Timely Confirmations in OTC Derivatives: A Herculean Task?
By Krishnan Ranganathan, Nomura
Originally published on TABB Forum
The US and Europe are responsible for nearly all outstanding open positions in OTC derivatives worldwide. Why is compliance with confirmation mandates so onerous, and how can the industry move toward more timely confirmations?
According to data published by DTCC, as of May 2014, out of the total open positions of all OTC derivatives transactions across jurisdictions, Europe contributed to 68% and the US to 29%. Asia’s share was a meager 3%. The derivatives markets in the US and Europe are governed by two key regulations: the Dodd-Frank Act (DFA) and the European Market Infrastructure Regulations (EMIR), respectively.
With effect from Sept. 1, 2014, the confirmations execution timeline for all five asset classes – Credit, Rates, FX, Equities and Commodities – becomes more aggressive, moving to T+1 for Financial Counterparties (FCs) and Non-Financial Counterparties exceeding the Clearing Threshold (NFC+s), and to T+2 for Non-Financial Counterparties below the Clearing Thresholds (NFC-s).
The previous Fed-driven industry standards allowed for more relaxed Issuance and Execution deadlines, where Execution of Confirms would sometimes take as long as T+30. Fed targets (DFA) do differentiate between Issuance and Execution, while EMIR does not and only looks at complete Execution of a confirmation agreement.
Based on data available, the industry average for compliance rate in Europe for electronic and paper combined is in the below range:
- FCs and NFC+s (confirmed by T+1): Credit: >95%; Rates: 90-95%; Equities: 45-50%; FX: >95%.
- NFC-s (confirmed by T+2): Credit: 90-95%; Rates: 80-85%; Equities: 45-50%; FX: 90-95%.
Of course, the above numbers are by no means sacrosanct, since different firms use different assumptions; but nevertheless, they are a good indicator of where the industry stands with respect to this requirement.
So what makes compliance such an onerous task? There are various contributory factors for confirmations not being able to be executed in a ‘timely’ manner. Some of the issues faced by counterparties could broadly be summarized as follows:
Standardization of templates is still a far cry, specifically for Equities, and this is where the compliance rates are woefully low. Firms do not have standard templates for structured, bespoke and complex trades for Equity products. Largely structured terms are not eligible for electronic confirmation. There are many clients with which the MCA (Master Confirmation Agreement)/bilateral agreements have been negotiated but not yet executed. In case of highly exotic trades, post-trade negotiation due to terms not agreed beforehand contribute to delays.
A significant percentage of paper volumes in FX are caused by deliverable Vanilla Options and Simple Exotics. There is no market-wide master agreement in place for these products. This imposes a limitation in terms of widening the MCA coverage, as the industry has to solely depend on paper confirmations. At least for complex and bespoke paper trades, it is important to pre-agree on the Confirmation terms to facilitate “dispatch” of confirmation on T+0. The industry is taking steps to fast track the execution of ISDA-published MCAs, while there should also be a constant endeavor to standardize more and more products.
There are certain operational bottlenecks that cannot be underestimated. In the majority of cases, Confirms are processed in batches and signed at one shot with total disregard to their chronology. There are delays on account of client-side novations or something as straightforward as delayed allocations. Absence of proper backup and contingency planning when authorized signatories go on leave or fall sick can delay the whole process. The bespoke and demanding nature of some client requests has a cascading effect on the execution of Confirms within the prescribed timelines. It is not uncommon for certain buy-side clients to ask for a confirmation in a different language or perhaps a franked or printed version. Of course, not to forget a few clients awaiting payment instructions before executing a confirmation!
The electronic platforms cater only to a limited number of products. Add to this the long lead time to on-board new products. Also, some platforms cannot accommodate certain life cycle events. It is very difficult to push smaller clients (e.g., NFC-s) and corporates or counterparties doing an occasional trade to use electronic platforms even where the product is eligible. Smaller clients often lack the infrastructure and have limited trading volumes to accept/receive electronic confirmations where the running costs attributable to a few platforms are extremely prohibitive. Absence of an industry or regulatory initiative to transition clients on to the electronic platforms adds to the problem.
There are many clients, especially the ones based outside the US and the EU, or even the smaller firms based in the EU, that are ignorant of the regulatory timeframes as applicable to them. They believe they are exempted because they are either domiciled outside the US or the EU or do not belong to the category of so-called “broker-dealers.” There is a growing need for client training sessions and more effective dialogues between the regulators to increase awareness of regulatory requirements.
So how do we achieve compliance? For confirmations to be executed in a ‘timely’ manner, in the strictest sense, there is need for a coordinated and concerted effort across the industry in specific target areas – be it in improving front-office discipline to reduce amends and late booking, pushing ‘existing’ clients to move to electronic platforms for applicable products while considering no ‘new’ paper-based clients, pre-agreeing the confirmation terms to facilitate early dispatch, etc., and not to forget conducting extensive client awareness sessions, to name just a few.
The sell side is rising up to the challenge by following a two-pronged approach. One which is short-term by adding additional headcount to ensure confirmations are dispatched on T+0 and returned by T+1. The other, which is strategic and longer term, is significant investment in template standardization (particularly for Equities) across the industry, as well as technological solutions, in order to reduce the reliance on extra manpower.
The buy side, on the other hand, is at the receiving end due to pressure to utilize electronic matching platforms for eligible trades. There is also pressure on them to execute confirmations once the transaction has been completed. This means buy-side firms are enhancing their business processes and augmenting their resource count to meet this new demand.