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Tackling SFTR and collateral optimization strategically
Taking a holistic approach to the regulatory landscape
Read the article and learn about:
The regulatory landscape for collateral management
Tackling the impact of SFTR
Tactical projects vs operating model optimization
Taking a strategic approach to regulatory-driven change
David Field Managing Director, The Field Effect
About the author
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.
The Securities Financing Transactions Regulation (SFTR) is the latest regulation influencing all aspects of the securities finance market in Europe including transaction activities and collateral management. SFTR is another effort by the European Commission to increase financial market transparency, improve execution and provide greater harmonization across Europe. This article gives general guidelines on collateral optimization in a time of constant regulatory change, especially when tackling the impact of SFTR.
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 for compliance at the expense of optimization. With phased integrations and multiple iterations (e.g. 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 now also 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’. Secondly, firms need to evaluate how they are approaching this change. 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, Managing Director, The Field Effect
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. SFTR and MiFID II illustrate some - but not all - of the challenge points for financial institutions:
Secure Finance Transaction Reporting (SFTR) imposes a set of reporting requirements covering all securities finance 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 that the reporting requirement will present significant challenges.
Our initial impact assessments [of SFTR] show that the reporting requirement will present significant challenges. One of the many challenges is reporting the re-use of collateral.David Field, Managing Director, The Field Effect
One of the many challenges is reporting the re-use of collateral. Not only must the collateral receiver report whether they have permission to re-use the collateral, they must report its actual re-use, including the Legal Entity Identifier (LEI) of the security issuer. What happens if the issuer doesn’t have an LEI - how can it then be reported? If the collateral giver delivers cash, any re-use by the collateral taker is likely to be pooled with other cash received, how should cash re-use be apportioned across givers and reported accurately?
This problem could be much worse for sophisticated firms that optimize collateral utilization in central support functions that trade collateral on behalf of multiple product and financing desks such as equities, fixed income and group treasury. In contrast, smaller firms may decide to delegate SFTR reporting to a service provider, who will of course need timely information from the trade principal on what collateral has been re-used - how will that happen? Could it lead to re-use restrictions? Last, but not least, is the more strategic issue of liquidity. Some firms may reduce or stop securities finance activity altogether. Some non-EU firms may conclude that European SFTR reporting is just too difficult or expensive when weighed against sometimes modest returns, and may decide to redirect their trading strategies towards non-EU collateral counterparts to avoid the problem altogether. If your firm is one of these, now could be the time to review your stance. If you face such customers, now could be the time to consider the impact on your business, and to build routes to alternative sources of supply and liquidity.
As a large and complex regulation, MiFID II has many implementation pain points. MiFID II became 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.
MIFID II has largely postponed reporting in securities finance transactions until the introduction of SFTR. But when SFTR is in force, anything not reported by it may require additional reporting under MIFID II. In addition, other articles will affect securities finance - such as those around best execution and the use of algorithms, whilst the use of collateral in derivatives products requires reporting under EMIR.
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.
Impact diagram for margin requirements for uncleared derivatives (MRUD)
As an example, the diagram above shows our view of the impacts of the margin requirements for uncleared derivatives (MRUD). 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.
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.
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.David Field, Managing Director, The Field Effect
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 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 one eye on the opportunity created by externally driven change, in order to benefit the business operating models.