July 13, 2012

The past few years have seen a slew of regulatory measures designed to mitigate the complexity and lack of visibility that were major contributors to the financial crisis. A key area of focus is Europe, and in early July, the EU Council finally announced formal adoption of regulations enforcing the use of Central Counterparty Clearing Houses (CCPs) for processing derivatives and reporting to Trade Repositories (TR).

At the same time, the Basel III Capital Requirements Directive (CRD IV) substantially increases the capital and collateral requirements for OTC derivatives in an attempt to shift trading onto exchanges and CCPs, thereby reducing both the likelihood and the impact of default for any trades that remain bilateral.

In the U.S., it is perhaps no surprise that the all-encompassing Dodd-Frank Act, which turns two this July, has something to say on the matter. It will enforce similar reporting and capital requirements to Basel III/CRD IV, and make central clearing for standardized derivative trades mandatory by the end of 2012.

The Dodd-Frank era will see increased regulatory oversight alongside higher capital and collateral charges for OTC trades – although there will be charge exemptions for firms who can demonstrate that derivatives were used purely for non-speculative hedging purposes.

The watchwords are transparency and liquidity. On the understanding that sunlight is the best disinfectant, the new rules are intended to strengthen the essential infrastructure supporting global financial markets and better position institutions to foresee, withstand and avoid financial shocks. After all, no one wants to be the next Lehman Brothers, no one wants to be exposed to the country that defaults on its sovereign debt, and no one can be completely confident that the already shaky markets would withstand another shock of that magnitude.

The Likely Impact

It should also be clear that if derivative trades leave the OTC, call-round or upstairs markets, then there will be a compliance cost for individual firms. There will be no more back-room deals with sketchy, ad-hoc or idiosyncratic reporting. As with any regulatory regime, the new demands will increase the volume of data that must be held and made readily available whether it is information on collateral obligations and liquidity, the chain of counterparties behind any given position, or demonstrable proof that any given trade is part of a hedging strategy rather than speculative activity.

That has obvious implications for the way in which data is managed within the institution.

TRs are recognized throughout the financial regulatory community for their ability to bring transparency to previously opaque markets. The Dodd-Frank Act has identified repositories as one of the "three pillars" of its new infrastructure requirements, and the standards proposed by IOSCO and CPSS will reinforce the ability of TRs to provide regulators with the tools necessary for analyzing and assessing systemic risk.

In this environment, voluntary reporting is consigned to history. The need to centrally collect and report data held in TRs has huge implications on a firm's data management infrastructure as well as its governance processes. The impact is particularly significant as the majority of current systems were not built to cope with the onslaught of requests for greater transparency the markets are currently witnessing.