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