The Way Ahead for Derivatives Clearing and Prime Services A JOINT WHITE PAPER FROM MINIUM, PROMONTORY, AND IBMFebruary 2018

Contents

1. Executive Summary...................................................... 1

2. The Regulatory Background ......................................... 2

3. Market Challenges and the Potential of Digital ............. 4

4. Potential Solutions for the Industry ............................... 6

5. Conclusion and Call to Action ...................................... 8

About Minium, Promontory, and IBM ................................ 9

DISCLAIMER

This joint white paper is a collaboration by Minium, Promontory, an IBM Company, and IBM regarding the subject. It is not intended to, and does not, confer any third-party beneficiary rights or remedies upon any person, and is not intended to, and may not be, relied upon by any other person for any purpose. This joint white paper is designed to raise awareness of some of the issues facing clearing and prime-brokerage businesses and, as a result, may not incorporate any or all matters that might be pertinent or necessary to a third party’s evaluation of the issues facing clearing and prime-brokerage businesses, or any other business or industry. This joint white paper is not a recommendation for, or endorsement of, any particular products or solutions and should not be viewed as an endorsement by any of the authors of any of the products or solutions of any of the other authors, or any other product or solution.

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1. Executive Summary

Firms that provide derivatives clearing and prime services are facing several important challenges:

• An ever-sharper focus on costs is making traditional information technology (IT) systems and operational processes look expensive and throwing the viability of entire business lines into doubt.

• The ongoing wave of new regulations is pushing businesses to innovate, because adapting existing IT systems is expensive and highly complex.

• There is a significant risk that competitors will establish a lead over firms that are still struggling with legacy infrastructures.

The market for derivatives clearing and prime services has undergone significant structural change. Firms are now facing important challenges, not only from new competition and new regulations, but also from their own legacy systems.

Since the crisis in 2008, there has been a dramatic reduction in the number of firms active in the market and a concentration of business among the largest providers. Meanwhile, the capital cost of clearing has increased sharply, as has the cost of keeping legacy systems and processes compliant with new regulations. Many firms have shrunk their books of business to cope, but the situation is unstable — for firms and the market as a whole. New strategies, business models, and processes must be found.

The patchwork of outdated systems most firms use today is not fit for purpose — firms simply will not be able to deliver the right level of return on equity for their clearing and prime-brokerage businesses without a radical reassessment of their technology stacks. What is missing is a system capable of ensuring a ‘single source of truth’ with up-to-date trade information that can be accessed by different functions to ensure alignment of different risk, controls, and financial processes. If that system could also produce a current view of collateral positions, including what has been pledged or recalled, control would be enhanced throughout the business.

With such a system, firms could begin to access newer technologies, such as augmented intelligence, that will enable dynamic recognition of issues and enhance the capabilities of operations teams. For example, if several clients are taking positions in an illiquid mid-cap stock, no individual position might trigger an alert. Overall, however, the firm could be building an excessive position without realising it. This type of system would enable firms to identify such a position, address regulatory requirements, and manage risk more effectively.

In addition, a system that can ensure a single source of truth would be easier to integrate with surveillance software, which would facilitate regulatory reporting and balance-sheet generation, among other capabilities.

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2. The Regulatory Background

Changes in market conditions have largely been driven by the regulatory agenda. For firms seeking to adapt, diagnosing issues and selecting the right path forward requires an understanding of regulatory drivers and future regulatory initiatives. The core of the regulatory agenda has been shaped by experiences from the last financial crisis:

“ Financial stability is a precondition for jobs and growth that can be threatened by a number of conditions. This includes highly leveraged and interconnected institutions from the bank and non-bank sector and failures in the functioning of financial markets. Unregulated, opaque over-the-counter (OTC) derivatives markets in which risks are not properly priced and/or mitigated were one of the fault lines that caused the global financial crisis.”1

Current Regulatory TrendsInternational Regulators Work to Finalise Post-Crisis Reforms

At the international level, policymaking for derivatives markets to implement the post-crisis reforms agreed on by the Group of 20 at the 2009 Pittsburgh summit is nearly complete, including requirements for the mandatory clearing and electronic execution of certain standard liquid contracts and guidance on central counterparty (CCP) resilience, recovery, and resolution.

The G-20 reforms to the OTC derivatives market — one of the most globally expansive and least-regulated financial markets before the crisis — have been substantial. As a result, international standards-setting bodies in 2014 established a derivatives assessment team (DAT),2 which launched a review of the incentives for central clearing arising from the interaction of a number of regulatory reforms. The DAT asked market participants to contribute to public surveys3 on the effects of G-20 reforms on derivatives markets and client clearing services, as well as other market-structure issues and observations.

The stated objectives of the G-20 reforms were to mitigate systemic risk (in part by increasing central clearing), to increase the transparency of derivatives markets, to enhance market integrity, and to protect against market abuse. Regulatory bodies, CCPs, and market participants continue to improve the resilience, recovery, and wind-down of CCPs, and to harmonise and improve the quality of trade-repository data.

ISDA Resolution Stay Protocols to Improve Cross-Border Resolution

Another important development has been the universal resolution stay protocol. Developed in 2015 by the International Swaps and Derivatives Association (ISDA), the protocol improves the effectiveness of cross-border resolution actions and is an important element of the operationalisation of resolution plans. To extend the protocol to the broader market, ISDA has been developing jurisdictional modular protocols, which outline the requirements for specific jurisdictions.

1. “Revision of the European Market Infrastructure Regulation”, European Systemic Risk Board (April 2017).

2. “Regulatory reform of over-the-counter derivatives: an assessment of incentives to clear centrally”, Bank for International Settlements (October 2014).

3. “Call for responses to surveys on incentives to centrally clear OTC derivatives”, Financial Stability Board (14 Dec. 2017).

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Review of EMIR Will Impact Markets and Margin Requirements

The European Market Infrastructure Regulation (EMIR) is a key regulatory initiative intended to ensure the safety of Europe’s derivatives markets and the provision of central clearing services. In effect since 2012, EMIR mandates the central clearing of standardized and liquid OTC derivatives contracts, and it establishes prudential and risk-mitigation techniques and operational requirements for derivatives transactions. Counterparties and CCPs are required to report all details of their derivatives contracts to trade repositories. EMIR also requires CCPs and trade repositories to fulfill prudential minimum requirements.

An important issue facing firms is how to address procyclicality in margin requirements. Since margin requirements are hardwired to market valuations, they tend to be procyclical, increasing in times of stress and burdening those posting the margin. While there is no commonly agreed-upon definition of procyclicality, using buffers and demanding long observation periods are key to addressing this issue. A long-term solution will also demand dialogue with regulators (including macroprudential regulators) and state-of-the-art technology.

The ongoing review of EMIR launched by the European Commission in May 2017 aims to calibrate the mandatory clearing requirements without altering the overall regulatory framework introduced by EMIR.

Operational Risk Management Should Address Resilience and Cyberrisk

Clearinghouses and investment banks should pay close attention to the operational risks associated with trading, clearing, and settlement. The risk environment can change rapidly, and so can industry practices and regulatory expectations.

Trading in, and clearing and settlement of, securities, derivatives, and foreign exchange requires firms to complement their compliance and risk management practices with sound practices for managing operational risk. Firms must address operational risk in a broad sense, focusing on three areas in particular:

• Resilience: New approaches to managing operational risk must also increase resilience.

• Security: Such new approaches must also incorporate technologies that meet regulatory cybersecurity requirements and expectations. It is important to address these issues and engage in effective dialogue with regulators.

• Data: New technologies must comply with regulations on the management of data handling. Regulators are already expressing concerns and tightening rules on data; the General Data Protection Regulation (GDPR) is the flagship example.

It will be important for CCPs to demonstrate to supervisors that they are properly managing operational risk and that they have implemented and designed systems and processes that incorporate industry best practices and supervisory expectations.

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3. Market Challenges and the Potential of Digital

Dramatic structural changes have occurred in the market since the 2008 financial crisis. The Futures Industry Association (FIA) reports that, of the 154 futures commission merchants (FCMs) active in the market prior to 2008, only 63 remain today.4 Even high-profile firms have recently opted to shutter their derivatives-client clearing operations. As a result, the clearing business is increasingly concentrated among the largest providers, with the top-five firms controlling 75% of the cleared swaps market.5

For the surviving firms, the capital cost of clearing has increased sharply, as has the cost of keeping legacy systems and processes compliant with new regulations. Many firms have been offboarding potentially profitable clients in record numbers as the true cost of operating the business becomes apparent. To adapt, firms must develop new strategies, business models, and processes.

Legacy Technology Has Exhausted Its Savings Potential Since the financial crisis, banks have exhausted traditional labour arbitrage savings in operations and technology support. They will need to cut costs and develop new business models to adapt, but given their current IT systems, future cost savings and efficiencies will be hard to come by. In addition, aging, outmoded technology will increasingly face security challenges as cybercriminals exploit vulnerabilities that are no longer cost effective or easy to fix.

Firms Could Improve Performance, Risk Management, and Control by Going DigitalPowerful real-time risk and processing technology can now be delivered cost effectively through cloud computing by leveraging the latest machine-learning techniques. Such solutions could enable unprecedented change in the cost profile of a clearing business.

A truly digital business will have access to real-time information on client activity. Firms will be able to be assess risks in real-time from several perspectives, including initial margin requirements (IM), value at risk (VAR), and stress VAR, as well as in-house margin methodologies. Consequently, users will not have to spend hours manipulating data for risk reports and can focus on more value-added activities. Furthermore, real-time visibility could lead to the elimination of costly capital buffers at CCPs and allow same-day response times when regulators or exchanges request information, potentially reducing costly penalties that hurt profitability.

In short, by adopting the new generation of technology, firms providing clearing and prime services will be able to better control the costs of doing business and optimise their balance sheets to position their businesses for growth and improved shareholder returns.

4. “FCM Tracker,” Futures Industry Association (Derived from Commodity Futures Trading Commission data).

5. “Financial Data for FCMs,” CFTC.

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Digitisation is an enabler that will allow firms to address challenges in four main areas:

1. Enhancing Returns and Capital by Optimising Deployed Balance Sheets

Clearers can deploy their capital more profitably on a day-to-day basis by ensuring they have real-time visibility into their clients’ trading.

For instance, clearers could avoid keeping outsized margin buffers with CCPs by responding to changing margin requirements intraday — possibly by calling clients for additional collateral during the trading day. To do this, they must be able to reconcile client positions and street-side positions with sufficient granularity to disaggregate omnibus margin requirements in real time.

By closely managing overall margin requirements, which will reduce risk, firms will be able to provide better service to clients, potentially enhancing returns on existing mandates and attracting new ones.

2. Improving Risk Control by Enhancing Limit Monitoring and Event Risk

Prime brokers and clearers must be able to monitor client credit quickly, efficiently, and accurately. This requires that they understand limits and collateral postings in real time to identify and pre-empt credit concerns before a client position needs to be involuntarily reduced, or before the client is denied access to the market.

New technologies can surface valuable details for risk and operations managers in real time, enabling them to focus on what is important for the client relationship and to avoid wasting time compiling data and reconciling spreadsheets. This can result in an improved client experience, not to mention more engaged and effective risk and operations teams.

Similarly, firms must ensure that they can adequately respond to event risk. Because of the patchwork of systems and processes in use today, responding to ad hoc monitoring requests can be difficult. For example, when there is an event that has the potential to significantly move the market (the way the French presidential election looked likely to move it last year, and the way the Brexit vote actually did move it the year before that) risk managers may want to check their exposure to certain assets that are likely to be affected. This should be an easy process, but it often requires running and reconciling multiple reports from multiple systems.

A real-time system with precisely labelled data could collate the necessary information faster and more accurately, allowing ad hoc monitoring of relevant sets of accounts or assets, which would reduce risk and increase efficiency.

3. Reducing Costs and Errors by Streamlining Delivery and Combining Real-Time Components

Legacy solutions put the strain of upgrading software to keep up with mandatory market updates or capacity constraints onto their user firms. New cloud-based technology alleviates these issues and enables savings on IT support and project-management costs.

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Most firms operate a patchwork of risk and back-office solutions, each of which addresses a specific aspect of risk, compliance, client service, or client reporting. Each solution purports to recreate real-time positions and valuations, but in practice, these solutions cause a proliferation of competing interfaces that must be monitored and maintained, exposing the firm to risks of inaccurate reporting and manual error.

A resilient, high-performance, real-time engine would significantly reduce operating costs and errors. Such technology could support the introduction of augmented-intelligence solutions that enable advanced exception-management logic, which would increase productivity in support functions, such as risk and client services.

4. Minimising Cyberrisk

Again, legacy systems are vulnerable and hard to protect. New, cloud-based technology environments that leverage the latest cybersecurity tools (including artificial intelligence), will give firms a better chance to stay ahead of cybercriminals.

4. Potential Solutions for the Industry

Manage the Level of Regulatory Change in a Cost-Effective MannerRegulatory change and supervisory expectations make it necessary for firms to invest in expertise and reshape their business models. Doing so will enable firms to do three things:

1. Explore new geographies: Firms can consider a wider range of markets and locations.

2. Refocus: Firms can exit underperforming businesses lines and focus on new businesses that will be relevant in the coming decade.

3. Invest in new technologies: Firms can invest in solutions that enable new, multicentre, and more efficient operating models, such as virtualization, cloud, and blockchain.

Systematically Embrace APIs, Cloud Computing, Cognitive Processes, and Blockchain Disruptive market forces create two significant challenges for legacy technology stacks and business models:

• The first challenge is the evolving regulatory climate, in which financial institutions have seen their balance sheets shrink and are looking to implement measures to reduce costs and standardise processes.

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• The second challenge is protecting core revenue streams from competition from financial technology organizations (fintechs), while continuing to develop new offerings to meet clients’ changing expectations and preferences.

To tackle these challenges, forward-looking organizations are turning to new technology solutions such as open application programming interfaces (APIs), cloud computing, cognitive processes, and blockchain.

1. APIs

APIs expose specific business capabilities. For example, one API might compute initial margin requirements, while another computes VAR. An API can be leveraged to many different regulatory requirements, eliminating redundant processes. APIs also have simple designs, making them easier to maintain and upgrade. Using cloud-computing APIs that can be run to scale eliminates large hardware requirements and can provide more timely results.

Financial institutions that have been successful in reinventing their core businesses have done so by embracing new technologies. One such example is generating new revenue streams by publishing paid APIs, which expose data from a firm’s core system. These APIs can be used by other companies however they choose. Additionally, forward-looking financial institutions who want to build new offerings can leverage an API architecture that often reduces the amount of time required to build APIs and go to market.

2. Cloud Computing

Cloud computing provides firms with access to vast amounts of computing resources without them having to physically own servers, write code, or set up any networks. As a result, firms gain the ability to scale to serve large numbers of clients while simultaneously containing costs.

3. Cognitive Processes

Firms can use cognitive processes, which use computer models to simulate human thought processes, to help analyse regulatory text to identify any obligations and assess the adequacy of their compliance programs. When combined with other data and services, cognitive processes can add significant value and differentiate new and existing offerings.

By using APIs and cognitive processes, financial institutions can compute regulatory calculations more consistently across the firm and enhance their ability to detect and adapt to regulatory changes.

4. Blockchain

Blockchain, or distributed ledger technology, enables the secure, flexible, low-cost management of secure value transfers across a global business footprint.

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5. Conclusion and Call to Action

Firms that provide derivatives clearing and prime services are facing several important challenges:

• An ever-sharper focus on costs is making traditional information technology (IT) systems and operational processes look expensive and throwing the viability of entire business lines into doubt.

• The ongoing wave of new regulations is pushing businesses to innovate, because adapting existing IT systems is expensive and highly complex.

• There is a significant risk that competitors will establish a lead over firms that are still struggling with legacy infrastructures.

Minium, IBM, and Promontory believe that there is an opportunity for firms that provide clearing and prime services to take a quantum leap forward by investing in new technologies that are tailored for modern businesses and aligned with the current regulatory environment.

A system capable of ensuring a single source of truth with real-time trade information that can be shared internally across all functions could significantly increase the profitability of clearing and prime-services businesses.

To capitalise on this type of investment, firms should consider four steps:

1. Ensure that forthcoming financial regulations are fully understood and, most importantly, that their impact on existing systems is clear. This will help firms identify which systems will struggle to handle new requirements and determine whether newer approaches could save time and money in the future.

2. Review issues with current systems to understand whether a modular replacement approach could yield significant business benefits. This will enable firms to avoid having to pursue a full system replacement in a single effort.

3. Ensure that new technological approaches to system architecture, as practiced by firms such as fintech ‘challenger banks’, are understood and that a plan is in place to prepare for the new technology ecosystem.

4. Devise a strategic plan to replace antiquated technology stacks, perhaps via a modular approach, to capture value from new technologies.

Minium, IBM, and Promontory encourage clearing and prime-brokerage businesses to explore the potential of new, real-time technologies to enhance their businesses through improved client service capabilities, reduced cost of ownership, and improved resilience to regulatory change.

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About Minium

Minium is part of Cinnober Group, the world leading independent provider of software to exchanges and clearing houses whose clients include LME Clear, B3 (formerly known as BM&F Bovespa) and Japan Exchange Group.

Minium’s vision is to deliver scalable and powerful software to banks and brokers that will modernise their risk and post-trade processes, in the same way that its parent Cinnober has revolutionised risk and post-trade for clearing houses. Our cutting edge technology enables banks and brokers to transform their business and reinvent the way they engage with their clients in the digital age.

For more information please contact info@miniumtech.com or call +44 20 3735 4777.

About Promontory, an IBM Company

Promontory is a leading advisory firm that excels at helping clients resolve critical strategy, risk management, and regulatory-compliance challenges. Our unique domain expertise, combined with IBM’s cognitive technology and scalable delivery capabilities, allows us to resolve challenging national and cross-border issues in financial services and other regulated industries. Founded in 2001 by Chief Executive Officer Eugene A. Ludwig, former U.S. comptroller of the currency, Promontory became a wholly owned subsidiary of IBM in 2016.

Learn more at promontory.com and ibm.com/banking.

About IBM Security

IBM Security offers one of the most advanced and integrated portfolios of enterprise security products and services. The portfolio, supported by world-renowned IBM X-Force® research, enables organizations to effectively manage risk and defend against emerging threats. IBM operates one of the world’s broadest security research, development and delivery organizations, mmonitors more than one trillion events monthly in more than 130 countries, and holds more than 3,500 security patents.

For more information, please visit www.ibm.com/security, follow @IBMSecurity on Twitter, or visit the IBM Security Intelligence blog a securityintelligence.com.

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