Regulatory Ops 2020: Handling Tower of Acronyms

Compliance, operations, and IT managers will be teaming up in newly created regulatory operations departments to do data aggregation, contract renegotiation and relationship management in 2020 as they handle a slew of new regulations commonly known by their acronyms or numbers.

A telephone survey conducted over the past month by FinOps Report (www.finopsinfo.com) of 100 C-level compliance, operations and IT managers from buy and sell-side firms in the US and Europe found that the US’ amended Rule 606 and new CAT top the list of expected pain points in 2020 for US firms. European-headquartered firms are far more worried about SFTR and CSDR. Replacement of LIBOR as a benchmark and regulatory requirements for initial margin for uncleared derivative transactions will stress out fund managers, banks and broker-dealers across both sides of the pond.

In many cases financial firms have already revamped their siloed regulatory reporting departments into new centralized regulatory operations units comprised of compliance, operations and IT managers able to sort through the data and workflow challenges of meeting the new requirements. Back-office folks will no longer have to do all the heavy lifting on their own. Three-quarters of the 100 executives contacted by FinOps Report say their firms have created the centralized regulatory ops units, or are in the process of doing so. Some firms have even appointed dedicated data managers to participate in the new group.

Completing reporting requirements on transaction activity or improved disclosure to investors means finding the right data fast enough and ensuring its accuracy. Contracts will need to be rewritten to address changes in reference benchmarks, or mandated initial margin for uncleared over-the-counter derivatives. Relationships with counterparties and third-party service providers, such as custodian banks, must also be reevaluated to determine how they fit into the new regulatory landscape. Financial firms will either be making some fast new friends or ending any toxic relationships.

FinOps Report has come up with the following explanations of the regulations causing the most grief in 2020, offering some recommendations on how to ease the compliance pain.

606: It’s the number of a rule adopted by the Securities and Exchange Commission requiring broker-dealers to fulfill client requests explaining where their trades were executed, why and for how much. What is new in 2020 is the need to disclose a lot more granular information designed to prevent conflicts of interest, such as actionable indications of interest, fill rates, spread sizes, adding or removing liquidity, and net fees and rebates. Although part of the enhanced Rule 606 became effective in January, the next critical deadline is in April when introducing broker-dealers must tell institutional clients all about trades executed by other broker-dealers using algorithms or smart order routers.

Introducing brokers, which carry the legal responsibility for disclosure, can only hope they get the necessary information from the executing brokers who want to keep the secret sauce of their trading activities to themselves. Introducing brokers and executing brokers will have to do some tough negotiating to reach an acceptable compromise. Executing brokers will also need to dig for the required data through their front-end order management and execution management systems as well as tranaction reports from trade venues.

Mark Davies, chief executive of Austin,Texas-based best execution reporting firm S3, says he has worked with Financial Information Forum (FIF), an industry group focused on solving regulatory implementation issues, to create an industry-accepted XML-based template for data transmission between introducing and executing brokers. The template alls for only a summary of routing and execution details rather than granular information on specific trades. Firms such as S3, BestXStats, and Dash Technologies also say they can help gather the information to generate the new Rule 606(b)3 reports for institutional clients.

CAT: Critics of the movie version of the Broadway hit CAT call it a flop. While compliance experts reviewing the SEC’s CAT are hesitant to denigrate the US regulatory agency’s efforts, they caution that creating a single database for US broker-dealers to report all equity and options trades executed on US exchanges will give everyone in the front, middle and back offices of broker-dealers a hangover.

For starters, information on trades executed for customers needs to be included as of an April test date and the specifications for customer account information could become problematic. The Financial Industry Regulatory Authority, which is operating the CAT system, allows broker-dealers to report a customer issued larger trader identification code (LTID) which would be provided by the SEC. Similar to the existing Electronic Blue Sheet Reporting, CAT does not compel a broker-dealer to require that its customer provide a LTID. However, the broker must identify and classify those accounts which meet the large trader criteria without an LTID as a UTID, short for unidentified larger trader identification. “Some broker-dealers are still struggling to enhance their existing functionality to consistently identify UTLID,” says Joanna Fields, managing principle of New York-based Aplomb Strategies, a regulatory consultancy. “The LTID process also allows a customer to have multiple LTID sub-accounts which are not part of the CAT specifications and could lead to inconsistent data reported to CAT.”

The specifications for account opening or account closing can also be problematic due to different nomenclatures between the US and foreign countries whose broker-dealers may open customer accounts and extend customer relationships into the US. “Foreign broker dealer systems date fields are often coded YYYY/DD/MM so US brokers must search across all accounts to ensure that all systems where data fields are in European format are identified so they can be mapped correctly for CAT reporting purposes,” says Fields.

At a minimum, broker-dealers need to include data accuracy and completeness checks as part of their ongoing operations and control processes to ensure the right information flows through the right systems into their CAT reports. “The data for CAT reporting must be extracted from a multitude of front, middle, and back office systems,” says Peter Gargone, chief executive of n-Tier, a New York-based software firm focused on data management for regulatory reporting. n-Tier’s platform allows firms to verify they have all of the required records for reporting and accurate data in all of the CAT’s reporting data fields. That data can be traced to an original internal source if there are any data discrepancies.

Data issues aside, cybersecurity risk is also a worrisome element of complying with CAT. “FINRA is rightly following the National Institute of Standard and Research’s two-factor authentication for data submission, but the second confirmation of the file submission will be sent to a mobile device,” says Fields. “Because broker-dealers have moved from mobile devices to a bring-you-own device model, they will need to ensure the confirmation hits only mobile devices which are registered with their firms and never leave their premises.” NIST’s framework offers US private sector firms guidance on how to assess and improve their ability to prevent, detect and respond to cyberattacks.

SFTR: Short for Securities Financing Transactions Regulation, this data-heavy requirement calls for dual-sided reporting to an EU-approved trade repository within one day after a securities finance transaction is executed or amended using about 155 data fields and a unique transaction identifier (UTI). Securities finance transactions conducted by a counterparty established in the EU, by the EU branches of a non-EU firm. and by an EU entity in the US, fall within the scope of the SFTR. So do securities finance transactions (SFTs) reused by EU counterparties or reused by some third-party counterparties. The SFTs include the gamut of securities lending and repurchase agreements as well as similarly collateralized operations consisting of a transfer of ownership.

Compliance experts say that fund managers, banks, and brokers need to focus on data quality so they have as few discrepancies as possible to deal with before reporting in either April 2020 or October 2020. “Sourcing the data will be a challenge as many firms have information related to securities finance transactions in multiple systems,” says Stuart Day, director of the SFTR program for data and post-trade processing technology firm IHS Markit in London. Fund managers, banks and broker-dealers will be forced to extract the data, enrich it and reformat it in the ISO 20022-compliant message types before sending the SFTR report to a data repository.

“Timestamping is another potential source of error when it comes to bilateral off-market trades because of different booking times between counterparties,” says Day. He recommends that prior to reporting, SFT transactions undergo a reconciliation process to improve the matching rates.

In December, the London-based International Securities Lending Association (ISLA) and four other trade associations published a master reporting agreement allowing market players to use a common template for reporting under SFTR and the European Market Infrastructure Regulation. Software vendors, such as IHS Markit, Pirum, Xceptor and Finastra, also say they can help firms with data matching, reconciliation and and reporting to trade repositories. London-based Kaizen Reporting says it offers pre and post-go live quality assurance services; the firm’s automated managed service will test the accuracy and completeness of every SFTR report.

CSDR: Short for Central Securities Depository Regulation, the regulation affects custodian banks, broker-dealers, and fund managers just as much as it does national European national securities depositories. Although developing a consistent methodology to penalize participants of securities depositories for failing to settle their trades on time sounds ideal, the standardization comes with substantial compliance pains for financial intermediaries and fund managers.

For starters, custodian banks and brokers which settle trades outside of a depository must report the “internalized” transactions to local regulators beginning in July. The even harder part comes when the settlement discipline regime– or penalty phase– kicks in requiring broker-dealers and custodian bank members of European securities depositories to break down monthly penalties for failed settlements charged by securities depositories into individual daily charges for each client — often a fund manager. The penalty must be deducted from the guilty party’s account and credited to the affected party’s account on a monthly basis.

The European Securities and Markets Association (ESMA), the pan-European regulatory agency, was initially expected to postpone implementing the interrelated settlement discipline regime and buy-in phase from September until November. The November 2020 date coincides with SWIFT’s annual standards release and addresses the penalty  mechanism in the European Central Bank’s T2S system, a centralized platform for post-trade settlement. However, in bowing to industry concerns about the administrative burdens and potential market liquidity problems in complying with the settlement regime ESMA agreed to ask for a further delay in implementation of the settlement discipline regime and interconnected buy-in requirements to February 2021. ESMA declined requests to exempt cash bonds from the settlement regime and to more gradually phase-in the buy-in requirements.

SWIFT, a La Hulpe, Belgium-based global message network operator has already altered its ISO 15022-compliant MT 537 and MT 548 messages to accommodate late matching and failed settlement penalties with the changes synchronized with the respective ISO 20022-compliant messages. SWIFT is working on changes to its message related to the buy-in process and other changes to align with the penalty mechanism of the T2S application that will be deployed in November.

“Custodian banks and brokers will be receiving daily reports on failed settlements must keep track of all the penalties, credits and debits charged,” says Daniel Carpenter, head of regulation at the Dublin-headquartered software firm Meritsoft, a Cognizant company. “They must reconcile daily all the figures with their own calculations before passing along the penalty information to their clients.”

The penalties asociated with failed settlements go far beyond pure monetary fines. The CSDR also imposes a mandatory buy-in for the buyer of securities either four or seven days after the trade failed to settle on time depending on whether an instrument is considered liquid or illiquid. The categorization can be subjective and there is plenty of industry debate as to what to do.

Operations managers say that reducing the number of failed settlements is the best approach to dealing with CSDR. Fund managers, custodian banks and brokers will need to rely on automated confirmation systems, trade matching systems and standing settlement instruction platforms to prevent any wrong post-trade details which would cause a trade to fail to settle on time, typically two days after it is executed. Fund managers and brokers will also need to reevaluate their securities lending and borrowing strategies and platforms to ensure they can source the right securities in time to meet their settlement obligations.

Meritsoft, which specializes in regtech, tax, claims and data analytics, says that its licensed and hosted platforms as well as end-to-end outsourced service helps firms forecast and calculate their penalties, credits and debits, and reconcile their calculations to those made by the European securities depository where their trades settled. Meritsoft’s technology also notifies firms when they are reaching a time at which a buy-in is required, manages the process of communicating details required for executing the buy-in and ensures all administrative costs are charged back to the responsible failing party. Meritsoft, says Carpenter, is in talks with European market infrastructures to provide a database with additional data attributes related to CSDR, such as identifiers for liquid and illiquid securities.

Taskize, operator of an intercompany workflow platform used by securities depositories in the Euroclear Group to clear up failed settlements faster, says that its platform will add the necessary penalty charge, buy-in notifications and workflows required by CSDR’s settlement discipline regime. “Euroclear is looking into supporting SWIFT message types for clients that wish to use them — typically those with high volume transactions,” says Philip Slavin, chief operating officer of the London-based Taskize. “Euroclear will also use Taskize for the rest of its member firms which have lower volumes and either cannot justify the investment in a SWIFT upgrade or are not SWIFT-enabled.”

LIBOR replacement: Changing just one little number can have a tsunami of downstream effects. Replacing the London Inter-Bank Offered Rate, a time-honored benchmark for derivative and fixed-income transactions, to other proposed benchmarks as of the end of 2021 will require fund managers, banks and brokers to review all of their contracts. Some contracts have fallback language of what to do should LIBOR become decommissioned. Many don’t.

Given that the gross notional value of financial products linked to US dollar LIBOR alone is estimated at US$200 trillion errors in transitioning to a new benchmark can be costly. The New York State Department of Financial Services has given regulated institutions until February 7 to show they have plans to address the cessation of LIBOR and switch to alternative reference rates.

“Trading desks will then have to decide whether to terminate the contracts, change their terms, or change their trading strategies because the replacement benchmarks are not equivalent and could change the economic value of the transaction,” says George Bollenbacher, director of fixed-income research for TABB Group in New York. “The side of the trade the counterparty is on will be critical to coming up with the right approach.” Case in point: a bank on the paying floating-rate side of a swap would want the risk-free rate in the new world, but the same bank in the receiving-floating side would want an interbank rate to be used for the exact same transaction.

The most obvious contracts to review for citing LIBOR are those between broker-dealers or fund managers and broker-dealers. However, Bollenbacher cautions that contracts with custodian banks involving overdraft fees and securities lending can also be impacted. His final words of advice: in winning the battle, don’t lose the war. “Firms need to make certain they reach agreements with any long-term counterparties on the changes to contracts, so there are no hard feelings,” says Bollenbacher. Legal experts predict that replacing LIBOR could ultimately generate plenty of work for litigation attorneys if counterparties can’t come to terms on fallback decisions.

Finding just which contracts contain language referencing LIBOR isn’t as easy as pushing a few buttons on a computer terminal. The language could be in contracts stored online electronically in either structured or unstructured form making it easy to overlook particularly if the volume of contracts affected is in thousands. Montclair, New Jersey-based Pendo Systems says it has a platform based on machine-learning which can alert procurement, risk, and legal managers to each contract at their firms referencing LIBOR, the fallback language available, the value of the contracts and counterparties involved. So far, large global banks have been the prime users of Pendo’s platform, but fund managers are starting to show interest.

IM: These two letters are becoming a four-letter word for trading and collateral management managers at buy and sell-side firms who have to calculate and exchange initial margin for uncleared over-the-counter derivative transactions. Calculating IM to reduce discrepancies between counterparties has been simplified a bit through widespread acceptance of the International Swaps and Derivatives Association’s SIMM methodology. Software vendors, such as AcadiaSoft, Cassini Systems and TriResolve, can also help firms with automated contract reconciliation, margin calculations and margin calls.

However, fund managers, broker-dealers and banks must still determine whether they fall under Phase five or the final Phase six in of the implementation timetable for initial margin so they can notify their counterparties and custodians before starting contract renegotiation. Phase five in September 2020 applies to funds and other entities with an average notional amount (ANNA) of more than US$50 billion in non-centrally cleared derivatives, while Phase six in September 2021 affects funds and other entitles with an ANNA of more than US$8 billion.

“Trading desks must continually monitor all legacy and new transactions to ensure compliance,” says Don Macbean, a partner with the law firm of Katten Muchin Rosenman in New York. “Once they have determined that the mandatory initial margin rules apply they will need to select a custodian and determine whether the custodial relationship will be under a third-party or triparty account control agreement.”

Contract rewriting and drafting can be simplified using a new platform from ISDA; however, waiting until the last minute to do the work isn’t wise. “You don’t want to be stuck in a long cue waiting for your documentation to be completed,” cautions Macbean. “The time to act is now.”

For all the grief compliance, operations and IT managers will suffer to handle rigorous new requlatory requirements in 2020, they can breathe a sigh of relief over some breathing room for at least two of the more cumbersome rules. FINRA has once again postponed the implementation of margin requirements for US covered agency transactions in its new Rule 4210 until March 2021 from March 2020 to consider proposed amendments, such as eliminating initial margin. The US Internal Revenue Service has also spared US broker-dealers in 2020 from having to deal with some provisions of Section 871(m) which requires them to withold tax on “dividend equivalent payments” made to non-US investors for certain derivative transactions referencing dividend-paying US equities. The IRS will continue to require current withholding on “delta-one” transactions; however, if its late 2019 notice stands as issued, withholding on “non-delta one” transactions will not be required until 2023. Phew!

(Editor’s note: This article was amended on February 6, 2020 to reflect ESMA’s announcement it would postpone the implemention of the CSDR’s settlement discipline regime and interrelated buy-in requirements).