Bob McDowall, research director for Europe at TowerGroup

An unprecedented overhaul of the securities industry is taking place under politically mandated reform. This is forcing markets and regulators to work more closely together to ensure that there is no repeat of the recent financial crisis. Writer Frances Maguire

The Securities Industry, used as it is to living with an ever-increasing amount of regulation, has, over time, built up its compliance departments and allocated the necessary budgets. However, the wide-scale financial reform currently under way is unprecedented and has caused the industry to collaborate with the regulators at all levels.

Companies and regulators are attempting to restructure the financial markets to ensure that there will never be another crisis as severe as the one experienced recently.

Bob McDowall, research director for Europe at TowerGroup, a US-based financial services research company, says the securities industry is now inextricably bound up with politics and regulation. In some ways, this has made regulation more predictable, as the new lines are drawn. Mr McDowall adds that the main impact of regulation on the middle and back offices relates to how financial institutions manage, handle and export/import data to and from internal and external sources. "This is an important facet in all regulation; it has to be," he says.

"The data has to be clean and has to come from a unified source. Data must be immediately accessible for management and must be reported promptly, accurately and in a standardised form. Data will continue to underlie successful compliance with new regulations for the foreseeable future."

Data access

An important challenge for middle and back offices is the means of access to data. The middle office, which has grown up somewhat haphazardly in response to enhancements to electronic trading over the past 20 years, currently handles two types of activity: execution-sensitive and operationally administrative.

According to Mr McDowall, the regulatory pressures and the consequent pressure on delivering the data will erode the role of the middle office.

He believes that if the industry is to incorporate the risk, and the liquidity capital risk requirements, the execution-sensitive functions of the middle office will move, and are already starting to move, to trade desks, with appropriate controls around them.

Mr McDowall says: "Technology enables risk, financial and market exposure to be assessed before the transaction is executed through the immediate availability of data. As a result, some functions will move from the middle office to the front office. This will put a question mark over whether we really need a middle office. And wouldn't it be better if all the different non-execution-sensitive functions were handled within the operation? In both cases, there is a driver for more immediate reporting."

While the immediacy of data required for trading is greater than that of post-trade operation, there is an increasing need for more responsive post-trade reporting, at least by end of the day.

Sharing information

A major challenge facing the entire industry is the issue of reference data. Banks are strongly opposed to sharing competitively sensitive data. Mr McDowall says that, in an ideal world, the industry would collaborate and provide a community-based reference data utility, but this is idealistic and early attempts have not been truly industry-wide. He suggests that a network similar to the telephone network is needed, to which companies can subscribe for information. However, he does not envisage this happening without some kind of government mandate.

Godfried DeVidts, director of European affairs at ICAP - a London-based broker and provider of post-trade services - and a member of the Committee of European Securities Regulators' Market Participants Consultative Panel, says there was no precedent for the recent financial crisis and agrees that there is a huge demand for data to help policy-makers understand the evolution of the market.

"This is why we now have the global focus on trade repositories for over-the-counter derivatives; for the first time, the regulators are defining what a trade repository should do and how it should evolve," says Mr DeVidts.

With the building of over-the-counter derivatives repositories already under way, there is now a huge discussion, particularly in Europe, about access to data from outside the EU, and whether the repositories should be domestic, regional and competing, when the markets are global.

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David Weisbrod, head of risk management for treasury and securities services at JPMorgan

Post-trade processing

It is widely accepted that the securities industry has invested vast sums in technology for trading and the front office, while not investing so much in the middle and back offices. This has left a huge discrepancy between pre- and post-trade processing, which needs to be addressed if the industry is truly to reform. According to Mr DeVidts, the need to speed up processing, so that post-trade data is available on a more timely basis, was one of the biggest lessons learned from the financial crisis.

David Weisbrod, head of risk management for treasury and securities services at JPMorgan, says data processing speed has been addressed most dramatically in a recent example of what can be achieved through industry collaboration with the regulators: the task force on tri-party repos set up by the US Federal Reserve in September 2009.

The task force brought together a wide cross-section of buy- and sell-side market participants to tackle how to make sure that the tri-party repo market, which is a fundamental component of how US broker/dealers fund themselves, was working as well as it should and how to make changes that would enhance it and fix any problems.

As a result, market participants have agreed to a number of operational changes, including altering the workings of trade-booking processing, trade confirmations and intraday collateral management.

Mr Weisbrod says: "For example, in the current process, some of the market participants do not submit trade information to the clearing banks in a timely manner, but now they are agreeing that the booking and submission of trades be done in a more standardised way, so there will be more discipline around how the trades are booked. There is no industry-formalised process, either two-way between the dealers and the cash investors or three-way with the clearing banks involved, and the task force has established that trade confirmation should follow best practice at the time of execution."

The most profound change is that the industry has agreed to introduce 'auto-substitution', an automated intraday collateral substitution methodology, which will enable the substitution of collateral on a real-time basis, by June 2011. It is claimed that auto-substitution will dramatically reduce the risk in the system by eliminating the intraday credit that the clearing banks provide.

Mr Weisbrod says: "This will enable the elimination of the 'unwind', the reversal of the repo at the beginning of the day when the clearing banks (Bank of New York and JPMorgan) step in and provide interday credit to the dealers. The clearing banks will no longer prematurely return the collateral to the dealer and the cash to the investor every day in the 'unwind'."

Instead, JPMorgan will introduce auto-substitution. In anticipation of the changes, JPMorgan has already begun implementing changes to its processes and building the technology needed to enable dealers to substitute collateral during the course of the day, and for JPMorgan to provide real-time assessment of that collateral, to ensure that investors are covered at all times.

While liquidity management, closely linked to collateral management, is part of the current financial reforms, the process began some years ago. In the move from Basel I to Basel II, the regulators signalled a move away from unsecured markets to secured ones, to the extent that the amount of non-secured liquidity that goes from one bank to another is actually non-existent. Collateralisation will be a lynchpin of reform, and the industry is already coming up with solutions that reflect this.

Mr DeVidts says that one of the issues to be addressed by the regulators in Basel III is the need for better liquidity management and getting away from overnight batch processing. The UK's Financial Services Authority has already pre-empted this issue.

"There is intense co-operation between the regulators and the industry because there is a realisation that the regulators cannot get ahead of new product development; they can only regulate afterwards," says Mr DeVidts. Likewise, the securities industry cannot get on with new product development until the new landscape has been fully defined. This is a balance that will dictate the way securities operate from now on.

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