Seizing the Opportunity: Regulatory Compliance as a Driver of Competitive Advantage
New CFTC guidelines around the clearing of swaps are putting unprecedented demands on futures commission merchants (FCMs). With the timeframe to accept or reject a trade for clearing now slashed down to exactly a minute, FCMs are grappling with the challenge of implementing systems to simultaneously calculate and monitor multiple measures of risk at high speeds and high volumes. Though these requirements pose an operational and technological burden for many firms, the byproduct of compliance is more efficient and robust systems, providing FCMs with an opportunity to improve the service they provide their clients, generate more business, and increase their market share.
While the CFTC rules are intended to support the post-crisis legislative objectives to “reduce risk, increase transparency, and promote market integrity within the financial system,” two specific rules – 1.73 – Clearing futures commission merchant risk management and 1.74 – Futures commission merchant acceptance for clearing – are transforming the day-to-day practices of FCMs. They must now rely on sophisticated risk analytics running against gargantuan volumes of data to be able to confidently decide if they should accept or reject a trade for clearing within 60 seconds of submission – a drastically compressed cycle compared with the traditional end-of-day timeframe most FCMs previously employed.
Although there have been several delays and extensions, clearing members understand they must now comply with the regulations. The new question is how they will go about doing it. Demands for greater transparency from every corner of the market are the reality in a post-Lehman, post-economic meltdown world. Cost challenges, operational issues, and cultural resistance by those reluctant to embrace sweeping systems reform, may cause some FCMs to delay necessary upgrades or take a band-aid approach using quick-fix solutions. Such shortcuts can be problematic and ultimately more costly in the long run. Instead, a radical systems overhaul may be the best route to achieve a reliable, long-term solution for risk management that outperforms the compliance mandates.
Above and Beyond
Rule 1.73 codifies the sound risk management practices already in place at some firms and creates a standard for compliance to which all clearing members must now adhere. Across the board, all FCMs are now mandated to limit their potential exposure with such measures that include:
• Establishing credit and market risk-based limits on position size, order size, and margin requirements
• Using automated means to screen orders and monitor adherence based on these limits, intraday and overnight
• Conducting stress tests of proprietary and customer accounts
• Evaluating their ability to meet initial margin and variation margin requirements
• Evaluating their ability to liquidate the positions they clear
• Testing all lines of credit
Rule 1.74 layers in an additional challenge in regard to timing, as it requires clearing members to pre-screen orders and to accept or reject trades on the firm’s behalf within the 60-second window and mandates merchants and clearing organizations to quickly communicate about accepted or rejected trades.
This structured framework for regular consistent screening, monitoring, and evaluation, along with strict time limits for clearing, is providing opportunities for FCMs to provide value-added services to their clients as they cull intelligence from the resulting risk and trade data.
Introducing brokers, hedge fund consultants, and others who wield influence when it comes to sending business to clearing providers are keeping a keen eye on the FCMs’ abilities to successfully navigate the regulatory requirements. As a result, risk management practices are bubbling to the surface as an increasingly important measure to consider when selecting an FCM, along with the usual factors such as fees and margin requirements, excess operating capital, reporting, and system integration capabilities. Invariably, strengths or weaknesses in these areas can make or break new business opportunities.
Building In Scalability Implementing scalable systems capable of satisfying not only today’s demands, but any in-depth analytical requirements that may come down the regulatory pike in the future, is the only true way for FCMs to flourish. The compliance landscape is likely to change with future administrations, as the language of existing rules is forever morphing, and addendums are routinely introduced. Amid such uncertainties, a secure, robust, and adaptable system is essential to satisfying the constant stream of regulatory demands. Given the increased competition in this space and the pressure to reduce overall transaction costs, systems must also add value by reducing total overhead and improving efficiency.
The CFTC’s new regulatory standards are a wake-up call catapulting the derivatives clearing industry into action. The investment that firms make in comprehensive risk management systems today will dictate their future operational processes for years to come. While the decision to commit the resources and budget to overhaul platforms may cause some collective hand-wringing, it is an imperative well worth accomplishing, as it will likely yield rich results over the long haul.
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