CROSSINGS

CROSSINGS The Sapient Journal of Trading and Risk Management

Edition Seven Fall 2012

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CROSSINGS: The Sapient Journal of Trading & Risk Management

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TABLE OF CONTENTS

INTRODUCTION: the Sapient journal of trading and risk management ...............................................................

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by Chip Register

EDITOR’S comments ................................................................................................................................................

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by Jonathan Davies

GLOBAL TRADE MONITORING, SURVEILLANCE AND REPORTING SYSTEMS: ....................................................... how new regulations are driving the need for these systems

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by Chakka Sreenivasulu and Hsing Hsing Li

MANDATORY ELECTRONIC EXECUTION: determining the most appropriate environment .................................

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by Ryan Baccus, Paul Gibson and Jon Szehofner

CLEARING CONNECTIVITY STANDARD: creating a more efficient and uniform approach .................................. for transmitting OTC clearing-related information

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by Jim Bennett and Jos Stoop

FOREIGN ACCOUNT TAX COMPLIANCE ACT (FATCA): can anyone in financial services afford to ignore this?.... by Karen Rossouw, Lizzy Conder and Mark Steadman

EUROPEAN ENERGY MARKET REGULATIONS: a brave new world for energy traders and utilities .................... by Ujjwal Deb and Shailesh Joshi

REFERENCE DATA: unlocking hidden information to gain a competitive advantage ......................................... by Jeremy Eckenroth, Raj Krishna and Anil Shenoy

CLASSIFYING DATA VISUALIZATION PATTERNS: a method for selecting and ....................................................... depicting accurate data visualizations

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by Julie Rodriguez and Francesco Brullo

ADVANCED PHYSICAL PORTFOLIO OPTIMIZATION: improving margins in a tight market ................................. by Rashed Haq, Aditya Gandhi and Sid Bahl

PALM OIL: unlocking the opportunity..................................................................................................................... by Anup Singh

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INTRODUCTION: The Sapient Journal of Trading and Risk Management We are at the point of change. For the US, key regulatory deadlines are imminent, and in Europe they will quickly follow in the spring of 2013. As firms drive to meet these deadlines, it is time to step back and ask the question: Will these mandates be able to deliver on their intent? Regulations, such as the Dodd-Frank Act, Basel III, Regulation on Energy Market Integrity and Transparency (REMIT), European Market Infrastructure Regulation (EMIR) and the Foreign Account Tax Compliance Act (FATCA) are changing incredibly complex market structures and mechanisms and these changes will ultimately affect operating models in ways we have yet to fully understand. Some market watchers suggest that, in trying to avoid another “too big to fail” scenario, this new legislation actually increases compliance and reserve capital requirements to such a degree that it will be difficult for smaller institutions to stay in the game. For those that can afford to play, the situation will force shifts—often substantial—in revenue models as well as cost management strategies. To create these shifts, firms will need to establish leaner trading operations that enable efficiencies in both processes and infrastructure.

This issue of CROSSINGS highlights some of the key themes impacting the capital and commodity markets and includes articles that address our changing regulatory landscape. I hope they provide some food for thought as we continue on this journey.

Best Regards,

Chip Register Senior Vice President and Managing Director Sapient Global Markets [email protected]

Much of the solution development work we’re doing for our clients is geared toward achieving operational effectiveness. On the one hand, firms are looking to create efficiencies through improved valuation and collateral management practices; and, on the other hand, they are seeking to reduce costs through better management and integration of front, middle and back office functions. In most cases, these solutions must also accommodate business model or corporate structure changes, sometimes large-scale, aimed at promoting revenue expansion within tighter, harsher regulatory paradigms. So as we near key deadlines in today’s regulatory reform, we’re not marking the end of the journey, but rather passing one of many milestones in a regulatory environment that continues to transform the financial markets. It is up to us to meet these deadlines and create operational infrastructures that help us thrive in the new order.

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EDITOR’S comments

Welcome to the fall edition of CROSSINGS. With so much change in the capital markets, we have tried to ensure that this edition balances the continued impact of regulations on our clients with new ideas for increasing efficiency and profitability within our clients’ organizations. The first half of this edition continues to look at the impact of new regulations on capital markets. Chakka Sreenivasulu and Hsing Hsing Li update us on the latest challenges facing broker dealers and asset managers when building global trade monitoring and surveillance reporting to regulators. The authors discuss the new demands for trade reporting and allocations and how to automate processes for reporting in order to reduce manual workarounds. This automation is vital if our clients are to reduce their operational risk. The next couple of articles update us on the OTC world. First, Ryan Baccus, Paul Gibson and Jon Szehofner write about mandatory electronic execution and its impact on an organization’s business model. Then, Jim Bennett and Jos Stoop detail how to create a more efficient and automated process for transmitting information on OTC cleared trades to regulators.

We close this issue with a look at the commodity markets. Rashed Haq, Aditya Gandhi and Sid Bahl discuss key considerations and recommended approaches for harnessing information to improve margins through advanced physical portfolio optimization. Our final article looks forward to an increasingly important asset class in commodities. Anup Singh discusses why palm oil is becoming so important in the commodity trading world and some of the challenges faced by traders interested in trading this increasingly important asset class. With every issue, we strive to include topics that are relevant to you and your business. Please take a moment to complete a brief survey at https://www.surveymonkey.com/s/sgmcrossings, so we can hear your thoughts on the themes and ideas covered in this edition.

Jonathan Davies

Editor No current regulatory update can exclude the impending impact of FATCA. Karen Rossouw, Lizzy Conder and Mark Steadman discuss FATCA and what this new tax legislation means for both our US and non-US clients. In our final regulatory update, Ujjwal Deb and Shailesh Joshi look at the European energy market and the effect new regulations will have on energy traders in Europe. In the second half of this edition of CROSSINGS, we switch emphasis from regulations to business processes and how they can be streamlined to create more profitability. Jeremy Eckenroth, Raj Krishna and Anil Shenoy look at sophisticated ways to redesign processes around reference data to make better use of that data and gain a competitive advantage. Julie Rodriguez and Francesco Brullo discuss ways of better visualizing data in order to leverage it more effectively in decision making.

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GLOBAL TRADE MONITORING, SURVEILLANCE AND REPORTING SYSTEMS: how new regulations are driving the need for these systems The 2008 credit crisis and expanding scope of the Financial Industry Regulatory Authority’s (FINRA) new regulatory program is creating tremendous pressure on Investment Advisor (IA) and Broker Dealer (BD) firms to automate their trade surveillance and reporting programs. There is an additional burden on IAs and BDs to automate compliance programs due to the impending deadlines of global legislation. All investment managers, wealth managers, hedge funds and broker dealers are affected by these new regulatory requirements. In this article, Chakka Sreenivasulu and Hsing Hsing Li discuss the key regulatory requirements and issues facing the buy side and highlight the current technology solutions available to help address them.

The Securities and Exchange Commission (SEC) Investment Advisors Act of 1940 mandates that IAs and BDs comply with various rules related to fair dealing, fiduciary duty, ethical standards of conduct, suitability, disclosure obligations, principal trading and advertising to their clients with respect to portfolio management, trading and reporting. Additional regulatory measures are periodically developed as a result of market events, such as a credit crisis, rogue trading or insider trading.

futures, complex derivatives and alternative investments along with equities, fixed income and foreign exchange, increases the complexity of an automated surveillance system’s compliance rules. The SEC has penalized many IA/BD firms for non-compliance as well as lax supervision of 1940 Act regulations. As a result, many IA/BD firms face huge reputational risks, along with millions in monetary fines if existing surveillance or

Figure 1: A High-level Corporate Regulatory Scheme and the Hierarchy of Surveillance and Trade Monitoring within the Scheme

FINRA 3130 – Annual Certification & Supervisory Processes

NASD 3012 – Supervisory Control System

NASD 3010 – Supervisory Procedure

• Process owned by CEO • Robust reporting between senior leadership and compliance leader • Trend spotting, early warning capability clear advantages

• Surveillance (Portfolio Monitoring, Allocation, Exception Reporting, Trading Practices) • AML, Employee Trade Monitoring, etc. • Corporate Audit Reviews, Branch Inspections & Internal Reviews

• Written supervisory policies and procedures (P&Ps) • Internal inspections • Supervision of RRS

A global investment strategy provides opportunities to further diversify and take advantage of idiosyncrasies within international markets. However, implementing this strategy inherently adds a compliance burden that requires firms to follow regulations for multiple jurisdictions. Furthermore, investing in multiple products and asset classes, such as CROSSINGS: The Sapient Journal of Trading & Risk Management

exception reporting processes fail. Past fines have either involved failure to recognize the violation or acceptance of a violation in the established business workflow. To minimize business risk and avoid fines, many IA/BD firms have put custom software applications in place to 6

automate trade monitoring and reporting. As firms evolve to adopt new regulations and other business goals, such as a global investment strategy and investments across complex instruments, it becomes more difficult to meet these objectives with custom applications. Current trends show that firms are replacing custom applications with more robust vendor products. This progression challenges IA/BD firms to select the right vendor product, establish a concrete compliance workflow and generate the required compliance exception reports. Most compliance vendor products are bundled with order management systems (OMSs) or execution management systems (EMSs). Since the cost of implementing and maintaining a system for compliance alone is high, the selection process can be quite involved. IA/BD firms tend to perform extensive research before deciding on a compliance vendor because the best return on investment may call for the replacement of the existing OMS or EMS. The key areas that these compliance systems must support, as mandated by the Investment Advisors Act of 1940, include portfolio management, trading practices, trade allocations and exception reports.

allocations. For instance, each block trading/bunching strategy executed should be verified for proper share allocation among clients.

Exception Reports Institutional and high-net-worth individuals are generally knowledgeable enough to review the compliance exceptions for their portfolio investment and trading strategies. Detailed trading activity exception reports provide clients with the portfolio transparency that they demand, so that they can investigate irregular activities and make recommendations to correct issues. In addition, the SEC, FINRA, US Commodity Futures Trading Commission (CFTC) and other regulatory organizations are using exception reports to gain visibility into regular trading activities and to view the consolidated anomalies throughout investment managers.

Figure 2: Portfolio Compliance System

Portfolio Management

Trading Practices

Portfolio Management All portfolios must strictly comply with guidelines from the SEC, FINRA, National Association of Securities Dealers (NASD), self-regulatory organizations (SROs), corporate investment policies and client investment guidelines. In particular, the trading activity in each portfolio must be consistent with client-directed trade allocations and each trade in a customer account must be assessed for suitability against client investment guidelines. New accounts, as well as closing accounts, have to be verified to conform to the firm’s policies, procedures and applicable regulations.

Portfolio Compliance System

Trade Allocations

Exception Reporting

Trading Practices Trading practices must conform to each firm’s policies and fulfill best execution obligations. IA/BD firms need to identify and evaluate conflicts of interests, high-risk trades and adherence to trading limits as well as risk limits. There is an ongoing need to monitor trader hedging activities, execution of approved products, mark-up transactions and aged inventory in accordance to a firm’s aged inventory policy.

Trade Allocations Many firms are being fined for performing inappropriate allocations to client accounts—leading to increased reputational risk and customer attrition. Clients have a strong desire to evaluate investment opportunities for proper

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Global Trade Monitoring Systems Most IAs choose order management systems, since these products provide portfolio management, trading (algorithmic trading, program trading, dark pools and Direct Market Access), middle office functions (trade corrections, broker confirmations), performance measurement and attribution (PMA) and transaction cost analysis (TCA) along with trade monitoring. On the other hand, BDs often prefer EMS bundles since they are exempt from the majority of fiduciary responsibilities like investment advisors. The DoddFrank Act, however, may remove their exemption from the Investment Advisors Act of 1940 and increase their trade monitoring responsibility.

Investment Advisors On a number of occasions, lax supervision has allowed corporate employees to break exposure or trading limits, allocate inappropriate soft-dollar generation and create ad hoc trade allocations. In April 2010, employees of a major global financial derivatives broker were indicted on fraud and other charges after racking up a $141 million loss through speculation in wheat futures contracts and the firm was fined $10 million for lax supervision by US regulators. This is one of many compliance infractions that could have been avoided by having a robust compliance business workflow with an automated compliance surveillance system in place. Investment advisors, or buy-side firms, must apply compliance rules on all portfolio holdings (portfolio compliance) before a trade is executed (pre-trade) and

afterwards (post-trade). Buy-side requirements for automated compliance systems include capabilities to set up generally required global investment guidelines, monitor trading activity, allow flexible business workflows in handling compliance exceptions and generate the required regulatory reports. These vendor systems should also be able to provide rules for global investment strategy, simple rule creation, client guidelines, flexible compliance violation handling, audit, reporting and multi-asset class support. A limited number of buy-side compliance vendor products bundled with an OMS can support multi-asset class global investment strategy. The vendors in Figure 3 are included based on their number of current clients, financial stability, asset class coverage, global investment support, and pretrade, post-trade and portfolio compliance capability.

Broker-Dealers Broker-dealers (BDs) play an important role in helping retail and institutional investors make significant financial decisions. As intermediaries, they connect investors to investments, which range from common stock and mutual funds to complex financial products. In doing so, they enhance the overall liquidity and efficiency of the financial markets. There are about 5,100 broker-dealers with over 600,000 registered representatives engaged in a variety of business activities, out of which, 985 BDs participate in investment advisory services. These 985 broker-dealers provide execution-only services (e.g., discount brokerage), custody and trade execution to a customer, along with other

Figure 3: Buy-side Trade Monitoring/Surveillance System Vendors

Advent

Bloomberg AIM/EMS

Line Data Audit Trail & Exceptions Reporting

Pre-Trade Compliance

ITG

Charles River Development

Fidessa Buy-Side


SimCorp

INDATA

Post-Trade Compliance

Portfolio Compliance

BNY ConvergEx Eze

SS&C Antares

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services, such as margin accounts, wrap fee programs, etc. A brokerage relationship may involve incidental advice with transaction-based compensation, or no advice and, therefore, no charge for advice. Section 913 of Title IX of the Dodd-Frank Act requires the SEC to evaluate the potential impact of eliminating the brokerdealer exclusion from the definition of “investment adviser” under the Investment Advisers Act of 1940. Once decided, BDs may also have to comply with the 1940 Act, signifying another momentous development for compliance processes and reporting. Figure 4. Leading Execution Management Systems

Eze Castle

Charles River IMS

Chakka Sreenivasulu is a Senior Manager in New York with 24 years of experience in financial services and the IT industry. His 12 years of financial services experience spans the front office, middle office, back office and regulatory (compliance/legal) business units in the asset/wealth management sector. [email protected]

Hsing Hsing Li is a Senior Associate in New York with more than eight years of experience in the financial services industry, including trading and market making at hedge funds and a broker dealer, as well as risk and valuation for investment managers. [email protected]

Bloomberg EMS

(EMS) Execution Management Systems Fidessa Latent Zero

Portware

UBS Pinpoint

Conclusion Regulatory demands continue to rise as more and more trading, allocation and reporting anomalies are detected by the SEC, FINRA and other SROs. IAs and BDs will need to automate regulatory compliance within their firms in order to adhere to new and changing mandates. As these firms evaluate vendor solutions, they will need to weigh both the desired return on investment (ROI) and total cost of ownership (TCO) with the functionality required for their business. Firms may occasionally need to have multiple order management and execution management systems to address global trading requirements across multiple asset classes and regulatory compliance jurisdictions.

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MANDATORY ELECTRONIC EXECUTION: determining the most appropriate environment In response to the G20 declaration, nations around the world have begun working towards developing consistent regulations for the global OTC derivatives market and are in varying stages of implementation. Since the industry has been driving towards many of these objectives for years, there is a considerable level of consistency between regulations. However, when it comes to the directive of utilizing electronic trading platforms, many market participants have voiced concerns about its impact, particularly because it requires changes to the structure of trading in the OTC market and could potentially lead to increased cost of execution for participants. In this article, Ryan Baccus, Paul Gibson and Jon Szehofner examine industry participant opinion on electronic execution, explore the perceived impact on an organization’s business model and, finally, discuss how the divided opinion has shaped an uneven regulatory landscape across the globe.

In the wake of the financial crisis, the G20 leaders laid out the path to reforming the Over-the-Counter (OTC) derivatives market by committing to the following four key objectives: 1. All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate

Electronic Execution

Expected to be enforced in 2013 in US (SEFs) and Europe (OTFs). No adoption of electronic execution mandate in other regions until further analysis is completed. Existing providers will ensure they are well positioned when mandate is enforced.

2. All standardized OTC derivative contracts should be cleared through central counterparties by end-2012 at the latest 3. All standardized OTC derivative contracts should be reported to trade repositories 4. Non standardized/centrally cleared contracts should be subject to higher capital requirements

G20 Declaration Pittsburgh September 2009*

All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and

Central Clearing

Finalized in the US and likely to be established for a number of jurisdictions by late 2012 and enforced early 2013. CCPs in US, EU, Japan, Hong Kong, Singapore, China and South Korea are expected to be operational to enable market participants to meet mandate.

cleared through central counterparties Trade Reporting

Requirements finalized in most regions and enforcement expected by late 2012 and complete before end of 2013. Services are being established. Global initiative endorsed by the FSB has been established to create common data standard for entity identification (LEI).

by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.

Capital Requirements

Basel III standard created which sets out requirements for additional capital for OTC derivatives to be phased in between 2013 and 2015. Global regulatory community also working to create harmonized margin requirements and standards for non-cleared trades (expected to be finalized by end of 2012)

Figure 1: The Original Declaration and Latest Status for Each Initiative CROSSINGS: The Sapient Journal of Trading & Risk Management

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The G20 declaration on market regulation has led to broadly consistent implementation across regions on three of these directives. Market participants are generally supportive of efforts to increase central clearing of trades and to improve post trade transparency. These initiatives were developed to build a stronger financial system and reduce systemic risk. The electronic execution element is more contentious because the proposed changes will affect the structure of the OTC derivatives market and there is divided opinion among participants as to whether this will actually achieve the goal of post-crisis public policy initiatives.

Divided Opinion Gary Gensler at the Commodities Futures Trading Commission (CFTC) has been particularly vocal in arguing the benefits of all buyers and sellers operating within a transparent marketplace. The CTFC points to benefits, such as more resilient liquidity, better information for valuation and reductions in trading costs. The underlying belief at the CFTC is that the centralization of trading activity gives extra incentives for new participants to join and enhances competition. Many of the larger “G15” banks agree that moving some swaps from low-tech, high-touch, bi-lateral voice transactions to multiple trading venues may have a positive impact on trading for some types of organizations in highly liquid products. These same banks, however, object to a broad enforcement that captures all OTC trades in the same way. The OTC market is characterized by low volumes and many industry participants believe that forcing bespoke derivatives to trade in the same way as listed products will make the costs of transactions unsustainable. As a point of reference on market activity, there are approximately 6,400 CDS traded in total worldwide daily (according to ISDA) and the LSE UK Equities order book is approximately 685,000 per day. Unless the product is highly standardized, electronic execution platforms could negatively impact liquidity and create uncertainty around the transaction. ISDA estimates that it will also increase transaction costs with the added expense of running a platform potentially exceeding $750 million and annual costs reaching as much as $250 million for the market. The majority of market participants believe eligibility for electronic execution should also differ according to the nature of a given trading model. Listed products with competitive pricing are likely to have deep liquidity. Therefore, a central limit order book (CLOB) model, which allows for completely transparent bids and offers, is suitable. However, for many traditional OTC products that are more bespoke in nature and

highly structured, a standardized CLOB model would not work because there is no standardization in either execution or the associated infrastructure. Figure 2 summarizes a number of trading protocols that can be used. With traditional OTC products, a “request for quote” model is likely to be the only model that would work and, according to ISDA, a regulatory requirement to do otherwise would render them worthless and shrink the market.1

“Dodd-Frank is very clear that we are, as a nation, moving towards both post-trade public transparency and pre-trade public transparency through SEFs (Swap Execution Facilities) and contract markets– that the public benefits from buyers and sellers coming together in a transparent market, where multiple parties can transact with multiple parties.” - Gary Gensler, CFTC

“The electronic execution mandate is both unnecessary and counterproductive as electronic trading is already developing rapidly as users take advantage of the existing choice in execution venues. The electronic execution mandate will take away users choice, create inefficiencies and discourage innovation.” - I SDA and NERA Consulting Group 11

Figure 2: Common Methods of Execution

Trading Protocols: Participation & Rules of Engagement

Appropriateness for the OTC Market

Request for Quote An “auction-style” inquiry directed to one or more dealers

Appropriate for highly structured contracts

• Non transparent • Trade only with other dealers • An RFQ is usually disclosed but can also be anonymous or partially anonymous • Indicative or firm pricing

• Significant number of OTC instruments covered • Index and single name Credit Default Swaps (CDS) • Interest Rate Swaps

Request for Market Request a dealer to make a two-way price

Appropriate for structured contracts

• Non transparent • Voluntary request from a single dealer • Can hide intentions • Indicative or firm pricing

• Newer protocol • Index and single name Credit Default Swaps

Click to Trade Real-time streaming prices from multiple dealers

Appropriate for liquid contracts An “auction-style” inquiry directed to one or more dealers

• More transparent • Streaming quotes • Initiate trades with a click • Firm pricing

• Continuous, streaming markets appropriate for only the most active contracts and liquid indices • Majority of CDS market is not large or liquid enough to support CLOB at present

Order Book Firm, executable bids and offers in a transparent order book

Only appropriate for highly liquid contracts

• Highly transparent • Anonymous • Trade with anyone on the platform • Firm pricing

• Most OTC derivatives not suitable for Order Book trading at present since trade frequency will not create a continuous stream of prices

As a result of the impending electronic execution mandate, a number of service providers are actively developing their platforms and expanding their client bases to ensure that they are positioned to capitalize on the demand for services from electronic trading venues. With the implied risk of trading activity being distributed across Swap Execution Facilities (SEFs), Organized Trading Facilities (OTFs) and exchanges, many in the dealer community are looking at ways in which they can aggregate the liquidity at these venues for their clients as a value-added service (known commonly as SEF aggregators)—assuming the regulation provides for the appropriate trading models to enable this offering. From a buy-side perspective, the commonly held view is that they would be in favor of electronic execution because it will drive down their transaction costs. However, along with the dealers, the buy-side community has voiced fears that the


pre-trade transparency, which certain types of electronic execution enforce, will harm liquidity. Many people agree with this view, including Barney Frank, of Dodd-Frank fame, who clarified recently that the regulation was not designed to stop the practice of voice brokerage and that five requests for quote before execution should not be the industry standard. This relieved many in the industry as they have long argued that if buy-side firms are forced to ask at least five dealers for a quote on a swap, information about trading intentions and trades will be more widely dispersed. This will create a situation whereby a dealer winning the trade from the asset manager may find it harder to hedge that position, as other rivals will be aware of the transaction. That increases the risk of portfolios being incorrectly hedged for abrupt swings in interest rates and other asset classes as investors seek cheaper alternatives to the OTC swap market. Figure 3 captures the diversity of opinion across the industry.

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Figure 3: Viewpoints from Across the Industry

Regulators

Dealers and Industry Associations

Buy side Firms

“Dodd-Frank is very clear that we are, as a nation, moving towards both post-trade public transparency and pre-trade public transparency through SEFs (Swap Execution Facilities) and contract markets—that the public benefits from buyers and sellers coming together in a transparent market, where multiple parties can transact with multiple parties.”

“The electronic execution mandate is both unnecessary and counterproductive as electronic trading is already developing rapidly as users take advantage of the existing choice in execution venues. The electronic execution mandate will take away users’ choice, create inefficiencies and discourage innovation.”

“The use of electronic trading tools by the buy side is driven by the pursuit of best execution, which ultimately benefits the end-investor through lower trading costs.”

Gary Gensler, CFTC

ISDA and NERA Consulting Group

Brook Teeter, head of advanced execution services sales, AsiaPacific, Credit Suisse

“We want to make it clear that people can do voice brokerage but we also don’t want to prohibit regulators from requiring price transparency before a transaction. We don’t think five requests for quote are necessary— we think that is excessive—but we just don’t want anything in this bill that says you cannot have price transparency before a transaction.”

“This isn’t about electronic trading— it’s about forcing people to trade that way. If you enforce electronic trading, it means the execution risk is transferred from its traditional underwriters—the banks—to their clients.”

“SEFs should be allowed to structure their RFQ platforms on whatever basis the SEF believes will serve its clients’ interests, whether one-toone or one–to-five, the question with respect to RFQs is what rule will protect a customer trading illiquid swaps while also guaranteeing pre-trade price transparency and increased competition.”

Barney Frank

Stephen O’Connor, Morgan Stanley

Joanne Medero and Richard Prager, BlackRock

Emergence of Regulation In contrast to the consensus achieved with reporting and clearing, the emphasis the G20 placed on “where appropriate” in its directive invited many jurisdictions to carefully assess the need and impact of implementing electronic execution. The Financial Stability Board (FSB), an international body charged with driving standards for the G20, highlighted this point on June 15 in their third progress report2 on implementation of OTC Market Reforms. In the report, they requested regulatory authorities from around the world to take action and investigate the benefits and costs of public price and volume transparency. The FSB also encouraged exploration of the potential impacts on wider market efficiency, concentration, competition and liquidity. At this time there is a clear divergence among regulators.

The European Securities and Markets Authority (ESMA) in Europe is looking to implement an electronic execution mandate through Markets in Financial Instruments Directive (MiFID) and Markets in Financial Instruments Regulation (MiFIR). Their Multilateral Trading Facility (MTF) and Organized Trading Facility (OTF) model is likely to be enforced in 2014. The CFTC in the US is further ahead although, at date of publication, the final rules for Swap Execution Facilities (SEFs) have not been published and timelines for enforcement are unclear and are now likely to be in 2013.

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While not officially part of the G20, the Monetary Authority of Singapore (MAS) and the Hong Kong Monetary Authority (HKMA) have adopted a selection of G20 commitments, specifically the clearing and reporting regimes. However, due to the size and relative illiquidity of these region’s OTC derivative markets, they have decided against implementing

rules for mandatory trading on regulated platforms. Asian regulators recognize that, compared to the US and Europe, the products traded locally are considered to have low volume resulting in an illiquid market that is unsuitable for an exchange trading mandate.

Figure 4: The Percentage of Transactions per Region (source: ISDA)

% Volume Worldwide

24.2

Jurisdiction / Legislation Progress

United States of America Regulation expected to be in force by the end-of 2012— announcement past due

Position on Electronic Execution

“We have to have bright lights into financial markets. There will be costs on financial institutions but there will be far greater benefits. Some might say we need to bring costs and benefits to financial institutions but I would say that is way too narrow. Transparency lowers the cost to the users of these products.” Gary Gensler, chairman of the CFTC, Interview with Charlie Rose

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European Union - ESMA Final rules expected to be in effect by mid-2014 in MiFID and MiFIR

“Significant efforts are underway to improve the stability, transparency and oversight of OTC derivatives markets. …trading in standardised OTC derivatives moves to exchanges or electronic trading platforms. This would imply that trading on exchanges and electronic platforms becomes the norm when the market in a given derivative is suitably developed.” ESMA, MIFID Review, December 2010, page 14

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Hong Kong – HKMA Consultation paper does not include rules to implement a mandatory trading requirement and calls out that further market consultation is needed before finalizing detailed regulations

“Although organised platforms are likely to improve transparency, they affect market liquidity and prices in ways that are beneficial for some participants while potentially not beneficial for others. … Relevant considerations may include whether the market is large enough to support multiple types of platforms to accommodate the goals of different types of traders, or so small that only a single platform is feasible.”

Singapore – MAS Consultation paper does not include rules to implement a mandatory trading requirement and calls out that further market consultation is needed before finalizing detailed regulations

“The IOSCO Report on Trading of OTC Derivatives…notes that…costs such as restriction of trading venue choice, limitations on platforms and costs of change/ uncertainty.”

Japan – JFSA JFSA plans to require electronic trading platforms (ETPs), however final rules and adoption have not been released as the JFSA will wait on final rules from CFTC

“Once the legislation has been promulgated, Cabinet Ordinance will be drafted.’


HKMA Consultation paper Oct 2011

MAS, Proposed Regulation of OTC Derivatives, Feb 2012

JFSA, May 2010 Amendment to the Financial Instruments and Exchange Act (FIEA)

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As a result of jurisdictionally divided market practices, one concern that has been raised a number of times in relation to US and EU-centered institutions is the possible loss of business for highly structured trades and the high risk of liquidity fragmentation. Highly liquid markets could become less so because dealers are forced out by excessive regulation into less liquid markets. This could result in decreasing suitability for electronic execution in the formerly highly liquid markets and encourage firms towards less regulated regions and markets.

Potential Impact The potential impact to the market is amplified when considering the “multiplicity effect” of introducing multiple regulations in parallel and the perceived reaction from end users that derivatives, which are now subject to additional capital and transaction costs, might become prohibitively expensive resulting in a decrease in trading volumes. Therefore, any mandated electronic execution must consider and factor in the potential of markets becoming less active and the potential need for guidance on scenarios where exemptions might be appropriate due to a lack of liquidity.

Conclusion There is a valid concern that the introduction of an electronic execution mandate could harm the OTC derivatives market by forcing complex derivatives to be traded in the same way as highly liquid products where the practice is not suitable. The very purpose of complex exotic OTC instruments is that the specific terms and dates can be tailored to suit the parties involved and defer the risk from those who are willing to pay. These products are so non-homogenous there is a reason why they have not been traded on exchanges up to now. In contrast, electronic execution for products with the necessary liquidity and maturity has the potential of achieving genuine cost and operational efficiencies. The question remains whether there is a need for regulation to achieve that goal and whether regulatory overreach could, in fact, damage the markets they are being introduced to protect.

Ryan Baccus is a Vice President based in London leading the Market Infrastructure and Initiatives Practice. With more than nine years of experience in the OTC derivative market, Ryan has led a number of highprofile engagements for major global investment banks, industry associations and central market infrastructure providers with a specific focus on execution and posttrade services. [email protected]

Paul Gibson is a Senior Associate based in London working in the Market Infrastructure and Initiatives Practice. Specializing in capital market initiatives, Paul has experience working as a business analyst on global regulatory reform initiatives across investment banking. Paul has also worked in both Tier 1 and 2 banks facilitating workshops and providing analysis on current-state and advising on target-state. [email protected]

Jon Szehofner is a Manager based in London and is one of Sapient’s leading consultants within the Risk Assurance Practice. Specializing in Regulatory Reporting, Jon has managed a number of key assignments at numerous Tier 1 investment banks, involving assurance reviews, detailed assurance testing and strategic automated solutions. Jon is also a member of the Professional Risk Managers’ International Association. [email protected]

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CLEARING CONNECTIVITY STANDARD: creating a more efficient and uniform approach for transmitting OTC clearing-related information New regulations impacting the OTC derivatives market have helped increase the volume of cleared derivative trades. However in spite of new regulations, large volumes of data are still being transmitted to custodians in a variety of different formats. In this article, Jim Bennett and Jos Stoop introduce the newly developed Clearing Connectivity Standard (CCS) and discuss how the standard is creating efficiencies and improving accuracy in the OTC derivatives clearing process.

Regulatory reform aimed at increasing transparency and reducing risk is changing the OTC derivatives landscape. New players are emerging and existing players are offering a variety of new services—increasing both the volume of cleared derivate trades and the number of relationships between market participants. Currently, data between asset managers, Futures Commission Merchants (FCMs) and custodians is transmitted in a variety of formats. At the center of the changing market,

custodians routinely receive a wide range of account-related information, such as fees, trade positions, netted positions, terminated trades and netted collateral, from FCMs. Most FCMs supply data in different electronic formats to their custodians, while many smaller FCMs still submit faxes or manually transmit the information. As a result, custodians must spend considerable time and effort manipulating the data into a consistent format that is usable by their systems and for their own purposes.

Figure 1: CCS Simplifies Information Transmissions to Custodians

FCM 1

FCM 2

FCM 3

FCM …

Clearing Connectivity Standard (CCS) CONNECTIVITY TRANSPORT

Northern Trust

Bank of New York Mellon

State Street Bank & Trust Co.

Other Custodian

AM 1

AM 2

AM 3

AM …


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With deadlines for Dodd-Frank fast approaching, the amount of information being transmitted to the custodians will only continue to grow. As the volume of cleared derivatives trade transmissions multiplies and custodians have to spend more resources reformatting non-standardized data, the instances of manual errors will increase, along with operational risk.

Traditionally, standards involve working groups and countless revisions and, as a result, can take many years to implement. CCS was developed in six months—a quick timeline that underscores the need for standardization and the commitment by the various industry representatives to act swiftly.

Setting the Standard for Cleared Derivatives Trade Transmissions

The agreement to create and utilize CCS signals a collective industry investment in improving the swaps clearing process. The standardized CCS format offers many benefits, including:

For many firms, the answer to these challenges lies in the newly created Clearing Connectivity Standard (CCS). CCS is a standardized connectivity format that can be used by the FCM community to transmit OTC clearing-related information on behalf of their asset manager clients to custodians. An initiative developed with input from three of the largest custodians and ten of the largest FCMs, CCS provides a guide for how to format and transmit required trade messages, called margin statements and outlines a messaging language format for how FCMs should report back to their clients and custodians on the success of those trades.

• Eliminating the need to spend time and money interpreting and reconciling data from different formats • Driving further automation of the clearing process through the re-allocation of capital into other focus areas • Reducing the overall costs of clearing swaps for asset managers, which may ultimately increase order demand

Figure 2: CCS Includes a Variety of Key Fields

Summary

Client Account, Summary Level Account and Margin Balances, Cash and Collateral Movements, including CCP Fees and Balances information

Details & Positions

Detailed Balances at the Trade/Position Level, Client Account, Trades, Positions and Collateral Information including commonly used identifiers across participants

Newly Netted Position

Daily New Trades, Terminated/Cancelled/Matured Trades and Netted Position impact

Daily Activity IRS

Daily New IRS Trade activity

Daily Activity CDS

Daily Trade Activity for new CDS trades

Daily Activity Collateral

Daily Collateral Activity (securities and cash)

Terminated Cancelled Trades

Daily Trade Activity for Terminated and Cancelled trades

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Adopting CCS There is no cost to begin using CCS, available in a Microsoft Excel file, and its adoption will not require considerable effort or changes to a firm’s existing technology infrastructure. Upon receiving the standard, firms will want to do the following:

• Understand the content and field structure • Map identifiers back to their own trades • Add placeholders for universal identifiers

In the future, asset managers who do not adopt CCS may face increased costs from custodians because it will be more difficult for them to utilize the non-standardized data.

Looking Ahead While the initial version of CCS focuses on the US and covers only Central Counterparty (CCP) eligible interest rate and credit default swap products, the standard will be expanded in future revisions to include:

• Feedback from a broader group of custodians, FCMs and asset managers • A change to Financial Products Markup Language (FpML) so that the standard can become real time, instead of batch based • An expanded number of participants, including more FCMs and new CCPs and asset managers • Additional products beyond credit and interest rates • Additional products cleared at CCPs • Other geographies outside the US

Jim Bennett is a senior executive based in NY with more than 25 years of experience in capital markets, OTCs and complex products. With a strong international background, Jim has helped firms navigate new regulations and adapt to changes in the global marketplace. [email protected]

Jos Stoop is a market expert in OTC derivative operations and technology with over 25 years of technology experience. Specializing in the areas of transaction processing and derivative operations, Jos has deep knowledge of trade capture, workflow, confirmations, payments, accounting, back-office reporting and data interfaces. [email protected]

For the many firms involved in the OTC derivatives market and facing Dodd-Frank legislation, CCS provides a more efficient and effective way to send and receive cleared derivatives trade data. The momentum that CCS has already generated in the market indicates that the standard will quickly become integrated as a core component within the OTC market infrastructure for asset managers.


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FOREIGN ACCOUNT TAX COMPLIANCE ACT (FATCA): can anyone in financial services afford to ignore this? As a result of a number of tax cases, the US government is attempting to close the US “tax gap” by enacting FATCA. With many governments in key financial services countries (including the UK, Germany & Switzerland) putting FATCA into their national law and regulations, financial institutions around the world must begin to identify the process and infrastructure changes needed to comply. The game-changing level of reporting requires not only technology solutions, but also a redevelopment or redesign of operations, policies and procedures. Karen Rossouw, Lizzy Conder and Mark Steadman explore the challenges foreign institutions might face with the implementation of FATCA and provide some insight into overcoming these challenges.

The Foreign Account Tax Compliance Act (FATCA) was introduced in 2010 to clamp down on the use of offshore vehicles by high-net-worth individuals to avoid paying US taxes.

The Act requires Foreign Financial Institutions (FFIs) to identify and report information about financial accounts held by US persons or foreign entities in which US taxpayers hold substantial interest. The definition of an FFI is broad and encompasses a wide range of financial institutions, including banks, insurance companies, asset management companies and the alternative investment sector. The penalty for any FFI not complying with the Act is a 30% withholding tax on all cash flows from US sources—a significant penalty.

Additionally, because FATCA regulations impose such high reporting and withholding burdens on financial institutions dealing with non-compliant financial institutions, it is expected that compliant entities will only want to deal with compliant entities. Therefore, non-compliance is not an option for firms that wish to do business in the global market.

For those required to enter into a direct agreement with the IRS (known as “participating FFIs” or “PFFIs”), FATCA compliance can be broadly broken down into the following key areas:

FATCA Compliance To comply with FATCA, an affected FFI will have to enter into an FFI Agreement. Different approaches are being undertaken by different countries to what is, in effect, becoming a piece of global legislation. The FATCA compliance requirements for any FFI will depend on where the FFI is “resident”, type of clients and products. A multinational FFI group may have to deal with multiple approaches depending on the locations in which they operate:

•D irect agreements between FFIs and the US Internal Revenue Service (IRS) requiring full compliance with the US regulations.

• Registration with the IRS but reporting requirements determined by local law in accordance with an intergovernmental agreement (IGA), providing for reporting to the foreign government, which will then report to the US. •A hybrid approach involving direct reporting by FFIs to the US supplemented by the exchange of information with the foreign governments upon request. These FFIs will benefit from a shortened registration process.

1. Identification and ongoing due diligence of existing and new account holders to identify US account holders and US major shareholders. 2. Annual reporting to the IRS on its account holders who are US persons or foreign entities with substantial US ownership or recalcitrants. 3. Withholding and payment to the IRS 30% of any payment of US source cash (proceeds as well as income) for:

a. Non-participating FFIs: FFIs that have not entered into an agreement with the IRS b. Recalcitrant account holders: Individual/foreign entity account holders failing to provide sufficient information to determine whether or not they are US persons/substantial US owners c. Non Foreign Financial Entities (NFFE): An entity that has not certified that it has no substantial US owners (also a recalcitrant account)

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A number of areas of FATCA compliance are contrary to local law and regulations. Ten significant financial locations (UK, France, Germany, Spain, Italy, Switzerland, Japan, Guernsey, Jersey and Isle of Man) have agreed in principle to enter into intergovernmental agreements with the US to support greater tax transparency while removing the barriers to FATCA compliance for FFIs in these countries. FFIs in these countries will also not be subject to, nor required to impose, the withholding penalties.

residents to their local tax authority. There will then be an automatic exchange of information between the US and UK tax authorities under the articles of the double tax treaty.

Current Timelines FATCA is due to become operational on July 1, 2013 and is likely to have wide-ranging implications on the way global financial institutions operate and their relationship with clients. Compliance dates are staggered and phased (see Figure 2).

The UK government became the first FACTA partner nation to sign an intergovernmental agreement (IGA) with the US on September 14, 2012. The IGA will require FFIs in each jurisdiction to report on accounts held by the other nation’s

Proposed Regulations

Model Agreement

FFIs must enter into an agreement directly with the IRS

No IRS agreement required; deemed compliant through satisfaction of reporting obligations to partner country

FFIs must withhold on and close recalcitrant accounts

Reporting obligation only for recalcitrant accounts

Each FFI in an affiliated group must separately register

Affiliate in non-partner country that has not registered with the IRS will not cause FFIs in partner country to be deemed non-compliant if affiliate satisfies reporting requirements and does not solicit US accounts

Passthru payment withholding begins January 1, 2017

Governments will agree to “work together” on passthru payment withholding

FFIs must deal directly with IRS on database queries

FFI will report to and deal only with local tax authorities on any queries

Reporting begins on September 30, 2014 with respect to 2013 calendar year

Reporting begins no later than September 30, 2015 with respect to 2013 calendar year

FFI agreement specifies condition of default (and loss of participating FFI status); generally requires “substantial compliance” to avoid default

US will request partner country competent authority to investigate non-compliance; participating FFI status lost with “significant noncompliance”

FFIs must report on accounts held by foreign entities with any “Substantial US Owner” (generally defined as a specified US person with 10% ownership)

FFI must report on accounts held by foreign entities with one or more “Controlling Person” (generally defined as more than 50% ownership taking into account attribution rules) that is a specified US person

Figure 1: The Requirements of Participating FFI (Direct Agreement) Versus a FATCA Partner FFI (Model Agreement)


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Figure 2: FATCA Timeline – Direct Agreement Phased-in Approach

1 Jan 2017 30 June 2013 Deadline to enter into FFI agreements

30 June 2014 Deadline to complete account verification for pre-existing bank account of > $1m

Onboarding procedures for new accounts need to be in place

1 Jan 2014 Withholding begins on US *FDAP Income

Key:

30 June 2015 Deadline to complete account verification for pre-existing individual accounts between $50k to $1m and entity accounts

30 Sept 2014 First limited reporting on US and recalcitrant accounts

1 Jan 2015 Withholding begins on withholding payments (gross proceeds and principal payments)

Full reporting including gross proceeds phased in Withholding begins on passthru payments

30 Sept 2015 Second limited reporting on US and recalcitrant accounts

Due Diligence Withholding Reporting

*FDAP - Fixed, Determinable, Annual, or Periodical income is all income, except: • Gains derived from the sale of real or personal property (including market discount and option premiums, but not including original issue discount) • Items of income excluded from gross income, without regard to the US or foreign status of the owner of the income, such as tax-exempt municipal bond interest and qualified scholarship income • First limited reporting. PFFIs are required to report only name, address, TIN, account number and account balance with respect to US accounts

There is still much uncertainty as the dates and requirements are still in a draft state. The IRS expects to publish the final FATCA requirements in the fall of 2012. FATCA partner countries have six to twelve-month extensions for certain parts of the implementation timetable although an extension to the registration requirements has not yet been announced, due to ongoing discussions between governments.

Challenges in Implementing FATCA FATCA will present a number of challenges to financial institutions. Regulatory bodies, industry experts and financial services providers all agree that this new US regulation is going to have a much wider impact than originally anticipated. These challenges include changes to processes, operations and systems. Some of the key challenges relating to FATCA compliance are listed in Figure 3.

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Figure 3: Key Challenges

Know Your Customer (KYC) Requirements

• Lack of automated KYC information • Extended requirements to cover more rigorous tests for citizenship or tax residence information (e.g. dual citizen, legal residents, ≥ 10% shareholders, place of birth) • Current systems that do not enable easily serviceable data requirements • Out of date KYC information

Lack of Central Customer Data and Legacy Systems

• Current KYC information that might be held in multiple repositories which may not be compatible • KYC information that might be distributed broadly across different relationship managers • Different document collection and identification requirement given KYC’s risk assessment approach

Legal Risk

• Potential conflicts with local privacy laws and regulations as a result of compliance with FATCA’s due diligence, verification, annual reporting and possible account closing requirements • Sharing limitations between local FFIs • Lack of privacy waivers from clients leading to account closures • Revision and review of service agreements to cover FATCA requirements and responsibilities

Technology

• Changes in data structure, data collection, calculation and reporting requirements across multiple systems • Requirements, developments, testing and implementation for each system impacted • Systems impacted: Account opening systems, withholding calculation systems, sales, all cash flows, corporate actions, tax reporting, website publications, automated website searches, reconciliation systems, data models, architecture systems and compliance systems

Regulatory Risk

• Ensuring the FFI meets its ongoing compliance obligations • New annual IRS/US Treasury reporting on a calendar year even if fiscal year is different • New written policy and procedures for non reporting FFIs on what accounts can be opened • Ongoing reviews • Ensuring that every member of the expanded affiliate group is either participating, deemed compliant or meets the conditions of the intergovernmental agreements

A Phased Approach To successfully navigate FATCA, financial institutions need to address these key challenges. The best way to approach FATCA compliance is in phases: Gap Analysis The impact of the FATCA challenges should be determined considering customer types, products, business units, client on-boarding, due diligence requirements and reporting software. This will require working with different functions across all business divisions in the organization to identify the gaps in current processes and procedures. Figure 4 highlights key roles and responsibilities.


Designing and Planning Solutions The results of the gap analysis are likely to drive how financial institutions plan to tackle designing and implementing the solutions that will address FATCA requirements. Designing and agreeing upon a communication strategy to the affected external and internal stakeholders at this earlier stage is also critical to the success of a FATCA project implementation. Execute and Build Phase 1 – Identification of account holders FATCA stipulates that every FFI must undertake a search of its client base to identify clients containing US indicia (e.g., address, residency, nationality, phone number, etc.) and classify each of these clients appropriately. This could potentially require the analysis of large volumes of existing customer and account data across multiple databases.

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Stakeholders | roles and responsibilities Figure 4: Key Roles and Responsibilities

Steering Committee

External advisers providing support

!! Responsible for FATCA compliance and senior management buy-in

Finance/Tax

!! Managing current reporting to IRS !! Identifying and classifying foreign entities !! Documenting foreign entity status !! Withholding experience !! Withholding/reporting requirements !! Managing budgeting and resource allocation

Legal

!! Reviewing service level agreements (SLA) !! Providing the legal process for redrafting service agreements !! Redrafting service agreements for FATCA !! Managing data protection issues and resolution !! Ensuring FFI agreement sign off

IT/Operations

!! Overseeing current IT systems !! Managing data querying/sampling !! Designing upgrades and implementations !! Providing system testing/ongoing assurance !! Implementing new reporting and monitoring controls

Compliance/Audit

!! Reviewing take on procedures/AML !! Conducting data sampling !! Revising KYC requirements/new account openings !! Training staff !! Conducting ongoing procedure audits

Communication to Stakeholders

!! Conducting client communications !! Communicating FFI status, pass thru payments % and website messaging

FFIs will need to report the name, address and taxpayer The draft regulations have introduced thresholds that should !"#$%&'()*+",-..""/0%(12+"#$'%$'0+($2"""3"""4#$25(612+(07"8"50+#09"""3""""",,:;"0