The repository of over-the-counter (OTC) and exchange-traded derivatives will be mandatory in Europe as of February and a number of repositories have already been authorised by the European Securities and Markets Authority (Esma). Mathew Lewis, vice president, head of European strategy and business development for The Depository Trust and Clearing Corporation (DTCC) talks to Risk on a number of key topics on where are we now and how ready the market is with regard to trade repository reporting.
Risk: Can you provide an overview of where we are at the moment, what needs to be done, and whether you think the market is ready for this date?
Mathew Lewis: Certainly. In November, four trade repositories were approved to hold the derivatives data both for OTC and some clarification recently on exchange-traded derivatives as well. And soon thereafter we saw two additional trade repositories approved. So here in Europe there are now six trade repositories in total and we were really given 90 days from the approval data of November 7th to start reporting. And the regulation has been written broadly enough that it's probably going to capture up to a million potential entities, so huge impact in Europe and a very large effort under way now as firms look to the reporting deadline and all of the things they need to do to get there.
Risk: You're talking about a lot of potential customers, and how market participants connect to the trade repositories obviously differs a lot depending on who they are. Could you explain that a little bit?
Mathew Lewis: I think there are a number of different kinds of ‘tierings’ of customers or customer types. Probably the largest number are the corporates themselves, and this is really the first derivatives regulation that is affecting them directly. Where they haven't really been regulated before, many of them are not actually aware of the derivatives regulation that's coming into play, and that's probably the bulk and a very long tail of the kind of million entities that we had been estimating.
And they have a couple of options in terms of reporting. One is to look at their broker-dealer relationship and determine whether the broker-dealer is actually offering to report on their behalf or whether they need to report themselves. The second kind of tiering of customers are really all the buy-side institutions, the asset managers, the hedge funds that are doing derivatives trading. And they themselves, again, can look at the delegation model if the trading counterparties they use are offering it and, for many of them, they're large enough that they're looking to report themselves. Whether that's because they are caught by other jurisdictions as well, where they're looking at this as something they want underlying vendors or administrators to do for them, so there are a few options that they need to consider. And then there are the broker-dealers themselves. Isda has about 190 broker-dealers on their Isda master list and all of those are looking to report directly for themselves and potentially offer delegation to their customers.
Risk: And for all of these derivatives users, what are the key challenges for them?
Mathew Lewis: I think there are a number of key challenges. One has just been that the data is out there, and for the long tail of corporates many of them are not even aware that it's there, so getting up to speed on the regulation itself, what assets are covered, what types of trades are covered, speaking to your local authority to determine what their plans are in each jurisdiction. And then I think there's a determination on technology. What technology is going to be used? Are they doing it in-house? Are they looking at a third party to do this for them or are they looking to have a bank that they trade with actually report on their behalf? And really just a broader education and understanding of what the requirements are is key to being able to hit that date and understand all the implications, both from the regulatory reporting perspective and from the technology aspects.
Risk: Interoperability between trade repositories is key. Maybe you could explain how this works, because I think a lot of people aren't quite sure?
Mathew Lewis: I think the ultimate goal was really to be able to have all of the trade repositories feed data into a regulator so they have this overall view of all outstanding derivatives exposure to be able to monitor systemic risk. And, in that process, particularly here in Europe, very much encouraging from the regulators to encourage a more competitive environment amongst the trade repositories. And, in doing so, it has created six trade repositories, with maybe more to come, and what that's meant is that, because Europe requires dual-side reporting – meaning both parties to a trade are actually reporting the transaction themselves – you then need to reconcile between you and your counterparty. This is something that institutions are doing offline, they've got their own processes in place, but now that you have multiple trade repositories and the same trade being reported by two different parties, you run into the need to reconcile on the trade repositories themselves. And the trade repositories have built their own reconciliation tools if both sides of the trade are coming into the same repository.
The challenge really becomes when one side of the trade is entered into one repository and the other side of the trade is entered into another, and a lot of the work being done now as to what data can be shared and what kind of reconciliation tools can be put in place to actually allow a party to enter trades into one and have it reconciled with trades entered into another trade repository. This is one of the challenges of the competitive model that Esma has really pushed for, you've got this diversity of data and the regulations haven't been prescriptive enough so that all the data is identical. So you have different trade repositories with different formats and that requires the trade repositories to come together and determine what the standard data-sharing model is going to be to allow for an easier reconciliation process.
Risk: You mention there are six trade repositories, so there is plenty of competition out there. Could you explain how the models differ between each trade repository and do you think there will be some kind of consolidation in the market as well?
Mathew Lewis: Esma has been pretty clear on what kind of business model needs to be in place. These need to be run at cost, you're not allowed to cross-subsidise, so you're really looking at creating an infrastructure that pays for itself, in some sense separate from its parent entity, which certainly removes a lot of the attractiveness to the business for commercial institutions. And DTCC runs as an industry co-operative so, from our perspective, we view this as a very natural business line for us to be in. Looking at the expense that the industry is going to take for having to report and then being able to build a business on an at-cost basis and charge that out, so I think our expectation is that we see, potentially, a few more trade repositories come into play. But, over time, there's only so much business out there and it has to be run at cost, so it won't surprise me in 18 months if we've seen some level of consolidation. And, if it's not in the number of repositories, it'll be in the efforts that are used to actually sell the repositories, so it won't surprise me if it's just not the focus of an institution.
But one thing that we're very conscious of is that, from the very beginning, our whole approach has been to do this globally, so that when you're having to report in any jurisdiction we are there to provide a trade repository in any of those locations. So we're in this for the long haul, we're an industry utility running this at cost, and certainly expect to see some consolidation over time.
Risk: If we look at what the regulators were trying to achieve, they wanted more transparency and, obviously, to fend off sort of systemic risk. Do you think they've managed to achieve that and, if not, what needs to be done so they can get closer to that goal?
Mathew Lewis: I think bringing all the data together is certainly going to increase transparency. There is no doubt about that. I think the challenge is that, in an effort to create a competitive environment here in Europe, what they've ended up doing is creating disparate pools of data that now need to be aggregated all over again. So, I think from a systemic risk perspective, there is now a challenge of how to bring all that data together into a very digestible form. I think they're going to achieve the goal; it's going to take a lot more time – well beyond February 12th before we get there – because there is a still a lot of standardisation that needs to happen.
Risk: There are two areas that we’d like to go into a little more depth on: collateral and the whole issue around backloading. Could you explain all of that, because there are a lot of conversations about that.
Mathew Lewis: There's some clarification from Esma as to the backloading, and that's really about looking at all of the historical transactions and those that are still open and actually having to load those by a given set of dates. And they've laid out some phased approaches to the backloading process, but the first date is not that far away. It is in May for all trades that are open after August 12th, or August 2012, so those trades need to be backloaded or need to be loaded into the system by then for reporting purposes.
On the collateral front, and along with valuations, the regulation stipulates six months, so what has happened there is after the go-live date for reporting derivatives transactions, you then have to look at both the valuations of those derivative positions and also then the collateral that is being held for those derivatives trades. And so that loading starts in the summer, and firms are now starting to look at what they need to do to get that data from the various systems they have it within to be able to load into a trade repository.
Risk: This whole process is going to come at some cost. Do you have a rough idea of how much it's going to cost the industry to do this?
Mathew Lewis: The cost of this trade reporting is in the hundreds of millions and, I think, based on work we're doing, particularly with the G-15, you can see some of those banks have spent north of 10 million themselves on individual projects. So I think the overall scale when you start to look at 200 or 300 broker-dealers, 500 or 600 fund managers, and potentially hundreds if not thousands of corporates, it's very easy to get to the 100 million mark, but there hasn't been any kind of formal survey of costs for the industry.
Risk: But it's just not cheap.
Mathew Lewis: It's not cheap.
Risk: And do you think other jurisdictions might follow the European model?
Mathew Lewis: Up to date, the European model has been somewhat unique in that it has required true dual-side reporting without any kind of thresholds, and what that has meant is it has caught a huge number of entities that you wouldn't necessarily expect to have to report derivatives trades and a huge number of institutions that probably don't even know they're doing derivatives trades, because they've received some kind of FX forward on another transaction they've done with the bank as part of the package of what they've been trading with an institution. So Esma's requirements are somewhat unique versus Dodd-Frank and elsewhere but what we are definitely seeing is the Asian regulation at the moment coming out of the Monetary Authority of Singapore, the Australian Securities and Investments Commission, Japan and Hong Kong has been a little bit more pragmatic in terms of phasing-in their approach, looking at the issues that are coming up with the European Market Infrastructure Regulation (Emir). And, I think, over the next six to 12 months we'll see some of the other jurisdictions in a much more measured, a much more limited dual-side reporting model, so certainly lessons learned from Emir and Dodd-Frank because they're in kind of opposite extremes in terms of reporting requirements.