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Reform Spawns Opportunity for Capital Markets - Q&A with BCG's Will Rhode

| FinReg

By Mark Jennis, DTCC

Originally published on TABB Forum

The success of the G20 agreement finalized in Sept. 2009 to enhance transparency and increase market stability while reducing counterparty, operational and liquidity risk will be largely dependent on the efficient management and effective allocation of collateral. The industry’s ability to meet this challenge, however, rests on cross-border collaboration and the development of holistic, industry-wide solutions.

Collateral has always been crucial to the efficient functioning of funding and capital markets and, in turn, essential for economic growth. Prompted by the G20’s reform agenda, however, the introduction of central clearing and increased margin requirements for non-centrally cleared derivatives has put a strain on the ability of market participants to manage their collateral processes, largely due to a combination of outdated and siloed collateral management systems and collateral fragmentation.

In fact, a recent academic study published in June 2014 by the London School of Economics (LSE) highlighted the increasing occurrence of collateral bottlenecks due to weaknesses in financial market infrastructure. These weaknesses lead to eligible collateral becoming immobilized in one part of the system and unattainable by credit-worthy borrowers that need access to their inventory of collateral for central clearing purposes and increased margin requirements for bilateral transactions. Additionally, such borrowers also need to track and optimize their available collateral, including assets held at other banks and custodians, to fulfil their investment and trading strategies. In today’s marketplace, the ability to successfully analyze the collateral implications of a trade before it is executed is paramount and enables more efficient management of the available assets.

Firms, having fully grasped their collateral obligations, are becoming increasingly concerned about their ability to comply with new regulations governing the use of derivatives, including Dodd-Frank and the European Market Infrastructure Regulation (EMIR). They now have a heightened level of awareness of the need to review their processes to account for new margin and collateral requirements for both cleared and non-cleared derivatives transactions, which will bring efficiency to their collateral management processes, enabling them to remain competitive and drive down costs. This has been made even more important now that assessments of available collateral have to be made in real time for transactions that are centrally cleared.

A large number of firms, however, are still using outdated processes and fragmented systems to manage their collateral. Indeed, too often, collateral is managed in silos across an organization – both geographic silos and across business lines. This makes it almost impossible to have a holistic view of what securities are in use and where securities collateral is at any given time. The net result: a sub-optimal collateral processing environment that is costly and by definition an environment that does not maximize the collateral possibilities of the firm’s entire portfolio.

There are currently a plethora of automated collateral management solutions encompassing everything from portfolio margining to collateral optimization, all attempting to address the different components of the collateral challenge. However, the sell side, buy side, central securities depositories (CSDs) and custodians alike all recognize that these fragmented solutions only address parts of the problem.

For firms that use fragmented and legacy systems, it is essential that they review their processes to ensure they can manage workflow changes – in many cases, legacy systems will no longer be flexible enough to adapt to the new regulatory requirements. Firms should therefore consider the impact of using these types of systems from an investment, trading and operations perspective. Perhaps an alternative would be to instead look at holistic solutions and offerings that can address these problems and help ensure compliance with collateral and clearing requirements worldwide.

Second, while reviewing processes and implementing collateral management solutions at an individual firm level is crucial, collateral mobility needs to be addressed at an industry-wide level. Given that its supply is finite, collateral must be able to move smoothly and efficiently throughout the financial markets – a collateral bottleneck in one part of the system can have a knock-on effect across the markets and risk choking the global flow of liquidity. Just as individual car owners do not control the traffic light system for the safe movement of traffic and reduction of congestion, nor can derivatives users be expected to manage global collateral mobility.  

Recognizing that the industry requires a solution to address both the scale and efficiency of the collateral management challenge, DTCC has been working on a key initiative, by leveraging infrastructure enhanced through a partnership with Euroclear. The joint venture will create a global Collateral Management Utility (CMU) that will follow the development of a Margin Transit Utility (MTU). [Note: Certain aspects of the MTU and CMU are subject to regulatory approval.]

The MTU, which is in advanced stages of development, will leverage DTCC-developed infrastructure, and will offer straight-through-processing possibilities for margin obligations. Using electronic margin calls between market participants, the MTU will utilize Omgeo’s ALERT database to enrich the agreed margin calls with the standing settlement instructions for cash and securities transfers and pledges, and then automatically generate and send the appropriate delivery/receipt, segregation and/or safekeeping instructions to the applicable depositories and/or custodians. The service culminates with the investment managers, Futures Commission Merchants (FCMs), and General Clearing Members (GCMs), dealers, and clearinghouses receiving electronic settlement status and record-keeping reports for all collateral movements. 

This facility will mitigate systemic risk and provide significant additional risk and cost benefits to both sell-side and buy-side market participants by increasing scalability and operating efficiency, and providing greater transparency across collateral activity. Longer term, the solution will connect collateral data with information reported to the DTCC Global Trade Repository (GTR), providing a complete view of risk exposures in the event of a future market crisis.

As envisioned, the CMU will harness the open architecture of Euroclear’s Collateral Highway and enable users on both sides of the Atlantic to consolidate assets under a single inventory and collateral management system. This provides them the possibility to optimally allocate mutualized assets to meet exposure obligations in both the European and North American time zones. Collateral processing is done across a single virtual pool even though the assets remain on the books of each depository, with each opening accounts in the other depository. Collateral allocations will seamlessly integrate with other settlement obligations at the relevant depository, significantly reducing the risk of blockages and settlement failures during market stress conditions.

The CMU will address the pressing problem of accessing collateral globally and automatically coordinate collateral settlements and substitutions with other settlement activity. Market participants often cite sub-optimal collateral mobility, allocation and settlement coordination as issues at a global level, and the CMU will fill this gap.

While the new derivatives trading and clearing environment will benefit the market and increase investor confidence in the long term, in the short term, firms must be equipped to adapt to these changes. The key to doing so is for market participants to understand their impact and to be able to prepare by implementing holistic and community-based infrastructure solutions. To that end, DTCC is continuing to collaborate with industry partners to develop solutions that address the operational challenges and risks associated with the increased demand for collateral. There was a great business myth circulating the stressed-out halls of corporate America around the time Lehman Brothers was starting to collapse.  It suggested that the Chinese character for ‘crisis’ was the same as ‘opportunity.’

Though it made some people feel better at the time, it turns out it’s not actually true.  As many linguistics experts have since pointed out, the character in question doesn’t translate to opportunity in the literal sense.  However, history may have proven the linguists wrong.  The financial crisis of 2008-2009 which set in motion an unprecedented fury of regulatory reforms and endless predictions about the demise of the capital markets as we know them, has indeed created some new opportunities.

According to Will Rhode, the new global head of capital markets research at Boston Consulting Group (BCG), many of those opportunities are just beginning to reveal themselves now.  He should know; his own career path has mirrored the evolution of post-reform financial markets as he’s made his way from Tabb Group, where he was a point man on derivatives reform from 2010-2014, to BCG where he’s now tasked with helping financial firms adapt to new regulatory changes.

We were able sit down with Rhode after he settled into his new role to hear his thoughts on the real-world impacts of the last several years of financial reforms.

DerivAlert: You recently joined BCG after spending four years – arguably the most volatile four years for derivatives reform – overseeing fixed income research at Tabb Group, tell us a bit about that transition and what you’re doing in your new role.

Will Rhode: Tabb Group actually launched its fixed income practice on the back of Dodd-Frank.  Like many other market participants, they responded to the sheer magnitude of that single piece of legislation which impacted markets in such a degree that it justified a dedicated research effort.  The implicit understanding at the time was that this was going to impact big businesses in every way: new businesses would emerge, like SEFs, different businesses would move to different customer segments, banks would have to adapt in a number of ways to service their clients, compete with each other and remain relevant.

The transition to BCG followed that cycle of rule writing, and implementation to the point where now we’re in the thick of things in terms of real management change.  With a strategic advisory firm of BCG’s caliber, we can now focus on how to help clients in the banking sector adapt. 

DA: What is your big picture perspective on the last four years of market reforms, starting with Dodd-Frank and, now, with SEF volumes starting to take off and a general sense of some “new” normalcy returning to derivatives markets? 

WR: The net result, when all is said and done is that derivatives reform – Dodd-Frank specifically – wedged a foot in the door to a regulated marketplace.  It didn’t blow it off the hinges, but it opened things up a bit. Incrementally, the door will open more and more.  Electronic execution will continue to increase.  Workflow tools will smooth over and introduce straight-through-processing, market participants will discover new efficiencies in terms of digesting clearing, among other things. 

Depending on your lens, it can seem like not much has changed because there was no big bang.  Because of all of the drama in the preamble, you expected an explosion.  The industry has done a good job of managing a phased-in approach so there was no fundamental event to undermine the transition. Kudos to the industry and the CFTC for the collaboration, their ability to build the pipes and actually implement changes that haven’t resulted in a seismic shift to market structure that would threaten liquidity. 

DA: How do you see the trading in derivatives evolving over the next five years?

WR: Increased electronification will change pricing models, ways in which transparency and competition are promoted, and who becomes the winners and losers.  SEFs have not reduced the number of dealers; they are not dealers; they are venues.  You might expect some execution margins to compress, but the obvious inherent segue is that costs would also compress as a result of the increased efficiency.  Over time, the profitability metrics for financial firms trading derivatives in a post Dodd-Frank world may be the same, if not better. 

DA: We’ve been hearing a lot lately about the rise of compression-style trading.  In fact, you were recently quoted in Wall Street & Technology making the case that central clearing under Dodd-Frank has become more expensive for the buy-side.  What role do you see compression playing in the growth of SEF trading volumes? 

WR: Dealer-to-dealer compression cycles have been in use for many years, but that was easier because there were only 14 major dealers.  The reason why this phenomenon is interesting now is that we are seeing the emergence of a kind of decentralized compression. It would have been more difficult for a central clearing house to organize this, but with tools provided by SEFs, we’re seeing the capability to execute straight-through processing from the buy-side.  Compression is a necessary operational tool to operate in a centrally cleared environment, managing complex portfolios and associated costs. 

DA: Let’s talk for a minute about Europe: the EMIR trade reporting deadline took effect a couple of weeks ago; how do you see European derivatives reform playing out versus what we’ve seen so far in the U.S.?

WR: This topic is near and dear for me because I started off with Tabb in Europe and observed the introduction of the early evolution of European financial markets reform.  It was a very different process than what occurred in the US.  MiFID, for example, was meant to cover transparency across all asset classes and then it was refined to cover equities alone.  Then, it was repurposed again to serve as the transparency piece of the G20 reforms across all asset classes. By virtue of having to be repurposed so many times, the rules are much less specifically designed for derivatives.  Add the fact that you have 27 member states each with regulation-hating members and several other overseeing bodies. You can start to see why the implementation process has been slower and made it more difficult to harmonize with established regimes.   

DA: For those who’ve been really challenged by derivatives reform, do you see a light at the end of the tunnel?

WR: We really are living through a renaissance in the capital markets industry right now.  It’s a very interesting time for all of us.  Years and years from now, people will look back on this period as the catalyst to so many new ways of doing business, the development of new markets, new opportunities.  I believe we’re going to see a lot more entrepreneurial behavior as a result.