf; however, experience with the outsourcing of reporting responsibility under Dodd-Frank and EMIR suggests that there will be no delegation to third parties until firms who generate reportable data are able to audit the custody capabilities of RRMs. As a result of its discussions with the industry, ACER currently expects that at least 200 entities will register as an RRM to fulfill their responsibilities. Given the resourcing constraints within ACER, the approval and onboarding of this many RRMs between adoption of the implementing acts and the go-live date will be difficult. ACER appears to be taking a phased approach to bringing the legislation to life, initially capturing standard contracts traded on organized market places (OMPs). This will be followed by a second go-live at a time to be determined, which captures standard and non-standard contracts, however and wherever they may be executed. The definition of standard is broad and includes anything offered on an OMP. Similarly, the OMP definition is fairly wide and includes bilateral trades done through brokers via voice. The only scenario not captured in phase one would be direct peer-to-peer trades not involving any third-party agency. THE IMPACT ON DATA MANAGEMENT The regulation drives many firms into a data management model that they have not previously had to consider. For example, market participants must ensure the recording and reporting of data, much of it mandatory, that most don t currently collect and that their books and record systems are not configured to capture. Assuming the capture problem can be resolved, the next challenge is configuring IT systems to transmit and reconcile the order, trade and fundamental data to ensure the integrity of information in repositories. Finally, firms will need to decide how to manage the monitoring of trader behavior to recognize activity which constitutes a breach in terms of insider trading or market manipulation. It is likely that this can only be done by implementing software which scrutinizes data patterns that are present within the firm s databases. One favorable element of ACER is that firms do not have to report trades that have already been reported to a trade repository in compliance with EMIR legislation. This will reduce the volume of REMIT-reportable derivative trades, but will not include the orders which led to those trades. This order reporting requirement is one of the more challenging. Orders to trade are not currently reportable under EMIR legislation, so although the exemption for trades already submitted is useful, the requirement to report the orders related to those trades under REMIT introduces a significant problem. Tracking and flagging the order data for EMIR-reported trades for further reporting to a different database could prove to be an enormous task. 56

57 Fundamental Data RRMs Order and Transaction Data Fundamental Data Investment Firms Energy Producers Large Energy Consumers TSOs Fundamental Data Fundamental Data Order, Trans and Fund Data Order, Trans and Fund Data Order, Trans and Fund Data ACER s ARIS system Figure 2. A Generalized Potential REMIT Data Flow Model Ctp ACER guidance is clear in trying to place the main burden on system operators rather than market participants; however, firms often express concerns regarding the passing of data across third-party platforms instead of direct to the repository itself. A proportion of the data reported is commercially sensitive, so there is apprehension related to any lack of security to protect their client or the exposure of valuable proprietary information to the third party. Add in the reconciliation burden of using one or more third-party RRMs, and it is clear that firms have some decisions to make. Even though there are many moving parts with REMIT, firms should be asking the following questions now rather than waiting for the Implementing Acts: In terms of RRM selection (if going down the third-party route): Have providers been identified, commercial agreements finalized and are contracts and SLAs in place? How will market abuse or insider trading be spotted and alerts generated within the organization? How will reconciliation take place to ensure that externally reported data has been delivered accurately for both orders and transactions? Has the approach for REMIT report delegation been agreed upon either for the counterparts or to the counterparts? Is the internal plan in place to be compliant in the six-month window between the adoption of the Implementing Acts and the go-live of REMIT reporting? CROSSINGS: The Sapient Journal of Trading & Risk Management 57

58 Conclusion Heading into 2015 and beyond, the market is expecting further directives and regulations in Europe around market abuse, (MAD/MAR) and financial instruments (MiFID II/MiFIR overhaul), which will bring additional burdens to some commodity traders who had previously been exempt. Firms need to deal with REMIT delivery promptly to prevent stacking of programs to meet the next wave of regulation. Requirements related to REMIT may not be the end of the story firms should continue to keep themselves abreast of the intentions of Norwegian and Swiss regulators. Although they are not bound directly by EU statutes, they are driven to ensure alignment with European regulatory efforts, particularly in cross-border markets such as the coupled power market. Plans are being drawn by both to have parallel repository schemes to collect data in their respective jurisdictions. If they haven t already, commodity market participants need to quickly come to terms with the fact that they are no longer immune to regulation and take steps to protect their ability to trade in their chosen sectors. A lack of prompt action could mean that firms will not be ready by the time legislation goes live, leaving them able to execute only non-compliant trades. A large number of market participants and infrastructure providers are uncertain about their readiness to meet ACER delivery expectations. Many firms appear to be dormant in their preparations, with some waiting for the adoption of the Implementing Standards before committing to a course of action. This could lead to further tactical delivery which will again diminish a firm s ability to drive efficiency across its compliance framework. Firms need to deal with REMIT delivery promptly to prevent stacking of programs to meet the next wave of regulation. 58

59 As the wider global program of legislation continues to roll, most if not all firms will have to change their trade execution approach and enhance the management of data records. To date, firms have taken a tactical approach to complying with regulations but this will ultimately lead to an inability to scale up to meet new business opportunities. Firms will need to begin to carry out strategic planning across the trade lifecycle and focus on some key areas including development in deal representation, standardization of data field values, enterprise-wide reconciliation of data and consolidation of system architecture to support margin and collateral optimization. This article was written in August of 2014 and therefore does not reflect any changes to the draft Implementing Acts from that point forward. THE AUTHORS David Wardley is an industry expert with over 30 years of experience in the commodities sector. He has developed significant commercial, operational, compliance and change management skills at a mix of blue chip financial institutions, independent trading companies and as a consultant. Responsible for the operation of businesses in both physical and financial commodity sectors, David has a wealth of experience across the full range of asset classes, energy, metals and agriculturals. Owen LaFave is a Director at Sapient Global Markets London office and has over fifteen years of experience within the energy and financial services sectors. He began his career implementing enterprise trading and risk management systems and transitioned to managing enterprise system implementations, frontoffice risk and control work and most recently regulatory compliance. Owen has spent the last year participating in many ACER working groups and is focused on ensuring Sapient Global Markets clients are prepared for REMIT compliance in the most effective manner possible. olafave@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 59

60 PURSUED BY A BEAR: implications of banks leaving the traded energy markets With investment banks winding down or selling off their energy trading divisions, there is a void developing in the traded market. In this article, Ujjwal Deb, Rashed Haq and Lukasz Hassa discuss the reasons for the banks exit, the impact on market participants and how the market might respond to these changes over time. The past year has seen an unprecedented exodus of global investment banks from the traded energy markets. This once-in-a-generation change is dramatically reshaping the commodity market landscape since the Enron debacle in the early 2000s, when many US merchants exited the energy markets and banks streamed in chasing high returns, which led to a commodities boom that lasted until Today, the industry is coming full circle, with banks leaving and commodity merchants reentering the market. Commodity trading revenue in 2013 for the top ten banks was $4.5 billion, down from $14 billion in 2008, according to Coalition, a London-based business intelligence provider. 1 The primary reasons for banks leaving the commodity business are the tightening of their margins, increasing reputational challenges and the new regime of regulation being implemented across the globe. The lack of volatility in commodity prices, especially for natural gas and oil in the United States and power in Europe, makes it harder to earn money from financial trades. Simultaneously, some of these banks have been levied hefty fines or have been investigated for manipulating markets. Finally, regulations, such as the Volcker rule limiting proprietary positions and CFTC position limits, are the latest in a long line of regulator actions increasing the burden of physical trading for banks. Of the ten largest commodity trading firms in 2013, eight were banks and six of those have exited or are looking to exit the market. The lack of volatility in commodity prices, especially for natural gas and oil in the US and power in Europe, makes it harder to earn money from financial trades. 60

61 RESPONSE BY MARKET PARTICIPANTS With the banks exit, how will the other market participants, such as utilities, oil and gas producers, consumers and merchants, respond to fill in the void? Investment banks (e.g. Deutsche Bank, JP Morgan, Goldman Sachs) Utilities (e.g. E.On, RWE) Traded Energy Markets Oil and gas majors (e.g. BP, Chevron, Shell) Merchants (Vitol, Mercuria, Trafigura, etc.) Figure 1. Key Players in the Traded Energy Markets With their business model under unprecedented threat from the onslaught of renewables, utilities are facing their own set of challenges. As a whole, European utilities lost half their market capitalization between 2008 and 2013, according to The Economist. 2 Low wholesale power prices and a lack of volatility have contributed to lackluster results from their trading desks. If it were not for lower gas prices, US utilities would fare similarly. As a result, utilities ability to take over a big part of the role of the banks in the energy markets is uncertain. Oil and gas producers and consumers have largely been bank customers focused primarily on trading just enough to satisfy the needs of their existing assets, such as refineries, pipes, etc. One notable exception is an oil major that announced last year that it will register as a swap dealer and provide some of the services traditionally offered by the banks. The remaining oil and gas companies are maintaining their prior position. Hedge funds have had limited physical involvement in the commodity markets and may face some of the same challenges as banks. Emerging players, often backed by private-equity-funded balance sheets, are positioning for some of the market share that the banks are leaving behind. However, it will take time for these firms to grow significant market share. This leaves the merchants, with large trading footprints, well placed to take advantage of the vacuum in the energy markets. Merchants have already begun to buy up energy assets across the globe and acquire businesses from banks (e.g., Mercuria buying JP Morgan s business, Rosneft acquiring Morgan Stanley s business). CROSSINGS: The Sapient Journal of Trading & Risk Management 61

62 EVOLUTION OF THE TRADED ENERGY MARKETS This rise of merchants is considered good for overall market safety because while they have significant presence to provide liquidity, they are not considered to be too big to fail. This is primarily due to two reasons. First, they are simply not that big, although they will grow over time. For example, Glencore is the largest merchant by assets and would rank 60th on the list of banks by assets. Second, banks are engaged in the business of taking short-term liabilities (bank deposits) and funding longterm assets (loans to corporates), which leads to a continuous need to roll over liabilities, leaving them very prone to bank runs. Merchants, on the other hand, do not generally engage in this kind of business and have current assets that are often greater than their current liabilities. Thus, the possibility of a merchant failure, giving rise to a wave of other failures, is remote. There are, however, risks to the rise of merchants. The transition will move the major provider of liquidity and complex financial products from the most transparent and most sophisticated firms to possibly the least so. Merchants are often the least transparent participants in the market because they are generally privately held and are less sophisticated and less experienced than the banks in managing the risk of financial products. End users who were used to having banks provide them with sophisticated hedging and other financial products will now have to look elsewhere to meet these needs. It is possible that merchants will ramp up this business area, especially since many have hired former bank employees. However, they will also face a steep learning curve in terms of process and system sophistication, something that took banks decades of effort and money to achieve. Lastly, the merchants smaller balance sheets will limit the liquidity that the banks were able to provide as market makers, particularly in cases of temporary liquidity loss in a particular commodity. AN ACTION PLAN FOR MARKET PARTICIPANTS For merchant firms to take advantage of this opportunity, they will need to position themselves for renewed internal governance and possible regulatory oversight. Internal governance will need to be enhanced to speed time-to-market for new business areas. Merchants will need to define an operating model that provides visibility across all business areas so that new products and offerings can be quickly assessed. Plus, they will need to establish relevant decision trees for hedging strategy and the review and management of residual risk in incomplete markets. Merchants will need to overcome two key challenges for this shift in governance to work. The first entails moving the organizational mindset from a siloed decision authority to an integrated one where some desks or business areas may have to take a small loss for other areas to make a greater profit, allowing the firm to benefit. Complex financial products cannot survive on their own: they need to live and thrive in an integrated portfolio. The second challenge is to increase the sophistication and speed of the integrated business and decision processes through the improved use of technology and quantitative methods. This requires a level of investment and sophistication that is unknown to most merchant firms. While Commodity Trading and Risk Management (CTRM) systems may have been a source of competitive advantage in the early days, today they are a baseline requirement. As they enter the energy and commodity markets, merchants must focus on 62

63 preparing their businesses from both a process and technology perspective in order to effectively compete. In fact, some of the larger players have already begun outsourcing the business process execution and technology pieces to vendors with proven experience and deep expertise with CTRM systems and the market. Undoubtedly, more will follow. For years, merchants have been able to avoid heavy regulation because most are privately held. Regulatory oversight is likely to change over time. Across different jurisdictions, regulators are increasingly stepping up their focus on the energy and commodity markets. For example, REMIT in Europe will focus unprecedented scrutiny on all players in the energy and commodity markets. (Read more about REMIT in the article entitled, REMIT: bringing physical commodity trading into the regulatory spotlight, on page 54). Dodd-Frank and the CFTC have already put in place sweeping requirements for energy and commodity firms in North America. CONCLUSION There is some trepidation among market watchers about how well merchants can fill the vacuum left by banks in the energy and commodity markets. However, with the right focus on transparency and increasing the sophistication of their decision-making and business processes, merchants can be in a good position to step up and lead the energy marketplace. Resources 1. banks-commodities-idusl6n0ln19o The Economist, How to lose half a trillion euros, October 12, 2013 THE AUTHORS Ujjwal Deb is a Vice President at Sapient Global Markets based in the Netherlands. He has seen the capital and commodity markets evolve over the last 17 years as a trader, risk manager and an advisor. Ujjwal specializes in harnessing technology to solve complex problems in the energy industry and has been responsible for multi-million dollar engagements at a variety of energy firms, focusing on asset optimization, data management and deal lifecycle management. udeb@sapient.com Rashed Haq is a Vice President of Business Consulting at Sapient Global Markets. Based in Houston, Rashed specializes in trading, supply logistics and risk management. He advises oil, gas and power companies to address their most complex challenges in business operations through innovative capabilities, processes and solutions. rhaq@sapient.com Lukasz Hassa is a Business Consultant based in London. He has extensive experience in middle-office operations and trade lifecycle management in the capital and commodity markets. Currently, Lukasz is working as a project manager on a major implementation of a front-to-back oil trading platform. lhassa@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 63

64 CHANGING PARADIGMS IN COMMODITY MARKETS: what are price reporting agencies doing to remain on top of their game? The commodity markets have witnessed major fundamental shifts in recent times. For example, advances in mechanical and chemical engineering in the energy markets have accelerated the ability to extract and process energy sources previously thought inaccessible at an unprecedented scale. Massive investments in infrastructure are transforming the future of extracting, processing and transporting raw materials everything from agricultural products, base metals, natural gas, coal, petrochemicals and refined products in order to meet the growing needs of the rising world population. New trade flows and trade patterns are emerging to supply new markets particularly in Asia. Rapid industrialization, growing populations and profound socio-economic changes affecting hundreds of millions of people worldwide are creating new game-changing consumption patterns. In this article, Leor Jivotovsky and Jeffrey Wang discuss how these new paradigms are affecting the Price Reporting Agencies (PRAs) and how they are adapting their product and service offerings in the face of these new realities. WHAT ARE PRICE REPORTING AGENCIES? PRAs are publishers and information providers who report prices transacted in physical and some derivative markets and give an informed assessment of price levels at distinct points in time. Their core activity comprises the publication of market reports containing the price assessments, market commentary and news, and business intelligence reports that analyze market and industry trends. As physical commodity markets continue to evolve, PRAs will continue to play a central role by providing the needed pricing, analytics and transparency to these markets and fulfill their roles as information providers. For example, Platts and Argus, two of the major PRAs, each publish over 8000 price assessments per day across energy, metals, agriculture and freight markets and are staffed by hundreds of reporters overseeing specific commodities. In the past, market participants possessed information advantages a phenomenon in economics known as information asymmetry. One can argue that because of PRAs, the competitive advantage that firms may have had in the past from superior price information has been largely marginalized. 64

65 PRAs fill an important role by collecting, collating, editing and disseminating information. In the absence of PRAs, subscribers would rely on alternative sources of market information and would need to augment their own internal collection and analysis activities likely at a much higher cost. PRAs provide much needed transparency in what is otherwise a largely unregulated and opaque $5.7 trillion a year physical market. 1 Unlike markets for stocks and futures, where trading is conducted on regulated exchanges with prices visible to all, the buying and selling of physical commodities is largely private. Although some physical exchanges have developed over the years providing trading venues for various commodity asset classes, such as the European Energy Exchange or the InterContinental Exchange, the bulk of physical trading is still conducted bilaterally and privately between counterparties. ENERGY METALS AGRICULTURE FREIGHT CHEMICALS Platts X X X X X Argus Media X X X X X TSI X IHS/McCloskey X The Baltic Exchange X X ICIS Heren X X Reuters X X X X X Oil Price Information Service (OPIS) Rim Intelligence Co. Asia Petroleum Price Index C1 Energy X X X X USDA X X DTN WPI/US Grains X X London Metal Exchange London Bullion Market Association London Silver Market Fixing Limited X X X Figure 1. The Major PRAs and What They Cover HOW ARE PRICE ASSESSMENTS FROM PRAs USED? Price assessments are used as references in physical supply contracts and ultimately determine the settlement value for the commodity being bought or sold and the cash flows that ensue. In other words, they represent the index in physical trade. Financial derivative contracts traded on exchanges or in the over-the-counter (OTC) market also reference price assessments. They are also used for mark-to-market purposes, as an indication of value for tax assessments and for analysis and planning purposes. They are used by commodity markets participants such as producers, end users, marketing and trading companies, banks, governments and regulators. CROSSINGS: The Sapient Journal of Trading & Risk Management 65

66 Prices may be assessed by a PRA but may not be considered a benchmark price. An assessment becomes a benchmark when it is well entrenched in physical commodity contracts as a price setting index. Only when price assessments are used as reference prices that ultimately determine the settlement value of contracts do they gain benchmark status. Becoming the benchmark is the prized achievement for a PRA as it establishes dominance and notoriety in that particular market and secures a steady stream of revenues for the PRA. Dependency on voluntarily disclosed market data means that socialization of assessment methodologies is important in the creation of a more thorough and accurate assessment. Market players need to be able to understand that participation in the process benefits all parties involved through efficient price discovery especially true in illiquid markets where only a few data points can be gathered. Firms are also more likely to utilize assessments when they understand what data is being used and how prices are ultimately published. METHODOLOGY Assessments adhere to specific sets of principles, guidelines and formulas. Assessment methodologies will vary between PRAs and even between different commodity assessments covered by the same PRA. Reporters monitor their markets, collect data and publish assessments by applying their methodologies and market analysis to the data collected. Market data (i.e., trade details, bids, offers) is gathered from participants across the industry via exchanges, telephone, instant messaging, and other combination of data platforms. Transaction details, bids, offers, volumes and counterparties are all voluntarily disclosed by market participants with the belief that participation leads to optimal price discovery and enhanced market liquidity. Various safeguards and quality control processes ensure that assessments are unbiased, not subjected to manipulation and reflect the true market price. Measures might include: the removal of lowest/highest bids and offers, removal of other outliers, normalization of data, required verification of supplied information, periodic reviews of participants, counterparty acceptances and other defensive tools. Ultimately though, acceptance is left to the best judgment of the editor/reporter in charge of the assessment. A SPOTLIGHT ON THE METHODOLOGIES Calculation methodologies particularly for oil markets have caused international scrutiny of PRAs. In 2011, the G20 Leaders Summit requested that IOSCO assess the role of PRA assessment calculation methodologies, as these assessments have impacted the physical oil markets, broader financial markets and the economy as a whole. The IOSCO subsequently published a report in October 2012 that identified significant problems with the methodologies employed by some major PRAs and provided recommendations on addressing these concerns. One problem highlights how different methodologies cause the price reported by one PRA to differ from that reported by another PRA for the same product location and delivery period. On particularly volatile days, the differences can be substantial. PRAs willingly describe their methodologies and insist that they adhere to them but judgment inevitably enters into the application of these methodologies. Although the industry views the work of PRAs to be high quality, some feel that PRAs exercise too much power and that there is no one to whom they can appeal when they believe the PRA s judgment to be wrong. Recent allegations of benchmark manipulation have attracted the scrutiny of regulators. Since contracts rely heavily on these benchmarks to determine pricing, market players have the incentive to try and 66

67 move assessments to their favor. These benchmarks are also used as a guide to price consumer end products, so end users may be bearing more costs than fair market price. In the last few years, PRAs and industry players have been probed and raided on accusations of collusion, a charge that they are vigorously contesting. In the face of this criticism, some alternatives to PRAs have emerged. One such solution is the Energy Data Hub (EDH) a service that collects market information from participants based on actual transactions, performs all of the validation and standardization processes, and then publishes market metrics such as prices, volumes and volatilities. EDH is a market utility that provides the industry with much needed price discovery and alternative benchmarks particularly in more opaque markets. One of the major differences with PRAs is that EDH only uses actual transaction data rather than bids and offers that are contained in PRA assessments. One can argue that such an approach legitimately represents market prices. DEMAND FOR NEW ASSESSMENTS With fundamental supply shifts and demand rebalancing, PRAs are constantly looking at their product offerings to see what assessments need to be created, modified or eliminated in order to respond to client demand and preferences. To support more editorial coverage in a particular market, PRAs can look at a market from four key dimensions: Market Fundamentals Market Participants Market Structure Market Positioning Market Fundamentals Factors to consider: History Supply/Demand Imports/Exports Trade Flows Market Drivers & Risks Market Trends Market Participants Factors to consider: Addressable Market Market Size Top Market Players Market Concentration Community Should We Launch? Market Structure Factors to consider: Contact Types Physical & Derivatives Markets Transaction Mechanics Contract Types Market Readiness Market Positioning Factors to consider: Current Capabilities Competition SWOT Competitive Advantage Figure 2. The 4Ms Guiding the Strategy for Price Assessments Legend: Research Components Evaluation Criteria CROSSINGS: The Sapient Journal of Trading & Risk Management 67

68 RECENT EXAMPLES A few examples of recent market developments can demonstrate how PRAs need to be thinking about their assessment coverage. According to the Energy Information Administration, US crude oil production will reach 8.5 million barrels a day (mbpd) of production by the end of 2014 up from just 5 million barrels per day in A lot of the new supply is coming from production basins that are not adequately served by a pipeline network. In order to bring this abundant supply from oil fields to refineries throughout the United States, rail with 140,000 miles of track has been the mode of transportation used. Figure 3 illustrates the phenomenal growth of crude by rail % 600 Crude Oil 43% Carloads (thousands) Other Petroleum Products % Crude Oil 2% 1% 2% 3% 4% 9% 18% Source: Association of American Railroads Figure 3. US Petroleum Products Rail Traffic (Originated Carloads) As an example and noted in Figure 4, one area in which production has exploded is the Williston Basin, where rail represents the major mode of transportation. To meet the growing needs of producers, the number of rail terminals (at a price of a few hundred million dollars per terminal) being built in just 3 years has gone up by a factor of 5 from 3 terminals to 16 and loading capacity has gone up 10 times in the same time period, as shown in Figure 5. 68

69 1% 20% 8% Exit Terminal Capacity (000s BPD) (LHS) # of Terminals (RHS) % Estimated Rail Truck to Canadian Pipelines Pipeline Export Tesoro Refinery Source: Association of American Railroads Figure 4. Estimated Williston Basin Oil Transportation Source: Platts, North Dakota Pipeline Authority Figure 5. Bakken Crude Rail Capacity and Total Rail Terminals As a result, PRAs have introduced new freight intelligence and rail price information and assessments at major crude rail junctions and rail terminals for crude and even other markets such as chemicals, forest products and grains. Applying the 4Ms to this example, the PRA must recognize how changing market fundamentals are pointing to new trade flows and transportation dynamics. A review of the market structure demonstrates to the PRA that new types of contracts have developed with new volumes. In addition, the addressable market and community includes new local producers and railway companies as potential new clients. With the analysis of the 4Ms, the PRA takes the step to launch the assessment. It must then ensure its quality and completeness to achieve industry adoption. Another area that has caught the attention of PRAs is the global liquefied natural gas (LNG) market. Since the 1960s when LNG was first produced in Algeria and delivered to the United Kingdom, demand has grown 500 times and has attracted 30 countries. Today, world LNG trade involves 158 country-to-country flows with over 370 sea transportation routes with 70% of LNG demand coming from Asia. Exports on average have been rising over the years, as shown in Figure 6. Demand is strong because countries are seeking supply diversity or energy security. Japan, for example, has practically replaced nuclear energy with LNG following the nuclear disaster in Other markets, such as Korea, Taiwan and China, are seeing natural gas displacing coal as a cleaner, increasingly abundant and relatively low carbon form of energy that can meet their growing needs. To support this demand, liquefaction capacity needed to liquefy gas into LNG has exploded with many projects currently under construction or being proposed, as shown in Figure 7. Viewing the LNG market across the 4Ms provides the PRA with a perspective on how its product strategy for LNG should evolve. CROSSINGS: The Sapient Journal of Trading & Risk Management 69

70 bcm Figure 6. Global LNG Exports Source: Bloomberg MMtpa Operational Under Construction Proposed Source: Bloomberg Figure 7. LNG Throughput Capacity (annual) 70

71 CONCLUSION PRAs will continue to play a central role in commodity markets. They will continue to develop new assessments that aim to accurately reflect the market value for these products. By adapting assessments to reflect new paradigms and emerging trends, they strive to provide the industry with the needed market information that ultimately helps make more knowledgeable business decisions. PRAs will continue to play a central role in commodity markets. Resources 1. Bloomberg, Feds $5.7 Trillion Gift Imperiled on Yield Rise: Credit Markets, June 7, 2013, trillion-gift-imperiled-on-yield-rise-creditmarkets.html 2. MarketWatch, Oil futures drop; U.S. production at highest in decades, August 12, 2014, THE AUTHORS Leor Jivotovsky is a Director with Sapient Global Markets Commodity Practice. Since joining, Leor has been involved in a broad array of initiatives supporting Sapient Global Markets advisory and business consulting services for clients particularly involving risk management. Prior to that, Leor had been involved in the commodity derivative markets since 1999 as a trader and risk manager and led the product management of a front- and middle-office system with a vendor. ljivotovsky@sapient.com Jeffrey Wang is an Associate within the Trading & Risk Management practice for Sapient Global Markets. Based in the New York office, Jeff currently provides commodity market analysis. His current role is that of analyst focusing on regulatory reform, digitalization and commodities research. Jeff was part of the campus new hires (class of 2012), graduated from NYU and took part in Sapient Global Markets Institute program in India. jwang5@sapient.com CROSSINGS: The Sapient Journal of Trading & Risk Management 71