What types of behaviours are the likes of SFTR, CSDR, and UMR driving in the securities finance industry?
The Securities Financing Transactions Regulation (SFTR) is a trade reporting requirement and in many ways, it shouldn’t be over-thought—it is what we do, and it is how we work. Other parts of the financial markets have been through this already with the European Market Infrastructure Regulation (EMIR), for example.
Driven by SFTR, lots of people will have to look at the nuts and bolts of their trading systems and behaviours, potentially needing to change the way they’re booking things to make sure they’re getting it right. In addition, we as an industry, will need to fix some of the fundamental structural issues we are facing.
In a data panel at the Securities Finance Technology Symposium, it was discussed that firms need to have the right foundations. It can be tedious to some, and we’d perhaps rather talk about artificial intelligence (AI), machine learning and all of the other shiny bells and whistles, but you need to get the base technology and data right first.
SFTR will drive the industry to be much clearer about data because it is a regulatory imperative. There are lots of things we would love to do but regulatory drivers mean that you have got to comply with regulation otherwise your business is over. SFTR is all about getting that data martialed at the right place and at the right level. For example, legal entity identifiers (LEIs) need a reference to every single entity. LEI’s are just one of a multitude of changes that can make our industry so much better in terms of efficiency and technology. SFTR is going to do a lot to make us change behaviours and, in the long run, adopt some much needed best practice approaches.
Central Securities Depository Regulation (CSDR) is one regulation that is creeping up behind us, and it is all about settlement certainty. If we don’t get some of these settlement behaviours right, then there will be fines. One of the unintended and not necessarily positive consequences of CSDR is around the periphery of market participants. Some market participants will not take the risk of lending a security, particularly if it is illiquid. People want settlement certainty and the illiquid stocks, by definition, can be harder to settle and thus carry more risk. This could lead to a reduction in the lendable supply of harder to settle assets, raising the risk of settlement failures, not reducing it.
Uncleared Margin Requirements (UMR) is another interesting topic. You’ve got the steady reduction of the thresholds in which you are required to post margin. We’ve gone from the seven biggest firms to the next 35 becoming eligible this September. The next charge, in September 2020, will affect just under 900 more firms because the next threshold drops dramatically. Suddenly, you’ve got lots of other firms that weren’t involved before who have now got to post margin that was never required before. From the securities finance industry’s point of view, it could be a great demand driver.
It is also something that we have to structurally think about because while a sudden uptick in demand is great, we’ve got to be able to manage it and make sure our systems are prepared. A lot of the topics discussed at symposium were about efficiency and automation; meeting these demands effectively is all part of that.
How will UMR affect the trading of non-centrally cleared OTCs and the future of collateral management?
I could argue that the trading of non-centrally cleared over-the-counter (OTC) transactions will start to become centrally cleared. When you think about what some of these regulations—such as SFTR—are trying to do, they are nudging the industry towards exchanges. The regulators love exchanges because they are transparent, efficient, and arguably more secure. There are lots of mechanisms there that regulators like, so, reading between the lines of SFTR, it is encouraging the use of central counterparties and exchanges. With UMR, it is uncleared OTC derivatives that are being targeted.
A recent study showed that few firms are fully compliant for the UMR due to be implemented September this year, why is this? What advice would you give to firms who are not yet compliant?
People are somewhat behind the curve; part of this is due to people’s one-by-one approach. If an organisation is not willing to put their money into investing what is required, then the regulators will no doubt take a dim view of their approach.
When EMIR went live, those who didn’t have an LEI could not trade, it was as simple as that. The regulators are strict. If you are not going to post margin on derivatives in line with the regulations, then don’t trade derivatives.
What challenges will CSDR present the industry with?
It is all about settlement certainty. However, people are not convinced that settlement efficiency is that bad. Some argue that it is a little bit of a sledgehammer to crack a nut.
A large part of the securities finance industry is about ensuring settlement certainty and that is where it started many years ago. It was a back-office operation undertaken to raise settlement certainty, for example to reduce failure rates through the borrowing of assets.
When we think about the fact that the regulators are now trying to codify that and say “you must do that and if you don’t then you’re going to pay a fine”, in some ways it is over-egging the situation as nobody wants to fail, and many take stringent measures to avoid it already.
Failure rates are lower than we think; the very industry that is trying to stop them—and makes its living, partly at least, out of stopping them—is potentially going to be impacted by this. It might be the lower liquidity end of smaller organisations, the lower liquidity stocks, the very things you really want to be available in an emergency because something is failing. It might be the ones who say “no, I won’t lend you that for fear of a fine”. So, we potentially have a negative impact.
Will it really improve behaviours? I’m not sure that behaviour is bad. People don’t go out of their way to fail on purpose.
Do you think firms will fully utilise technology to help overcome challenges associated with SFTR?
Yes, I do. If you don’t apply heavyweight technology to SFTR then you will fail. When we think about some of our largest clients at FIS, they might have half a million outstanding positions that can generate more than a million life cycles per day, all of which are reportable to the European Securities and Markets Authority (ESMA). Those lifecycle events have up to 80 matchable fields in them. Having a number of employees trying to solve that in any sense manually will simply fail. Think of the enigma code and how they had to break it over a 24-hour period, and once that 24-hour period had gone, all work on it was gone too. The daily reporting of transactions under SFTR will be a lot like that. If you are going to be reporting 1,000,000 life cycles a day, when the cut-off ends for that day, you’re starting again. If you have made one error on one matching field in 10 percent of those trade messages, which is very conservative, it is actually 100,000 breaks that you’re building up every day. If you don’t fix them then by the end of the week it is 500,000 breaks. You have to apply heavyweight technology to cope with that. As I said earlier, the right approach would be to avoid these breaks in the first place by focusing on the foundation data and accurate processing. Getting the basic stuff right will pay significant dividends in the end.
Your technology has to be in a position where you’re able to send every lifecycle event to ESMA. ESMA wants to be able to audit from start to termination every single transaction. In order to do that, they need every life cycle event because if they jump one then the front is not going to meet the back. The importance of technology, and applying that technology thoughtfully, is an absolute prerequisite to success with SFTR. The industry is being driven into the dark corners that we didn’t really worry about before and we have to get that stuff right. We need technology to meet the complexity of requirements that ESMA is asking for.
In a panel at the Symposium, the moderator asked panellists if they thought ESMA knows what is coming in terms of the tsunami of data. And, I’m not sure they do. We’re talking about a million life cycle events per day from just one of our many clients. The quantities of data are absolutely enormous. It is going to be interesting and a little bit worrying at the same time. The International Securities Lending Association and the International Capital Market Association are trying to help ESMA understand what they’re in for. There is so much data to sift through that I do not envisage any meaningful analysis or response from ESMA until some time after SFTR goes live.
How prepared are firms for SFTR? Do you think there will be a large number of firms who will not meet the deadline in Q2 2020?
There is a very wide range of readiness. There are some organisations who have had people and budgets in place for some time. They are coming to us and saying: “give us another version of the software, what have you built so far, we’re ready to test, we’re building our own internal mechanisms”. There are some organisations who are absolutely on it and there are some who have only recently said that they’ve come to the decision that they want our system, and they have less than 12 months until go-live.
Now that a date is known, people can put a project plan in place. For some organisations, up until that point, the people who hold the budgets and hold the priority lists have said until they know when they have to comply they are not going to do anything. Therefore, there are different states of readiness. I would suggest very few are not going to make it. They have to. It is a date you have to meet. If you don’t you’re breaching your regulatory responsibilities, and if you do that, then you are not trading.
I think an interesting variation of the question would be, “how many people are going to make a mess of it?”. They may be live and they are putting data over the wall to the trade repository, but is it correct? Much of the assessment each nationally competent authority will make, will probably include how much effort and commitment the reporting firm has expanded on SFTR. Firms that can demonstrate effective preparation and testing, for example, will likely be in a better position than those that cannot.
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