single source of clean data

IntroductionIt’s a given that full automation for many key trading and related operational processes will not be achieved overnight. For many financial services firms, their top concern for securities processing will be the impact of the newly established regime for executed and cleared over-the-counter (OTC), exchange-traded and bespoke bilateral derivatives. Also high on their list is a major opportunity to achieve real straight-through processing (STP) for the new matrix of collateral management. Most firms will also want a real-time, holistic view of the essential transaction data streaming from traders to operations.

Each of these operational challenges is a work-in-progress that has data management at its core. In each case, data needs to be pulled from many sources and distributed across the enterprise. For many firms, this still involves many manual steps and obstacles. These problems, however, are not insurmountable.

Historically, OTC derivatives trading, clearing, and settlement have been unregulated, bilateral processes. The trade workflow was often handled through manual intervention, pushing data and metrics throughout a bank or other securities trading organization.

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Single Source of Clean Data: Modern Data Management

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“ The key is to establish a single source of clean data for all financial information shared. ”

Counterparties then communicated via mail, fax, and phone. The regulators, the markets and advances in technology have made a completely manual approach insufficient for most firms. In order for firms to compete, all departments within a trading enterprise must see the same data from the beginning of the transaction to the final stages of post-trade processing.

The key is to establish a single source of clean data for all financial information shared among front-, middle- and back-office operations. The correct data is essential as discrepancies can lead to breaks in the transaction workflow. For instance, when a firm does not have accurate data about its funding position, as evidenced in the collateral management mishaps that led to the collapse of Lehman Brothers, disaster ensues.

The Great Recession revealed, among other things, that OTC derivatives processing was based on weak or nonexistent data infrastructures that resulted in a lack of adequate operational and counterparty financial risk management. The missing information about a firm’s exact funding position in the market can have dire consequences.

“ Data management challenges require firms to maintain a universal clarity in order to transact, manage, and survive in today’s dynamic data landscape. ”

“ The right data will prove to be essential in conquering the new collateral problem. ”

Single Source of Clean Data: Modern Data Management OpenLink Insights

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The current data management challenges require firms to maintain a universal clarity in order to transact, manage, and survive in today’s dynamic data landscape.

Single Source of Clean Data: Getting on the Same Page Global regulatory reforms have yielded multiple data problems, especially for collateral and margining management. This has caused an overriding demand for transparency. In particular, approximately $3 trillion to $4 trillion is needed to fulfill collateral obligations for the burgeoning

reforms of the OTC swap markets1. An additional $10 trillion worth of collateral will be needed by the industry over the next two to three years. However, a collateral shortage is looming as there is only $18 trillion of high quality paper in the world (see figure 1).

The right data will prove to be essential in conquering the new collateral problem. The first step will be to retrieve the correct price of an OTC derivative and then source the exact amount of collateral from a diminishing resource to cover a transaction.

Finding the best price for an OTC instrument transaction is more than reviewing the latest market data. First, firms have to gather a multitude of data points such as the various margin amounts at competing clearinghouses, collateral eligibility, haircuts associated with collateralized positions and associated processing fees. These information flows have to be synthesized at the front- office in order to understand the true value of entering a new OTC derivative position. Secondly, these data points have to be the same information that the back-office receives to ensure seamless processing throughout the OTC trade lifecycle. At the same time, all parties working in tandem to implement efficient collateral

management in a proactive manner must use this same set of clean data. Finally, a trading enterprise that consistently stores data will have far more accurate reconciliations with its elected swap data repository (SDR), an entity that facilitates market transparency and price discovery.

But there are other uses for the right data.

Firms need to employ data analytics that can be applied to meet the onset of new OTC derivative regulations and guidelines. The

figure 1:

Present and Future Demands for Collateral

$18 TrillionHigh Quality Paper

in the World

$10 TrillionCollateral Needs in 2–3 Years

$3-4 TrillionImmediate

Collateral Needs

1 TABB Group. 2014. Margin Call: Risk Analytics for the Buy Side, www.tabbgroup.com

www.tabbgroup.com

“ The best response to these challenges is a front-to-back IT solution that covers the entire value chain of execution, clearing and post-trade processing of OTC derivatives. ”

“ Data for risk management must serve limit controls, reconciliation and accounting. ”

“ Firms need data to underpin securities lending for collateral purposes and for repo market access with the attendant funding and haircut treatments. ”

goal of risk analytics is to optimize trading activity while minimizing risk. A broad category, risk analytics can be applied to calculating the effect of price fluctuations on portfolio performance, sourcing the cheapest, most abundant source of collateral and monitoring trade workflows. Furthermore, risk analytics need to be available to traders, operations, accounting, corporate finance, and other groups within a firm that facilitate securities processing. This is to ensure that all of these parties are sourcing collateral by using the latest best practices while mitigating the associated uncertainties. The ultimate goal of risk analytics is to understand the fundamental and idiosyncratic characteristics of the pledged collateral and acquire a holistic view of present and near-term risks.

Unfortunately, time is of the essence for price discovery, risk analytics, and other functions that have to occur at the utmost speed. The U.S. Commodity Futures Trading Commission’s Rules 1.73 and 1.74 specify that futures commission merchants (FCMs) and clearing brokers must accept trades for clearing within 60 seconds. The same rules state that derivatives clearing organizations (DCOs) have 10 seconds to accept transactions.

Given the parameters, OTC market participants require assurances that the clearinghouse will not reject the trade. If a trade is rejected, firms are obligated to meet an immediate margin call or possibly face repercussions that include and are not limited to breakage costs and penalties to unwind the position, not to mention the price impacts of re-entering the trade.

The best response to these challenges is a front-to-back IT solution that covers the entire value chain of execution, clearing and post-trade processing of OTC derivatives (see figure 2). It must also support the following transaction lifecycle processes:

•Pre-tradeAnalysis: Data coverage begins with activities done before a transaction

is executed. This includes investment research, sales and marketing of new collateral assets like corporate bonds, position review for managing portfolio line items on a daily basis, risk limit compliance to ensure proper risk-taking activity and liquidity sourcing for margin-efficient transactions.

•TradeExecution: This refers to capturing data at or near the time that a transaction is consummated. Key information is needed for order management, routing, and execution.

•MiddleOffice: This level is the first line of post-trade analysis and processing. This encompasses the booking and accounting of positions and facilitating allocations. The financial instrument’s valuation is used for benchmarking and measuring performance. The risk analytics at this stage are used to optimize the investment activity and help minimize market risk while optimal collateral management compels firms to do a better job of record-keeping, valuation, risk, and posting of collateral.

•Back Office: Data for risk management must serve limit controls, reconciliation and accounting. Desk-level risk data is aggregated and monitored to make certain that financial thresholds are not breached. The back office plays an important role in the firm-wide auditing and reconciling of all account activity. Back-office staff members also handle trade break procedures and interact with all parties, for example SDRs, to fully resolve trade failure issues.

•AssetServicing/Custody: Data can ensure transparency, safekeeping, accounting, and efficient transfer of collateral.

•Ancillary Services: Firms need data to underpin securities lending for collateral purposes and for repo market access with the attendant funding and haircut treatments.



“ Asthenew world of derivatives trading takes shape, asset managers,FCMs,CCPs, SDRs and custodians need a reporting and communication standard for their swaps transactions. ”

Harbingers of HopeThe second decade of the 21st century for the global financial services industry should not be known solely for a wave of complex financial rules, regulations and guidelines. The regulatory overhaul has also spurred innovation in the form of a new standard to help with clearing links, the emergence of central counterparty clearinghouse (CCP) providers and advances in STP.

As the new world of derivatives trading takes shape, asset managers, FCMs, CCPs, SDRs and custodians need a reporting and communication standard for their swaps transactions. In short, they need to simplify integration with data systems, and automate reconciliation in order to make clearing and communications more concise and efficient. The Clearing Connectivity Standard (CCS) is being offered as a new industry-led reporting and communication benchmark for OTC derivatives. The CCS effort targets buy-side firms by offering to automate many forms of regulatory-mandated reporting, including splitting margin payments to CCPs.

The benefits of CCS are connectivity, the netting of positions, and recording data for other uses. The CCS push will include functionality to separate payments for initial margin, variation margin and commissions. In fact, they can be grouped together and netted off, or paid separately via CCS. In

other words, a buy-side firm with multiple CCP accounts will be able to automate the separation of payments at the account level.

The absence of a formal standard for formatting or transmitting data between entities can delay onboarding to SDRs. Without a standard, firms face increased operational risk, costly interface development and maintenance issues with each custodian. However, CCS is gaining traction as a standard for the financial industry — it has been well received by the International Swaps and Derivatives Association (ISDA) and Securities Industry and Financial Markets Association (SIFMA).

Five of the largest clearing brokers in the U.S. — Bank of America, Merrill Lynch, Barclays, JPMorgan, and UBS — have thrown their support behind CCS. ISDA officials have also met with representatives from Eurex, Intercontinental Exchange (ICE), Singapore Exchange, and the Tokyo Stock Exchange to garner further support.

The flexibility of CCS also enables it to adapt to the future needs of ongoing regulatory reform. For instance, CCS will be moving away from its comma-separated values (CSV) file format to the XML-based industry standard Financial Products Markup Language (FpML). The FpML implementation will allow CCS to be used widely across the Internet.



Ancillary Services

Back OfficeAsset

Servicing/Custody

Pre-Trade Trade Execution

Middle Office

Front-to-Back OTC Processing

figure 2:

Transaction Lifecycle Processes

“ The goal of STP is an impeccable, automated electronic transfer of identical information to all parties in as close to real-time as possible. ”

What is a CCP?

Overseen by clearinghouses, CCPs are intended to bring a new transparency to derivatives trading. A CCP interposes itself between the original counterparties to a trade by becoming a seller to every buyer and a buyer to every seller via novation. This can help reduce counterparty credit risk and helps ensure that all information about a trade is centralized. In other words, a CCP provides a “golden copy” of data to all parties that should be privy to the information.

CCPs are structured to fortify the contractual obligations embedded in the derivatives positions. CCPs are used to manage and mitigate the credit risk of counterparties during the lifetime of a derivatives contract. For instance, the CCP calculates the change in value of the positions of its members on a regular basis in order to determine the collateral required to meet margin requirements.

What is STP?

STP is the total automation of the securities-trading process, end-to-end, from trade order to settlement (see figure 3). The goal of STP is an impeccable, automated electronic transfer of identical information to all parties in as close to real-time as possible. STP requires automated workflows, from the front-office, all the way to the back-office without manual intervention.

The Upside of STP:

•Eliminates the re-entry ofOTCderivativetrade information after the transaction has entered the workflow.

•Provides automatic links and paperlessprocessing, from front-to-back, regardless of the parties involved and/or their geographic locations.

•Automatesworkflow in order to facilitatetransaction monitoring and exception alerts.

•Applies manual prevention or dataprocessing on an exceptional basis.

•Providesanabsoluteconnectionbetweenexternal partners involved in a financial process including trading platforms, clearinghouses, confirmation platforms and other information providers.

•Reduces operational risk via enhancedcontrols, and minimized transaction costs.

Second, the increasing commoditization of financial products within the industry is leading to decreasing profit margins. Maintaining the profit level will depend on cost reductions that can be achieved via the operational efficiencies of STP.

STP could play a vital role in helping firms cope with the regulatory environment by facilitating the amalgamation of market information. This would involve all parties such as traders, operations staff, accountants, and corporate finance professionals to source for the enterprise the cheapest collateral and monitor price fluctuations in the respective portfolio positions. This helps build the case for the advantages of STP, including lower transaction costs and higher profit levels.



“ Anewmodeofdata management is taking root in this new regulatory regime. ”

Roadblocks to Automation andEfficientCollateralManagementA new mode of data management is taking root in this new regulatory regime. Robust information dissemination and pledging the cheapest source of securities are becoming realities. CCPs and STP could effectively bring about full automation, and could help firms find relevant market inputs relating to liquidity and margin requirements. However, there are roadblocks that still stand in the way such as:

•Lackofstandardization

•Conflictingvaluationmethods

•Manualtransactions

•Futureregulatoryreform

Lack of Standardization

OTC derivative instruments do not yet have a specific set of classifications to provide clarity across the industry. This makes it difficult for trading enterprises to secure and post collateral for derivatives positions in a timely manner. By contrast, for exchange-traded assets, a risk-weighted calculation serves as the main method for determining the amount

of collateral needed. For now, global OTC derivatives include interest rate contracts, foreign exchange contracts, credit derivatives, equity contracts and commodity contracts, which include forwards and swaps. Bilateral transactions are based upon contracts that are historically tailored to the needs of the two parties to the transaction. Processing these frequently complex instruments also requires managing data that underpins lock-ups, notice periods and settlement schedules. These non-vanilla products require a greater amount of sequential, non-standard communication among multiple parties. Hence, the number of breaks increases exponentially.

The industry also suffers from multiple, incompatible data formats that force firms to navigate blind alleys. This creates obstacles when firms attempt to share data for a multitude of front- and back-office functions. This also impedes efficient data sharing with CCPs and SDRs. Historically, there has been no impetus for industry standards for data formats, thus distinct and idiosyncratic identifiers are the status quo within the OTC marketplace. The ongoing result of more trade breaks wastes time and millions of dollars in annual expenditures.



STANDARDIZATION

Standardization of business processes

ACCURACY

Accuracy of trade information STABILITY

Stability and security

SPEED

Trade information has to be passed in

real-time among the buy-side firm, the

sell-side entity, and all other companies

supporting the transaction process

STP

Pre-Trade Execution Post-Trade

figure 3:

The Critical Success Parameters of STP

“ Marketparticipants lack the ability to value OTC products and the associated collateral in a timely and reliable manner. ”

ConflictingValuationMethods

Market participants lack the ability to value OTC products and the associated collateral in a timely and reliable manner. The usual suspects relating to valuation issues are conflicting third-party pricing data offerings, incorrect pricing of OTC instruments in illiquid and historically opaque markets, and inconsistent proprietary pricing models. For relatively standard instruments such as interest rate swaps, different valuation methodologies still lead to pricing differences.

Valuation issues do not stop there. In this sphere, the CCP is the law of the land. The parties in a bilateral OTC transaction have been able to discuss and agree upon the price

and margin requirements of the OTC product in question. Today, no such mediation is in place for OTC markets. The CCP has the right to call as much margin as it feels is necessary for the respective transaction. There is a sense of powerlessness in this regard. Some firms are creating direct contacts to the CCP to ensure that its definition of collateral is the same as the FCM’s. Others are accepting what the CCP dictates even if the clearing process may be flawed and may cause failed trades.

ManualTransactions

The commonplace manual processing of OTC transactions results in errors and high risks. Manual processing tends to increase as the nature of the OTC derivative becomes more complex and more customized. Even for relatively standard instruments such as an interest rate swap, processing a trade confirmation can take up to two weeks. Buy-side firms have often been cited as struggling to manage the novation process with a combination of paper-based files and Microsoft Excel spreadsheets that can lead to failed settlements. Firms have often employed 50 or more full-time and/or part-time middle-office and back-office personnel to work on highly complex reconciliation problems.

Market research has shown that 90% of audited spreadsheets contain errors. The OTC marketplace is not familiar with auditing, which leads to even more mistakes (see figure 4).



figure 4:

Audited Spreadsheet Error Count

90%Audited Spreadsheets

Containing Errors

10%No Errors

“ The TIW is the financial services industry’s first and only centralized global repository for trade reporting and post-trade processing of OTC CDS contracts. ”

“ IT systems that are able to handle today’s requirements are not necessarily suited for the regulatory guidances and clarifications that are likely to come over the next six months. ”

Future Regulatory Reform

Regulatory reform for global markets is far from over. A consistent flow of global regulations with multiple time-frames and deadlines has become the norm. IT systems that are able to handle today’s requirements are not necessarily suited for the regulatory guidances and clarifications that are likely to come over the next six months. For instance, the December 2012 implementation deadline of the G-20 commitments for coordinated securities market reform has already passed. Sovereign regulators still have yet to harmonize their respective regulatory rules. Harmonization could even take more time due to further delays and extensions, adding more data management and system update burdens.

More complications are coming. The provisions across regulations are not uniform. The European Market Infrastructure Regulation (EMIR) legislation does not cover the complete gamut of OTC derivatives markets. However, Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act covers the whole spectrum. Data management systems need to have enough flexibility to reconcile the regulatory disparities. Systems also need to be receptive to future updates on an ongoing basis.

CaseStudy:TheCDSMarketCredit default swaps (CDS) are highly standardized, negotiated derivatives transactions that were created to shift the credit exposure associated with fixed income instruments. Essentially, CDS buyers get a level of insurance against a negative credit event such as a default on a loan or on a mortgage. Nearly all, or 92%, of CDS transaction volume is now electronically confirmed2,3, which was the major industry concern before the Great Recession. The high percentage of CDS electronic confirmations has given the Trade Information Warehouse (TIW) a prominent role in the industry.

The TIW is the financial services industry’s first and only centralized global repository for trade reporting and post-trade processing of OTC CDS contracts. TIW comprises a trade reporting repository that operates and maintains the centralized global electronic database for virtually all CDS contracts outstanding in the marketplace along with a robust infrastructure that gives market participants a wide range of automated operational capabilities. When uploaded to the TIW, each transaction receives a unique identifier and the lifetime events of the transaction may be aligned among counterparties to the trade. TIW supports CDS credit event processing for bankruptcy and failure to pay and has the STP links to various third-party providers for portfolio reconciliation and compression, and exposure management.

All major market participants are currently connected to TIW and settle coupon payments and payments resulting from credit events through the central settlement system. Moreover, major market participants have committed themselves to settle 90% of settlement volume on electronically matched transactions via TIW and the central settlement system4.

The trading of CDS instruments and post-trade processing serve as a model for other OTC derivatives because:

•ThereisanSTPinfrastructure—namely,adata repository that supports automation, mitigating human error.

•Market participants have dedicatedthemselves to using the same infrastructure to effect transactions among themselves.

•CDS processing is seen as event-driveninstead of trade-driven due to the long maturities of CDS.



4 International Swaps and Derivatives Association (ISDA). 2009. Operations Benchmarking Survey, www.isda.org

2 International Swaps and Derivatives Association (ISDA). 2009. Operations Benchmarking Survey, www.isda.org

3 Markit. 2009. Q3 Metrics Trend Report, October 2009, www.markit.com

www.isda.org

www.isda.org

www.markit.com

“ STP can provide a trading enterprise with a sole vantage point for all securities. ”

“ Anewdynamic of data management is crucial to efficient collateral management. ”

ConclusionOverhauling the OTC marketplace is required in order to replace manual intervention in derivatives trade processing. Departmental heads at trading enterprises are pushing vendors and standards bodies for a universal view of balance sheets at firms. All the while, the amount of global high quality collateral is limited due to regulatory requirements (see figure 4).

A new dynamic of data management is crucial to efficient collateral management and a real-time, holistic view of data streaming from the front-office to the back-office. The challenges of systematically calculating collateral positions and creating the single source of truth have become increasingly more difficult as the number of disparate data points multiply at an exponential rate. STP and CCPs can help firms address these difficulties. STP can provide a trading enterprise with a sole vantage point for all securities. CCPs centralize the settlement process and produce margin requirements that change according to portfolio values on an intraday basis. In addition, breakthroughs such as the Clearing Connectivity Standard will move the industry closer to 100% automation and collateral maximization.

Nevertheless, data management issues still persist in the OTC marketplace. There is no standard for OTC derivative categorization. Valuation methods differ among parties. Some trade processes are prone to human error and could benefit from automation.

Ultimately, much of the forward progress is likely to be rocky because of an ongoing regulatory reform process. Despite the uneven progress the industry may take, trading enterprises need to stay focused on the vital need to provide uniform data management for derivatives transactions.


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