In September 2016, the International Swaps and Derivatives Association, Inc. (“ISDA”) published a wide-ranging white paper entitled “The Future of Derivatives Processing and Market Infrastructure.”[1] The white paper proposes a “path forward” from the new regulatory ecosystem created in response to the financial crisis and the resulting compliance burden on market participants.
As described in the white paper, tight time frames for complying with regulatory requirements prevented market participants in various jurisdictions from making necessary changes to compliance, operational risk management, and other processes in an optimal manner. The resulting complex workflows have created challenges. The white paper’s proposals are intended to foster a “standardized, efficient, robust and compliant ecosystem that supports the needs of an array of market participants.”[2] In particular, the white paper identifies three key areas for improvement: (i) standardization; (ii) collaboration; and (iii) technology.
(i) Standardization
The white paper emphasizes that greater standardization is needed, particularly in collateral management matters. ISDA collateral committees are currently identifying opportunities for improvement in this area as the first wave of margining rules comes into effect. These opportunities relate to standard account control agreements, eligible collateral matrices, netting of swap obligations with collateral cash flows, and segregation account standards for bilateral margin. The white paper also addresses standardization with respect to data standards, documentation and process.
Regarding data standards, the white paper notes that product identifiers and trade identifiers should be globally consistent. A globally consistent product identifier would facilitate regulatory reporting and aggregation of trade data across borders, and also facilitate removing data fields that various post-trade activities require to match.[3] The unique trade identifier (“UTI”) standard has already been generally accepted by various regulators globally.
In addressing documentation, the white paper emphasizes the benefits of increased standardization of credit support annexes, particularly given the need for review and, in some cases, replacement of such documents in connection with the new margin requirements.
With respect to process, the white paper notes that the current derivatives ecosystem consists of a complex set of interdependent, duplicative systems and processes with inconsistent operating results. The white paper suggests that industry participants agree on the simplification of these processes. Once agreed, such processes should be technically encoded as common domain models that systematically reflect how the market operates.
(ii) Collaboration
The white paper states that firms should collaborate on areas of mutual benefit where no competitive advantage exists. For example, in response to the new derivatives regulations, firms have individually built and maintained the same functional solutions. Firms could, instead, “mutualize” the building of such solutions (particular in post-trade activities) by, for example, leveraging cloud technology to interact with one another on external infrastructure, rather than relying on expensive servers and other hardware within their respective organizations. Similarly, reporting repositories could collaborate to store information on a single secure but mutually accessible database, rather than storing the same information on multiple databases.
(iii) Technology
The white paper also examines potential opportunities and solutions offered by RegTech (regulatory technology) and FinTech (financial technology). “RegTech” refers to software and technical standards that provide mutual benefit to both regulators and market participants in complying with regulations (technical standards include, for example, the UTI system described above, as well as the adoption of legal entity identifiers for reporting purposes). Currently, many firms obtain and examine the same reference data regarding products and clients to make eligibility decisions with respect to various regulatory requirements. This approach leads to duplicative efforts and potential inconsistencies. Common regulatory eligibility models that effectively encode a consistent interpretation of rule eligibility, therefore, could provide significant benefits.
“FinTech,” which refers to the broader area of financial technology beyond RegTech, also offers opportunities for improved efficiencies and cost reduction. The white paper states that blockchain or distributed ledger technology (“DLT”) is of particular interest.[4] As a processing model that operates on the basis of a single representation of each transaction, commonly referred to as a “golden record,” DLT could provide significant benefits to the derivatives industry. According to the white paper, the industry should establish a mechanism to designate DLT records as the final, indisputable “golden record” as early in the trade lifecycle as possible. Such an approach would allow post-trade activities to leverage and rely on DLT records as definitive. DLT records could form a central data store that allows post-trade activities such as collateral management to be performed by solution providers and infrastructures. The white paper states that the development of “smart contracts” also may provide opportunities as a further application of DLT within the derivatives market.[5]
Finally, the white paper notes that, if DLT ultimately takes a more prominent role in the derivatives ecosystem, regulators may need to reconsider existing regulations, in which case collaboration between regulators and industry participants will be even more important.
[1] The Future of Derivatives Processing and Market Infrastructure, ISDA (September 15, 2016) (available at: https://www2.isda.org/attachment/ODcwMA==/Infrastructure%20white%20paper.pdf).
[2] Id. at. 3.
[3] ISDA previously published a paper setting forth key principles for any global product identifier construct. See Principles on the Development of Derivative Product Identifiers (May 23, 2016) (available at: https://www2.isda.org/attachment/ODQwOQ==/Product%20identifier%20principles%20FINAL.pdf).
[4] A previous issue of Derivatives in Review (available here) describes DLT and recent activities undertaken by the Commodity Futures Trading Commission regarding DLT.
[5] For a description of “smart contracts,” see id.