The reporting of derivatives to trade repositories has failed to produce data of much value to regulators on either side of the Atlantic, thanks to its botched introduction. As early problems diminish, fund managers are pondering how to make derivative reporting routine.
Reporting of derivatives transactions in Europe under the European Market Infrastructure Regulation (EMIR) began on 12 February 2014. What followed was chaos. There were many reasons for this. One was the last-minute insistence by the European Commission, against the advice of the European Securities and Markets Authority (ESMA), that reporting include exchange-traded derivatives. This brought into scope a whole class, not only of derivatives but of market participants who had previously thought EMIR captured over-the-counter (OTC) derivatives only. Their number included many fund managers that had previously planned to self-report searching for a third party clearing broker to help. “Trade repositories were overwhelmed by requests from managers,” says Imad Warde, founder and managing director of HedgeGuard. “They were so overwhelmed some stopped answering emails.”
Another source of chaos was the enthusiasm of the regulator for competition. ESMA licensed no less than six trade repositories - the Depository Trust & Clearing Corporation, Regis-TR, UnaVista, CME Trade Repository, ICE Trade Vault Europe and KDPW - and, unlike the trade reporting requirements in the United States, insisted both sides of a trade report it. This created the twin problems of “pairing” OTC derivative trades reported to a different repository by each counterparty, and then “matching” the terms of the trade between the counterparties. In the early weeks, millions of transactions proved impossible to pair between repositories, which made it equally impossible to match the two sides. Matching itself created additional problems, with repositories lacking clear guidance or a common understanding of which fields they needed to match. The repositories appealed to ESMA for advice.
However, ESMA itself was struggling. Clarification of the technical standards to which the trade repositories should work ran remarkably late. The crucial 78-page questions and answers paper from ESMA was not finally published until 11 February 2014, the night before reporting became mandatory. Neither before nor after reporting started was it made clear whether an FX forward is a reportable derivative or not. Which existing trades had to be reported depended on a complex chronology driven by the dates on which the EMIR became law.
The identifiers crucial to pairing and matching became a free-for-all. The Legal Entity Identifiers (LEIs) needed to identify counterparties (see the “LEIs: what they are, who needs one and where to get one,” in the COO Guide to Derivative Reporting in Europe, page 18) were relatively straightforward to obtain, although not every counterparty woke up to the fact they needed one for every fund they managed, and others wondered which of 22 so-called preliminary Local Operating Units (pre-LOUs) issuing LEIs they should apply to. “There was an initial panic when firms first had to obtain LEIs but nearly all managers are using them now,” says Angus Milne, chief compliance officer (CCO) at The Children’s Investment Fund in London.
It was the important unique product (UPIs) and unique transaction (UTI) identifiers that proved most problematic (see the “UPIs: what they are, who needs one and where to get one” and “UTIs: what they are, who needs one and where to get one,” in the COO Guide to Derivative Reporting in Europe, pages 26 and 22). The regulators devised multiple methodologies for creating them, and never made clear which party to a trade was responsible for assigning them to the transaction, beyond indicating that trading platforms and central counterparty clearing houses (CCPs) were the best solution – despite the fact that neither the trading nor the clearing of OTC derivatives has yet begun in Europe, even now.
Inevitably, counterparties started making up their own UTIs, in an effort to meet their obligation to report trades within a day. “The regulator needs to tell the market what it wants,” says Robert Barnes, regulation manager at the Futures Industry Association (FIA) in Europe, an organisation that represents the interests of derivatives users. “Firms still do not know what they are meant to report and this is causing on-going confusion with inter-trade repository reconciliations. Trade repositories are struggling to match the data, and there is immense confusion. The generation of the UTI is causing problems. The regulator has not issued clarity about who generates the UTI or indeed how it should be generated. I have heard of an asset manager that informed its clearing member that it would generate the UTI only for the clearing member to say it would generate the UTI. Both firms are now generating different UTIs and predictably they do not match, which means the trade repository cannot pair the trades. Until the regulator actually tells one of these firms they are in the wrong, this situation will continue.”
Without an agreed methodology for generating a UTI, let-alone a common UTI itself, matching was impossible. A week before reporting in Europe began, the Financial Stability Board (FSB) published a paper - Feasibility study on approaches to aggregate OTC derivatives - expressing concern that reporting to multiple trade repositories in different formats was rendering the reported data useless to regulators in monitoring and managing systemic risk. Though the paper came up with several proposals for aggregating the reported data, including a centralised model, the FSB has yet to publish any concrete conclusions.
The FSB paper was inspired by the realisation of the Commodity Futures Trading Commission (CFTC) that the OTC derivative data being reported to the three established swap data repositories (SDRs) in the United States - the DTCC, CME Group and ICE - was a mess. Reporting started earlier in the United States, with CCPs reporting rates and credit swaps from October 2012, and swap dealers the same instruments from December that year. Reporting of foreign exchange (FX), commodity and equity swaps started in January 2013. By 31 October 2013, all types of counterparty in the United States were reporting.
But the data they submitted was of poor quality. By January 2014 the CFTC had decided to launch an internal investigation into the quality of the data, to be followed in March 2014 by a public consultation on the issue. In July this year CFTC commissioner Scott O’Malia called on regulators throughout the world to harmonise swap data reporting through mutual recognition by national regulators of trade repositories in other jurisdictions. This marked a change of approach by the American regulator, whose initial reaction to international differences in trade reporting was to claim extra-territorial rights over the reporting of any trade involving any counterparty linked to the United States. It would obviously help trade repositories and their users if there was a single global reporting standard.
It would help the prime and clearing brokers and custodian banks to which most European fund managers and institutional investors have looked to “delegate” the task of reporting. The investment banks in particular have never made any secret of their limited appetite for reporting trades on behalf of clients and, once exchange-traded derivatives were added to the reporting obligation, capacity constraints became obvious. Managers that previously intended to self-report a small number of swaps realised they could not cope with reporting their futures as well. “Initially, some clearing brokers were reluctant to provide delegated reporting for all of their fund manager clients,” says Ben Pugh, chief operating officer at Ovington Capital. “Today, it seems they are more willing to offer this service.” But for how long?
Managers certainly need to be better prepared for a withdrawal of service by clearing brokers than they were in the run-up to the February 2014 start of reporting in Europe. The unpredictable nature of regulatory decision-making meant many fund managers were under-prepared when reporting started in Europe in February 2014. “Managers were definitely not prepared for EMIR in February 2014,” adds Warde. The last minute inclusion of exchange-traded derivatives was certainly a shock. Christian Voigt, a senior regulatory adviser at Fidessa, says the level of preparedness among managers reflected anticipation of postponement. “Some were ready and some were not,” he says. “ESMA had asked the European Commission to delay EMIR implementation because it felt industry participants were not up to regulatory standards, and needed more time to resolve outstanding issues.”
As late as October 2013, a mere three months before reporting was scheduled to start, a survey of 40 hedge fund managers by SunGard and Aite Group found derivative reporting under EMIR ranked behind Foreign Account Tax Compliance Act (FATCA), Form PF, Annex IV of the Alternative Investment Fund Managers Directive (AIFMD) and the Open Protocol reporting template of Albourne Partners in a list of reporting priorities. “Fund managers were as prepared as they could be given the circumstances and that swaps reporting was a big unknown for many market participants,” argues Tracey Adams, a senior executive at SunGard.
As reporting settles down in Europe, fund managers are preparing for the day when clearing brokers in particular stop offering delegated reporting. They have never wanted to do it, seeing the role as fraught with risk and devoid of revenue. With $12 billion in assets under management The Children’s Investment Fund had less trouble convincing its clearing brokers to report to trade repositories on its behalf than smaller funds, but CCO Angus Milne is already preparing a back-up solution. “We delegated reporting to our clearing brokers and there was little argument about it,” he says. “The clearing broker does not charge additional fees for this service. But clearing brokers are under no contractual or legal obligation to offer delegated reporting. If a clearing broker turned around and said it was all too much hassle and stopped reporting, the manager would be in an awful lot of trouble. It is essential to have a Plan B in place. We are ourselves building a Plan B and we are working on a contingency agreement with a provider, which is yet to be determined. In a worst case scenario, we could report ourselves directly to the trade repository but this would be extremely costly.”
If the cost of doing the work in-house is prohibitive, one obvious set of institutions to take on the task are the global custodian banks to which many large fund managers have outsourced their middle and back office operations. Yet most custodians were tardy in their response to the opportunity. Managers who approached their custodians for help as late as January 2014 were surprised to find no service was being offered. As Imad Warde of HedgeGuard points out, custodians are ideally placed to handle delegated reporting for buy-side clients. “We think custodians have a key role to play here because they are uniquely placed as they have a comprehensive list of all of the trades executed by their fund manager clients,” he says.
The global custodians counter that they do not have the resources or operational know-how to report derivatives, although it is clear that they also dislike the risk-reward ratio. State Street, which has fully embraced the notion of providing a fee-based outsourced reporting service to its fund management clients, is the honourable exception. “I would not say the custodians are reluctant to undertake delegated reporting,” says Christian Voight. “But non-compliance with EMIR is not an option and there are still issues that need to be resolved. EMIR is highly complex, and custodians will need to invest heavily in internal infrastructure if they wish to report to trade repositories on behalf of clients.”
Technology vendors and especially the approved reporting mechanisms (ARMs) such as UnaVista, the London Stock Exchange subsidiary, are other obvious candidates to report derivatives on behalf of fund managers. UnaVista already reports 1½ billion trades a year on behalf of fund managers regulated under the Markets in Financial Instruments Directive (MiFID), so adding derivatives is an obvious extension of its existing service. The firm can map and re-format data before it is submitted to a trade repository, or deliver reports prepared by managers to data specifications set out by UnaVista.
MarkitServ is another service provider that boasts it can report trades to repositories, claiming it already assists fund managers in the United States, Australia, Hong Kong, Singapore and Japan with regulatory reporting. Approximately 1,500 firms also use the MarkitServ derivatives confirmation and affirmation service, which means the firm has an electronic record of OTC transactions in hand. For firms trading rates, credit, equity and FX derivatives, MarkitSERV can use its data to compile a report and submit it to a trade repository, says Henry Hunter, managing director at MarkitSERV.
Other potential providers of regulatory reporting services to fund managers include technology providers such as ConceptOne (see profile, page [TK]). It offers EMIR reporting through its Regulatory Enterprise Risk Management (RegERM) service. Fund administrators, on the other hand, have so far displayed limited enthusiasm for reporting to repositories on behalf of fund managers. An exception is SS&C GlobeOp (see profile, page [TK]). Administrators argue that the regulatory uncertainty ahead of the start of derivative reporting in Europe, and the continuing lack of standardisation of reporting templates at the global level, has made it too difficult for them to design an effective service.
The reporting of collateralised trades under EMIR, which started on 12 August 2014, has already provided a test of the readiness of fund managers, and it passed without undue incident. A longer term challenge fund managers are wrestling with is “back-loading” batches of historic derivative trades. All trades outstanding on the day that EMIR came into defect (16 August 2012) had to be reported with 90 days of the start of reporting on 12 February 2014, unless they were a trade that existed before 16 August 2012 and had expired before 12 February 2014. These trades have to be reported to a trade repository within three years of 12 February 2014, which means early 2017 (see “Backloading: how far back does it go, and how hard is it to do?” in the COO Guide to Derivative Reporting in Europe, page 32).
This task is relatively straightforward for exchange-traded derivatives, where automated messaging, confirmation and matching records are available. For bi-lateral OTC derivatives, it is more complicated, as records of these transactions are inevitably harder to locate and format. In extremis, finding the details involves combing through historic email exchanges between traders and their counterparts. MarkitSERV has a system in place which helps fund managers comb through trades dating back to 16 August 2012. Angus Milne of TCI is confident. “We are well placed to report backdated trades,” he says. “We keep good records but, simultaneously, we do not do a massive amount of trading. This might be much more of a challenge for a high frequency trader, for example.”
The next important question for managers is when the patience of European regulators is going to run out. The clearing of OTC derivatives starts in June 2015, and regulators will want all of the problems that emerged in reporting to be cleared up long before then. Initially, regulators took a relaxed view, with the Financial Conduct Authority (FCA) in the United Kingdom in particular indicating that it did not expect managers to be fully compliant with their reporting obligations for some months – though it did demand concrete evidence of material progress (see “The FCA View,” in the COO Guide to Derivative Reporting in Europe, page 110).
“The regulators are being pragmatic about trade reporting,” noted Robert Barnes of the FIA this summer. “They recognise some firms have had challenges although they want firms to be making a concerted effort to get things right. Angus Milne agrees. “The word on the street is that regulators have been sympathetic,” he says. “We were ready to fulfil our trade reporting obligations on day one although the DTCC had some problems processing the data so for a period of time, it was not functioning as it should have been. The regulators accepted that. The FCA has been aware of all of the issues surrounding trade reporting and it is being sympathetic where firms are making a genuine effort. However, I doubt the FCA will look kindly on firms that have done nothing to get prepared.” Quite soon, the FCA can be expected to start fining fund managers that have failed to make concrete progress towards fulfilling their reporting obligations.