Is evolution the antidote to regulatory pain?
27 June 2017
A robust collateral management solution provides an aggregated single source of truth, according to Tory Clements of Lombard Risk
Image: Shutterstock
The 2008 financial crisis highlighted substantial weaknesses in global capital and liquidity requirements. Consequently, the Basel Committee on Banking Supervision made significant revisions to its guidelines intended to strengthen capital adequacy. Basel III regulatory changes pose a significant challenge, with market participants and regulators at odds regarding the impact of upcoming regulations.
The 2016 year-end liquidity squeeze in the repo market, largely attributed to the effects of European Central Bank quantitative easing and regulation, raised concerns about the ability of markets to handle stress in the new regulatory environment. Repo markets have historically served as vital sources of funding and the more stringent regulatory leverage and capital ratios have reduced market activity due to balance sheet cost.
The US Dodd-Frank Act has caused banks to reduce market making activities and shed proprietary trading desks, reducing the number of market participants.
Consequently, traditional sources of liquidity have become limited and expensive at a time when collateral requirements are increasing. Regulations affect market participants differently and it can be expected that uneconomical strategies will be replaced with alternative funding structures. However, demand for high quality assets is immediate and expected to grow globally across business lines.
The International Capital Market Association鈥檚 European Repo and Collateral Council has requested a delay to evaluate the regulatory impact ahead of enforcement. With no foreseeable abatement in forthcoming regulation, securities lending market participants must find alternate means to survive in this new world order.
The industry has yet another hurdle to surmount with the impending Securities Financing Transactions Regulation (SFTR) reporting requirements. SFTR covers securities and commodity lending, repo and sell/buy-back transactions and Article 4 stipulates arduous trade repository transaction reporting and recordkeeping requirements. Banks, investment firms, central counterparties (CCPs), central securities depositories, financial counterparties and corporates must all comply with the regulation.
Likewise, the requirements affect any counterparty transacting with an EU-based branch entity. Institutions will be required to report on data points like those required in the European Market Infrastructure Regulation (EMIR), such as trade and loan data, counterparty, collateral, jurisdiction, and documentation. Presently, the SFTR reconciliation requirements exceeds that of EMIR, implying a more significant industry burden than in the past. The volume and disparity of required data, plus dual-sided reporting, presents an implementation challenge for many organisations that do not have all the data currently reported or aggregated from a single golden source. With implementation in 2018, firms must choose a reporting solution quickly, then formulate and begin implementation immediately.
Compliance with the new regime will prompt fundamental changes to a firm鈥檚 internal infrastructure and require new workflow processes. The unintended benefit of industry regulatory overhaul may be risk reduction in the long run stemming from incremental process efficiency and improved data quality.
The progressive nature of Basel requirements may allow market participants to comply with regulations gradually, but the complexity and cost of meeting multiple requirements will likely result in a reduction in the number of institutions participating in the securities lending market. With regulation as a change catalyst, we can expect to see a continued increase in the use of alternative lending structures (such as CCP, principal lending, peer-to-peer, pledge and evergreen).
CCPs have grown in popularity and are building new models to satisfy market demand. This, in turn, requires platforms to support new lending structures end-to-end and in near real-time. As initial margin rules phase in, demand for highly-quality liquid assets will only increase.
If regulations correlate to high-quality asset constraint, expansion of eligible collateral guidelines could be the outcome鈥攂ut not necessarily the correct antidote. Monitoring and managing liquidity intra-day efficiently is key to trading institutions鈥� profitability. This hastens the need for interoperable connectivity and alignment across front office, risk, treasury, collateral and settlement processes for both the sell and buy side.
Technology investment might be likened to regulatory impact insurance. Regulation is driving considerable change to conventional business models, forcing a shift from vertical to horizontal management. Non-cleared over-the-counter derivatives margin requirements demanded large sell-side participants to comply by 1 September 2016, prompting many institutions to upgrade their system infrastructure and overhaul business processes. Smaller firms, which fell under the 1 March 2017 regulatory deadline, faced similar challenges.
Repo and securities lending institutions are addressing similar issues and cross-product synergies may ease the operational burden. Firms will likely need to address internal operations and systems, and adopting a holistic view, rather than a siloed approach, may prove advantageous.
Now more than ever, in an asset-constrained landscape, the transparency between front, middle and back office is essential to risk and cost management. Internal integration and external connectivity are critical for real-time management of exposure risk, collateralisation, compliance and reporting.
As in other business lines, the high cost of collateral will be a key driver in the securities lending business. In an environment where high-quality liquid assets are in increasing demand, across multiple business lines, optimisation and transformation of collateral is essential to manage costs.
The 鈥榦ptimal鈥� optimisation module is adaptable rather than prescriptive and scalable to the evolving needs of the firm. Likewise, expansion of collateral eligibility aligns well with scalable optimisation. Efficient automated substitution, coupled with safe settlement functionality, provides a real-time risk advantage, especially in times of market dislocation.
A robust collateral management solution serves a dual purpose, in both managing risk and in mitigating the burden of regulatory reporting requirements, by providing an aggregated single source of truth. Technology solutions today offer a unique opportunity to standardise processes, support interoperability and help buy-side and sell-side firms create and realise bespoke competitive advantages. Evolution, clearly, can be both a benefit and an antidote to regulatory pain.
The 2016 year-end liquidity squeeze in the repo market, largely attributed to the effects of European Central Bank quantitative easing and regulation, raised concerns about the ability of markets to handle stress in the new regulatory environment. Repo markets have historically served as vital sources of funding and the more stringent regulatory leverage and capital ratios have reduced market activity due to balance sheet cost.
The US Dodd-Frank Act has caused banks to reduce market making activities and shed proprietary trading desks, reducing the number of market participants.
Consequently, traditional sources of liquidity have become limited and expensive at a time when collateral requirements are increasing. Regulations affect market participants differently and it can be expected that uneconomical strategies will be replaced with alternative funding structures. However, demand for high quality assets is immediate and expected to grow globally across business lines.
The International Capital Market Association鈥檚 European Repo and Collateral Council has requested a delay to evaluate the regulatory impact ahead of enforcement. With no foreseeable abatement in forthcoming regulation, securities lending market participants must find alternate means to survive in this new world order.
The industry has yet another hurdle to surmount with the impending Securities Financing Transactions Regulation (SFTR) reporting requirements. SFTR covers securities and commodity lending, repo and sell/buy-back transactions and Article 4 stipulates arduous trade repository transaction reporting and recordkeeping requirements. Banks, investment firms, central counterparties (CCPs), central securities depositories, financial counterparties and corporates must all comply with the regulation.
Likewise, the requirements affect any counterparty transacting with an EU-based branch entity. Institutions will be required to report on data points like those required in the European Market Infrastructure Regulation (EMIR), such as trade and loan data, counterparty, collateral, jurisdiction, and documentation. Presently, the SFTR reconciliation requirements exceeds that of EMIR, implying a more significant industry burden than in the past. The volume and disparity of required data, plus dual-sided reporting, presents an implementation challenge for many organisations that do not have all the data currently reported or aggregated from a single golden source. With implementation in 2018, firms must choose a reporting solution quickly, then formulate and begin implementation immediately.
Compliance with the new regime will prompt fundamental changes to a firm鈥檚 internal infrastructure and require new workflow processes. The unintended benefit of industry regulatory overhaul may be risk reduction in the long run stemming from incremental process efficiency and improved data quality.
The progressive nature of Basel requirements may allow market participants to comply with regulations gradually, but the complexity and cost of meeting multiple requirements will likely result in a reduction in the number of institutions participating in the securities lending market. With regulation as a change catalyst, we can expect to see a continued increase in the use of alternative lending structures (such as CCP, principal lending, peer-to-peer, pledge and evergreen).
CCPs have grown in popularity and are building new models to satisfy market demand. This, in turn, requires platforms to support new lending structures end-to-end and in near real-time. As initial margin rules phase in, demand for highly-quality liquid assets will only increase.
If regulations correlate to high-quality asset constraint, expansion of eligible collateral guidelines could be the outcome鈥攂ut not necessarily the correct antidote. Monitoring and managing liquidity intra-day efficiently is key to trading institutions鈥� profitability. This hastens the need for interoperable connectivity and alignment across front office, risk, treasury, collateral and settlement processes for both the sell and buy side.
Technology investment might be likened to regulatory impact insurance. Regulation is driving considerable change to conventional business models, forcing a shift from vertical to horizontal management. Non-cleared over-the-counter derivatives margin requirements demanded large sell-side participants to comply by 1 September 2016, prompting many institutions to upgrade their system infrastructure and overhaul business processes. Smaller firms, which fell under the 1 March 2017 regulatory deadline, faced similar challenges.
Repo and securities lending institutions are addressing similar issues and cross-product synergies may ease the operational burden. Firms will likely need to address internal operations and systems, and adopting a holistic view, rather than a siloed approach, may prove advantageous.
Now more than ever, in an asset-constrained landscape, the transparency between front, middle and back office is essential to risk and cost management. Internal integration and external connectivity are critical for real-time management of exposure risk, collateralisation, compliance and reporting.
As in other business lines, the high cost of collateral will be a key driver in the securities lending business. In an environment where high-quality liquid assets are in increasing demand, across multiple business lines, optimisation and transformation of collateral is essential to manage costs.
The 鈥榦ptimal鈥� optimisation module is adaptable rather than prescriptive and scalable to the evolving needs of the firm. Likewise, expansion of collateral eligibility aligns well with scalable optimisation. Efficient automated substitution, coupled with safe settlement functionality, provides a real-time risk advantage, especially in times of market dislocation.
A robust collateral management solution serves a dual purpose, in both managing risk and in mitigating the burden of regulatory reporting requirements, by providing an aggregated single source of truth. Technology solutions today offer a unique opportunity to standardise processes, support interoperability and help buy-side and sell-side firms create and realise bespoke competitive advantages. Evolution, clearly, can be both a benefit and an antidote to regulatory pain.
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