Dodd-Frank Act:

a shift to liquidity risk puts new demands on IT systems

New US legislation embodied in the Dodd-Frank Act will have a direct impact on over-the-counter (OTC) derivatives, clearing and counterparty risk and exposure. This article discusses the paradigm shift in investment management workflow processes arising from the new regulations, examining settlement flows and liquidity issues, and the type of investment management software system architecture that will be required.

by Arne E. Jørgensen, Domain Manager at SimCorp.

Passage of the Wall Street Reform and Consumer Protection Act, more popularly known as the Dodd-Frank Act, signifies the biggest US regulatory change in several decades and will have a profound impact on the investment management industry across its entire spectrum of business, software system and financial processes – not least in the area of central clearing and counter-party risk and exposure.

While Dodd-Frank encompasses a wide range of financial provisions, this article confines itself to the new regulations that specifically relate to the central clearing of OTC derivatives as outlined in section 7 of the Act, and the repercussions for settlement flows, liquidity and risk management. The main purpose here is to address these issues by listing the principal functionalities an investment management institution must consider when choosing a software system to meet these challenges.

INVESTMENT SYSTEM CAPABILITY CHECKLIST

This article should be read as a catalogue of the potential challenges and issues, which asset managers may face in relation to the business processes linked to a particular investment management system. In other words, the points made in this article can be used as a checklist for a self-assessment of software system capabilities.

First, we examine the scope and scale of Dodd-Frank, identifying the main provisions related to OTC derivatives, clearing and counterparty risk and exposure. We seek to define the main issues to address, applying a pragmatic approach to assessing technology considerations, risk and counterparty exposure, central clearing and various key points such as initial and variation margin.

We then go on to identify the main data management parameters necessary to support compliance with the reporting requirements for payment transparency and disclosure as contained in the rules related to central clearing of OTC derivatives, drilling down into the following areas:

• valuation;
• automation;
• quality;
• transparency;
• scalability;
• reporting.

Finally, and in relation to these main parameters, we describe the type of best-practice software system architecture investment management companies need to support the transparency of transaction flow and reporting requirements to comply with the specific provisions related to central clearing. Identified are the various investment management system functionalities and processes that are required. These include data maintenance, trading and settlement, initial and variation margins, and finally the verification of, and processes related to, software system outputs such as valuations and reports.

SCOPE AND SCALE OF DODD-FRANK

Signed into law in July 2010, the Dodd-Frank Act covers a wide spectrum of financial reform, but has a clear goal of reducing, or at least controlling, the amount of systemic risk in modern markets. The main thrust of the legal provisions embodied in Dodd-Frank seeks to correct structural weaknesses in the US financial industry, such as the risk posed by activity that falls outside direct regulatory supervision (i.e. trading in OTC derivatives), the systemic risk posed by very large financial entities failing, and the dangers of not requiring underwriters and securitisation companies to maintain some exposure to the assets they securitise.

While the goal of reducing systemic risk may be clear, the timing of these changes is not – creating an ongoing challenge not only for market participants but also for those who manage the software systems as new ways of assessing and settling margin calls are adopted and new reporting requirements are absorbed.

Sweeping as it may be, the legislation is still a work in progress. Many crucial details remain unclear and the industry will have to await details of the rules with which it must comply. Changes in the area of OTC derivatives are to be phased in over a period of time. Yet the precise timing for implementation remains uncertain. The first of two phases related to OTC derivatives for central clearing initially limited to Credit Default Swaps (CDS) and Interest Rate Swaps (IRS) was set to take effect from July 2011. However, the timeline is under revision.

What is already clear is that the Dodd-Frank Act will have a major impact on the investment management systems and operational processes of asset management institutions. Among the areas most affected will be OTC derivatives, clearing and counterparty risk and exposure. A related challenge derives from the continued use of OTC derivatives during the transition to a new market structure and as the goal of a stable, robust and liquid market is realised. To use OTC derivatives appropriately now and in the future, investment management companies working in this space will need tools that offer a clear understanding of exposure to risk, leverage, and counterparties, given the complexity and inter-connected nature of the modern financial markets.

INVESTMENT MANAGEMENT SYSTEM CONSIDERATIONS

OTC derivatives are indeed complex, both in their structure and in their impact on the investment portfolio. The basic assessment to make is: does the investment management company have all the tools necessary to determine its various exposures to risk? Does the company use disparate systems to manage investments leading to an inability to holistically review risks? An increased focus on risks, and lessons learned, will lead to a push for IT departments to provide tools that allow for a greater understanding of current risks.

The old standards sought to measure weights in classifications such as currency, credit ratings and issuer exposure. With the increased complexity of the markets, that definition must extend to include counterparty and leverage, but also measures that capture non-linear returns and specific risk-exposure characteristics of certain security types.

RISK AND COUNTERPARTY EXPOSURE

Counterparty exposure is not as simple as keeping track of those with whom you trade. Any OTC transaction will involve counterparty risk, as the potential payment of profits will directly involve their ability to pay, or even, as after the bankruptcy of Lehman Brothers, to retrieve pledged collateral against trading activity.

Before the crisis, counterparty exposure analysis aggregated all exposures due to trading activity, performed stress tests on likely profits expected, then assessed if any party was overexposed. But now, financial accounting standards are driving the demand for transparency by incorporating a Credit Value Adjustment (CVA) directly into the reported fair value of derivatives, meaning all fair market or exit values must expressly capture the monetised value of the counterparty credit-risk. With this move, counterparty risk is no longer a pure administrative task; pre-deal calculation of CVA affects valuation of current holdings, modifies collateral requirements and dictates preference in trading partners.

Exposure is also a factor of leverage, as any derivative – either exchange traded or OTC – will increase exposure to certain risks without a cash outlay to actually purchase the underlying security. A key tool to assess the degree of leverage is Virtual Cash – the amount of capital saved by transacting in a derivative versus a direct purchase of the underlying security, index or risk factor.

CENTRAL CLEARING

Another aspect of Dodd-Frank for consideration is a move away from collateral bilateral trading into a margin-based model using Swap Execution Facilities (SEFs) for execution and price discovery, and exchange-style Central Counterparties (CCPs) to limit the exchange of collateral and mitigate systemic risk. Regulators will also have to determine what must be cleared through a CCP, and therefore traded through an SEF, in order to meet transparency requirements as dictated by Dodd-Frank. The CCP-based trading and clearing process is illustrated in Figure 1.

The clearing of trades via a central counterparty is a well-known and established practice for exchange-traded instruments – it was basically one of the functions the exchanges were originally created to handle, although specialisation entered only later, creating a space for dedicated CCPs. Typically, these trades are very short-lived, stretching just from trade date to settlement date, which limits the operational risk, the counterparty risk, as well as the market risk.
Futures are different. They live longer, typically 3-18 months. Upon maturity, they are usually cash settled by paying the difference between the original price of the underlying and its market price at maturity. To minimise the risk, this difference is paid in instalments (i.e. the variation margin as described below) as the price develops over time; at the end, the accumulated variation margin will be the final settlement amount. As security against market changes in the period between the investor’s failure to pay and the broker’s ability to unwind the position, an initial margin (as also described below) is made up front, to be returned at maturity.

 
Fig. 1. CCP-based trading and clearing process  

OTC DERIVATIVES

Perhaps the greatest change for those who trade derivatives will come as rules related to the Dodd-Frank Act and similar mandates overhaul the way swaps are traded, moving from opaque bilateral trading into a transparent, centralised and standardised model.
Under Dodd-Frank, the initial scope for central clearing is limited to CDS and IRS instruments. With maturities of typically 5-30 years, they are both very long lived. The CDS bears a strong resemblance to an insurance contract. Described simply: if you own a bond and take out a CDS on it, your counterparty pledges to buy the bond at par value in case the issuer defaults. Like an insurance contract, you pay a periodic fee for your certainty and this fee is basically a sunk cost at maturity.

An IRS is simpler in construction, with merely the periodic (i.e. yearly, quarterly, monthly) exchange of fixed- versus floating-rate interest payments (or the net difference thereof). An IRS at market terms starts with the value zero and ends upon its maturity with the value zero (or the net value of the last interest payment). However, given its very long lifetime, its market value can fluctuate dramatically in between.

While Dodd-Frank attempts to reduce the systemic risk inherent in the trading of OTC derivatives, it only sets the foundations for this new structure, not the specific details. It does not specify execution method or price discovery mechanics of the Swap Execution Facility (SEF), nor if this is simply a new name for existing providers. As the rules governing an SEF are clarified, the pricing definition will become clearer as well. In terms of price discovery, the method chosen will have a direct impact on current systems if straight-through-processing (STP) is an organisational goal, as indeed it must be where implementation of Dodd-Frank is concerned.

INITIAL MARGIN

Given the long lifetime of CDSs and IRSs and the extensive, albeit temporary, fluctuations in market value this can cause, CCPs will require substantial amounts of high quality, highly liquid collateral as initial margin for these contracts. This makes collateral management a central function. It will serve no good purpose to have liquid government bonds out on repurchasing agreements (repos) and plenty of lower grade bonds in the inventory when collateral has to be posted for the next OTC derivatives transaction.

It will be crucial for the collateral manager (whether internal or external) to have the full picture on which to base decisions and measure the efficiency of the collateral management process. It also means that the trading desk will have to consider the collateral implications of their trades – before making them. The costs and consequences of not having the necessary collateral at hand could turn out to be substantial.

VARIATION MARGIN

Again in terms of the variation margin, the long life times of CDSs and IRSs will make their market values very volatile. By way of example: the worst day in 2008 saw long swap rates move by 40 basis points from one day to the next. For a pension fund hedging its combination of 10-year government bonds and 40-year pension obligations with $50 billion notional of long, centrally cleared IRS, such a move would trigger a variation margin (cash) payment of over $2 billion.

Hence liquidity management can suddenly take on completely new and potentially huge proportions for investment management companies. The CCP may have taken over the counterparty risk, but the new liquidity risk has become just as critical as credit risk was earlier – except that company personnel may have much less experience in dealing with liquidity risk in their business and investment management system processes.

MAIN DATA MANAGEMENT PARAMETERS

Turning to an examination of the main data management parameters necessary to support compliance with the reporting requirements for payment transparency and disclosure in the Dodd-Frank Act’s provisions related to central clearing of OTC derivatives, the areas for consideration include valuation, automation, full data quality and transparency, scalability, and reporting.

Valuation
Standing behind valuation is obviously data sourcing. Investment management companies having to deal with the Dodd-Frank Act’s provisions related to central clearing of OTC derivatives should have or look for a platform that can consolidate disparate data sources to obtain a true and accurate snapshot of risk exposure, as well as gain insight into liquidity, valuations and other important metrics. In relation to Dodd-Frank, the main purpose of valuation is to use it for both initial and variation margin calculations.

Automation
An optimal IT system to meet Dodd-Frank requirements will offer a high degree of automation to support a full straight-through-processing (STP) workflow across different functions in order to minimise any manual processing errors that can lead to financial loss and reputational damage. The system should be sufficiently automated to deal with real-time communication with the CCP and the counterpart, including automatic handling of rejects. Automatic settling of daily variation margin balances in relation to processing of CDS and IRS instruments is also a key ingredient here.

Quality
An appropriate data system accommodating the Dodd-Frank provisions should provide near real-time updates to ensure robust data quality for informed decision-making. The updates must be able to encompass the settlement process, variation margin settlement, as well as exposure calculation. Access to timely information is critical for both making investment decisions and managing risk. Investment management organisations should consider the implications of this when deciding on their operating system.

Transparency
When gearing up for regulatory compliance with Dodd-Frank, investment management companies should select a solution that can provide and process all the necessary information required. Even in the best process, errors can sometimes occur. In that event, it is important to have validation procedures and the necessary transparency to identify and correct the error. This includes full transparency of the input data used as well as the calculation models. The more advanced analysis the investment company requires, the higher the demands on transparency. It is therefore key for the organisation to choose and implement a system that ensures transparency in how the information has been derived.

Scalability
As the requirements of Dodd-Frank in the area of central clearing of OTC derivatives become clearer, and as the legislation is expanded to include more and more OTC derivatives, a system is required that has the necessary scalability to adapt and include the new instruments as they are added. The system also needs to scale to ensure the organisation’s growth potential.

Reporting
The system must be able to contain reporting mechanisms that identify, monitor and absorb new Dodd-Frank requirements that arise in connection with any new central clearing mechanisms and structures as and when they come on stream. Using a common integrated platform for as many calculations as possible, whether related to valuations, margins or whatever, streamlines the reporting process, increases transparency and mitigates risk.

INTEGRATED INVESTMENT MANAGEMENT SOFTWARE

By way of summary, the Dodd-Frank Act’s provisions stipulating central clearing of OTC derivatives will force greater transparency in transaction flows, which in turn will require a centralisation of data sources to provide a 360° view in order to ensure that the best investment decisions are made.

These obligations, in combination with the all-encompassing need to accommodate greater diversity in the market as well as regulatory reform along the lines of Dodd-Frank, will drive investment management companies to adopt a more integrated approach in their long-term strategy for software system architecture.

An overhaul of the system that drives the OTC derivatives market, through Dodd-Frank and associated rules, offers an opportunity to review, and possibly retool, the applications investment management companies rely on to process OTC derivatives. At this stage, more is unknown than known, and the main focus in the coming months will be to stand ready to adopt the changes in market form and structure, while continuing to manage the risk inherent in the current system.

To meet these new and emerging requirements, an integrated investment management software system provides the best enterprise solution. An integrated yet modular configuration has the scope and scale to embrace all the instruments covered by the Dodd-Frank provisions in all the areas examined in this article. Whether valuation, automation, full data quality and transparency, scalability, or reporting, a one-stop solution that is capable of addressing all these points offers the best way to proceed.

Ebbe D. Kjaersbo is Chief Business Consultant at SimCorp North America. With over 11 years of experience at SimCorp, he is an expert in trade settlement processing and in other areas of automating investment management processes. In his current role, Ebbe Kjaersbo leads a team of specialists who implement SimCorp Dimension. He works with SimCorp’s buy-side clients to streamline and automate complex front-to-back office processes, ranging from settlement via central clearing to regulatory compliance reporting. His diverse skills extend from the development of SimCorp standard interfaces to third-party applications such as Bloomberg and SWIFT, to managing multi-million dollar on-time/within–budget projects. He holds a Masters in Mathematics and Economics.

Justin McBride is Chief Business Consultant at SimCorp North America. With over 14 years of industry experience, his areas of specialisation span a wide area of front-to-back office operations including trade lifecycle processing and settlement. In his current position, Justin McBride leverages his previous consulting experience with buy-side firms in access of US$100 billion in assets under management to support proof-of-concepts, requests-for-information and product demonstrations. Before joining SimCorp in 2003, Justin McBride worked for Thomson Financial Investment Management Systems. He began his career at Financial Times Information, where he consulted on the implementation of Extel fundamental data products. Justin McBride is a graduate of the University of Edinburgh, with an honours degree in Economics and Business Studies.

Arne E. Jørgensen is Domain Manager at SimCorp. With wide experience in the development and implementation of investment management systems, ranging from central banks over pension and insurance to discretionary asset management, spanning three continents, he has combined business knowledge and IT knowledge. Arne E. Jørgensen was pivotal for both the business and the technical aspects of the solutions SimCorp provided to its clients for the introduction of the Euro in 1999, of IFRS 1999-2005, and of the EU Savings Directive in 2005. The role as domain manager includes monitoring and analysing regulations and legislation like IFRS 9, US-GAAP, NAIC, FATCA, and he is currently heading the Central Clearing Task Force (Dodd-Frank and EMIR) at SimCorp’s Copenhagen headquarters. He holds an M.Sc. and a Diploma in Finance.