Holistic risk management: remembering operational risk in over-the-counter derivatives market reform

April 2013 | SPECIAL REPORT: MANAGING RISK

Financier Worldwide Magazine

The global financial crisis drew attention to the systemic importance of the Over-the-Counter (OTC) derivatives market, and the serious risk that this market presented to the broader economy. In response to this, the Dodd-Frank Act in the US and the European Markets Infrastructure Regulation (EMIR) in Europe have worked to regulate the OTC derivatives market with the aim of addressing the weaknesses in the system by changing the way in which OTC derivatives are traded and cleared.

OTC derivatives are privately negotiated contracts and, as such, related information is only available to the contacting parties. This creates a challenge for regulators who need to put measures into place to balance the move towards a more transparent market. The privacy surrounding OTC derivative negotiations create complexity for financial institutions that are looking to identify the nature and level of risks involved in the trading process. To prevent such risk and learn from market stress of the past, like the financial crisis in 2008, regulations are a necessary move toward improvement. That said, OTC derivatives play an integral role in global capital markets and preserving their benefits, such as aiding price discovery, managing risk, adding to liquidity, improving market efficiency for the underlying asset, and reducing market transaction costs, is important for regulators to take into account.

Although EMIR came into force on 16 August 2012, full implementation requires the European Commission to finalise 20 sets of technical standards. Approval of those standards is expected in 2013, and if approved as proposed, the part of the regulation associated with operational risk management of non-cleared OTC derivatives has a targeted timeline of mid-2013. Thus, some financial institutions are now partnering with their technology providers to prepare their systems for the asset classes that they will be under obligation to clear.

On a global scale, both Dodd-Frank and EMIR have far reaching implications for the OTC derivatives industry. EMIR requires any financial institution that has entered into a derivatives contract, to report and risk-manage their derivative positions, while implementing effective controls for reconciliation and dispute resolution. In addition, some European financial institutions may also need to add functionality to clear certain asset classes that are required by Dodd-Frank if they have clients located in the US.

The introduction of Central Clearing Counterparties (CCPs) to clear OTC derivative trades, also targeted for mid-2013, is another pivotal aspect of Dodd-Frank and EMIR. The CCPs will be responsible for clearing trades, collecting and maintaining margin, overseeing delivery and trade settlement, and reporting trade data. The goal of the CCP model is to minimise the impact that would arise if one counterparty failed to make the required payment when it is due. The CCP would take on that risk as a centralised party, protecting the trading parties from risk associated with late payments.

Whether or not the CCP obligations will reduce risk as intended by the regulators is still a matter of discussion in the market. Certainly, multilateral transaction netting across counterparties should reduce the systemic, counterparty and settlement risks posed by the bilateral trade model. CCPs could also reduce the potential knock-on effect of a major counterparty failing, as the failure would be absorbed by a CCP’s default protections, including the collateral posted by all counterparties. The centralised CCP model should theoretically also help to reduce the web of complexity caused by maintaining many bilateral trade agreements. Moving to a ‘hub and spoke’ model will improve the visibility of trade details and their overall exposure.

However, a contrary argument is that CCPs could instead concentrate and magnify risk, with potentially systemic consequences. CCPs must therefore be effectively regulated with strict management procedures in place to prevent risk of their own failures.

It seems, however, that while the market concerns itself with reducing counterparty and settlement risk by trading through CCPs, there could be unintended consequences elsewhere in the trade lifecycle. These regulations will place additional burden on operational risk for financial institutions that trade OTC derivatives.

Dodd-Frank and EMIR will demand increased portfolio reconciliation frequency, especially for those OTC contracts that cannot be cleared through a CCP. Additionally, the CCP represents a new party in the trade process, adding new message flows that must be reconciled, in addition to the existing controls that are in place. As an organisation may need to deal with multiple CCPs to address the full gamut of instrument types, the centralisation and standardisation of these reconciliations will be beneficial in increasing transparency across the entire organisation.

The demand to lodge collateral with the CCP will drive an increasing focus on collateral management processes. Financial institutions will look to optimise the levels of collateral posted with each CCP, adopting a minimum quality collateral model that provides ‘just enough’ coverage to meet their obligations. Effective reconciliation of posted collateral against requirements will help to smooth this process.

Financial institutions will need to implement all of these new reconciliations whilst ensuring that existing financial controls and operational reconciliation processes continue to meet the increasingly stringent regulatory demands. Given the increased frequency and complexity of these reconciliations, this will be no easy feat.

Automation of these complex tasks will almost certainly be a necessity. Through automated controls, an organisation will be able to implement consistent and repeatable reconciliation processes that will scale up to the increased frequency demanded by regulators. Real-time monitoring and reporting will also be simplified through standardised processes across all trading instrument types. Automation also removes error-prone and costly manual reconciliation processes, enabling staff to shift their focus to activities that create value.

Though there are no concrete dates associated with EMIR and Dodd-Frank as related to the clearing of OTC derivatives and CCPs, the implementation of these new processes will help mitigate systemic, counterparty and settlement risk, restoring confidence in the financial markets. It is vital that the essential controls to mitigate operational risks, like having an automated technology system, are not overlooked. Financial institutions must take a holistic view of their trading infrastructure to capitalise on the changes mandated by these regulations in order to deliver an automated back-office that can overcome cost burdens and optimise process efficiency and risk management.

Andy Mellor is Portfolio Manager, Financial Control Solutions, Risk and Compliance and Simon Garwood, is Product Manager, Investment Services, at Fiserv. Mr Mellor can be contacted on +44 (0) 845 013 1024 or by email: andy.mellor@fiserv.com. Mr Garwood can be contacted on +44 (0)845 013 1213 or by email: simon.garwood@fiserv.com.

Andy Mellor and Simon Garwood

Fiserv