This document summarizes a panel discussion on the impact of regulations on the over-the-counter (OTC) derivatives market. The panelists represented different parts of the OTC transaction value chain, from trade execution to reporting and clearing. Key points discussed included the uncertainty created by various US and European regulations; differences between the Dodd-Frank Act and European regulations; challenges around defining what can and cannot be cleared; and how regulations may change trade execution and post-trade processing. The panelists expected significant changes to systems, business models, and the relationship between buy-side and sell-side firms as a result of new OTC derivatives regulations.

1. TCS Capital Markets Forum DEFINING TR ANSACTION BANKING
OTC Reform: The New Reality
in association with financial-i.

2. TCS Capital Markets Forum OTC Reform: The New Reality – Introduction
The panellists: (from left to right)
l Jesus Benito, CEO of Spain’s Iberclear, talks about l Joe Reilly, executive director, LCH SwapClear talks
post-trade reporting of OTC trades and why Europe about central clearing of OTC derivatives.
needs its own trade-reporting repository. l Michael Mathias, director, Capital Markets
l Philip Popple, a derivatives product specialist, BNY Consulting, Tata Consultancy Services, outlines the
Mellon Asset Servicing, talks about the impact of potential impact new regulations are likely to have on
OTC regulation on the buy side. systems and IT for the buy and the sell side.
l Alex McDonald, CEO of the Wholesale Market l Bob McDowall, senior consultant analyst, Aite
Brokers’ Association, looks at the impact of OTC Group, provides an outside-in view of what an
regulation on trade execution. analyst sees within the OTC derivatives marketplace
l Jeff Gooch, CEO of MarkitSERV, talks about the and talks about OTC regulation both in the US
impact of regulation on post-trade processing; trade and the EU.
confirmation and matching.
Introduction
The market abhors uncertainty, yet we are in a situation how regulation is likely to impact the different ele-
where we face a number of regulations passing through ments within the OTC transaction value chain; from
various regulatory bodies in the US and Europe, which trade execution, confirmation and matching, through
means that market participants are unclear about how to reporting, clearing, the end user or buy side, and
the OTC derivatives markets will be impacted in future. finally the IT systems’ changes that will need to be
made in order to meet regulatory demands.
For example, the industry is concerned about the Dodd-
Frank Act in the US, the Markets in Financial Instruments In the following pages you can read the insights of our
Directive or MiFID II, the European Market Infrastructure panel of thought leaders on where the biggest changes
Regulation (EMIR), and global regulations like Basel III. are likely to occur, the major differences between the
EU and the US with respect to OTC derivatives’ regula-
In this first TCS Capital Markets Forum entitled, OTC tion, and the questions that industry insiders are keen
Reform: The New Reality, held in association with to have answered.
financial-i in London on the 9 March, our objective was
to cast some light upon that uncertainty. We invited a
number of panellists representing the service provider Michael Mathias, director, Capital Markets
part of the OTC derivatives industry, to talk about Consulting, Tata Consultancy Services
68 Financial i · Q1 · 2011

3. Regulatory overview TCS Capital Markets Forum
A work in progress
The days of waiting until all questions regarding
forthcoming OTC regulation are answered, are
over, says Bob McDowall, senior consultant
analyst, Aite Group. Even if institutions are not
sure of the destination, they are expected to
start the journey.
The OTC initiative started life as one of the G20’s
responses to the 2008 financial crisis. The proposition
was that:
“All standardised OTC derivatives contracts should be banks in the OTC derivatives market a regulatory or
traded on exchanges or electronic trading platforms financial advantage.
where appropriate, and cleared through central count-
erparties by the end of 2012 at the latest. OTC deriv- In order to allow regulators to have an overview of the
ative contracts should be reported to trade repositories. derivatives market, the Commission is proposing that all
Non-centrally cleared contracts should be subject to trades be reported to trade repositories, which can col-
higher capital requirements.” lect and collate information on trades. It proposes that
legislation will provide a common legal framework to
This statement gave birth, in a relatively short time politi- address authorisation, registration requirements, access
cally, to the proposed draft legislation by the EU and US and participation, disclosure, data quality, timeliness
regulatory bodies. From the EU perspective, the European and legal certainty of registered contracts.
Commission wants non-standard or bespoke derivatives
to be priced to take into account the systemic risk they To ensure transparency and market integrity, the
entail and believes collateral levels need to be higher to Commission wants all standardised OTC derivatives
reflect the risk bilaterally cleared derivatives pose to the contracts to be traded on exchanges or electronic plat-
financial system when they reach a certain critical mass. forms, which are defined by the Markets in Financial
As a result, it proposes that financial firms entering into Instruments Directive (MiFID) as regulated markets,
non-standard contracts must post initial margin in propor- in particular multilateral trading platforms and system-
tion to the risk profile of the counterparty and variation atic internalisers. Such moves would make it easier to
margin in relation to the changes in value of the contracts more effectively regulate the OTC derivatives market,
over time. This is intended to encourage participants to although there could be negative side effects on
use standardised contracts that are centrally cleared liquidity.
wherever possible. Bilateral non-cleared OTC contracts
will also be subject to higher capital charges. Two different regimes
It was the express intention of the European
The gap between the relative capital charges for cleared Commission to make regulation consistent with the pro-
and non-cleared derivatives provided within the capital visions for OTC derivatives in Dodd-Frank. They have
requirements directive will be widened. The Commission been marginally successful, but there are significant dif-
believes that regulation should allow non-financial institu- ferences between the two regimes. For example, global
tions hedging specific exposure to be able to continue banks may find maintaining their compliance difficult
to transfer risk without posting additional collateral. if the risk of standardised contracts in the EU and the
However, there is currently no definition of a non-finan- US do not align. In addition, there is a risk of financial
cial corporate counterparty, and it acknowledges that any institutions being able to take advantage of regulatory
definition should not give institutions that compete with arbitrage if the systems are not kept broadly in line.
‘‘
Global banks may find maintaining their compliance difficult if
the risk of standardised contracts in the EU and the US do not
align. In addition, there is a risk of financial institutions being
able to take advantage of regulatory arbitrage.
2011 · Q1 · Financial i 69

4. TCS Capital Markets Forum Regulatory overview
The Dodd-Frank Act imposed a clearing obligation
on all parties who trade a clearable contract, save
for a very narrow exemption for non-financial enti-
ties, which enter transactions to hedge or mitigate
commercial risk. The EU regulation appears to be
more lenient than Dodd-Frank in that non-standard
financial entities only become subject to a clear-
ing obligation if their position exceeds a clearing
threshold.
Another interesting difference between the two
regulatory regimes is what is subject to clearing?
The EU regulation applies to derivatives contracts
that are traded over the counter. The Dodd-Frank
Act applies to any agreement, contract or transac-
‘‘
tion that is or in future becomes known to the trade
as a swap, a broadly-defined term that encompasses Another question is trading
virtually every OTC derivative currently traded in
the markets. Spot foreign exchange transactions OTC – how much will move
remain outside the scope of regulation, but while to electronic trading on
the EU definition also excludes commercial for-
eign exchange forward contracts, the US definition exchanges? The other
is broader as it merely permits the US Treasury interesting issue is what
Secretary to exempt foreign exchange swaps and
forwards from the clearing obligations. Finally, the cannot and will not be
Dodd-Frank Act mandates that all centrally cleared cleared? Who and how will
trades go through an exchange or a swap execution
facility (SEF) to increase the pre-trade price trans- that be defined?
parency and efficiency of the derivatives market.
Destination not yet finalised should achieve the objectives of greater security while
Lets turn to the challenges, and obviously they vary reducing the operational risk and cost to clients. One
by market participant. The first thing is regulatory of the other areas is the change in business model
uncertainty and lack of granularity. Unfortunately, we – will the buy- and sell-side relationship change?
cannot wait to commence the planning and implemen- Obviously there will be greater post-trade connectiv-
tation until there is a degree of certainty. The days of ity. Will there be a smaller number of relationships?
waiting until all questions are answered, I’m afraid, are Will there be a much greater examination of what they
over, and institutions are expected to start the journey would see as the independence of the clearing service,
even though complete details of the route are yet to and particularly independence and transparency of the
be finalised. settlement pricing?
Another question is trading OTC – how much will There are also some other interesting issues in terms
move to electronic trading on exchanges? The other of national differences and concerns. The UK regulator
interesting issue is what cannot and will not be has pointed out that the European authorities cannot
cleared? Who and how will that be defined? Will new bear the fiscal responsibilities in the event of the fail-
models evolve for this innovative business, and will ure of a CCP (central clearing counterpart), and that
those models have the attributes of high margin, high full supervision should therefore reside with the CCP’s
risk and high capital with a cap? In other words, will home state. There are also other issues to do with the
there be a decline in interest in that business that need for operational and prudential standards for CCPs
cannot and will not be cleared? so that we don’t get viral risk being transmitted cross-
border because one of the CCPs defaults or cannot
One of the investment management associations satisfy its obligations.
has urged the European Commission to widen the
approach to collateral management so that long-term There is the immediacy for action, the planning has to
investors are not disadvantaged by having to convert begin now, there are project risks and costs, and more
their portfolios into unproductive assets merely for technology is needed, particularly for the major
collateral use. Retaining collateral within the custodian, institutions that conduct this business across all asset
subject, of course, to ring-fencing charges or pledges, classes and different jurisdictions.
70 Financial i · Q1 · 2011

5. OTC Reform: The New Reality – Trade execution TCS Capital Markets Forum
The wrong way round
Alex McDonald, CEO, Wholesale Market Brokers’
Association, says the regulators have got it the
wrong way round and that Basel III and capital
mechanisms should be in place first before tack-
ling how OTC trades are executed, cleared and
reported.
In the latter months of 2008 the G20 came together
and termed the word ‘exchange’ and said most OTC
trades had to go on exchange. Why years later are we
still adhering to what was a viewpoint expressed in the
middle of a panic, which might not have had all the due
consideration and understanding of the performance and range of hybrid-type products where you trade around
the workings of the global marketplace at the time? an MTF or the economic fundamentals are brokered on a
screen. Then there is voice for more bespoke trades. This
What we have had to do in terms of the OTC brokers begs the question, when is a deal done? Is it done when it
who put together nearly all the OTC trades in the world is arranged, confirmed, affirmed or when it is cleared, and
and, if you like, their regulators and their policy makers, at what point could it be undone?
is redefine the term ‘exchange’ to capture what is done in
the real world. And remember, if the OTC market is two Deals are done under two basic models, either name
orders of magnitude bigger than the exchange, it is like give-up where names are passed and the deal is purely
putting a rather large ocean into a pint pot, which makes arranged, or on a matched principle where the broker
it very difficult, and again overtly political. puts his name in between the two. Let’s look at how this
might change. Liquidity venue applies to those trades that
The Basel III process is always going to be key, and until are defined as standardised and clearable. Under MiFID
that is globally operational, the rest of it is very difficult. there is the idea of an organised trading facility (OTF),
If you started off with a new capital mechanism to make which the UK Financial Services Authority opposes saying
things safe, then you could come back to how trades that it is too broad and that we just need the standardised
work, how clearing might work, how you can scale it clearable bit, which should come in and sit alongside
or make it all proportionate, and how you can therefore an MTF.
define market abuse and methodologies around that,
rather than starting at the back and trying to go forward. However, MTFs are designated contracts. The idea is to
This explains why there is delay, deferral, argument and bring the negotiated world of OTC into that scope of
politicisation, and why Dodd-Frank, the European Market regulation, but many trades are negotiated around an MTF
Infrastructure Regulation and the Market Abuse Directive price under the provisions of the firm. So, if you like, they
cannot go anywhere. are hybrid between MTF and off-MTF as well as being
hybrid between electronic and voice. It is very difficult to
So what do we do and how will it change? The inter- draw all of that into one regulation.
dealer brokers are so broad they are brokering everything
from cash and derivatives, secondary hedge funds through There will have to be a level of post-trade transparency
to overnight cash deposits to local authorities and deriva- and a level to which I believe the inter-dealer brokers all
tives and cash in between. Some inter-dealer trades are apply to now, which is automating their business so that
done automatically, either using a multilateral trading facility from the point of trade it is an electronic flow straight
(MTF) or a foreign exchange outside the scope of MiFID- down to the point of affirmation and confirmation, which
type products, which are purely automatic, and where the allows the trade repository function to work into clearing
price and size of a deal is broadcast live. There is a whole or settlement.
‘‘
There is a whole range of hybrid-type products where you
trade around an MTF or the economic fundamentals are
brokered on a screen. Then there is voice for more bespoke
trades. This begs the question, when is a deal done?
2011 · Q1 · Financial i 71

6. TCS Capital Markets Forum OTC Reform: The New Reality – Post-trade processing
Getting the message across
Although post-trade processing providers like
MarkitSERV have already delivered efficiencies
to the OTC markets by electronically confirming
trades, Jeff Gooch, CEO, MarkitSERV, says in the
new world, the ways in which the industry operates
and interacts will look radically different.
Regulation of OTC derivatives is complicated; no one
really knows what is going to happen. That presents a
challenge to everybody across the industry. We are all
going to spend a lot of money on technology, staffing, the trade means you have to update a trade in a way
and for some of us, it will be a very radical change in that didn’t historically have to happen, with the excep-
business models. tion of the inter-bank interest rate market. Furthermore,
regulators now know what you did, so that information
I am going to make two suppositions about the future. is going to have to be posted to a database somewhere.
One, it is going to take longer to get there, certainly a There are several requirements in Dodd-Frank for
lot longer than most of the politicians think. Two, it is public dissemination of trading information, and it is
going to be a much different place from today. The idea pretty clear that MiFID II will have similar requirements
that the OTC markets are not going to radically change is in Europe. These reporting requirements are a radical
just incorrect. There will be radical change. Whether that change for the industry and they add to the increase
is necessary or not we can debate, but the reality is the in operational intensity that we expect to occur. One
guys on Main Street in the US, and pretty much every- of the priorities for us at MarkitSERV is developing the
body in France and Germany, believe the OTC markets solutions required to enable efficient reporting and get-
are at fault and they want to see change. ting messages where they need to go.
The new world is probably going to be safer, certainly The second factor in the new world is that everything
more transparent but it is also going to be a lot more has to happen a lot faster. If Dodd-Frank is implemented
operationally intense than anything we do currently. unchanged, you are pumping trade data out as soon as
Today’s bilateral world for derivatives is very straightfor- technologically possible, and in no case later than 15
ward, believe it or not. Quant traders sit there with com- minutes. From an IT perspective, we have technology
plicated models, but for the back-office guys it is very and the networks that do that quite easily, but a lot of
simple. Two people speak on the phone, they kick some the business models that underlie that information will
brokerage to an inter-dealer broker and you have a trade, have to change radically, particularly for fund managers.
and, traditionally, you get a nice piece of paper that rep- Many traditional fund managers are suddenly waking
resents that trade. Over the last several years, MarkitSERV up to the operational implications of the need to post
has helped the industry automate some of that process allocations electronically and the need to deal with col-
and electronically confirm transactions. lateral messaging at the fund level from lots of CCPs on
daily rather than weekly cycles.
Today, you agree the document, electronically sign it,
match it, affirm it. In the new world, those processes start Everything we do has to get automated and faster, and
to look radically different. To start, a lot more people will when we’ve finished, we will work out whether we
want to know about trading activity and trade details. have a market left to service. I believe we’ll still have a
Approximately 70% of OTC trades will be centrally dynamic market. It’s just going to be different and it’s
cleared. Those trades are going to have to go to a clear- going to require new levels of electronic messaging to
inghouse and be accepted or rejected. The act of clearing make it all work.
‘‘
Many traditional fund managers are waking up to the operational
implications of the need to post allocations electronically
and the need to deal with collateral messaging at the fund
level from lots of CCPs on daily rather than weekly cycles.
72 Financial i · Q1 · 2011

7. OTC Reform: The New Reality – Trade reporting TCS Capital Markets Forum
Improving market practice
Many firms may be opposed to more regulation
of the OTC markets, however, Jesus Benito,
CEO, Iberclear, says the best approach is to
accept there is going to be change and then
look for ways to improve the way the business
is conducted.
There are going to be big changes in future in the
derivatives markets. Regulation is the main focus
of the current discussions in Europe and America
and also in other countries, and the current situa-
tion, whether we like it or not, is that the US regu- to improve current market practices. This is the most
lation is more advanced than European regulation. intelligent way of doing things.
However, it is of the utmost importance to have
both these regulations in line, and that other mar- Our vision is that this market is global, and if you
kets around the globe look at what the American mean global it’s not only global in geographical
and European regulations are going to be if we terms, it’s global in the way that it is not only Europe
are to avoid regulatory arbitrage as much as pos- and the USA, it is also the financial institutions that
sible. Some of the technical consequences of the are dealing with this market and the corporates
Commodity Futures Trading Commission (CFTC) who are also part of this market. And we have to
regulations will mark the path to be followed by take into account a lot of the necessities that the
European and other global regulators. corporates need from this market, and therefore we
believe we have to give a solution for not only the
The consequences of more regulation imply more 14 biggest dealers in this market, which are obvi-
cumbersome tasks, and therefore this means more ously very important, but they are not the only par-
cost. If you ask anyone whether they want to be ticipants. Also, even if the regulators want to push
more regulated, they would probably say, ‘No ahead for more standardisation, more contracts to be
thank you. I’m okay, I do not need more regu- tradable, more contracts to be passed through clear-
lation’. The point is that if the regulation is not ing, there are very good economic reasons to have
properly designed there could be undesired effects bespoke contracts, especially between the banks and
or collateral damage, which could be very dramatic corporates.
for the markets. You can have different attitudes
towards the regulation. Of course, you can be We believe in competition, definitely. We believe in
totally opposed to regulation and try to avoid it, competition also in the trade repository field, and
but I don’t believe at this point in time that is the we believe in a one-stop shop for participants rather
correct way to do things. The second approach is than participants having to connect with five dif-
to accept that there is going to be some form of ferent trade repositories. We also think that we can
regulation and to try in the best possible way to offer to the market, whether they are financial insti-
have the best possible regulation concerning trans- tutions or non-financial institutions, good services in
parency. The third option is that you can accept order to improve the current ways the administrative
regulation and try to take advantage of it in order tasks are conducted in this business.
‘‘ You can be totally opposed to regulation and try and avoid
it, but I don’t believe at this point in time that is the correct
way to do things. The second approach is to accept that
there is going to be some form of regulation and to try to
have the best possible regulation concerning transparency.
2011 · Q1 · Financial i 73

8. TCS Capital Markets Forum OTC Reform: The New Reality – Central clearing
Clearing matters up
When you introduce the buy side into the
equation, clearing starts to get complicated, says
Joe Reilly, executive director, SwapClear, particularly
in terms of how margining, segregation and
omnibus arrangements may work.
There is a lot of uncertainty as to where the future lies,
but we can tell you for certain that there is currently USD
266 trillion-worth of interest rate business already being
cleared in today’s marketplace. It is also fair to say that
the things we worry about most, and what the buy side
are certainly worried about most, are cost, segregation, direct clearing members of the clearinghouses, and the
portability, what levels of protection are they getting, and clearinghouse itself. So what type of legal arrangement
what are the risks they are being exposed to? is in place? Typically in Europe, the arrangements are
normally on a credit intermediation basis, which means
If we address the cost issue first of all, in terms of the that the client has a principal relationship with its clear-
USD 266 trillion number, cost was a no-brainer because ing member and not the clearinghouse. There are also
if you look at the zero capital charge weightings to be agency models, which are more akin to the futures mar-
able to support your portfolio versus the cost of clearing, ket where clients have relationships with the clearing
the benefits were mind-bogglingly superior to the actual member but acting through an undisclosed principal.
cost associated. When we introduce the buy side into the That is a complex legal arrangement and it is clear in
equation things change, because they don’t necessarily these early days of buy-side clearing, that it is not fully
get the full capital and balance sheet benefits. understood by a wide section of commentators.
What type of costs do the buy side need to worry about? There are different types of segregation being offered
They need to worry about initial margin, which is the by clearinghouses, but it is very important that the buy
core protection that the clearinghouse gains in the event side understand all the implications of segregation. It is
of a default, coupled with the variation margin, which in clear that the segregation that is in place for the futures
summary is the P&L, which the buy side would normally market in the US is very different to the segregation
experience on movement of their mark-to-market expo- rules that are in place in Europe. In particular, there is
sures under their credit support annex agreements. It’s a very strong debate going on around what clients are
the transactional cost and the cost of collateral. Those are exposed to in omnibus arrangements. So you have the
the sorts of things, which are very concerning to the buy concept of clients having co-mingled positions with
side, and we have to be open and honest and say that other clients, and that is a situation which clients trad-
costs are going up from that perspective. ing OTC instruments are not used to, but in the futures
market that is a very common arrangement.
One of the key benefits of clearing for the buy side is
protection against default, and you have to be concerned One of the key areas that needs consideration is
about what levels of protection are we offering to clients, when we talk about ‘portability’, what happens in the
and that’s a complex question. You have to determine event of a default of a clearing member? One of the
whom are you trying to protect yourself from? In terms of pitfalls of today’s clearing models is that there is no
protection there are two key models out there, which are guarantee of portability, although we think that por-
different depending on the jurisdiction and the clearing- tability will start to become guaranteed and emerge
house. One is called the principal-to-principal model, and as and when we move closer to full clearing
that is really talking about the relationship between the initiatives.
‘‘
What type of costs do the buy side need to worry about?
They need to worry about initial margin, which is the core
protection that the clearinghouse gains in the event of a
default, coupled with the variation margin.
74 Financial i · Q1 · 2011

9. OTC Reform: The New Reality – The buy side TCS Capital Markets Forum
Collateral damage
Greater regulation of the OTC markets poses a
lot of unanswered questions for the buy side
who face increased margin and collateral costs,
says Philip Popple, Derivatives Operations, BNY
Mellon Asset Servicing.
It is difficult to justify why central clearing is being forced
upon the buy side, because it is resolving a problem that
is a sell-side issue rather than a buy-side issue. Having
said that, the buy side are engaged and are looking to
move forward, and there are a number of issues that
come to light. bonds. If, for example, an equity long fund may have
some OTC derivatives but they don’t have spare cash
In the operating models that are going to emerge in the or bonds sitting around as eligible collateral; they have
future, it appears that we are going to have three differ- equities, and that is probably not going to be eligible
ent models. We are going to have an exchange-traded for use in a CCP model.
derivatives-shaped model, a traditional OTC deriva-
tives model, and a hybrid model, which is centrally- I don’t think the buy side yet understands what will
cleared OTC trades, because upfront they are going to happen in a default scenario because if they are able to
be traded bilaterally, but once they have gone through put up any bonds as collateral, they will expect those
the trade and the confirmation cycle, they will fall into instruments to be theirs. Yet, I understand that in such
a centrally-cleared and margined solution that is more a scenario, it is difficult to move the collateral with
akin to exchange-traded derivatives. So the buy side are trades. They may be different shapes and very often it
now seeing a different level of complexity and systemic means that portfolios that are lodged as collateral need
requirements that weren’t there before. to be liquidated.
I anticipate increased lobbying from those entities and What we will end up with is the existing book of OTC
organisations that may wish to claim exemptions, but trades remaining as they are and being collateralised
from my perspective I can’t see how that will ever work. bilaterally, and then future trades going through a CCP
Whilst there may be possibilities for exemption, trades being margined. There is going to be a reduction in
with the sell side will be subject to a capital charge if the opportunities to net off the collateral at a single
they don’t centrally clear. So from a commercial perspec- counterparty, so the cost of collateral is also going to
tive, I don’t see how the sell side will trade outside clear- increase because we are going to have two models.
ing because they will incur the capital charge on their My final point is that from the buy side, often we are
side. There will need to be some changes and clarity as looking at liability-driven investment and trying to
the Basel III regulations come through. match liabilities with the assets. In order to do that they
have to both be valued on the same basis, otherwise
We foresee an increase in margin costs. One of the there will be a mismatch. So in future we may see one
problems is eligible margin. In the bilateral model there pricing model for investment purposes, and for the col-
has been evolution over the last few years and the collat- lateralisation or margining it is going to be a different
eral in a bilateral OTC model is generally bonds or cash; model. There is a conflict there that will need to be
the majority is cash. On the buy side there isn’t a great resolved on the buy side, and they may have to try and
deal of cash floating around; they would rather put up find other ways of valuing or reporting.
‘‘
I don’t think the buy side yet understands what will happen
in a default scenario because if they are able to put up any
bonds as collateral, they will expect those instruments to be
theirs. Yet, it is difficult to move the collateral with trades.
2011 · Q1 · Financial i 75

10. TCS Capital Markets Forum OTC Reform: The New Reality – Technology
Making sense of it all
For both the buy and the sell side, regulation
means a number of process and IT system
changes particularly with respect to new execu-
tion, clearing and reporting requirements, says
Michael Mathias, director, Capital Markets
Consulting, Tata Consultancy Services.
Changes to the derivatives’ architecture in response to regu-
lation are manifold. Starting with connectivity, the panel was
unanimous that there is much uncertainty and ambiguity.
One thing, however, is clear, and that is that the sell side
will require connectivity to the multiple OTC clearinghouses systems that may not set out their contracts and trading
that are likely to emerge. Additionally, Dodd-Frank in the portfolio in the prescribed format for standardised con-
US also discourages the use of single dealer portals, which tracts. How this can be resolved depends on each firms’
could result in a proliferation of exchanges. We envisage an architecture. In the case of vendor systems, these may
environment with multiple swap execution facilities (SEFs) need to be upgraded so that standardised contracts can
and multiple clearinghouses, possibly divided along asset be reflected, traded and passed straight through to the
class lines. Connectivity becomes a real challenge in this clearinghouse. If they are in-house systems, then poten-
landscape. tially there is quite a lot of rework required.
Margin: Assets eligible for initial margin are cash and gov- Complex trades: Often banks use workarounds to reflect
ernment bonds, while cash is only eligible for variation mar- complex trades in their systems. For example, a callable
gin. The buy side prefers not to pay cash as margin since swap might be booked as a set of cash flows and a
this impacts investment returns. There is an opportunity for ‘swaption’, with individual cash flow legs loosely linked
the sell side to provide collateral substitution services but thistogether. This approach may, for internal systems pur-
adds a further layer of complexity in terms of technology poses, correctly reflect the risk and cash flows, but the
and systems. workaround will not be effective for confirmation pur-
poses. Additionally, it is unlikely that the clearinghouse
Risk management: Much of the risk management performed will reflect a trade constructed in this way. Therefore,
by brokers will now be performed by CCPs. However, clear- remediation is required with respect to the way trades
ing brokers will need to take on new clients and will have are held in terms of the workaround.
to process additional volume. From a technology perspec-
tive, brokers will need to upgrade their client credit risk sys- Buy side: From the buy-side’s perspective, key areas
tems (risk, margin management and collateral management) for change concern the new execution, clearing and
to keep pace with the CCPs. Additionally, there is a need to reporting requirements. Some trades will go straight
look at the risk before a client is on-boarded, and to man- through in terms of being standardised and executed
age risk through the transaction life cycle. Furthermore, sell- on-exchange. Others will go directly to clearing but
side derivative clearing members will probably have other won’t be executed on-exchange, and yet others will
businesses; for example, they could be prime brokers with a need to be traded bilaterally. This means that there are
high level of bilateral derivatives trading. It will be necessary three or more different types of trades that are being
to factor the new client/clearing risk into the enterprise-wide cleared through multiple clearinghouses, with the rout-
risk profile of the clearing broker. This adds even more ing based on complex criteria. It is necessary to auto-
complexity to the technology requirements. mate the clearing of derivative contracts with systems
that are able to make sense of all that. Finally, reporting
Systems re-mediation: The Dodd-Frank Act refers to stan- is a complex area, however, it mainly impacts the sell
dardised contracts that should be traded on exchanges side because the buy side can delegate its reporting to
and cleared through CCPs. Companies will have legacy the sell side.
76
‘‘ We envisage an environment with multiple swap execution
facilities and multiple clearinghouses, possibly divided along
asset class lines. Connectivity becomes a real challenge in
this landscape.
Financial i · Q1 · 2011

11. OTC Reform: The New Reality – Q&A TCS Capital Markets Forum
More questions than answers
Panellists fielded a range of questions on the politicisation of OTC derivatives reform, buy-side
challenges and how central clearing and trade repositories will work in the new reality?
Given the ‘tsunami’ of regulation that the OTC industry faces, good, as long as it doesn’t become a race to the bottom
audience members were unsure as to who the regulations on margin.”
were really designed to protect? Alex McDonald, CEO of
the Wholesale Market Brokers’ Association says the raft of Jeff Gooch, CEO of MarkitSERV, says the choice of clear-
new regulations: Dodd-Frank, MiFID II and the European ing depends a lot on the buy-side firm you’re talking to. He
Market Infrastructure Regulation; would add more silos, says hedge funds led the push for access to clearing. Most
costs and compliance for the end user (asset managers, of them got to choose their own clearing brokers, their own
liability managers, corporates). “It is likely to make all prime brokers and, presumably, their own CCPs. Gooch
financial instruments more expensive,” he says. “By redi- says hedge funds will concentrate their positions over a few
recting the working capital of the financial system into institutions. Yet, traditional money managers come from a
clearinghouses as margin in the form of high quality liquid world where the underlying plan sponsors often choose the
assets, the regulations will impede bank lending and yet custodian for cash settlement, and in many cases, expect to
they remain a political selling point to the electorate.” choose the clearing broker and may even be the underlying
CCP their trades go through. “A lot of these guys are start-
On the clearing side, the buy side face a number of chal- ing to worry,” says Gooch, “particularly those with a wide
lenges around margining, collateral and segregation. Joe variety of underlying clients. They may have to more or less
‘‘
Reilly, executive director, SwapClear, says there are fun- connect almost everybody because they pitch for business.
damentally two different types of segregation: one where
your assets are completely segregated from the assets of the
clearing broker’s house account, and also segregated from You have
the other clients within that clearing broker’s arrangements,
which provides the maximum amount of protection for the
pros and cons
client and the greatest probability for the clearinghouse. for everything,
However, he says this may prove to be a more expensive
solution for clients as it limits the ability of the clearing bro-
but we believe
kers to take advantage of offsetting positions for differing in competition
clients, commonly known as omnibus arrangements, which
is the second option.
for the trade
repositories
In terms of whether clients are likely to get the same col-
lateral back, or the collateral that was pledged or offered
field also.
to the clearing broker in the event of a liquidation, Reilly Jesus Benito, CEO,
says that’s not necessarily a problem if a backup clear- Iberclear
ing member can be found to take on those positions.
However, he says there are all sorts of issues around valu- They can’t say, ‘I’m not going to take that business because the
ations of collateral and haircuts. “The traditional arrange- clearing broker is such and such or the underlying CCP
ment which has been offered to European clearinghouses preference is LCH’”.
for the exchange-traded businesses is what’s called an
omnibus arrangement,” Reilly explains. “The typical omni- On the trade repository side, participants are also faced with
bus arrangement is a net omnibus arrangement where choice. Jesus Benito, CEO of Iberclear, which set up
offsetting positions are calculated so that the amount of REGIS-TR a trade repository in Europe, says there is dis-
collateral or margin posted to the clearinghouse is differ- cussion about whether there should be one single trade
ent to what will be collected from the clients.” repository per asset class or competition. “You have pros
and cons for everything, but we believe in competition for
One audience member asked how much choice there would the trade repositories field also,” he says. But how do you
be in terms of where, for example, a Canadian entity trad- ensure a high level of co-operation between global regula-
ing dollar swaps out of London, could direct those trades tors and market participants? “It is going to be complicated,”
for clearing? “My view is there will be choice,” says Reilly. says Benito. “At the level of the regulators, there is a specific
“There are many debates as to whether one CCP is the right follow-on from the central banks and the regulators in the
answer or whether there should be many CCPs, and of G20 countries to co-operate and to co-ordinate the legislation.
course there are commercial dynamics which push the argu- The US is marking the path and Europe is following. We really
ment towards a single CCP, but the reality is competition is hope that both regulations are in line.”
2011 · Q1 · Financial i 77

12. Enabling Link Up Markets to
reduce complexity in European
cross-border securities transaction
processing in eight months.
That’s certainty
Link Up Markets is a joint venture by eight leading European Central Securities Depositories
(CSDs). Link Up Markets wanted to simplify cross-border securities transaction processing and
needed a common messaging platform to connect (link) various CSDs for simple, secure and
cost-effective messaging and tracking along with access to reference data. Clearstream Services
S.A. partnered with Tata Consultancy Services (TCS) in linking the CSDs by implementing TCS
B NCS Solutions, Service Integrator and Corporate Actions. As one of the world’s fastest growing
financial services technology brands and an integrated product suite, TCS B NCS enabled Link
Up Markets to validate, transform and route messages between the CSDs by absorbing
differences and variations in communication standards across markets while also providing
storage and web-based access of corporate actions and events data to the CSDs and their
participants. Empowering Link Up Markets to look at increasing the current market share in
cross-border settlement volumes within a timeframe of eight months. And, of course, enabling it
to experience certainty.
To learn how TCS B NCS can help your organization experience certainty,log on to
www.tcs.com/bancs or email us at tcs.bancs@tcs.com