With the radical overhaul of the over-the-counter derivatives market structure starting to kick in, asset managers, hedge funds, corporate and other derivative end users are facing major business, operations and technology changes, according to a new report by Woodbine Associates, which provides a readiness assessment and checklist for the buy side.
The comprehensive report urges buy side players to take immediate action or risk an organization’s ability to trade swaps after the required clearing deadline passes.
The 50-page report, “OTC Derivatives Readiness Guide: Business and Regulatory Requirements for Asset Managers and Other End Users Under Title VII," provides extensive analysis in seven key areas, including centrally cleared swaps, bilateral non-cleared swaps, execution through SEFs, pre-trade analysis and product selection, collateral management and post-trade processing, reporting and recordkeeping and specific entity requirements. In addition to providing a check-list for readiness, it advises participants on what types of infrastructure they need to comply with Title VII of the Dodd-Frank Act.
As for the timetable, mandatory clearing will begin to phase in for market participants trading select interest rate and credit default swaps on March 11, 2013, notes the report. While regulated entities such as swap dealers and major swap participants must comply, buy side firms could be impacted depending on their regulatory classification. Active funds, private funds executing on average 200 or more swaps per month over the preceding 12 months, will be required to comply on March 11, 2013.
Next, commodity pools, private funds (other than active funds or third party sub-accounts) and other financial entities will need to comply on June 10, 2013. Entities that include subaccounts managed by third party investment managers and Erisa pension plans and others subject to the mandate are required to comply by Sept. 9, 2013.
Participants will need to select one or more central clearing counterparties (CCPs) to clear OTC transactions for each product and asset class. “For many participants, minimizing (initial margin) IM will be the single most significant factor in reducing the cost of clearing and will play an influential role in CCP selection,” wrote the report’s author, Sean Owens, director of Fixed Income at Woodbine Associates.
As a result of central clearing and CCP margining, buy-side participants will need to prepare for changes in the pre- and post-trade workflow, including the use of middleware to connect and transmit data in real time to CCPs, FCMs, execution venues, third party custodians and others.
In the report, Owen advises firms to “expeditiously begin the process of selecting clearing relationships and negotiating applicable documentation so that these agreements are in place prior to when clearing must begin.
Choosing one or more futures commission merchants (FCMs) is another critical part of the newly regulated derivatives market. Firms can either become a direct member of a CCP to clear their proprietary swaps or access a CCP through a member firms’ FCM. The FCM will play a key role as a service provider for cleared swaps transactions, according o the report.
“In addition to credit quality, a primary consideration in selecting an FCM will be cost. Swap clearing will be expensive,” wrote Owens.
As far as technology changes, the report emphasizes the need for middleware as the glue that holds together all the disparate clearing and execution entities and data reporting requirements.
“Middleware will play an essential role in connecting participants and transmitting data between CCPs, FCMs, custodians, trading venues and market utilities. For centrally cleared swaps, participants will need middleware to transmit trade data necessary for post trade affirmation, CCP trade acceptance and block trade allocations.
Woodbine suggests that electronic messaging and communication will be important as firms will need to automate elements of their post-trade processing to respond to CCP margin calls and changes in collateral requirements on an intra-day basis.
To avoid overhauling their internal systems, buy side firms may need to reply on solutions offered by MarkitServ, BloombergVCON, ICE Link and others, to trade, clear and process swap transactions, notes the report.
While there is no shortage of firms planning to offer swap execution facilities (SEFs) or DCMs, there a number of factors for the buy side to consider when choosing execution venues. These factors include: certainty of execution and clearing, execution protocol, venue liquidity and participant composition.
Order management systems should play a critical role in pre-trade screening and internal and external compliance, but these systems will need to be updated for cleared derivatives. Others are emerging such as SEF aggregators, such as SwapsHub, which plan to offer connectivity to multiple SEFs and DCMs for swaps, futures and cash securities, the report noted. These applications can provide a central point of access for execution and offer a consolidated view of positions across multiple FCMs and CCPs. “This consolidation will be critical for firms pre-trade analysis of margin and execution costs,” the report said.