OVERCOMING THE COST AND COMPLEXITY OF CENTRAL CLEARING MANDATES

Transcription

1 OVERCOMING THE COST AND COMPLEXITY OF CENTRAL CLEARING MANDATES

2 Central clearing and recent change in the over-the-counter (OTC) derivatives markets in the US and Europe has focused on minimizing systemic risk to the financial system. Firms subject to mandatory clearing and the associated reporting requirements are impacted by increased costs with an adverse effect on profitability. Regulations, such as the European Market Infrastructure Regulation (EMIR), place tremendous pressure on the clearing community since it requires both sides to report all cleared positions to trade repositories (TRs). Conversations over clearing costs are migrating to the forefront of the ongoing debate over OTC derivative clearing. More importantly, firms are searching for ways to alleviate these costs. Regulatory mandates have not only increased IT spending, but have also driven the emergence of new business models in which functions that were once performed by each financial institution individually are evolving into industrialized utility solutions. Meanwhile, the buy side and sell side alike seek help from futures commission merchants (FCMs), investment banks, custodians and service providers for regulatory reporting and delegated reporting for their clients. But for banks, asset managers and insurance companies, regulatory reporting is not within their core competency. The industry is on the brink of transformation, as firms 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. This is especially true as firms consider how to increase efficiencies, reduce costs and improve returns while addressing the global nature of regulations. Sapient Global Markets conducted a survey at the FIA EXPO in November 2014 in Chicago to examine the impact of central clearing mandates among brokerdealers, buy-side firms, exchanges, FCMs, proprietary high-frequency trading (HFT) firms, regulators and sellside firms. From the 120 responses, three key challenges and opportunities came to the surface: the cost of clearing, regulatory uncertainty and complexity and the concept of clearing utilities. Overcoming the Cost and Complexity of Central Clearing Mandates 2

3 MAJOR IMPACTS ON THE BUSINESS Central clearing mandates affect different areas of the business in different ways, which can vary depending on the type of firm. The areas impacted the most are portfolio performance, compliance, cost of clearing, risk management, operational complexity, margin management, staffing/capacity, reporting and collateral management. In Sapient s survey at the 2014 FIA EXPO, firms were asked how central clearing mandates have impacted various areas of their business. Compliance had the highest overall rating among 50% of respondents, and 4 out of the 7 types of firms (57%) highlighted compliance as impacting their business the most. On a scale of 1 to 5, with 5 being the greatest level of impact, FCMs rated reporting as having the greatest impact (rated at 3.95), while sell-side firms said operational complexity and margin management (rated at 3.88) had the most effect. Portfolio performance ranked lower than other factors (2.53). However, an argument can be made that the cost of clearing and compliance ultimately affects portfolio performance. A conclusion can also be made that respondents do not believe central clearing mandates are affecting their choice of products. For exchanges, collateral is crucial because of concerns over concentration risk and credit, as well as increased scrutiny by regulatory bodies. Exchanges gave collateral management high ratings in terms of impact on their business (3.63), although exchanges also rated all areas of their business high in terms of impact on the business. How have the new CENTRAL CLEARING MANDATES impacted the various areas of your business? (with 1 being the LEAST level of impact and 5 being the GREATEST level of impact) Collateral management Reporting Staffing/capacity Margin management Operational complexity Risk management Cost of clearing Compliance Portfolio performance SAPIENT CORPORATION

4 How have the new CENTRAL CLEARING MANDATES impacted the various areas of your business? Sell Side (8) Regulator (8) Prop HFT (14) FCM (20) 4 out of the 7 types of firms (57%) highlighted COMPLIANCE as impacting their business the most. Exchange (39) Buy Side (20) Broker Dealer (11) Collateral management Reporting Staffing/capacity Margin management Operational complexity Risk management Cost of clearing Compliance Portfolio performance Overcoming the Cost and Complexity of Central Clearing Mandates 4

5 REGULATORY UNCERTAINTY, COMPLEXITY It is no secret that central clearing mandates are overwhelming firms ability to generate the required reporting due to its sheer volume and complexity. But a key concern of many market participants is continued regulatory uncertainty and the lack of understanding of changing rules. The Sapient survey revealed that the area of greatest concern for all respondents other than sell-side firms is in understanding the regulations, including 62.5% of the regulators who completed the survey. The second and third greatest concerns among respondents were cost impact and implementing a technology solution, especially among FCMs and sell-side firms. These were the top three concerns for 81% of firms interviewed, other than the sell side. Concerns around the effect of risk profile changes and the impact of collateral and margin management were of least concern to all firms (an average of 17.76%). As market participants are mainly focused on keeping the business running, it is not surprising that collateral and margin were of least concern since continued low trade volumes translate into higher amounts of collateral and cash. What is your greatest concern related to new clearing regulations? Sell Side (8) Regulator (8) Prop HFT (16) FCM (25) Exchange (43) Buy Side (20) Broker Dealer (12) 0% 20% 40% 60% 80% 100% Understanding the regulations Cost impact Implementing a technology solution Change to firm s risk profile Impact on collateral management Impact on margin management Other 6.77% 1.00% Understanding the regulations 4.69% 6.30% 18.71% 36.13% Cost impact Implementing a technology solution Change to firm s risk profile Impact on collateral management Impact on margin management Other *chart shows cumulative average for all firm types 26.47% SAPIENT CORPORATION

6 Most respondents were confident that their firm is either ahead of pace or keeping pace with regulations, with a strong trend toward keeping pace. This is likely due to the cost of regulatory reporting and the frequent change of rules, leading some firms to decide it is best to react to regulations, rather than to get ahead of them. More than 55% of exchanges said they were ahead of pace, which is notably higher than the 44% of regulators who said the same. On average across all firms, less than 3% said they were trailing the regulations. However, more than 12% of proprietary HFT firms believed that their firm was behind on the new clearing regulations, which is considerably higher than all other types of firms. Cost and uncertainty of rules impact smaller firms ability to keep pace due to fewer resources to dedicate to the effort. How prepared is your firm to comply with new clearing regulations? Sell Side (8) Regulator (8) Prop HFT (16) FCM (25) Exchange (43) Buy Side (20) Broker Dealer (12) Ahead of pace Keeping pace with regulations Barely keeping pace with regulations Trailing the regulations I don t know 0% 20% 40% 60% 80% 100% 13.80% 2.83% 9.97% 35.61% Ahead of pace Keeping pace with regulations Barely keeping pace with regulations Trailing the regulations I don t know *chart shows cumulative average for all client types 37.77% Overcoming the Cost and Complexity of Central Clearing Mandates 6

7 COST OF MANDATORY CLEARING The central clearing environment is creating more challenges for businesses to reach their revenue targets and make the necessary investments to meet new and evolving regulatory mandates. The high cost of resources to meet reporting requirements will only increase as the cost of non-compliance will begin taking effect in 2015 in the United States and Europe. Sell-side firms are especially affected because compliance with new regulations ultimately increases costs, which is taxing their current business models. For FCMs, the technology required is pure cost. In the Sapient survey, 40% of FCMs and 37.5% of sell-side firms said cost was their greatest concern related to the new central clearing regulations. The cost of central clearing can be viewed in two distinct parts: operations and infrastructure, which is highly commoditized and market and capital, where there is opportunity to impact profitability. With operations and infrastructure, there is little strategic advantage or opportunity to differentiate services or increase revenue. However, with market and capital, which require risk management tools and collateral management capabilities, rules are prescribed and only become meaningful to firms once cross margining comes into play. Therefore, focusing on efficiency and cost of operations and infrastructure is the only viable path for market participants to positively impact profitability. The marginal cost of clearing regulations is outpacing the clearing market itself as additional products enter the central clearing environment. As US regulators are urged to employ a phase-in period for foreign exchange (FX) derivatives to be traded on swap execution facilities (SEFs) after they become subject to mandatory clearing, firms will be faced with additional costs. The industry must assess the marginal cost-benefit of mandating additional products to be cleared. While some firms are leaving the business due to cost pressures, other firms with the capital and efficiencies in place are entering the business. The cost of clearing remains an obstacle for many large custodians, although firms with strong credit and client footprints are in a strong position to enter the business even if they may not have the operations and infrastructure in place. SAPIENT CORPORATION

8 THE EMERGENCE OF CLEARING UTILITIES Market participants, regulators and exchanges are beginning to recognize the idea of clearing utilities as the answer to reducing the cost of complying with central clearing mandates and improving business profitability. The cost and effort to acquire the architecture to support central clearing is just part of the equation. What was built today may or not be appropriate tomorrow; therefore, operations and architectures need to be flexible to change in step with regulations, and the burden of maintaining the architecture to support regulatory change may be too great for many firms. Regardless of the time, cost and effort that many organizations have spent building their own regulatory systems, many in-house systems are inadequate to meet the demand. The enormous strain of EMIR reporting on an organization today and the advent of other products entering the mandatory clearing space will cause many systems to fail unless significant investments are made on an ongoing basis. Those institutions that did not initially provide OTC clearing on behalf of their clients are seeking client clearing utilities, although so far, many have underinvested in systems to support the activity. For these firms, the cost of capital and establishing an infrastructure are key challenges, but they have an opportunity to commercialize utilities to manage compliance, risk management, operations and infrastructure, while minimizing the cost of clearing. In the Sapient survey, buy-side firms, FCMs, proprietary HFTs and sell-side firms all indicated potential positive interest of 50% or more in a purpose-built utility to address unique buy-side clearing requirements. Broker- Dealers and FCMs may be more receptive to utilities in the future because they address the cost of operations and infrastructure. Potential positive interest in a purpose-built utility (mutually owned by market participants or non-profit firms) to address unique buy-side clearing requirements 18% 10% 15% 10% 17% 14% Broker Dealer (12) Buy Side (20) Exchange (43) FCM (25) Prop HFT (16) Regulator (8) Sell Side (8) 16% Overcoming the Cost and Complexity of Central Clearing Mandates 8

9 Would you be interested in a purpose-built utility (mutually owned by market participants or non-profit firms) to address unique buy-side clearing requirements? This would bring market participants together into a consolidated framework. Sell Side (8) Regulator (8) Prop HFT (16) FCM (25) Exchange (43) Buy Side (20) Broker Dealer (12) Yes, very interested Yes, but only if it was mutally owned/non-profit No Maybe I don t know 0% 20% 40% 60% 80% 100% 16.06% 24.91% 11.10% 12.53% Yes, very interested Yes, but need to more fully understand the offering No Maybe I don t know *chart shows cumulative average for all firm types 35.40% SAPIENT CORPORATION

10 THE EMERGENCE OF CLEARING UTILITIES At the heart of regulatory reporting are data and standards for formatting and transmission. Much of the data reported across the different regulatory mandates is redundant, driving demand for a consolidated reporting solution to alleviate the need to report the same information multiple times to multiple bodies. This challenge came to the attention of the Commodity Futures Trading Commission (CFTC) following a plethora of no action letters from market participants. The CFTC has since commissioned a special council to review required data and analyze how to streamline reporting for the marketplace. The rise of OTC cleared derivative trade transmissions requires reporting standardization amongst FCMs, custodians and asset managers. The lack of formal standards for formatting and transmitting data has led to an increased operational burden and risk. As such, mandatory clearing highlights a major problem for all firms product identification. The Universal Product Identifier (UPI) has long been thought of as an unattainable concept 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. With the move towards electronic trading and greater straight-through processing (STP), market utilities and clearing demand this. A UPI would provide a catalyst to standardization as well as help to improve the reporting process as a whole and help to reduce the operational burden for all market participants. Collateral managers, custodians and service providers are responding positively to utility models. In the meantime, industry discussions around margin methodology and collateral management results push forward, but what form this will take in the future and the investments required to solve these challenges remain to be seen. Buy-side firms notably appear keen on designating non-core business operations to industry-wide utilities. In the Sapient survey, 75% of buy-side firms indicated a potential positive interest in utilities. Of the 75%, 10% said they were very interested and 45% said they were interested but need to more fully understand the offering. The demand for utilities among the buy side is in direct response to their position at the center of their asset manager clients and the clearing brokers to deliver the information they need. It is also in FCMs best interest to deliver different types of reports for each of the asset managers, who dictate to their custodians and FCMs the specific report formats they require. Such a utility would allow them to share the cost of meeting these needs, as well as make client onboarding a simpler and more efficient process. Overcoming the Cost and Complexity of Central Clearing Mandates 10

11 Would your firm be interested in designating non-core business operations to industrywide utilities? Examples include the transformation of messages into a standard format or a utility to assist with a firm s KYC obligations. Sell Side (8) Regulator (8) Prop HFT (16) FCM (25) Exchange (43) Buy Side (20) Broker Dealer (12) Yes, very interested Yes, but only if it was mutally owned/non-profit No Maybe I don t know 0% 20% 40% 60% 80% 100% 16.06% 24.91% 11.10% 12.53% Yes, very interested Yes, but need to more fully understand the offering No Maybe I don t know *chart shows cumulative average for all firm types 35.40% SAPIENT CORPORATION

12 CONCLUSION Regulations are greatly increasing reporting requirements, particularly in the mandatory central clearing space. Firms are now faced with the task of collecting trade data, transforming it into required formats and submitting it all within a specified timeframe. These requirements are greatly increasing the cost and effort of compliance, which is adversely affecting business models and profitability. 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 standardize access to common intellectual property, company resources can be better allocated to strategic initiatives that result in greater efficiency and business profitability. Solutions are emerging to address the challenges of central clearing mandates and have the opportunity to level the playing field for most market participants through greater efficiency and cost reduction of reporting and compliance. Sapient Global Markets is in a unique position to provide solutions that help market participants minimize the cost of mandatory central clearing. Its solutions and strategy practice, as well as collaboration with industry associations, include a clearing utility environment, regulatory reporting solution and a clearing connectivity standard to address sell-side challenges. About Sapient Global Markets Sapient Global Markets, a division of Sapient (NASDAQ: SAPE), is a leading provider of services to today s evolving financial and commodity markets. We provide a full range of capabilities to help our clients grow and enhance their businesses, create robust and transparent infrastructure, manage operating costs, and foster innovation throughout their organizations. We offer services across Advisory, Analytics, Technology, and Process, as well as unique methodologies in program management, technology development, and process outsourcing. Sapient Global Markets operates in key financial and commodity centers worldwide, including Boston, Chicago, Houston, New York, Washington, D.C., Calgary, Toronto, London, Düsseldorf, Frankfurt, Geneva, Munich, Milan, Zurich, and Singapore, as well as in large technology development and operations outsourcing centers in Bangalore, Delhi, and Noida, India. For more information, visit sapientglobalmarkets.com Sapient Corporation. Trademark Information: Sapient and the Sapient logo are trademarks or registered trademarks of Sapient Corporation or its subsidiaries in the U.S. and other countries. All other trade names are trademarks or registered trademarks of their respective holders. Sapient is not regulated by any legal, compliance or financial regulatory authority or body. You remain solely responsible for obtaining independent legal, compliance and financial advice in respect of the Services. Overcoming the Cost and Complexity of Central Clearing Mandates 12

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