INSIGHT REPORT RECONCILIATION INDIVIDUAL CLIENT SEGREGATION IN PRACTICE MANAGING THE OPERATIONAL IMPACT OF EMIR

INSIGHT REPORT RECONCILIATION INDIVIDUAL CLIENT SEGREGATION IN PRACTICE MANAGING THE OPERATIONAL IMPACT OF EMIR

Contents 1 A new era for derivatives operations 1 EMIR comes into effect 2 Client segregation under EMIR 3 The impact of individual client segregation 3 The role of reconciliation in individual client segregation 4 Reconciliation checklist 5 Plan to control the costs of client segregation

Individual Client Segregation in Practice Managing the Operational Impact of EMIR 1 A new era for derivatives operations The global financial crisis of 2008 revealed an urgent need to improve the transparency and risk management practices of the over-the-counter (OTC) derivatives market, worth around $500 trillion in notional value. As a result, in 2009, the G20 summit passed a resolution stating that: All standardized OTC derivatives contracts should be traded on the exchanges or via electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs) by end of 2012 at the latest. EMIR comes into effect What is EMIR? Five years on from the G20 summit of 2009, EMIR essentially translates world leaders high-level decisions about the derivatives market into European regulation. In general terms, it has the same intent as the US s Dodd-Frank Act: to mitigate systemic risk and increase transparency. However, the specific requirements of the two regulations vary in particular, the individual segregation mandate is specific to EMIR only. Who does EMIR affect? In terms of organizations, EMIR applies to all buy-side and sell-side firms involved in derivatives trades, defined as any bilateral or exchange-traded transaction between two counterparties. These include financial institutions such as investment banks, brokers and institutional asset managers, and non-financial corporations that trade derivatives. Geographically, the regulation affects any entity that was established in the EU or is trading either with an EU entity or on a European exchange. How will EMIR affect your organization? In line with this resolution, the US and Europe, the two biggest markets for OTC derivatives, passed the Dodd-Frank Act and the European Markets Infrastructure Regulation (EMIR) respectively. As well as mandating the central clearing of standard OTC contracts, both regulations require derivatives counterparties to report trading activity to an approved trade repository. Singapore, Australia and Japan have now also approved similar rules. For the global derivatives market, the new reporting obligations represent a major operational challenge. With the EMIR requirement now in effect, this paper aims to highlight the potential impact of client segregation on a firm s exchange and CCP reconciliation processes. It also provides practical advice on steps organizations can take to minimize the impact of setting up and reconciling individually segregated accounts at the CCP. Sell-side institutions EMIR will affect sell-side financial institutions such as investment banks and brokers in a number of different ways. As well as reporting all derivatives trades to a registered repository, they must clear standard OTC contracts at a CCP. Should their customers request it, they will also need to maintain individually segregated accounts at the CCP, for both their OTC and ETD investments. Buy-side institutions and corporations Buy-side financial institutions, and non-financial corporations that trade derivatives, have the same obligation as the sell side to report their OTC and ETD trades to a repository. They must also make sure they keep an accurate record of the Unique Trade Identifier (UTI) that must now be attached to each trade. In addition to reporting under EMIR, buy-side institutions, both financial and non-financial, must have formalized, robust and auditable portfolio reconciliation processes. That means matching their own data on portfolio positions against their broker s statements. While portfolio reconciliation is itself a long-established practice, EMIR has introduced tighter guidelines on how to manage the process and, in particular, disputes between the buy side and brokers.

2 Individual Client Segregation in Practice Managing the Operational Impact of EMIR Client segregation under EMIR To protect investors, sell-side institutions have always been required to keep their own holdings and those of their clients segregated. Recently, however, this rule has failed to prevent a number of well-publicized bankruptcies from putting customer assets at risk. In light of such events, EMIR will now require CCPs and their general clearing members to offer further levels of segregation and protection for investors assets and positions. The requirement applies to both ETD and cleared OTC derivatives. What levels of segregation must CCPs now offer? A CCP will be required to offer two basic types of account segregation: omnibus client segregation and individual client segregation. Omnibus client segregation is the official term for the level of segregation offered until now at derivatives clearing houses. Here, the CCP keeps one set of records and accounts for the assets and positions of each clearing member, and a second, separate account for the assets and positions of all that members clients. Under EMIR s new individual client segregation requirement, Europe s CCPs must allow their clearing members to keep a separate account for the holdings of a particular client: clearly distinguishable from all their other clients assets and positions. Which financial institutions will be affected? Once a CCP has made individual client segregation available, all sell-side institutions that are registered as clearing members will have to offer their investors the option of segregating their positions and margin (as well as any excess margin) in the CCP s books and records, by holding them in an individually segregated account (ISA) at the CCP. Alternatively, investors can opt for their assets to remain in their broker s existing omnibus account at the CCP concerned. Separate models for individual client segregation may be offered by the CCP. In one (sometimes called the sponsored principal model), the clearing member is dis-intermediated and clients deal directly with the clearing house in particular settling their own margin calls. In another, sometimes known as the ISOC model, the assets and positions of a client are fully ring-fenced from those of other clients, but the clearing member still acts as an intermediary, and margin calls are commingled. In giving clients a choice between an individually segregated account and an omnibus segregated account, the institution must inform them of the cost and level of protection offered by the ISA option. When will individually segregated accounts become available? According to the regulatory requirements of EMIR, all derivatives clearing houses based in the European Union will introduce the option of opening individually segregated accounts by the end of 2014. Different clearing houses will start providing support for individual segregation from different dates, some as early as Q1. Once a clearing house starts offering support for ISAs, so must its general clearing member.

Individual Client Segregation in Practice Managing the Operational Impact of EMIR 3 The impact of individual client segregation The regulatory requirement to offer individually segregated accounts to investors will affect sell-side institutions on two levels: financially and operationally. Financial impact From the financial perspective, individual client segregation will limit brokers ability to cross-margin between the holdings of different investors. Under the omnibus client segregation arrangement, sell-side institutions can offset one client s position with another, for example a long-side contract with a short-side contract. This netting of positions allows them to post less collateral at the CCP than they have actually received from their customers. The role of reconciliation in individual client segregation For investment banks and brokers, reconciliation will be key to maintaining accurate records on individually segregated accounts. By reconciling their books and records against those held at the CCP at the level of each individually segregated account, institutions can validate their data and guarantee that positions, trades, cash and collateral deposited are correct for their clients on a daily basis. This will, however, require firms to reconcile large numbers of accounts within their environment without increasing cost and risk. When a client s holdings are kept in an ISA at the CCP, there is no longer an opportunity to take advantage of such netting. The margin the sell side receives for a trade will be exactly what it posts at the CCP. Operational impact While the potential loss of cross-margining opportunities is clearly beyond the sell side s control, there is much that firms can do to manage the significant impact that individual client segregation will have on their operations and systems. From having to maintain just two accounts at the clearing house, sell-side institutions may soon need to handle tens or even hundreds of individually segregated accounts. So, there is an urgent need to prepare operations in general, and their reconciliation processes in particular. The challenge will be to manage these pressures without also increasing their running costs.

4 Individual Client Segregation in Practice Managing the Operational Impact of EMIR Reconciliation checklist To prepare their reconciliation operations for individual client segregation, sell-side institutions must consider their ability to manage the following key operational challenges. 1. Reconcile larger numbers of accounts For best practice, firms should reconcile their own records of investors assets and positions with those held by the CCP. Previously this would have involved matching just two accounts at the CCP against the details on their own system. Now that the number of client accounts at the CCP is set to expand, so must their back-office account setup and omnibus regeneration logic. In other words, every individual account that firms open for a client must be reflected in their own back-office systems, for continued one-to-one reconciliation at the end of every trading day. It is therefore critical that the reconciliation process can withstand a sudden increase in the number of accounts to be reconciled. This means putting processes in place that can manage a higher number of reconciliations in around the same amount of time: ingesting and working with larger amounts of data, without extra pressure on existing resources and staff costs. 2. Gain a consolidated view of accounts With multiple new accounts to manage, firms will routinely need to analyze a much larger amount of reconciliation data especially to learn their overall position at a CCP. For those using manual processes, such as a single spreadsheet for each account, consolidating their reconciliation results and gaining a holistic picture of their clearing house activity will create new time and resource pressures. 3. Rapidly set up new accounts for reconciliation As well as needing efficient new ways to handle unprecedented numbers of clearing house accounts, sell-side reconciliation teams face a major on-boarding challenge. Each time a client requests a segregated account, one must be set up not only at the CCP but also on the sell-side firm s reconciliation system, in the short time before the account becomes active. As accounts are unlikely to have the same name at the CCP and in the back office, they will then need to be mapped from one system to the other, using translation logic. This intricate set of processes will typically need to be repeated for multiple clients and clearing houses, which will represent individually segregated accounts in different ways in their systems and the reports they publish to members. Rigorous review and approval stages must also be built in, to minimize errors and risk. Here, in the interests of both time and costs, the challenge for operations teams will be to manage these new complex tasks without the intensive involvement of IT specialists. High levels of automation and intuitive systems will therefore become increasingly essential for the efficient on-boarding of new accounts for reconciliation. So, while matching has to take place at the level of individual accounts, sell-side institutions must also have easy access to both a detailed and an aggregated view of all their CCP reconciliations.

Individual Client Segregation in Practice Managing the Operational Impact of EMIR 5 Conclusion: plan to control the costs of client segregation By the end of 2014, all sell-side institutions that clear derivatives in Europe will need to manage the impact of individual client segregation on reconciliation operations. How successfully they do so depends largely on how well they prepare their systems. Retaining a high proportion of manual processes will inevitably expose firms to mounting costs and risks, with pressure on resources and higher numbers of reconciliations to be completed before the market opens each day. The more individually segregated accounts they open, the greater the potential for escalating numbers of breaks and issues. In this situation, firms face an important choice: to hire more staff or to invest in automation. The former will create costs in both the short and long term. Through automated systems and well-defined processes, however, sell-side institutions can gain a highly efficient, scalable solution to their growing operational challenges. As demand for individually segregated accounts grows, investment in automation will therefore almost certainly prove the more sustainable option.

About FIS IntelliMatch Operational Control solution suite FIS IntelliMatch Operational Control provides organizations with a comprehensive reconciliation solution for data collection, rules processing, automated matching, exception management and reporting, helping them manage derivatives market change. The suite of solutions enables firms to ensure connectivity to a fast-changing market infrastructure, increase efficiency for lower operational costs, and reduce risk to manage regulation and market volatility. Disclaimer The information contained in this document is provided for informational purposes only and does not purport to be legal, tax or professional advice. This document is provided on the understanding that its content is based on information available as of the date of publication and is solely intended to promote discussion and inquiry on the subject matter. The individual circumstances of a firm should always dictate the actions, if any, a firm takes with regard to the subject contained herein and FIS will not be held responsible for the results of any actions a firm may take in reliance upon or as a result of reading the information in this document. About FIS FIS is a global leader in financial services technology, with a focus on retail and institutional banking, payments, asset and wealth management, risk and compliance, consulting and outsourcing solutions. Through the depth and breadth of our solutions portfolio, global capabilities and domain expertise, FIS serves more than 20,000 clients in over 130 countries. Headquartered in Jacksonville, Florida, FIS employs more than 55,000 people worldwide and holds leadership positions in payment processing, financial software and banking solutions. Providing software, services and outsourcing of the technology that empowers the financial world, FIS is a Fortune 500 company and is a member of Standard & Poor s 500 Index. For more information about FIS, visit www.fisglobal.com www.fisglobal.com twitter.com/fisglobal getinfo@fisglobal.com linkedin.com/company/fisglobal 2016 FIS FIS and the FIS logo are trademarks or registered trademarks of FIS or its subsidiaries in the U.S. and/or other countries. Other parties marks are the property of their respective owners. 1398