Counterparties to derivative trades have a wide range of considerations to think through in less than two months before new European regulations come into force.
After spending much of 2013 with their heads in the sand hoping that trade reporting would somehow just go away, many industry participants faced a rude awakening when the European Securities & Markets Authority (ESMA) authorised several trade repositories on November 7, 2013. This meant that the deadline for reporting all derivatives trades – over-the-counter and exchange-traded – would be just 90 days later on February 12, 2014.
It is not just complex derivatives that must be reported. Even the humble (but widely traded) FX Forward is included in the regulation’s scope. And it is not just big banks who must comply. All financial and non-financial counterparties must begin reporting.
So whether you are a bank, broker, investment manager, insurance company or corporate, the pressure is on. As The Banker went to press, organisations were hurriedly analysing the requirements in more detail. Their efforts will be focused on several underlying processes, which will be the basis of an effective reporting regime.
Finding identities
Regulators require that both parties to a trade are identified with a legal entity identifier (LEI). All market participants must therefore ensure that they have created an individual LEI for any of their legal entities that will enter into derivative trades. For some organisations, a greater challenge will be to ensure that each of their counterparties (even those that are not subject to European Market Infrastructure Regulation [Emir] or Dodd-Frank regulations) has an LEI. Various utilities have been authorised to create pre-LEIs, such as the publicly available CICI Utility.
In Europe, both parties to a trade are required to report the trade to a registered trade repository. The trade repositories will link the two sides of the trade by means of a globally unique identifier for the trade, which is known as the unique trade identifier (UTI). The success of Emir reporting is therefore critically dependent on streamlined processes for managing UTIs.
The process for generating and sharing UTIs varies by underlying asset class and in some cases is even dependent on how and where the trade was executed. Perhaps the most challenging asset class is currency derivatives, in part due to the huge size and distributed nature of the foreign exchange market. The foreign exchange industry has agreed that a trade’s UTI must be included in the confirmation of the trade, which for much of the market is effectively the Swift confirmation that is sent post-trade.
The parties to the trade must agree who is responsible for generating the UTI, which could be one of the two parties or an execution venue or execution agent. If no bilateral agreement is in place, there is a default International Swaps and Derivatives Association protocol for deciding on a trade-by-trade basis which party is responsible for UTI generation.
In any event, the UTI must be shared within the trade confirmation. Both parties to the trade have an obligation to report by the end of the day following execution (T+1), so a timely and efficient trade confirmation process is of paramount importance to ensure that the UTI is agreed between the parties in advance of the reporting deadline.
Reporting or delegated reporting?
ESMA allows entities to either report trades themselves or to delegate reporting to a third party, such as a trading counterparty or other service provider. Crucially, however, the legal responsibility for reporting remains with the entity itself.
Deciding on the best model for any organisation depends on several factors. For example, firms will have to find out if all their external counterparties offer a delegated reporting service. Do they execute intra-group trades, for which there is no external counterparty? How will they reconcile reporting status if they have delegated trade reporting? Are they able and willing to provide their delegated reporting party with all the required reporting data?
The trade repository
ESMA authorised several repositories in November 2013 in order to provide a competitive market. Naturally, there are differences between the individual repository providers, in terms of features such as on-boarding, connectivity and data standards, and ancillary services. The range of features available will be of greater or lesser importance to different market participants. In some cases a seemingly small difference in the offering can potentially have a huge impact on a project.
At this late stage, many are still concerned that firms are not ready for the February deadline. In Europe, particularly, companies face a much greater challenge than in the US. Reporting in Europe applies to both parties to the trade, meaning the sheer number of entities that will have to report is vast. In the foreign exchange industry, for example, there is a huge challenge around generating the UTI and sharing it. This sounds trivial, but participants should not underestimate the difficulty of sending and agreeing the UTI.
Given the very tight timescales for compliance, most organisations are, sensibly, looking for a solution that as far as possible builds on their existing processes and capabilities. The challenges are not to be underestimated, but the processes are now largely well defined and concrete and workable solutions are available.
Joe Halberstadt is head of foreign exchange and derivatives at the Society for Worldwide Interbank Financial Telecommunication (Swift).
