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The regulatory landscape for collateral management
Tactical projects vs operating model optimization
Handling change as the status-quo
Taking a strategic approach to regulatory-driven change
David Field, Managing Director
The Field Effect
Nick Stafford, Head of Operations
The Field Effect
With the regulatory merry-go-round turning at a healthy pace, the industry is starting to feel the effects of successive tactical projects and a race to compliance at the expense of optimization. With phased integrations and multiple iterations (see MiFID II, Basel IV, UCITS V), it feels like work finishes only for another iteration of regulation to be published. In collateral management, the key short-medium term regulatory timelines include; EMIR margin requirements (Dodd-Frank has already been implemented in the US), MiFID II implementation, and the reporting obligation of SFTR. This all means, regulatory-driven change is here to stay.
How can we handle change at such a pace? Firstly, organizations need to be comfortable with change as the ‘status-quo’, they need to ensure their change function is fit-for-purpose, and they must ensure that methodological approaches to preparation and implementation are embedded. Secondly, firms need to evaluate how they are approaching ‘the problems’. The volume of change projects has increased since the financial crisis and firms are often switching focus to assessing new regulations too late, meaning that tactical projects are regularly the only option. This leads to highly inefficient front-to-back office processes and technology architectures.
The need to move from a tactical to a strategic approach
As margins have been squeezed due to increasing capital requirements, the waste caused by tactical projects is getting more and more difficult to absorb. Short-termism is a key contributor and firms should consider opportunities to widen the lens of their regulatory focus. Specifically on the buy side, many custodians are pulling back from offering some of these services as an outsourced model because it is becoming increasingly expensive.
As margins have been squeezed due to increasing capital requirements, the waste caused by tactical projects is getting more and more difficult to absorb.David Field & Nick Stafford, The Field Effect
We wholeheartedly endorse the concept of a central change function and even a Chief Regulatory Officer as a senior position in any financial organization. Endorsement comes with a condition – their KPIs must be based on the efficiency of regulatory compliance. Our view is that constant change is unlikely to abate, the impact of this change is inefficiency, and the challenge facing the industry is to formulate a better strategic approach to a constantly shifting business operating model.
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Below, we briefly outline the regulatory landscape for collateral management in the investment management industry. The following four headings illustrate some - but not all - of the challenge points for financial institutions:
Margin Requirements for Uncleared Derivatives (MRUD) – EU implementation
This regulation mandates the exchange Variation Margin (VM) & Initial Margin (IM) bi-laterally for trades which cannot be cleared through a CCP (for the US, see the already implemented Dodd-Frank Act). VM requirements have been in force for all market participants since 1st March 2017. Implementation has not been successful with many firms not yet ready to exchange VM, either because of operational deficiencies or lack of proper legal documentation. Regulators have been encouraged by trade associations to take no action (known colloquially as ‘forbearance’) against non-compliant firms until the next Initial Margin (IM) phase-in date – September 2017. The process, control, and technology impacts for firms who have not previously been required to exchange margin are significant.
As a large and complex regulation, MiFID II has many implementation pain points. MiFID II becomes EU law in January 2018, with a number of different obligations including transaction reporting. Many firms are facing a race to be compliant by January and the contractor/consulting market has been busy to try and staff up last-minute projects.
Secure Finance Transaction Reporting (SFTR) imposes another set of reporting requirements over and above those outlined within MiFID II. Covering all Sec Fin trades, counterparts must report at transaction level to their trade repositories any new transactions or material changes to existing traded positions, including haircuts and collateral positions and valuations. There are 153 fields to report with approximately 40% being new. There are also industry-level challenges, including the requirement for Unique Transaction Identifiers (UTIs), which will have to be consistent across reporting on both sides of the transaction. There may also need to be a reconciliation and agreement process if both sides of the trade report materially different data. Our initial impact assessments show the reporting requirement to be a significant challenge.
Will the UK be heading towards a ‘hard Brexit’ in 2019? This would mean no retention to open access of the single market and, crucially, no guarantee of an EU ‘Passport’ for UK domiciled banks. This is not just a problem for UK/EU institutions as many firms from other jurisdictions (e.g. US & China) use the UK to host subsidiaries and do business with the whole EU. Post the ‘Great-Repeal Bill’, the regulatory environment will be uncertain – there are likely to be legal document re-papering requirements to ensure agreements, such as ISDA Master Agreements along with other contract types to either remove references to EU law or change the entity or jurisdiction.
Work on these four challenge points will either continue or commence over the next three years. Key to understanding how to approach them is to model impacts against the different dimensions of the business operating model.
To examine the impact of any externally (e.g. regulatory) or internally (e.g. merging desks) driven change, it is helpful to break down the business operating model into six key dimensions. Within the six dimensions, you can map impact against 44 sub-dimensions – for example ‘process’ can be broken down into activities, tasks, and work practices. Putting a score against each dimension will allow you to identify and visualize the areas your organization should focus on.
This diagram is our view of the impacts of Margin Requirements for Uncleared Derivatives. Let’s examine each of the highly-impacted dimensions:
Process – Firms should now be calculating VM but must prepare for IM. Some firms may not have sophisticated enough margin calling processes to cope with higher volumes. Collateral eligibility requirements must be met, necessitating new or expanded processes to deal with upgrades to High Quality Liquid Assets (HQLA). Industry working practices have evolved, there is a greater focus on utilities or the use of Triparty settlement services.
Controls – Instituting preventative and detective controls is vital to ensure that bilateral margin is called, received and reconciled against depot accounts and / or triparty agents (if used).
Roles and responsibilities – with new processes comes amendment to or new jobs or functions. The firm must ensure that they are recruiting the right experience and/or training existing staff to perform these duties.
Value – Will there be a collateral squeeze reducing the availability of HQLA and therefore increasing the price? Will this act as a drag on business performance?
Technology – Will you have to fund connectivity to new industry utilities? New functionality must be built. e.g. margin calculation, calling, valuation and selection. What level of automation do you require? Do you adapt, build, or buy?
The challenge, once you understand the impacts of any proposed change is to design a consistent operating model. Each organization has different priorities and ensuring that you take a holistic view across all dimensions, will be the best way to guarantee success. Just at a process level, you need to decide how you are going to change pre-trade, execution, collateral IM/VM calculation, margin call agreement, collateral processing and settlement processes. Even if you decide to outsource collateral management, you still need to understand and define end-to-end business requirements and understand the handoffs between the internal organization and an outsourced supplier.
Advises buy-side, sell-side, CCPs and custodians on collateral strategy, operating model and technology change.
Managing a change portfolio
Each regulatory or internal change driver is going to have an impact on the business operating model. Inefficiencies are not just the unfortunate consequence of tactical fixes borne out of slow reaction to regulatory requirements, but also because multiple change projects often occur in silos. As programs of change are mobilized independently of each other, the potential for communication across projects, for consistency of approach to technical or process requirements, and for program synergies is regularly overlooked. Many firms have central change functions capable of deploying resources onto projects, but responsibility for reacting to a regulation is often devolved to the business function it directly impacts. Implementing a business function whose responsibility is to consider the impact of regulatory change to the organization at a macro-level may help to ensure a consistent approach and efficiency benefits. The key is to think of these projects as opportunities to generate benefit to the organization as well as avoiding non-compliance issues.
Programs in-flight should be designed with an agile mindset, allowing emerging regulatory requirements to be integrated where there is significant commonality. Regulators also think with this mindset - ESMA stated they had considered MiFID II and MRUD requirements when designing SFTR. Whilst SFTR has its own challenges, both internal to organizations and for the market generally, there is an opportunity to take advantage of work already being done to reduce its disruptive impact. This opportunity to combine work can only be realized if the firm takes a holistic view towards change.
The industry trend over the past ten years has been towards constant accelerated change, particularly in the middle office. The challenge is to create an organizational model which embraces change, if not openly then at least flexibly, with a constant eye on the opportunity for this externally driven change to be used as a catalyst for benefit to the business operating models.
About the authors
David Field, Managing Director, The Field Effect
David is an acknowledged expert in clearing and collateral management with over 20 years financial services consultancy experience. He has advised buy-side, sell-side, CCPs and custodians on collateral strategy, operating model and technology change. David is a regular contributor at industry conferences as a speaker, panelist and moderator, and is the author of numerous specialist white papers. In 2014 he founded The Field Effect, a boutique consultancy specializing in advisory, transformation and delivery projects across investment banking. Previously David was a main board member of Rule Financial.
Nick Stafford, Head of Operations, The Field Effect
Nick is a consultant, business analyst and product manager. Nick joined The Field Effect in 2015 from Matrix Solutions (now Strategic Insight) and has co-authored several articles a white papers whilst also being deployed on projects with Tier 1 banks and hedge funds.