The swaps risk regime – The details matter
The Dodd-Frank (US) and Emir (EU) legislation is an attempt to lay
the regulatory framework for a new vision for the OTC derivatives markets.
Unfortunately that new vision and the regulation of the resulting markets were
defined by legislators with partial understandings of market practices.
Industry members similarly had an understanding of past best
practices but not a vision of the future markets being contemplated by
regulators. When the rubber hit the technology road and the square peg of OTC
swaps transactions did not fit into the circular opening of either the futures
or equity market infrastructure, things began to deteriorate quickly.
In the US the swaps data reporting and record keeping regulation
was, at its core an attempt to design a new infrastructure for the primary OTC
product, swaps transactions. It started with aspirational objectives framed by
politicians.
Then the framework was laid out through new government edicts
authored by legislators. Thereafter, regulators crafted new regulations to meet
politicians’ aspirations and legislators’ edicts.
Regulators thought that no detail was spared as they interpreted the
overarching legislation into rules. However, as it is now quite clear a limited
blueprint was drawn up. Regulators, the SEC and CFTC in particular, borrowed
ideas from what they had already and separately known about equity and futures
markets.
They combined their own understandings with industry input received
through consultative papers, advisory meetings and dialogue with lobbyists and
industry professionals. Both regulators had imperfect understandings of what
the new world should look like. These regulators and the industry as well tried
to accommodate their existing methods, processes and technology to the
constantly changing landscape of global regulation.
With techniques and concepts borrowed and reshaped from existing
infrastructure and best practices of other markets, regulators launched the
most sweeping design of a new OTC derivatives market. Somewhere along the way
industry members, academics and lobbyists input their thoughts and admonitions.
That there was no overall system’s design, just a hodgepodge of regulations
that was inconsistent at best and terribly wrong in the main was obvious to
all. Then why was the ship left to sail?
The short answer was that the industry acquiesced simply because there
was no unified view and everyone seemed to be lobbying for their own advantage.
To see this in action we need only look at the three primary infrastructure
trade repositories that existed at the time, Tri-Optima, DTCC’s Deriserv and LCH.
Clearnet. They evolved to serve the twenty or so major OTC derivatives dealing
banks for inter-dealer transactions representing their clients’ trades. This
was thought to be a model to serve the new order to come, a swaps data repository
(SDR) that would collect swaps data at a granular level.
In some grand scheme the US SDR run by DTCC had set its sights on
being the global SDR. That model proved wanting. Each SDR had their own way of
inputting data, their own way of updating data, their own way of compressing
data and their own client bases. Each was competitive with the other.
What was peripherally understood by regulators was that many more SDRs
would arise including data vendors and software companies seeing opportunities
for new business. That was thought to be
a good outcome, more competition, more innovation, lower cost, etc. It was even
envisioned that existing futures exchange conglomerates would see threats from
equity market infrastructure utilities and move aggressively into supporting
their own SDRs. This has come to pass
and there are now 23 SDRs globally presenting a new issue of data aggregation
across all these new entities.
What was contemplated but left on the sidelines was some vague
notion of data standards. Yes it was needed but lawyers and policy people and
economists don’t have the intuition or understanding of defining rules that are
inherently forerunners of systems blueprints. The inevitable chaos of a
dysfunctional implementation arose when the rubber hit the technology road.
The counterparties in the swaps
transaction (the legal entity identifier – LEI), the swaps transaction itself
(the unique transaction identifier – UTI) and the product category (unique
product identifier – UPI) was to be included in all transactions so that these
transactions could be uniquely identified and aggregated for risk analysis. The
LEIs, with no control or parent entity as part of the code proved useless as a
mechanism to aggregate data by related counterparties sent to SDRs.
In the EU the UTI was to be constructed using
the LEI at its base. In the US, the UTI is prohibited from being constructed
with a LEI. The nearly 60 data elements that are sent to any chosen SDR have
not been standardised. The information in LEI registries (there are 30
globally) likewise have not yet been standardised. No wonder these transactions
can’t be matched in any one SDR. Neither can they be aggregated across SDRs for
observing risk to any one business, nor its component counterparties.
To make matters even more complicated, into the mix of the new SDRs come
new infrastructure utilities: swaps execution
facilities; derivative clearing organisations; central counterparties;
collateral depots; price tickers and market data distribution systems. This is
an attempt to automate the life cycle of a swaps transaction. It was also an attempt by the CFTC to lead on
global derivatives regulation, perhaps contemplating it becoming the global regulator
which was never to happen because the rest of the world does not see the US regulator
as benign.
Along with all the new infrastructure comes a complex set of new
rules on margining, collateral, clearing of trades and novation of trades in central
counterparties, all with the good intent of global OTC derivatives transparency
and oversight.
The blueprint for this new market was drawn up in multiple
international silos of sovereign regulation. It was designed with an imperfect
understanding of market practices, and with an understanding of legacy
infrastructure systems woefully lacking in the use of the technology of our future.
Like any great new building, especially one that is being built for the first
time a complete blueprint is needed. Laying one brick on another, as we are now
doing, is doomed to impose additional costs and risks on the entire effort,
perhaps even topple it before we reach the top.
Allan D. Grody is President of Financial InterGroup Holdings Ltd. His work and writings focus on the
intersection of risk, data and technology. He is writing a book on
Reengineering Financial Institutions. More in-depth research can be obtained at
https://www.fig-uk.com/products.php
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