T+2 POTENTIAL POST-TRANSITION WOES: CONFIRMATION / AFFIRMATION

The transition to T+2 settlement throughout the European Union (EU) is scheduled for January 2015. Some countries may transition before this date. Henceforth, from January 2015 equity and bond trades will settle two days after trade date across the EU. This is a major accomplishment as it’s the first region to reduce the time between trade and settlement date from T+3.

One unknown consequence of this change is the impact on Confirmation / Affirmation (C/A) rates.  The C/A process occur between institutional investors (buy-side) and their brokers (sell-side). Institutional trade volumes represent the largest number, and greatest value, most broker’s business. 

The C/A process is the presentation (confirmation) of trade details by the sell-side and approval (affirmation) from the buy-side. The current rate of successful affirmation on or before T+1 is between 60-70%. In a T+2 environment positive affirmation must be made on trade date.

Un-affirmed trades must be reconciled to ensure timely settlement and to avoid failed settlements. In the current T+3 environment manual work-arounds are used to identify and resolve un-affirmed trades. But  in a T+2 enviroment, with one less day, manual work-arounds will be less effective. As a result the industry must respond to this situation to ensure the success of T+2 settlement.

There are alternative responses that can address this situation; one is for the buy-side to review and respond to the confirmation on trade date. Another alternative is for the buy-side to empower their custodians to affirm trades on their behalf. Both will permit sufficient time for exceptions to be resolved and advise custodians of the pending settlements. Both alternatives can be implemented with minimal changes to buy-side internal worksflows and minor technology modifications.

These alternatives are short term solutions to the C/A process. The global industry needs an integrated model so that the C/A process is incorporated into the order-trade workflow. The C/A process should be automated with minimal touch-points required. There are systems in place today that come close to this model, but they have not been fully embraced by the community. The industry must determine why these systems aren’t  fully utilized. They must address these issues or commission development of a system that is acceptable to all order to trade lifecycle participants

What’s your opinion on this situation?

               Any idea why affirmation rates are so low?

                        Are  there other viable alternatives?                        

                        

MORTGAGE BACKED SECURITIES 2.0 – PART ONE

Twice in the same week two entities published their recommendations on a new mortgage securitization process that would turn mortgages into tradable securities. Their motivation is to ensure that lending institutions are able to access the capital markets.

The need for a reset to MBS 2.0 is that the agencies responsible for purchasing and securitizing mortgages issued by lending institutions, Federal Home Loan Mortgage Association (FHLMC) and Federal National Mortgage Association (FNMA) were absorbed by the federal government. This action was in response to the credit crisis, increasing late payments and growing defaults by homeowners holding mortgages securitized by FHLMC and FNMA. Both agencies, known government sponsored enterprises (GSE), were public companies owned by shareholders before being taken over by the federal government.

Prior to the credit crisis the role of these agencies was to purchase qualifying mortgages, turn the mortgages into securities, and guarantee the timely payment of principal and interest, which were sold to investment banks who in turn sold them to investors. This process was established in the late 1960’s and was designed to provider lending institutions with a way to move the mortgages off their books and recapture the capital lend to home buyers.

Congress and the Federal Housing Finance Agency (FHFA) are struggling with finding a system to improve market liquidity and address the potential risks causing market disruptions. The ultimate solution will come from the federal government; particular focus will be on correcting some of the shortcomings of the original model, such as:

·        Implicit guarantee that the federal government would back the two GSE in the event of a crisis. This certainly was true……

·        Marginal impact on low to moderate income home buyers

·        Conflicts in regulations and between public and private objectives

A new securitization model is a critical step in the recovery and at a minimum, must ensure

·           Consistent, nationwide supply of mortgage financing for residential mortgages to qualified home buyers

·           Assistance to low and moderate income homebuyers, i.e. subsidized mortgages

As I wrote in an earlier blog, the ideal response to this opportunity will be a result of a collaborative effort between Congress, FHFA and representatives from the Capital Market. This mix of interests will ensure that each is represented and that the model will be a “best practice” approach to the stated objectives. At this point the following are some of the broad principles that should be addressed:

·        Securitization model that combines a federal government and private industry guarantee that timely principal and interest payments will be paid to investors on qualified mortgages

·        Transparency on the underlying mortgages in any securitized pools or tranches sold to investors

·        Investment grade rating on the securitized pools or tranches

I will review the recommendations offered and explore this topic further in another blog. Meanwhile, let me know your thoughts regarding..

What is your opinion about this?

Your ideas on the new securitization model?

Are there other viable alternatives available?

CLEARING ENTITIES – WHEN ARE THERE TOO MANY?

It seems that every week there’s an announcement of a new clearing entity supporting a market or product. Clearing is critical and provides safety and risk mitigation for market participants. But I wonder if there can be too much of a good thing?

Granted, clearing is a basic requirement of a sound financial services industry, and should address trade matching, collection of initial and variation margin and the clearing entity acting as the Central CounterParty. But is forming a new clearing entity the most effective approach?

In a market without a clearing entity, one is needed to provide critical services. This often requires regulatory changes, perhaps on a national scale, to begin the process. The local infrastructure must be in a position to support this process. This includes funding and contributing the expertise to define the processing and control functions. This is a heavy burden for an emerging or pre-emerging market to undertake.

Perhaps leveraging the expertise of an existing clearing organization, rather than creating a new entity, is a better alternative. This would permit clearing services to be made available faster and potentially with less pain and expense usually associated with forming a new entity. The potential benefits of this approach are considerable as it would reduce the costs associated with development and encourage the use of clearing in new markets.

Further along this line, I question why new clearing entities are being formed in markets where there is an existing entity already providing clearing services.  Are clearing services for one product substantially different from another product?  Are there benefits of using an existing platform?

If there are legislative or regulatory issues that demand a new entity, the industry should appeal this situation as it results in a fragmented clearing process. Additionally it requires firms to join multiple entities, support redundant interfaces and holding positions and balances across multiple entities all which results in increased costs.

Perhaps some products can’t be co-mingled or require unique processing streams and / or reporting.  Or segmentation may be required to mitigate associated risks. This can be addressed via a holding company structure where different processing streams within a clearing entity would maintain the required segmentation.

The old approach of “cloning” an existing infrastructure, to support a new requirement, has been the “go to” approach for financial services firms for far too long. As seen many times, this seemingly simple approach is costly in the long run with multiple interfaces, maintenance of different but similar applications and processing multiple processing streams.

Once in-place these cloned systems are almost impossible to replace or eliminate due to the ever evolving demands for new products, faster processing or new markets.

Fewer clearing entities will flatten the landscape and reduce fragmented processing streams. It will also support cross-margining and improved collateral management. In the future fewer clearing entities will ease the transition to global interfaces among clearing entities.

So, when will we learn from the hard lessons and modify our approach to the never-

ending demands of the industry?

What is your opinion about this?

           Are there other viable approaches available?

                 How many clearing entities memberships does your firm have?

THE 20% DOWN PAYMENT ON HOME PURCHASES, PERHAPS A PART OF THE PAST?

The SEC recently redrew their objection to softening of new proposed mortgage regulations. Instead they reached a compromise to re-evaluate, and potentially adjust the rule, two years after the effective date and then every five years afterward.

The softening, at this point, includes elimination of the down payment and the requirement for lenders to retain 5% of a loan’s risk once it has been sold to investors. This is a dramatic change from the standards discussed as recently as 2011.

The impetus for these changes is to improve the housing markets which many in housing industry, as well as affordable housing groups and regulators believe is being hampered by the current down payment requirement.

Home buyers were not the only, or even primary, reason for the credit crisis. But they certainly contributed to the enormity of the situation via default on making their mortgage payment.

Is elimination of the down payment an appropriate response to a weak housing market? Will it weaken a home buyer’s commitment to pay the mortgage? Will defaults increase over time? At the same time is two years too long to judge the success or failure of this change? Perhaps we should track payment history to ensure that we avoid mini-crises.

This is another step in modifying the Dodd Frank Act (DFA) which is still evolving. At the same time Congress is still discussing the future role of FNMA and FHLMC. And now, we are considering eliminating a major part the mortgage qualification requirement?

Addressing the weaknesses in the housing market is critical to the financial recovery. But deciding which entity will guarantee repayment to investors, and how the guarantee will work is critical to investors as well.  

The bottom line is that investors provide the flow of capital to lenders to ensure that there are competitive mortgage to homebuyers. As such Mortgage Backed Securities (MBS) must provide a level of safety to investors so that they will remain attractive to investors. 

         Is this a positive change?

                 What other changes should be made at this time?

                             Or, should we be maintain the traditional 20% down payment?

THE FUTURE OF THE MIDDLE OFFICE

The Middle Office evolved as a result of various issues facing Sell-side firms. Two issues, in common, to these firms were:

1.     a need for additional controls to improve the accuracy of the trade details at the beginning of the trade lifecycle

2.     the need to identify and resolve issues causing trade settlement delays

The response was to establish a function that would be closer to the front office, where client facing activities tak place, than the traditional back office. That’s how the name Middle Office came to be and has stuck.

Eventually buy-side firms, as well as other industry service organizations, also established a middle office function as well. This allowed each to functionally match-up to broker/dealers, custodians and prime brokers. Over time the focus of the Middle Office grew to include accounting, reporting and other control activities. The role of the Middle Office has improved operational efficiencies, reduced the cost of resolving delayed and failed trade settlements.

As the time between trade and settlement date shrinks, the Middle office may again prove to be an essential function in maintaining operational efficiency.  The reduction of time between trade and settlement date results in less time to resolve problem trades. This loss of time will require firms to rethink existing internal practices to ensure that there is sufficient time to identity, analyze the cause and resolve the issues that may delay timely and accurate settlement.

Today resolution of problem trades often requires interaction across various front, middle and back office areas. This can take a considerable time and may result in settlement delays. A shortened trade-settlement schedule may result in an increase in unresolved trades. This will have a negative impact on settlement and post settlement activities plus increase operating costs.  One approach might be to reduce the number of departments or staff involved in trade and settlement processing.

Restructuring operational responsibilities is one alternative to consider. Perhaps moving the activities associated with pre-settlement and settlement, now performed by the Back Office, to the Middle Office may be worth a review.

A new infrastructure might include reassigning functions between the Middle ad Back Office areas as follows:

1.     Middle Office – all post order(trade) execution through settlement functions

2.     Back Office – all post settlement through to asset servicing functions

This change is a huge leap from the structure that has been in-place for years. It is similar it to the introduction to technology in the 1960’s which resulted in new work flows, new departments and procedures. Technology continues to support the business and the impact is the same, with slight variations and the evolving changes are accepted as (business as usual.  

This is one approach. There is sufficient time for the industry to ponder the impact of reducing the trade-settlement and explore appropriate responses.

         Do you agree that this is a situation we will face?
 

                Is splitting functions between Middle and Back Offices viable? 
      
                     Can you offer alternative responses?

MULTIPLE SYSTEMS = MAINTENANCE CHALLENGES

The approach broker / dealers adopted early on in the development of application technology was to develop product-centric systems. For example a, equity system fro equities, a government systems for Treasury and a MBS system for mortgage backed securities. As a result, today firm have multiple processing platforms, each supporting specific products. The driver behind this approach was to create a template system that could be cloned to support other product systems. For example if the base fixed income system was the Treasury bond system, it could be used as the foundation for corporate and municipal bonds. Extraneous or unneeded functionality would be stripped while new functionality unique to corporate and municipal bonds would be added. This allowed firms to avoid "reinventing the wheel" each time they introduced a new product and sped up the process as well.

The outcomes were many similar, but different processing systems, each requiring expertise, maintenance and support. For example some products settled one day after trade date, others five days after trade date while mortgage backed securities can settle up to six month after trade date. Differences were pervasive throughout the trade life-cycle as well as in reference data, trade entry, and asset servicing and reporting. This required systems developers and maintenance staff to have current and relevant expertise and knowledge of each product and the related processing functions. The bottom line is that this resulted in increased information technology costs and often delayed new functionality and updates to be applied, even today.

Firms are still struggling to find an approach to address this challenge.  In the past 30+ years have seen many innovations in database design, programming languages and other advances that can provide benefits to financial services firms processing systems. But first they must reduce the number of product-centric systems to facilitate an efficient future environment. There are various alternatives; one is to build a new multi-product system to replace the product-centric systems. But the alternatives require a major effort in cost and resources. And have to be done in the current environment of keeping costs down.

 

         What is your opinion about this?

          Does this cause firms to less competitive?

                                Are there other viable approaches available?

CONSOLIDATED AUDIT TRAIL (CAT) – A REAL OPPORTUNITY

The Securities Exchange Commission (SEC) Rule 613 requires the timely collection of securities transaction executed in US markets.  In addition to the SEC, CAT is being created with the active collaboration of the registered exchanges and FINRA which are commonly known as Self Regulatory Organizations (SRO). The first step focuses on the reporting of US National Market Securities (NMS), which includes listed equities and options.

Though a driver of this effort is the “Flash Crash of 2010” I believe that it reflects the regulators realization that they need to be more proactive in gathering timely data on all transactions flowing through the US infrastructure. Logically they are starting with trade data, which are currently dispersed across multiple markets. There are a still number of open issues that remain to be addressed by the regulators but I am confident that the other participant’s interests and concerns will be addressed to the benefit of the industry.

Though this effort requires substantial efforts to develop and implement, it is a real opportunity to bring the industry into the 21^st century. In addition it should provide an opportunity to sunset or eliminate various trade reporting systems that provide similar data to specific regulators. Also, I believe that this data collected by a central source may, in the future, provide other benefits to the industry as well.

            Do you believe that there is real value in this new rule?

                        If so, what are the benefits? If not, why not?

                                    If not, what the alternatives to meeting the regulatory needs?

COLLATERAL MANAGEMENT OR MIS-MANAGEMENT……

Depending on the level of preparation, it could be either of the above. Traditionally collateral management was a back office function with little or no impact on the front office. But the Dodd-Frank Act (DFA), European Market Infrastructure Regulation (EMIR) and Basel III require participants to collateralize trades and other transactions.

Broker-dealers have been collateralizing clearing and guarantee funds for many years. But buy-side firms, such as hedge funds and other fund managers, have not had the same experience. They will now be required pledge collateral to support their transactions. If they don’t have appropriate or sufficient collateral they will need their custodians or clearing brokers to locate the needed collateral.

This requires custodians, clearing brokers and industry service organizations to enhance their services. As such it is a new source of revenue to industry service organizations and a new cost for their clients.

Electronic interfaces among the industry service organizations as well as investor will be critical to ensure that transactions are collateralized at minimal costs.

            What are the critical issues facing your firm?

                        How will you optimize the collateral you have?

                                    What are the available alternatives to improve collateral?

WHAT'S UP WITH THE LEGAL ENTITY IDENTIFIER?

It’s been a while since the need for recognizing legal organizations and their related entities has been identified. There have been a number of announcements on initiatives but little definitive movement on a coordinated global response to LEI.

Remember that it was difficult to determine their exposure of derivative trades especially for firms, like Lehman, that were facing a credit crisis. The initial drive for LEI was the Dodd Frank Act (DFA) and European Market Infrastructure Regulation (EMIR). Their focus was to reduce counter-party and systemic risk related to derivatives trading and settlement.

February 12^th was the date for SWAP trades to be processed with LEI. Problems were expected but the news about this event has been sparse.

What are your thoughts, good, bad or neutral, concerning global legal entity identifiers?

                        Are the regulators ready to respond to reported anomalies?

                                 Should a global identifier be extended to other assets?

SUPERVISORY COLLEGES FOR INTERNATIONAL CREDIT RATING AGENCIES

These organizations were established as a result of recommendations that the International Organization of Securities Commissions (IOSCO) made in their final report published in July 2013.  Supervisory Colleges for International Credit Rating Agencies creates a mechanism for sharing and discussing information regarding:

• Compliance with local or regional laws and regulations
• Implementation of, and adherence to, the IOSCO Code of Conduct for CRA
• Establishment and operation of rating models

•  Methodologies, internal controls, procedures to manage conflicts of interest
• Procedures for handling material non-public information
• With the goal of promoting better understanding of the risks faced or posed by international CRA and how relevant supervisors are addressing these risks

One lesson learned, was that credit rating agencies face conflicts. The Supervisory Colleges are a creative approach to avoiding similar missteps.

The colleges for S&P and Moody’s will be chaired by the Securities and Exchange Commission (SEC) and the college for Fitch will be chaired by the European Securities Markets Authority (ESMA. The SEC

              What’s your opinion about the need for supervision of credit rating agencies?

     Is this an appropriate response?

What are the critical best practices for the CRA?

CENTRAL SECURITIES DEPOSITORIES (CSD) - THE FUTURE OF LOCAL CSD

How will the announcement by the London Stock Exchange (LSE) to create a Central Securities Depository in Luxembourg impact local CSD? 

Today, most CSD are country-based service centers supporting local market participants via immobilization or elimination of physical certificates, providing book entry trade settlement, collecting interest and dividend payments and processing corporate action. Currently little or no interface to other local CSD is available.

The current local CSD infrastructure requires global participants to join multiple CSD to establish a first-hand presence in local marketplaces. This is expensive beyond multiple membership fees. It requires additional record-keeping, compliance with local regulations, increased risks if regulations don’t offer sufficient protection and additional interface applications.

There are two International Central Securities Depositories (ICSD), Clearstream and Euroclear that address some of inefficiencies of local CSD. They offer services across multiple marketplaces and offer centralized reporting. The LSE announcement adds another ICSD entity for global participants.

                What is the ideal CSD? (Local, International or a combination)

                            Should it be member or privately owned?

                                          How should they be regulated?