Getting Ahead of the Dodd Frank Curve: Striving For Best Practices

Although it has been over a year since The Dodd Frank Wall Street Reform Act was passed, the buy-side is still working out what market practices should look like for its sector. The Act (which requires firms to execute many of their swap deals through electronic platforms, process many of their swap transactions through a centralized clearinghouse, and report their transactions to a trade repository) has challenged the way the buy-side firms handle their collateral and margin management. It is apparent from recent press that preparing to comply with the provisions of the Dodd-Frank is at the top of the agendas for fund managers, yet many are uncertain about what steps to take first.The new regulations press for stronger infrastructure and better management of data, which inevitably will require an increased investment in technology. A recent report by TABB Group suggested that over-the-counter derivatives market participants will spend $3.4 billion on clearing and back-office technology alone; some top buy-side firms are to spend between $10 million and $15 million each on derivatives reform-related technology. While the market was awaiting the final rules from the CFTC and the SEC, many firms have been hesitant to make technology investments. The impending SEC regulatory reporting requirements are now mandated by June 2012 under Rule 204(b)-1. To ensure compliance and keep ahead of these far-reaching changes, it is prudent to put measures in place that are expected to be required under the new regulatory regime.

Fund managers also have to prepare to meet the stringent collateral requirements imposed by the central counterparty. Perhaps the greater challenge is that buy-side firms will need to change their approach to margin management. Under the central clearing model, margin calls will move to same day; firms with a siloed approach to collateral management will face the greatest challenge, as they struggle to track their positions and exposure as activity increases. More active market participants will also have to manage the operational complexity of a portfolio with both cleared and uncleared contracts. As a result, they will need to manage margin calls from a broader spectrum of counterparties, potentially with vastly different eligibility criteria and settlement timeframes.

The Lehman collapse proved that risk management is vital to the buy-side. Daily margining is an important risk mitigation tool; and the new legislation in general should be perceived as an opportunity to upgrade outdated technology and post-trade procedures. A year ago, the International Swaps and Derivatives Association (ISDA) set the benchmark for best practices for collateral management with its “Best Practices for the OTC Derivatives Collateral Process” paper, which lays out a comprehensive framework to be used as a reference/checklist to see how a firm measures up on the end-to-end process. We would recommend that firms determine where their gaps lie, set priorities and build out a continuous process improvement plan with increased emphasis on the automation of such key functions as valuation, reconciliation and collateral management.

With increased CSA volumes and central clearing, collateral activity will grow significantly for investment managers, and many firms are likely to struggle to continue to manage collateral in-house. Participants will have to either build their own systems to handle the complex collateral requirements, license a [less expensive] existing system, or partner with an outsourcing provider. The challenges for small and mid-size fund managers will be far more difficult than for large players with deeper pockets. Licensing an existing system (or using an outsourcing provider) is likely to be the most cost-effective and places the responsibility of having up-to-date technology on a third party. When selecting a system or an outsourcing provider, especially for firms with low trading volumes, we would suggest seeking a vendor with the most appropriate fee structure (e.g. “pay as you go” price model), which is not dependent on activity per day.