[Peter Meechan, Director of Business Consulting at Sapient Global Markets in New York City, and Pauline Tykochinsky, Senior Manager in Sapient Global Markets’ Data Management Practice, are co-authors of this article.]
During the past few years, firms have had to deal with a series of global regulatory changes, including the Dodd-Frank Wall Street Reform Act in the US; European Market Infrastructure Regulation (EMIR), Markets in Financial Instruments Directive (MiFID), and Regulation (MiFIR) in Europe; and reporting and clearing requirements in Asia.
These have resulted in numerous international regulatory bodies enforcing a series of new regulations for various jurisdictions, such as the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) in the US; the European Commission (EC) and European Securities and Markets Authority (ESMA) in Europe; the Financial Market Supervisory Authority (FINMA) in Switzerland; the Federal Financial Supervisory Authority (BaFin) in Germany; and the Financial Advisory Committee (FAC) in China, to ensure transparency of trading activities and reduce systemic risk.
A key area of change has been in the over-the-counter (OTC) derivatives space where new mandates that involved real-time trade reporting and mandatory clearing highlighted a major problem for all firms: product identification.
Many of the regulations are tied to individual product types. For example, some products need to be reported to the CFTC, whereas others need to be reported to the SEC; some products must be cleared with a central counterparty, whereas others can remain bilateral. The problem lies in the definition of the products. The nature of the OTC derivatives industry means that many products have evolved over time to become highly customized for individual client needs, and there is little standardization across firms as to how a product is defined or named. What one firm calls product ABC, another may call DEF. Making matters worse is that the regulator may call the same product XYZ. Anyone who has worked on implementing the new Dodd-Frank rules will have experienced the difficulty of deciding which rules apply to which trades and positions and how such trades need to be classified when reporting.
While the problem may have been brought to light by the implementation of rules for OTC derivatives, it also exists within a range of asset classes, including loans and mortgages. It is an issue that runs across asset classes for functions that need to include all of a firm’s positions but treat them differently based upon product type. A key example of this is with capital treatment, whereby calculations need to be treated differently based upon product but aggregated across all of the firm’s positions.
Is the Universal Product Identifier the answer?
The ideal solution to this problem would be a standardized way of referencing each product, based upon a set of differentiating attributes that are understood by both the industry and global regulators.
Covering the entire spectrum of asset classes and financial services, from loans and credit cards to derivatives and bond positions, a Universal Product Identifier (UPI) will enable a holistic approach to identifying all trades and positions, including capital calculations, reporting, clearing mandates, and booking rules. While such an idea sounds great in theory, historical attempts at achieving global agreement have fallen short, even within a subsector of the industry.
Standardized identification exists today in other asset classes, such as the International Securities Identification Number (ISIN) for bonds, commercial paper, and warrants. But, could such an identifier also work for areas that have historically resisted standardization? And could disparate areas of the industry come together to utilize a single standard?
There are many types of problems a UPI could address. The complexity of the UPI could differ depending upon which use cases were included. Each type of market participant has a different level of interest in solving for each problem, so a consensus needs to be reached. Problems that have attracted the most interest include...
- Product/trade identification: What do we call this when executing, reporting, or booking?
- Capital calculation treatment: How do we calculate capital for this position?
- QIS categorization: How do we categorize this position during quantitative impact studies?
- Regulatory body and rules for trade reporting: Where and how do we report this trade?
- Mandate to clear eligible CCPs: Do we need to clear, and what are our options?
- Mandate to execute via an SEF: Do we have to offer this trade on an SEF?
- Mandate for collection of margin: Do we have to collect/pay initial margin?
- Booking rules: What system do we book this trade on, and to what legal entity do we book it?
- Short Sale: Handling different levels of restrictions known as e-codes across various jurisdictions.
- Tax: Consolidating several tax laws such as transaction tax, stamp duty, etc., across countries.
- Cost Basis Rule (CBR): Supporting long-term gain loss reporting (IRS).
The difference in each of these issues is the level of detail that needs to be attached to a UPI to determine the outcome. For example, the attributes required to determine if an OTC trade is CFTC or SEC reportable are different from the attributes required to determine if such a trade must be cleared. In other words, the UPI needs to be tied to a taxonomy. But questions remain. Does this taxonomy need to be completed prior to solving for each case? Can the same taxonomy structure be applied to all uses cases (just at a different level)? Or, does the structure need to flatten out?
Another challenge in categorizing some asset classes is the requirement for dynamic classification that is triggered by a recent security event. For example, some regulatory disclosures require a more granular classification of loan products, driven not only by the initial contract agreement but also by certain subsequent lifecycle events. These could include default on payments; some operational specifics in booking the product, such as held-to-maturity versus available for sale; operation loss events; and certain risk metrics, such as fair market value (FMV), etc. Similarly, commodities options require information about the last tradable date to assess exposure and capital requirements.
With certain credit products (e.g., credit indexes), the regulatory treatment of the product changes based upon the number of names at time of execution. Therefore, a product traded one day could be reportable to the CFTC, and the same product traded a week later could be reportable to the SEC. One way to address this is to limit the hierarchy of the product to data points that are fixed and leave dynamic items to the transaction. This would make for a simplified product taxonomy but adds an additional set of criteria to be used in regulatory determination. As such, it does not solve the entire problem.
Key to deciding upon the use cases is to determine the scope across asset classes -- i.e., can a UPI provide solutions across OTC derivatives or across all areas? A cross-industry-sector UPI would certainly help when calculating capital, but implementing such a solution across areas that already have their own IDs (e.g., securities) raises its own set of problems.
Solving across all asset classes is a lofty goal, but one that can be achieved. However, it is better to start with one area -- such as OTC derivatives, which have the most diverse set of products and the most pressing need from a regulatory perspective -- and then expand to other areas. This means that when any solution is being designed, the end goal (one of true universal acceptance across asset classes) needs to be considered. This way, the solution can be extended rather than redesigned during each phase, and some level of input would be required from all sectors at all stages of design and implementation. If a particular industry sector solves the problem in isolation, they will have a difficult time trying to force their design on an industry sector that already has some form of identifier.
The final prerequisite is involvement from the regulators. It is pretty clear that most of the use cases revolve around the regulatory treatment of trades and positions. The UPI will only be effective if the regulators that decide upon the treatment are using the same taxonomy to make their determinations. Therefore, their endorsement is as critical as industry acceptance.Jim Bennett is a managing director at Sapient Global Markets based in New York City with more than 25 years of experience in capital markets, OTCs and complex products. With a strong international background, Jim has helped firms navigate new regulations and adapt to changes ... View Full Bio