Redefining the Target Operating Model for Non-cleared Derivatives: A Business Imperative July 2015
Table of Contents Non-cleared OTC Derivatives Market Changes are Increasingly Real... 3 Financial Markets Business Lines are under Threat... 3 Transforming Organization and Business Processes: The New Target Operating Model... 3 What is a Target Operating Model?... 4 Non-cleared OTC Derivatives TOM: Primary Impact Areas... 5 Organizational and Business Process Impact of Non-cleared OTC Derivative TOM... 6 Time is Tight... 7 How InteDelta can Help... 7 Further Information... 8 2 2015 InteDelta Limited
Now that more realistic timelines have been announced for implementation of non-cleared derivative margin reform, banks are focusing on how to re-shape their business operating models to allow derivative desks to remain commercially viable in the post-compliance world. Nick Newport, Managing Director of risk management consultancy InteDelta, outlines the path which leading banks are taking. Non-cleared OTC Derivatives Market Changes are Increasingly Real Despite shifting milestones for implementation, the advent of stricter rules for the governance and risk management of non-cleared OTC derivatives is becoming ever more tangible. In March 2015, BCBS/ IOSCO published a long-awaited timeline revision for non-cleared derivative margin requirements compliance. This announcement set an initial implementation date of 1st September 2016, but allows for a phase-in of both Variation Margin (VM) and Initial Margin (IM) requirements. These timeframes remain stretching but, at least in comparison to the earlier dates, they are now realistically achievable for most market participants at least from an operational compliance standpoint. Financial Markets Business Lines are under Threat Whilst regulatory compliance is patently costly both from the perspective of project implementation and also ongoing running costs, for many banks this is only the tip of the iceberg. The more fundamental consequence of the rules for banks is the impact on the ongoing commercial viability of many business lines due to increased costs of doing business, particularly from the need to bear the cost of funding substantial IM requirements. When these are taken together with increased capital charges (across market risk, counterpart credit risk and liquidity risk) there is a material effect on the overall Return on Equity and headline profitability for many banks. In response, banks can either pass the costs on to customers (which is unlikely to be sustainable for end clients either), shut down unprofitable business activities or find ways to more efficiently manage scarce financial resources such as capital, liquidity and collateral. Banks are actively working to change the way they now manage their non-cleared OTC derivatives businesses to meet this challenge. Transforming Organization and Business Processes: The New Target Operating Model Historically, the end to end business process for managing derivatives was very straightforward and worked in clearly delineated horizontal siloes. The front office priced and executed trades; post trade processes were carried out by operations; and independent risk functions controlled risk exposures, limits and capital. This operating model was easily sustained by the pre-crisis economic conditions. Large counterparty defaults were few; funding and liquidity was widely available; balance sheet resources were not significantly constrained. The crisis turned this market environment upon its head and banks have needed to transform their operating models in response. The first major post-crisis step in operating model change for non-cleared OTC derivatives was the introduction of Credit Valuation Adjustments (CVA). This development passed large swathes of front line responsibility for the management of counterparty risk away from risk functions over to new CVA desks in the front office. These changes serve as a template for the organizational change which is now being undertaken on an even larger scale, primarily driven by non-cleared margin regulations. 2015 InteDelta Limited 3
In the evolving operating model, new activities need to be undertaken and some old activities need to find new homes. The contributions of the front office and risk are no longer siloed, they are now integral to the end to end process for managing non-cleared derivatives (both pre-trade and posttrade). However, this does not mean that the support functions are less involved Operations and Legal in particular have many new activities to undertake. What is a Target Operating Model? Use of the term Target Operating Model (or TOM) has now become widespread across financial institutions. The scope of usage does differ fairly widely depending upon the situation, however at its most fundamental level a TOM is the target framework for how a business will be managed from an organizational, governance and business process perspective. Sometimes this might also include a high level view of supported systems architecture too. A schematic overview of the TOM components is presented below. Diagram 1: Target Operating Model Components InteDelta Target Operating Model Functional ownership matrix definition Segregation of duties analysis Staffing / skills Functional process synergies Technology availability Organisational Model Definition Business Process Model Definition End to end process analysis Process efficiency Process controls Process harmonisation Technology automation Defining a TOM for non-cleared derivatives needs to begin with an understanding of the regulation and industry/market context. This regulatory context then needs to feed into the organization s business strategy. Once these are clearly articulated, the TOM can be defined in full alignment with this strategy. This logical flow is presented below. Diagram 2: Ensuring the TOM Supports Business Strategy Regulation and Market Context Business Vision and Strategy Target Operating Model 4 2015 InteDelta Limited
A good example of how understanding regulatory context and business strategy will inform the TOM for non-cleared OTC derivatives is to be found in the need to understand the commercial feasibility of each OTC derivative business line in the new future state environment. Even with an operating model which maximises efficiency of capital, liquidity and collateral inevitably some businesses, desks and product lines will no longer be profitable. This business feasibility needs to be undertaken at an early stage and will inform the TOM in important ways. Non-cleared OTC Derivatives TOM: Primary Impact Areas An overarching objective of the new TOM for non-cleared OTC derivatives is to ensure that ownership and execution of processes are in the right places to ensure efficiency, independence, and control. This should minimise risk, maximise profitability and maximise operational efficiency. The diagram below provides a high level overview of the departments involved in the end to end process model for non-cleared derivatives, with an emphasis on the process interaction required to support the new processes for collateralisation and margin. Diagram 3: Target Non-cleared Process Interaction for Collateralisation and Margin Desks Providing Collateral Desks Needing Collateral Treasury Enterprise Collateral Management / Funding Desk CVA Desk Risk Operations Collateral Management Desk Legal Settlements For most banks, working towards this target model is very much a work-in-progress. Many banks have come a long way already but there is still a lot to be done. At a more detailed level, the table below outlines some of the main changes in organizational and business process responsibilities needing to be implemented by banks in moving from the current state operating model to the new TOM. 2015 InteDelta Limited 5
Table 1: Organizational and Business Process Impact of Non-cleared OTC Derivative TOM Department Organizational Changes New Business Processes Front office Determination of future viability and strategy for each non-cleared OTC trading desk Central teams for managing price, liquidity and funding risks relating to collateral Define touch points with CVA/FVA desk Define touch points with central Treasury function Ownership for pre-trade pricing of margin costs Ownership for efficient collateral allocation Ownership for collateral cost attribution Ownership for collateral sell off in default events Ownership for model based disputes Set up of new middle office function to support front office in operational aspects of new activities Calculation of current and forecast IM Calculation of model based haircuts Collateral transfer pricing Pledging decisions and efficient collateral allocations Margin analytics, stress and scenarios Liquidity forecasting Cleared vs non-cleared decision making processes Oversight of booking of collateral movements Valuation of collateral Oversight of eligibility and concentration criteria Collateral liquidity Risk management Definition of a clear governance and process model between front office and risk for managing the risks involved in margin and collateral for non-cleared derivatives Key areas for consideration: IM calculations, haircuts calculations, ownership of eligibility and concentration criteria, collateral liquidity s Modelling IM in the capital model, especially under Internal Models Modelling IM in PFE models IM model backtesting and escalation processes IM model validation processes IM stress testing and scenario analysis for internal risk management Systematic wrong way risk identification, including on IM Automated and monitoring of concentration risk Modelling haircuts in risk models, aligned with industry models Collateral liquidity Dispute resolution processes and impact on Margin Period of Risk (MPOR) Involvement in new procedures to avoid cliff effects where large portfolios of non-eligible collateral need to be replaced Collateral management unit Definition of a clear governance and process model between front office and operations for end to end process Key areas for consideration: Pledging decisions, collateral booking, margin calculations, collateral valuations Daily VM exchange required with all covered counterparties FX haircut implies calculation by currency Monitoring of multiple agreements per counterparty Incorporation of IM into margin and dispute processes Incorporation of new haircut models into margin and dispute processes Monitoring of eligible collateral types, concentrations, wrong way risk Collateral segregation tracking: 3rd party segregation, default processes, re-hypothecation Intragroup margining: Variation Margin, exemption, intragroup risk monitoring Operations Ownership of external validation processes (reconciliation, confirmations, matching, trade reporting) are being harmonised across back office teams New reconciliation processes Changes to margin payments processing due to new utilities emerging Non-cash processes Increasing number of custodian contacts Legal and documentation Definition of ownership for agreement terms: negotiation, maintenance and distribution Definition of ownership for managing contingent liabilities (termination events etc) New documentation and changes to existing trading and collateral documentation New contract terms alongside legacy portfolio contract terms Agreements with counterparties that Initial Margin will not be collected for physically settled FX and principal exchange on cross currency swaps Agreements with counterparties not to exchange Initial Margin below the threshold Agreements with non-covered entities not to apply the rules Agreements with indirect clearing counterparties not to apply the rules Digitisation of documents and processes Centralisation of documentation storage, processing and distribution Finance and Treasury Definition of a clear governance and process model between front office and Treasury for balance sheet management and collateral funding Changes to feeds and regulatory reporting (e.g. RWA impact) 6 2015 InteDelta Limited
Time is Tight Ideally, a fully agreed TOM would be in place at the outset of every bank s non-cleared margin implementation project and all other implementation activities could use that as a reference point. However, agreeing large scale cross-departmental organizational change in banks is always difficult. Gaining agreement over a new TOM therefore takes time, particularly as it involves re-allocation of processes ownership across departments. Time is a particularly scarce resource when regulatory deadlines are looming. In reality then, most banks are still in the process of defining the end state TOM at the same time as they also develop the process and system capabilities to meet regulatory compliance. Even with the extended timelines for non-cleared margin compliance, time is still tight and there is still very little room for slippage. However, it does now give some banks a hope that, even from day one, they can not only comply but also transform their business models to protect the commercial viability of their OTC derivative activities. This InteDelta paper was originally commissioned by our partner firm Finadium and appeared in the June 2015 edition of Finadium s Securities Finance Monitor magazine https://www.secfinmonitor.com/sfm-magazine/. How InteDelta can Help The challenges faced in implementing the changes required to support non-cleared margining regulations are likely to be significant. InteDelta can help firms to implement these changes in the most effective way, and in line with industry best practices. We can help financial institutions build a programme of change in response to non-cleared margin regulations. Depending upon specific client needs, as part of such a change programme, some of the common services we provide are detailed below. Regulatory Impact Assessment We can help financial institutions to understand the detail of the non-cleared margining regulations and the impact these will have on their organisation. Our regulatory impact provides a detailed review of organisation, processes, policies and systems in order to assess what a given firm needs to do to address the compliance requirements, mitigate the impact and build on opportunities resulting from the regulation. The output of such an engagement is an impact and action plan. Target Operating Model Definition As outlined within the main body of this survey, responding to the non-cleared margin regulations will require (for most firms) a re- of the organisation and governance of the end-to-end collateral management process. We support firms in re-defining organisational structures and business processes through our collateral management Target Operating Model. This involves: Definition of governance and accountability principles for collateral processes Definition of strategic business organisation, department mandates and roles and responsibilities across front office, treasury, risk and operational functions Definition of target ownership of collateral management business processes Gap analysis of target organisation, governance and ownership versus current state 2015 InteDelta Limited 7
Industry Benchmarking We can provide formal market input to institutions embarking on the changes required by the non-cleared margin regulations. This can incorporate: Peer benchmarking (i.e. formally benchmarking your plans versus your identified peers) Client validations (i.e. surveying your clients to ensure your planned changes are aligned with their views and preferences) We use our wide collateral management industry network to obtain participants to support such benchmarking exercises. Changes to Risk Methodologies, Policies and Documentation As detailed within the survey, these rules will require significant changes to not just systems and processes, but also risk methodologies, policies and documentation. We can support impacted firms in each of these areas. Typically this may involve: Definition of Initial Margin and haircut methodologies, in line with the regulatory constraints Design of a validation and backtesting framework, including exceptions escalation process Support for updating risk policies to take into account Initial Margin, revised haircuts, eligibility, concentration limits, segregation approaches etc Detailed review of all legal agreements to identify where revisions are needed System Selection and Architecture Design As with most large scale regulatory change, significant systems change will be required to meet the demands of the non-cleared margin regulations. We support institutions to determine the extent that existing systems can be leveraged to support the new processes or, alternatively, what other technology options are available. For many firms, consideration of the external software vendor market may be necessary in order to support some or all of the new requirements. We have in depth knowledge of the risk and collateral management vendor landscape and use this to help or clients make the right technology choices. Implementation Support Through the lifecycle of change required to implement the non-cleared margining requirements, we support institutions through provision of the following services: Project management Subject matter experts (across collateral management, risk, regulation etc) Business analysis Functional testing Further Information If you would like to discuss any of the issues addressed in this White Paper, please contact: Nick Newport Managing Director Email: nicholas.newport@intedelta.com Tel: +44 (0)20 7887 2203 www.intedelta.com 8 2015 InteDelta Limited