ASTASSETSERVICINGTIMES

Regulatory Handbook 2014

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Responsibilities and opportunitiesThe overriding message of this, the first Asset Servicing Times Regulatory Handbook, is unequivocally that with more regulation comes more responsibility, but also more opportunity.

Aside from whether you can be described as glass half full or glass half empty, there is much to be aware of and thinking about: if the Alternative In-vestment Fund Managers Directive’s depository requirements don’t affect you directly, then what about indirectly? What of your American clients under the Foreign Account Tax Compliance Act? Is T2S all it is cracked up to be?

Included within these pages is all of the informa-tion and advice you could want on key regulations, covering what to expect within the next 12 months and beyond. Thanks goes out to the European Central Securities Depositories Association and Bank of America Merrill Lynch, whose sponsorship and support has been instrumental in putting the Regulatory Handbook together.

If you have any comments or suggestions for future issues of the Regulatory Handbook, please do drop us a line.

Editor: Mark Dugdalemarkdugdale@assetservicingtimes.comTel: +44 (0)20 8663 9620

Deputy editor: Georgina Laversgeorginalavers@assetservicingtimes.comTel: +44 (0)20 8663 9629

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ASTASSETSERVICINGTIMES

Responsibilities and opportunities

EditorMark Dugdale

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IntroductionAre you keeping regular?

page6

EMIRThe journey to derivatives reform page12A spring clean page20

T2SA bounteous harvest page24

AIFMDTime is of the essence page36

CSDRThe evolving landscape of settlement and custody

page44

FATCADown to the wire

page50

Liquidity lessonsCollateral: the double-edged sword? page53Regulatory reform: redefining the FI relationship

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Intraday nerves page58

Vendor profiles page60

Notes page62

Detract from business page16

T2S success page26

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Contents

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FATCA, AIFMD, EMIR, MiFID, SOX, UCITS, LEI, T2S. All of those acronyms, and these besides the other big names such as Basel III and the US Dodd-Frank Act. The uncertainty seems to start with the monikers themselves, let alone the sub-stance within them. We know what they stand for and have a pretty good idea of the broad implica-tions, but what of the impacts on our firms that are not clear from a distance? Many banks, invest-ment managers or fund managers haven’t stud-ied them in enough depth and aren’t prepared for the measures passing into law until the deadlines are nearly upon them. In KPMG’s report, Evolv-ing Banking Regulation, the detail declares that: “Many banks and their regulators have achieved less than they should have done over the last six-and-a-half years … there remains concern that regulatory reforms are hindering the ability and willingness of banks to support economic recov-ery.” A remark such as this from such an august institution is a sobering one.

Legal and compliance departments are still in alarming disarray four months before the Alterna-tive Investment Fund Manager’s Directive (AIFMD) is to become official, having had nearly three years to get ready since it was approved. FATCA (For-eign Account Tax Compliance Act) ‘fatigue’ is set-ting in to the extent that the credit unions prefer that it didn’t exist.

Large sums have been spent on investigation and preparation and this doesn’t seem to have helped the process along—even the Internal Revenue Service (IRS) has failed to publish crucial docu-mentation in a timely fashion. A lot of institutions still remain uncertain as to exactly how they will be affected; a surprising number will not be ready for the regulations as they become forces in law. Some don’t like what’s coming and will opt out rath-er than adapt. The same is true of UCITS V and some companies are not yet fully in line with the reporting obligations laid down by the European

Legislation and regulation are once again frustrating financial institutions of all flavours as they strive to stay compliant, says Rupert Booth

Are you keeping regular?Are you keeping regular?

AnOverview

6

be less onerous if supported by the application of clever technology.

A legislative project manager might imagine setting up his undertaking in an application that can forge a process to achieve compliance with all imposed regulation. In an ideal world, the necessary documentation would be stored in the system, administered and interpreted expert-ly as it is threaded through the system online and circulated from the database via email to the subject matter expert for completion and author-isation, internally and externally. All the issues would be raised and tracked as it went, alerts dispatched and the agents prompted for input.

When the gaps appeared, they would be flagged up, and if an account needed opening or an agent appointed, this could be done with the same tool, automatically, transparently and efficiently. Sound too good to be true?

Not in this case—compliance projects can be performed as just described, with all the above as standard. If the institution gets the right stake-holders together with the right paperwork for the relevant piece of legislation, timely compliance is the likely outcome, with a side-order of greater network visibility into the bargain, not to mention a fully-integrated and cohesive management platform on top. Its presence means that the es-tablished compliance procedure can persist in readiness for the next impenetrable piece of leg-islation, and the next, for the following 10 years and beyond.

The knowledge needed to execute the project will not therefore walk off with the departure of the executive; it is there to stay, embedded in the system. Obviously this won’t head off legal tan-gles or stop the regulatory bodies dragging their heels over the publication of vital documents for completion and submission by the effected at the very last minute. At least, however, the project will be set up and prepared for initiation within the system. Most critically, the institution has the correct framework in place, documentation de-monstrably in order, a clean and relevant nostro database and a network, one which fulfils all the legislative and regulatory requirements for each market, ready for the future.

The world of continual turmoil in which risk man-agers, network managers and legal executives operate will prevail. They must be equipped to ac-commodate constant change, the priority to build a persistent compliance engine placed front and centre, fully prepared to head-off regulatory risk as it arises.

The technology to achieve the execution of gov-ernance projects in the same space as the man-agement of all external relationships is a vital technology. To mitigate current operational and commercial risk and to position your bank for com-pliance with financial legislation at the same time, with the same tool, is smart thinking.

For the preservation of your firm’s reputation, and most vitally, to provide security for you clients’ as-sets, it’s a smart investment. AST

Market Infrastructure Regulation (EMIR), which be-came law in 2013.

Even the relatively ancient Markets in Financial Instruments Directive (MiFID), of 2004 vintage, is still presenting problems for some, and its short-comings are being addressed by MiFID II, rumbling through Brussels as you read.

Settlements, legal and risk departments are nego-tiating an increasingly populous minefield: central clearing for certain classes of OTC derivatives, complex reporting to trade repositories, conduct of business and prudential requirements for cen-tral counterparties, and duties to make certain data available to the public and relevant authorities, in-cluding remuneration. The list goes on to include capital requirements, revamped tax reporting re-quirements, leverage ratios and liquidity require-ments, post-trade transparency, appointment of custodians for certain funds and legal entity iden-tification. These are just a few of the choices from a veritable smorgasbord of corporate obligations. How much of a risk is this? Put simply, if you aren’t compliant, your clients’ assets might not be safe, your company’s name will be on the line and your reputation will be peril—so the risk is a huge one.

It’s worrying, then, that for those tasked with the containment of such exposure, the systems and processes with which they are equipped are woe-fully unequal to the task.

Much has been written recently about risk man-agement being a much wider responsibility within a financial institution than just that of the risk manage-ment department. This has never been truer than at present as, for instance, network managers face the world of institutional risk head-on. They must know where all the institution’s accounts lie across the provider network and what cash or assets reside in each; essentially, that the nostro database is clean, current and accurate.

Have the right accounts been opened at the right agents for the right reasons? Indeed, have we got the right agent—do we need others? To get all this right is a daunting prospect, but it is all part and parcel of ensuring that the reporting and asset security aspects of our army of regulations is formally observed. It might involve serious re-organisation from the ground up, and at the very least a bit of re-shuffling would be needed to keep the house in order. Those responsible for running with this have it tough, but it’s a job that might

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AnOverview AnOverview

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“ The world of continual turmoil in which risk managers, network managers and legal executives operate will prevail

”

September 2009: In Pittsburgh, G 20 leaders ask the Financial Stability Board to force all standardised OTC derivative contracts to be traded on exchanges or trading platforms and cleared through central counterparties by the end of 2012

August 2012: The European Markets Infrastructure Regulation (EMIR) comes into full force

March to September 2013: Time to implement technical standards

November 2013: First repositories are registered

February 2014: Just 90 days later, the requirement arrives to report trades into a trade repository begins for all European derivatives users, fi-nancial institutions and corporates alike. Each transaction needs a unique trade identifier (UTI), and all trades dating back to 16 August 2012 meeting the reporting criteria had to be reported to an approved repository

February 2014: Reports start to come through of companies not ready to comply, overwhelmed repositories, and arguments between buy and sell sides as to who generates the UTIs

EUROPEAN MARKETS INFRASTRUCTURE REGULATION

EMIR: key events

are that mandatory clearing will extend to non-de-liverable forwards (NDFs) and beyond. The US Department of the Treasury has, however, ex-empted FX swaps and forwards from the manda-tory clearing obligation.

In Europe, the process leading to commencement of the mandatory clearing regime has begun, with the authorisation of the first central counterparty. Nasdaq OMX CCP was authorised in March 2014 and that event triggers a period of consultation that will likely lead to the commencement of mandatory clearing. It is not certain how long this process will take, but market expectation is that the clearing re-gime will begin no sooner than Q4 2014. The scope of the EMIR clearing regime is likely to track the scope of the Dodd-Frank regime to a large extent.

Risk mitigation

While Europe has fallen behind in terms of man-datory clearing, the European Securities and Markets Authority (ESMA) has, nevertheless, taken a far more rigorous approach to risk mit-igation. In a marked contrast to the conventions adopted elsewhere, EMIR imposes risk mitiga-tion obligations on all parties to a derivatives contract. Over recent months these have gradu-ally been implemented to establish a more rigor-ous and controlled environment.

Since March 2013, ESMA has imposed the obli-gation on all counterparties trading derivatives to ensure timely confirmation of the terms of the rele-vant contracts, using electronic means where pos-sible. The permitted timeframe will be shortened progressively through 2014. In the OTC deriva-tives space the use of utilities such as MarkitWire and DSMatch will help to achieve this objective for the more standard products. For exotic swaps and for Forward FX, it is commonplace for coun-terparties to trades to exchange direct communi-cation in order to achieve trade confirmation. This creates the potential conflict of which party will be responsible for the generation of the unique trade identifier (UTI) that is necessary for subsequent transaction reporting. Also mandated since March 2013 is the requirement for all parties to value de-rivatives contracts mark-to-market, or where mar-ket conditions prevent that, mark-to-model on a daily basis.

In September 2013, the OTC derivative portfolio reconciliation and dispute resolution obligations came into effect. Parties holding portfolios of de-rivatives must agree between them a process for reconciling the key economic terms including each party’s valuation of the contracts in ques-tion. EMIR imposes this obligation on both parties to a trade, although the activity may be delegated to a third-party service provider. The frequency of reconciliation is dictated by the size of the portfo-lio and by the trading status of the counterparties (financial counterparty/non-financial counterparty/non-financial counterparty exceeding the clearing threshold). Delegation of the reconciliation activity by one counterparty to the other is permitted under the regulation. Where the buy side is able to rec-oncile, sell-side brokers will generally delegate this activity to their buy-side counterparty.

Reporting requirements

In the US, transaction reporting requirements under Dodd-Frank are single-sided and are generally the responsibility of the sell-side swap dealer. In the future, this responsibility is ex-pected to be adopted by swaps execution fa-cilities (SEFs) and derivatives clearing organi-sations (DCOs). In comparison, EMIR requires both parties to a derivative trade to report the transaction details, as of 12 February 2014, to approved trade repositories. Designed to pro-vide transparency and to monitor systemic risk, the data required includes such information as whether a trade is a hedge or speculative, domicile information of the trading firm, maturity dates and transaction references.

Using a UTI, trade repositories will be able to pair and reconcile counterparty trade details. Under EMIR, both parties to a derivatives trade have an obligation to provide data to these repositories, although they may delegate this action to their counterparties or another third party.

The details must be reported no later than the work-ing day following the conclusion, modification or termination of the contract. Recently, the UTI has gained media attention as a result of perceived discrepancies between trade body proposals and ESMA guidance around the way UTIs should be generated and the format they may take.

In the aftermath of the 2008 financial crisis, con-cerns were raised over the role which OTC deriv-atives played in events leading up to the crisis. The following year, at the G20 leaders’ summit, this topic was high on the agenda and an accord was announced articulating reforms in the largely unregulated over-the-counter (OTC) derivatives market. Since that time, regulators have been leading a coordinated effort seeking to achieve the aims of the G20 leaders’ accord and we have seen the enactment of legislation in all regions.

Clearing requirements

In the US, under the auspices of the Dodd-Frank Act, mandatory central clearing of derivatives has been underway for more than a year and was adopted using a phased approach at three-month intervals. Swap dealers and major swap partici-pants were first to be subject to the clearing ob-ligation, followed by second- and third-tier users. Initially focused on interest rate swaps and credit default swaps in the more liquid indices, indications

Philip Popple discusses the requirements and challenges inherent in EMIR, while also looking across the pond to the US

The journey to derivatives reformThe journey to derivatives reform

13

EMIRLCR EMIR

12

In many scenarios, there is no single source of all the data required for complete reporting. As such, data must be compiled from disparate sources, cre-ating a substantial challenge for market participants. In scope are all derivative types, exchange-traded, OTC and FX Forwards.

In addition to the reporting of new derivatives transactions, EMIR requires counterparties to re-port certain historical trades. If a transaction was outstanding on 16 August 2012, or was entered into between that date and 12 February 2014, it will have to be reported. However, there are differ-ent due dates depending on when the transactions were executed and whether they expired before 12 February 2014.

Following this, in August 2014, for parties to deriv-atives contracts will be the requirement to report derivative portfolio valuations and collateral associ-ated with these portfolios.

Lastly, the commencement of the reporting re-gime has prompted ESMA to write to the Euro-pean Commission in a bid to resolve differences between EU member states concerning the defi-nition of the term ‘derivative’. These differences date back to the implementation of the Markets in Financial Instruments Directive (MiFID), but the introduction of a common reporting regime has heightened the need for consensus. The contro-versy relates mostly to the dividing line between spot and forward transactions. The commission has called for empirical data from national regula-tors to help determine a unified approach. Collateral and margin

The margining model employed for futures and other exchange traded derivatives will be replicated in central clearing of OTC derivatives. Clearing bro-kers with membership at the agreed central coun-terparty will pass the initial margin requirement and daily variation margin (profit/loss) amount between end customers and the CCP.

Similar collateral exchange or margining require-ments are anticipated for those illiquid or non-stand-ard OTC derivatives that remain un-cleared. The relevant technical standards are yet to be published, but the expectation is that European and other reg-

ulators will adopt the framework proposed by the Basel Committee on Banking Supervision.

The journey to OTC derivatives reform continues to be a difficult one. In Europe, significant changes and the rules relating to these changes are still awaited. In the meantime regulators and the industry at large continue to struggle with the requirements already in place. AST

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EMIR

“ EMIR requires counterparties to report certain historical trades. If a transaction was outstanding on 16 August 2012, or was entered into between that date and 12 February 2014, it will have to be reported

”

tion to perform daily valuations. For FCs, this was not a big burden or huge change to the operation-al processes that already existed. OTC confirms have always been exchanged between trading counterparties. The main change relates to the timing in which this now has to occur, whereas before EMIR there was no time stipulation unless agreed contractually.

From now until September 2014, the period is T+2 for credit derivatives, interest rate and some FX. For most other OTC it is T+3, but this will be reduced to T+1 and T+2 respectively from 15 September 2014.

In order to meet this time frame, a process known as negative affirmation has been widely adopted across the industry whereby the obligation is placed on the counterparty to raise any objections to the de-tails in the confirmations. If they do not do so, within the given time frames, the terms of the confirmation are deemed to have been accepted. To assist with this change in market practice, the International Swaps and Derivatives Association (ISDA) issued an amendment agreement that can be agreed bilat-erally or the terms can be incorporated into the ISDA schedule or master confirm.

With regards to daily valuations, counterparties need to review internal processes to ensure they are compliant, but this is not a huge burden for FCs as this is largely undertaken already as part of good risk management.

Next, the provisions relating to portfolio compression, portfolio reconciliation and dispute resolution came into effect on 15 September 2013. There were two ways these requirements can be adopted: either through adherence to the 2013 EMIR portfolio reconciliation, dispute resolution and disclosure protocol, or bilaterally. Again, these requirements are not hugely burdensome to regulated entities for the reasons already explained.

The last of the risk mitigation techniques relates to the timely, accurate and segregation of initial margin for non-cleared OTC derivatives. However, these requirements have been significantly delayed and are unlikely to be effective until 2015 at the earliest and some predictions are as late as 2019. While funds are very familiar with this

process, corporates, professional firms and pen-sions plans are not and this will be a significant change for these entities.

Transaction reporting

On the 12 February 2014, the transaction reporting rules for all OTC and exchange-traded derivatives (ETD) came into effect. This requirement applies to all FCs and NFCs. The details of any OTC derivative trades (including subsequent modifi-cations and terminations) must now be reported without duplication, to a trade repository. But, there is a further obligation to back load some historic trades entered into after 12 August 2012 but closed out before 12 February 2014. Counterparties have three years until 2017 to do this, but one has to question why this is even necessary as it is burdensome to the industry without any real justification.

To avoid duplication, most dealers have undertaken to make the trade reports on behalf of their coun-terparties and these arrangements are governed by bespoke EMIR delegation agreements. There are a few tensions in the agreements surrounding liability but it is understandable given most dealers are pro-viding the service for free.

An issue currently facing the industry is that all EU counterparties entering into derivative trades must now have a pre-legal entity identifier and there are now also unique trade identifiers for derivatives. The issuance of these identifiers is currently underway but it is incomplete, so the repositories are unable to match a lot of trades simply because the identifiers are missing. This should be resolved over time but right now it is causing great deal of problems.

The European Securities and Markets Authority (ESMA) asked the European Commission for a delay in implementing these rules because the in-dustry was not ready, but the commission refused. The question I would like the regulators to answer is what exactly will they all do with all of this data? This was an issue that the Financial Stability Board (FSB) raised in a paper it published on 4 February 2014—just eight days before the go live date. The FSB wants to ensure that regulators are able to reduce systemic risk by using the reported

The European Markets Infrastructure Regulation (EMIR) implements, within Europe, the manda-tory clearing of certain OTC derivative contracts through central counterparties (CCPs); and a requirement for non-cleared OTC derivative con-tracts to be subject to more stringent risk mitiga-tion requirements including the requirement to transaction report all OTC derivative contracts to a trade repositories.

Although EMIR came into force on 16 August 2012, its provisions have been taking effect throughout 2013 and 2014 and are ongoing. This article looks at these provisions and how they affect the buy side.

Who is affected?

The scope of EMIR is much wider than just the regu-lated community, known as financial counterparties (FCs include EU broker-dealers, banks, pension funds, UCITS funds, alternative investment funds whose manager is authorised under the Alternative Investment Fund Managers Directive (AIFMD)),

and applies to all OTC derivatives users known as non financial counterparties (broadly, NFCs are en-tities established within the EU that are not financial counterparties and these are divided into NFC+ or NFC for clearing purposes).

So the burden of these regulations falls on corpo-rates and professional firms too, and the new rules could be a burden for these entities, as regulations will bite for the first time. FCs are already subject to regulation and most of the risk mitigation and transaction reporting requirements already exist in some guise or another. It is not a substantive regu-latory change but more about changing processes or re-papering contracts. The biggest change for everyone is going to be the need to centrally clear certain OTC transactions and the changes in how margin is calculated for cleared trades.

Risk mitigation requirements

The first of the risk mitigation rules came into force on 15 March 2013. The obligation for timely con-firmations became effective, along with the obliga-

Is EMIR a benefit to the market, or will it increase costs, asks Kate WormaldDetract from businessDetract from business

17

EMIRLCR EMIR

16

data effectively. But doesn’t this beg the question why was this has not already agreed? No doubt, further changes will be needed.

What next?

Certain OTC derivatives will need to be cleared once ESMA decides exactly which contracts will be subject to the rules. In general, these will in-clude credit default swaps, some FX and interest rate products. The clearing obligation will com-mence in stages, but the first CCP in Europe—Nasdaq OMX—is now authorised. Consequently, ESMA works quickly and when its draft is en-dorsed, it is possible that the clearing obligation will begin sometime in late 2014.

The purpose of mandatory clearing was meant to reduce counterparty risk exposure by counterparties

facing the CCP and not a dealer, but there are issues as far as we are concerned with this model, which effectively mirrors that of a clearinghouse for an exchange. It seems everyone has forgot-ten about the financial crisis bought about by Barings collapse.

Most OTC users will use indirect clearing because they are not big enough to be a member of the CCP. Effectively, there is no change to the counter-party risk exposure, per se, it only changes where the margin is held. Some would say this is an im-provement but only if all of the margin, including the independent amounts (initial margin), are also held with the CCP. If not, the excess margin will still be with the dealer and unprotected in the event of the dealer’s bankruptcy. This exposure might also

be increased if netting between the OTC cleared and non-cleared products is unavailable, which is the intention in order to keep the CCP whole in the event of a member’s bankruptcy.

Furthermore, the documentation is user-unfriendly, especially in relation to the margining provisions, which are significantly different to those familiar with ISDA’s credit support annex. Before, margin haircuts and rates were pre-agreed and margin calls made once a day. For cleared OTC deriva-tives, margin calls could be intra day, or even sev-eral times a day for same day delivery. There are also no controls over how much margin the dealers can request, as the regulations do not require this to be matched to what the CCP seeks from them, so unless strict terms are pre-negotiated into the agreements, there is nothing to control how much they can request. Consequently, with these various

issues the documents take a lot of time to negotiate and counterparties really need to get focused and start to put these arrangements in place.

The changes to the margining provisions will also mean the cost of funding will inevitably rise and be passed on to the buy side, and as most indirect clearing arrangements use omnibus accounts, in the event of a shortfall in the account there is pro rata sharing of losses among the counterparties.

Is this a benefit to the market? Will it really help with future financial crises or will it simply in-crease of the cost of doing business and create new financial entities that themselves will pose systemic risk because they will become too big to fail? We suppose only time will tell. AST

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EMIR

“ The purpose of mandatoryclearing was meant to reduce counterparty risk exposure by counterparties facing the CCP and not a dealer, but there are issues as far as we are concerned with this model, which effectively mirrors that of a clearinghouse for an exchange

”

KDPW Group, including the Polish central securities depository (CSD) KDPW and clear-inghouse KDPW_CCP, is the most important infrastructure institution on the Polish capital market, and is working on new services in response to the newest EU regulations in cen-tral and eastern Europe. The group is the only player in the region to offer OTC clearing, trade repository services, and LEI assigning.

The group offers a competitive, integrated and complementary package of depository, clearing, settlement and added-value services.

Thanks to synergies between KDPW and KDPW_CCP, the KDPW group can provide its clients with the highest international standard services. KDPW plays the role of the CSD in Poland.

Additionally, KDPW offers also trade reposito-ry services (KDPW_TR) regarding to European Market Infrastructure Regulation (EMIR) require-ments. DPW_TR was one of the first four such institutions to be registered in Europe, and the only one in Central and Eastern Europe. KDPW has been also awarded the pre-LOU status in the LEI assignment system.

Trade repository services

EMIR requires companies to comply with the obligation of reporting details of derivative con-tracts concluded both on the regulated mar-ket and in OTC trade to special entities: trade repositories. The obligation start date was 12 February 2014.

Trades can only be reported to institutions with fulfill the requirements laid down in EMIR, as confirmed by registration of the trade repository with ESMA.

The European Securities Market Authority (ESMA) has registered the KDPW trade repos-itory, confirming that it fulfills all trade reposi-

tory requirements under EMIR. KDPW_TR was one of the first four such institutions to be reg-istered in Europe and the only one in Central and Eastern Europe.

KDPW has been the first player in the region to open a trade repository, and did so on 2 Novem-ber 2012. It has also been the first player in Cen-tral and Eastern Europe to apply to ESMA for the registration of KDPW_TR in May 2013.

The registration of KDPW_TR by ESMA allows it to operate across the EU. The registration application covered the reporting of all types of contracts under the reporting obligation (com-modities, credit, foreign exchange, equity, inter-est rates and others—irrespective of whether the contracts are traded on or off exchange); consequently, financial institutions will not have to use the services of two or more repositories.

Parties required to report contracts may report them directly to the trade repository in KDPW, for which they must be KDPW_TR participants (ordinary reporting participant or general report-ing participant), or fulfill the obligation through another reporting participant of KDPW_TR. Ac-cording to EU regulations, the reporting obliga-tion may be delegated to a central counterparty: on the Polish market, to KDPW_CCP.

KDPW_CCP does not charge any fees for in-termediary services; consequently, reporting of derivatives contracts by KDPW_CCP on behalf of a clearing member or its clients does not in-volve any additional costs to clearing members other than fees charged by KDPW (for reporting a trade to the repository and for maintaining con-tract details in the repository).

KDPW_CCP reports derivatives contracts exe-cuted or cleared by KDPW_CCP. KDPW_CCP only reports to the trade repository operated by KDPW, which means that it not report derivatives contracts to any other repository. AST

KDPW CEO Iwona Sroka outlines how the Polish CSD is improving its services in response to EMIR

A spring clean A spring clean

Unlocking the potential.Securities Services

Liquidity, dark pools, collateral pools … the options are seemingly endless. But before you drown in a sea of choices, it may be worth talking to the people who have an interest in keeping you afloat. As one of Europe’s few truly international post-trade service providers, SIX Securities Services has learned to adapt to changing landscapes, chart new and innovative courses and deliver to the highest standards of quality. The result is satisfied customers, who enjoy having experience and expertise at their side. Solutions for the future. Now.

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0214001_SIX_adv_diver_4c_148x210.indd 1 06.05.14 16:42

EMIR

20

TARGET2-SECURITIES

T2S: key events 2006: Project is initiated

July 2008: After two years of consultations with the market, the European Central Bank’s (ECB) Governing Council commits to build the platform

July 2008: Operation of T2S (coordinated by the ECB) is assigned to four central banks of the eurosystem: France, Germany, Italy and Spain

2009: A memorandum of understanding is signed between the eurosystem and 28 European central securities depositories (CSDs)

June 2012: Euroclear’s eurozone trio (CSDs Euroclear Belgium, Euroclear France and Euroclear Nederland) sign up to T2S

2013: A plethora of firms connect to T2S via SWIFT, including Interbolsa, BNP Paribas Securities Services, the Slovenian CSD, Clearstream, and Societe Generale Securities Services

December 2013: Half of respondents to a survey on T2S say that the cost of compliance is what concerns them most about the settlement engine

May 2014: Marks the beginning of the ‘User Testing Phase’

2015: T2S is scheduled to go live

LCR

At the end of last year, SIX Securities Services conducted a survey that provided some unsettling results. Around half of all respondents to ques-tions on TARGET2-Securities (T2S) said that the cost of compliance was what concerned them most about the settlement engine.

But it was not just the cost of evolving the European settlement landscape that worried respondents, who came from 14 major financial institutions. Forty one percent of them considered the challenge of over-hauling IT systems to be their biggest worry.

One respondent said that the cost of unbundled asset servicing was what troubled them the most. Another said: “My major worry is that custodians are still ref-erencing T2S as if it is a standalone consideration for clients. This is simply not the case for clients seeking a full service model. T2S, or settlement standardisa-tion, is just one of many developments impacting the market in the 2015-2017 timeframe.”

Robert Almanas, head of international services at SIX Securities Services, said at the time: “Make no mistake—financial institutions should not ap-proach T2S as a mere compliance project. T2S needs to be considered as part of the whole wave of regulatory changes affecting the financial mar-kets over the coming years. For example, T2S is an opportunity for financial institutions to optimise capabilities such as collateral management and cash management which are becoming much more important under other pieces of regulation.”

There is now a certainty that T2S will happen, despite a number of crucial open areas, and the implementation plan has been defined.

The firm has opted for a direct connection to T2S—from Switzerland through SIX SIS Ltd (the central securities depository for Switzerland).

Last year, it formed a partnership with Keler, Hungary’s post-trade infrastructure, to provide international settlement and custody services.

Keler, which is owned by Hungary’s central bank and the stock exchange of Budapest, serves as the sole CSD for Hungary.

The partnership with SIX Securities Services ena-bled Keler to optimise its international settlement capabilities. The transfer of Keler’s portfolio to SIX Securities Services was completed at the beginning of November.

Thomas Zeeb, CEO of SIX Securities, said that with T2S on the horizon, bringing with it significant implications for CSDs across Europe, it was an important step in establishing SIX as one of the three main providers of cross-border services at an infrastructure level in Europe.

György Dudas, CEO of Keler, added that the key objective of this move was to enhance cross-bor-der settlement efficiencies and asset servicing ca-pabilities on a truly global scale, allowing the firm to succeed in what has become an increasingly competitive post-trade environment.

Though cost is widely viewed as a downside, Avi Ghosh, head of marketing and communications at SIX Securities Services, said that that the firm’s investment in preparing for T2S can be turned into a competitive advantage.

“We think that we will have a competitive advan-tage on par with our key rivals in Europe because we will not be passing on the project management and development costs to our clients,” he says, adding that longer term-benefits of the initiative such as CSD consolidation were also attractive.

Ultimately, Ghosh pointed to opportunities for con-solidation in domestic markets with further “inter-nationalisation”. He explains that clients stand to benefit from both lower pricing for cross-border transactions and a single access point for multiple markets. In his view, these are valid reasons to get on board and plan for greater business development off the back of the rapidly approaching initiative. AST

Though cost and the prospect of IT overhauls are still a concern for the industry, SIX Securities Services asserts that there are great gains to be made from T2S—if you’re looking in the right place

A bounteous harvestA bounteous harvest

www.kdpw.eu

We are the LEI Numbering Agency (pre-LOU)We Offer Also Trade Repository Service KDPW_TR

24

T2SInsight

T2S is giving unprecedented opportunities for firms to expand the range and quality of their services. A panel of insiders share their trade secrets

T2S success

How are you changing your business models as a result of T2S?

Graham Ray: Our business model centres on provid-ing options, giving clients the choice of how they want to connect and what services they want to use.

From a practical perspective, we’re creating a set-tlement hub in Frankfurt. So, via Deutsche Bank AG, we’re creating a single central access point to TAR-GET2-Securities (T2S).

There’s one contractual relationship, one technical infrastructure, one settlement hub. But our clients will still be serviced by local staff in each market and they can decide on the functionalities that serve them best.

Each location supports the Deutsche Bank AG Frankfurt account with the local central securities depository (CSD) and the client can choose, for example, to maintain relationships with local CSDs and conclude an SLA for their account operations or to benefit from the single market access that Deutsche Bank provides.

And as we interface with all CSDs and to T2S directly, we can choose the most efficient set-up for messaging and reporting to clients.

This local presence is extremely important because services like asset servicing, proxy voting, and tax continue to be specific to local markets, even in a post-T2S world.

Ultimately, the account structure and service levels you choose will determine which new T2S functions are available to you. We’re decoupling all these ser-vices so settlement, for example, is separate to asset servicing.

Tom Casteleyn: The implementation of T2S will be a major market-changing event.

We see T2S as giving us unprecedented opportuni-ties to expand the range and quality of our services, both as a custodian and as a CSD; we fully intend to use those opportunities.

As a custodian, we shall be directly connected to the T2S platform; we shall build and use direct links to

multiple CSDs on T2S; and we shall be a payment bank. This will allow us to enhance our settlement, custody, and collateral management services. We see these developments as benefiting the full range of our clients, but we see especial benefits for sell-side and intermediary clients.

As a CSD on T2S, we shall use T2S as our settlement system. In other words, we shall be a core European market infrastructure.

This will allow us to offer for all securities on T2S an optimum set of settlement, custody and collat-eral management services to those clients who wish to access, and to contract with, market infra-structure directly.

In short: in a T2S world, we shall have a one-stop, comprehensive and modular service offering.

György Dudás: It has been an industry-wide view for some time that the business model of single market providers will have challenges, clients will look for regional and global solutions and regu-latory changes and competition will put great pressure on margins of all players. T2S is clearly another factor that promotes free choice and en-courages competition, especially among CSDs. T2S will create opportunities for those adopting the changes and developing client driven solu-tions swiftly. Keler is one of those CSDs that ap-proaches T2S proactively and invests to become competitive in the new era.

We are looking to move out of our original sphere of operation, or if you like, our comfort zone, and offer new solutions, cover new markets and expand our client base. As T2S takes off European settle-ment will expectedly become a commodity service and everyone will look to have scale, increase the income base and bring down the operational costs. Keler’s conscious decision to join T2S was followed by a decision to launch a strategic mod-ernisation programme.

Within this programme we are replacing our main systems, reengineering our business processes and introducing a number of new solutions to our clients before the T2S go-live. In accordance with our busi-ness strategy, our efforts will shape Keler to be more client-focused than ever before. G

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26 27

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How will IT systems (upgrades and complete renewals) play a part in this?

Dudás: IT systems will define winners and losers in the post-T2S world, as T2S brings efficiency and low costs to the settlement world and those will have an advantage who can pass these bene-fits on to the clients. Successful players will have an effective and highly automated IT infrastructure supporting a business strategy that is open for the changes and challenges.

We at Keler are in the process of replacing our current CSD platform with Tata Consultancy Ser-vices’s BaNCS system. The project will provide us with efficiency gains and our clients will benefit from implementing international best practices that are consistent with the regulatory initiatives. It is a sub-stantial investment into our future operating model, which shows our commitment to client focus and continuous innovation.

Ray: Of course they play an important part, because the system needs to capture the data in a central location. Distribution channels—whether you’re talking about cash or stock—need that central point. The IT systems are what enable us to connect to T2S and remain flexible enough to deliver all the relevant services involved in the post-trade process.

That flexibility is delivered by creating systems with independent components. So, we’re building all of our connectivity to T2S into a platform that is sep-arate from the custody books and records. That gives us the ability to be extremely nimble because you only have to build each component once and then reuse it where appropriate.

We use our Autobahn App Market to deliver all of these services. It provides one internet-based front end for all Deutsche Bank services across all busi-ness units—including market information, news-flashes and client service systems.

Because our services are modular, the client can choose full or partial service with regard to mes-saging, settlement, or asset servicing only. The functionalities we then deliver in terms of instruction processing and reporting will be adapted to their requirements: for example, we can tailor channels,

real-time reporting and the harmonisation and cus-tomisation of datas.

Casteleyn: T2S is a major IT infrastructure project. All entities that will communicate directly with T2S, such as CSDs, directly connected CSD partici-pants, national central banks, and payment banks, will inevitably have to effect major IT changes, even if only to be able to communicate with T2S using T2S messaging formats (such as ISO 20022).

There will also be a knock-on impact on entities that use intermediaries to communicate with T2S. What T2S means is that each CSD that has signed the T2S Framework Agreement, and that has our-sourced its core processing to T2S, has adopted a new, and very different, settlement system.

This means that compared to the current situa-tion there will be changes in the contents and for-matting of securities settlement instructions, and in the matching and settlement process. These changes will have an impact all the way down the custody chain.

In what ways do you think the system will affect CSDs?

Ray: The impact on CSDs is going to be very sig-nificant because of the outsourcing of settlement activities. They are clearly going to have to make changes in order to adapt to T2S. Something that was proprietary is now going to be outsourced. There’s a technology impact but, more than that, CSDs will have to revisit their own business model.

T2S also challenges CSDs in terms of their relation-ships with other CSDs. How do they link up? What activities do they collaborate on?

I think each CSD affected by T2S will have to figure out how they’ll differentiate themselves. Some, for example, will be able to boast volume and scale or reach across the region; others will focus on their collateral tools.

One interesting element will be how they bring non-central bank money into central bank ac-tivities. Take the bond market as an example. Especially at ICSD level, there is an opportunity

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28

PanelDiscussion

to bring the benefits of central bank money into that space.

Dudás: The implementation of T2S and the harmonisation of regulations and market prac-tices bring a level playing field to all CSDs and give the freedom of choice to clients without geographical barriers.

When T2S will be operational in its entire geogra-phy, settlement will not be the differentiating factor anymore, but all those services that one can build around it, let that be asset servicing, reporting, li-quidity, or collateral management solutions.

As a result, CSDs will find themselves competing even on their home markets and unprecedented stress will appear on their revenues, expenses and efficiency. An escape from the threat of losing business and scaling down can be developing com-petitive offerings, becoming more flexible towards clients and their needs and even moving up the value chain and offering solutions similar to those of the agent banks.

We at Keler have been preparing for these chang-es for years now, and we undoubtedly see an op-portunity to capture market share by investing into our competitiveness.

This means a complete paradigm shift for a mo-nopolistic organisation, however, we have the advantage of having a history with adventuring in competitive markets, including servicing inter-national financial institution clients and providing cross border solutions.

Casteleyn: As mentioned previously, T2S will have a major IT impact on CSDs.

An even more important impact will be the business impact on CSDs. What T2S will do is to create settlement interoperability between CSDs.

This will move the provision of CSD services from a largely non-competitive situation to a much more competitive situation, in particular for settlement services.

On the T2S platform, settlement services provided by CSDs will very largely be homogeneous.

The differentiator between CSDs (ie, the reason why a CSD participant will choose to use the services of one CSD rather than another) will be the provision of issuer, custody, and collateral management services.

Even if T2S introduces competition directly only in settlement services, there will be a snow-ball effect. No CSD participant will want to use, and to contract with, all 24 CSDs on T2S. CSD partic-ipants will have an interest in trying to minimise the number of CSDs they use on T2S. This will mean that CSDs will have an incentive to provide a pan-European service offering that covers all securities on T2S; this will also mean that there is the prospect that over time the number of CSDs using the T2S platform will decline.

Do you anticipate declining revenues for sub-custodians?

Casteleyn: The competitive forces that affect CSDs will also have an impact on subcustodians, as the core service of a subcustodian is to provide an access route to a CSD.

We believe that in a T2S context the current business model of a single market subcustodian is endangered.

As with CSDs, subcustodians will be under pressure to provide a pan-European, or at least multi-market, service offering; there will also be considerable de-mand for them to be able to provide modular, and stand-alone, portfolio services.

Competitive pressures will probably mean that mod-ular and stand-alone portfolio services will need to be provided on a pan-European, or at least a multi-market, basis.

Dudás: It is difficult to predict how the revenues of the market players will look like post-T2S, but it is likely that sub-custodians will see increasing com-petition by their peers and some CSDs/ICSDs en-tering the space.

Their competence in asset servicing and local cur-rency liquidity will remain inevitable for the clients, however shrinking, or disappearing settlement rev-

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PanelDiscussion

will be a tendency for settlement volumes to migrate to T2S from possibly less efficient and less secure settlement environments.

Another, possibly more significant, factor will be collateral management services. Collateral pools on T2S, and the associated collateral manage-ment services, will exert gravitational pull on pools of collateral located outside of T2S.

In the short to medium term, we do see the prospect that some investment fund activity, and some ac-tivity in EUR-denominated international bonds, will migrate to T2S.

We do, however, believe that the prospects for widening the scope of T2S are relatively limit-ed. If the issuer CSD of the security is not on T2S, and if the currency of the transaction is not a T2S-currency, then there are inevitably limitations on the efficiency of settlement, and in particular on the efficiency of cross-CSD set-tlement, on T2S.

Post- T2S, which areas do you foresee to be the focus of more harmonisation?

Casteleyn: The implementation of T2S will require major steps forward in the harmonisation of legal and regulatory environments, of market practices, and of technical processes, across CSDs in Europe.

The fourth T2S harmonisation progress report that will be published in March 2014 will give

a comprehensive overview of T2S-related harmonisation work.

It will be very clear from the report that by the time of the implementation of T2S there will be a still uncompleted harmonisation agenda.

Among the particularly important, but also particu-larly intractable, unresolved harmonisation topics will be the topics of tax, and of shareholder registra-tion and transparency.

One topic, to which so far relatively little attention has been paid, but which will increase in importance as CSDs move towards a more competitive envi-ronment, is the topic of the harmonisation, and/or consistency, of national regulatory requirements.

Dudás: T2S harmonises settlement but it leaves corporate actions, corporate governance and the related asset servicing untouched, therefore I be-lieve it will follow suit in the coming years.

There were initiatives for harmonising parts of asset services (eg, CAJWG) in recent years but given the complexity of the matter, it is presumed that it will take further years to complete.

Ray: As I said earlier, I think the industry should be really focussed on getting to T2S first. It’s a big pro-ject and there’s still a lot to do to make is successful.

Criteria around settlement day, penalty fines, corpo-rate actions—these all need harmonising. We need to make sure that all of this is done before we go ‘post-T2S’.

But it’s not just about harmonisation. We should also consider reach.

How, for example, does T2S reach out into the wider community? How should it interlink to en-able businesses to come onto the platform? I think there’s scope for T2S to be leveraged for a wider community.

In that context, the ECB is certainly looking at re-couping some of the costs involved in T2S. Is T2S really the platform to connect Europe to the rest of the world? Done right, it could well be. AST

enues, potentially appearing new servicing models and increasing compliance related expenses might put stress on their margins, or might even challenge their entire business model.

Ray: From a revenue perspective, it’s not as simple as just looking at sub-custody. Certainly, settlement is going to be commoditised. And, indeed, the true value of pure settlement is debatable.

But, as revenues from settlement decline, the val-ue of other benefits—such as liquidity and intra-day credit—that sub-custodians have provided as a matter of course comes to the fore.

In the future, we’re likely to see those servic-es unbundled and charged for separately. That kind of transparency has to be a good thing for the client.

Clearstream is allowing investors to settle in one cash account all eu-robonds and other securities that are issued by markets excluded from T2S. What do you think the ramifications are for widening T2S’s scope?

Ray: This has to be looked at in the right context. T2S certainly has the potential for wider scope and this is linked to the CSD regulation.

As each step of the process—harmonising settle-ment cycles and regimes, dealing with the issu-ance restrictions that exist today, for example—the scope of T2S becomes wider.

I think it will depend on the community how they want to leverage these developments. Do issuers want to limit themselves to their home markets? What is the tangible liquidity value of introducing eurobonds onto the platform?

In the meantime, we should be focused on deliv-ering Phase 1 of T2S over the four agreed waves. Once that’s done, we can look at widening the scope—in terms of currencies and reach.

Ultimately, people will seek out the most secure place to perform their activity, some impacted par-ties may only be acting defensively at the moment.

Dudás: CSDs/ICSDs, having the geographical cov-erage, will compete in comforting clients by offering T2S’s settlement efficiency and building their own solutions around it.

Competition will in result efficient solutions and expand what T2S can offer.

Liquidity of securities outside the eurozone is dominantly in local currency, which requires local currency settlement. While a potential rami-fication of T2S to these regions might happen for securities, we expect that cash settlement and liquidity provision in local currency will remain key importance on the short term.

However, it is likely to stay a hot topic how provid-ers can offer a standardised service outside the T2S geography.

Since Keler’s home region—Central Eastern Eu-rope—is a segmented market and is mostly out-side the T2S geography and the eurozone, we taim to develop solutions that offer standard ac-cess across the markets and efficient handling of the local specialties.

Furthermore, we believe that an efficient T2S ac-cess will be demanded by market participants in this region, as not many local CSDs will eventually offer that.

Casteleyn: We believe that T2S will function as a highly efficient, effective and secure settlement system. This means that there

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ALTERNATIVE INVESTMENT FUND MANAGERS DIRECTIVE

AIFMD: key events December 2008: European Commission admits it is uneasy about hedge fund and private equity activity

May 2010: The EU Council and the European Parliament’s ECON committee adopt conflicting versions of the Alternative Investment Funds Managers Directive (AIFMD)

July 2010: AIFMD is published in the Official Journal of the EU, to be transposed into national law by 22 July 2013.

July 2013: Reports come in that uneven progress is being made in implementing the directive across the EU. Only a dozen or so countries have fully transposed AIFMD into their national laws

LCR

and managers who choose to apply later in the transition period have better access to best prac-tice. Additionally, regulators, consultants, lawyers, service providers and industry associations are still developing best practice. A late application and use of industry best practice can therefore reduce both compliance cost and compliance risk. This should, however, be put in contrast with the challenges to comply as the time available is getting shorter and there is more and more demand on the same con-sultants, lawyers and service providers from an increasing number of managers. A legal contract takes a certain time to negotiate. An IT project often takes longer than planned. A compliance effort con-ducted in emergency mode does not allow for stra-tegic considerations, such as a review of the number and function of group management companies, fund platform consolidations, re-domiciliations, or conver-sions from or to UCITS.

And the list of compliance tasks is long. There may be a tendency to focus on operating conditions and organisational requirements. Compliance with re-muneration provisions has, for example, gathered many headlines. But even this is only one of the internal compliance tasks that managers typical-ly have to consider. Complying with the risk man-agement, valuation and liquidity management pro-visions will be potentially challenging—especially when compliance is done in the spirit of the directive rather than merely to the letter of the law.

An internal focus may reduce the resources avail-able on the delegated tasks. The depository needs significantly more information under AIFMD to discharge its duties. The scale of this information

requirement should not be underestimated. It is the manager’s obligation to ensure the depository receives the required information in a timely man-ner from the manager itself as well as its delegates. The contract with the depository is possibly also the largest ‘AIFMD legal building site’. A compression, at an industry level, of legal negotiations to the last months and weeks is not in anybody’s interest.

The regulatory report is another external building site that many managers may focus less on now as assumptions are made, such as ‘our adminis-trator does our reporting now, this is just more of the same’. The AIFMD regulatory reporting scope is, however, beyond any fund regulatory reporting in Europe today. Many commentators ask the le-gitimate question: “what are the regulators going to do with all that information?” The US Form PF reporting experience is a practical reference for the scope and scale of the AIFMD reporting require-ment. The fund administrator simply does not have all the available information and the manager must deliver a large part of it, especially as it relates to portfolio and risk data.

On balance, we should recognise the diversity of funds and managers that need to comply with AIFMD. This means the learning curve for some is much steeper and the work required to comply more challenging. For some, AIFMD has led to a review and re-shaping of some of their funds, creating more work, if not directly AIFMD related. This also helps to explain the seeming delay in compliance. The work on AIFMD will not end on 23 July 2014, and the im-pact of this new directive will continue to play out for some time yet. AST

The transition period for the Alternative Investment Fund Managers Directive (AIFMD) is drawing to a close. The 12 months from 22 July 2013 to 22 July 2014 seemed like a reasonable transition period for managers falling into the scope of the directive. However, a study BNY Mellon conducted in Decem-ber 2013 assessed how far the fund management industry still has to go in preparing itself for compli-ance. The study measured preparedness by asking managers if they had already submitted their appli-cation for authorisation to their regulator.

Only 12 percent answered that they had. This means that a full 88 percent of managers were plan-ning to submit their authorisation, and demonstrate their compliance, in the second half of the transition period. There are number of reasons behind these statistics, such as complexity, resource challenges, work on other regulations, volume of work. If we were to run the survey again today we would not be surprised to see a substantial number of respond-ents still planning to submit their application in the remaining months. If this is the case, this would mean that the industry is pushing an ever growing pile of pending authorisation requests ahead of itself and is thereby condensing the effort required to a shorter and shorter time-frame.

Regulators are aware of this scenario. Some regulators have actively encouraged earlier sub-missions, probably with the intent to reduce the concentration of their own efforts to the very last weeks, as well as in recognition of the risk of non-compliance for the industry as a whole. Some regulators are also issuing, and continuously up-dating, Q&A documents. These papers and other

guidance documents constantly provide further detail as to how a manager should comply. And, it is also through these papers that divergences be-tween the regulatory regimes become apparent—sometimes through what is said and sometimes through what is not said. Some regulators appear more willing to give further guidance on the way the directive should be applied in practical terms. Oth-er regulators are less forthcoming. They may be waiting to see how other regulators and the indus-try address the practical issues that the directive is creating. Questions relating to the optional fields in the AIFMD regulatory report, the depository cash monitoring as well as asset segregation are but a few examples of issues where, at this point in time, there is a perceived regulatory divergence.

Managers are therefore also faced with the task of weighing up the benefits of early compliance versus the advantages of a late submission. A few managers submitted their application for authorisa-tion almost a year ago. A few were already author-ised and compliant with AIFMD on 23 July 2013. These managers have been able to lay down the basis for increased distribution and asset gather-ing, through the passport, at an early stage. Man-agers who have complied early have also reduced their compliance risk. This means that these man-agers have a head start and can now focus on, and divert effort to, other regulatory, performance and cost reduction initiatives.

The managers who choose to submit their applica-tion for authorisation late may have several reasons to do so. One reason may be a ‘let’s wait and see’ approach. Best practice takes some time to form

A compression of legal negotiations around AIFMD to the last months and weeks is not in anybody’s interest, says Rolf Bachner

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On balance, we should recognise the diversity of funds and managers that need to comply with AIFMD. This means the learning curve for some is much steeper and the work required to comply more challenging

It is no secret that one of the most contentious issues arising out of the introduction of Directive 2011/61/EC on Alternative Investment Fund Managers (AIFMD) related to that of depository lia-bility. In seeking to achieve greater levels of investor protection, AIFMD requires, the appointment of a depository to carry out specific functions including the safekeeping of assets and more controversially seeks to impose stringent liability provisions on depositories where they have failed in that duty.

In summary, the directive looks to the depository to accept liability in two distinct situations. Firstly, the directive imposes a near strict liability stand-ard for loss of custody assets and secondly it im-poses liability for any “other losses” arising out of a depository’s negligent/intentional failure to per-form its obligations.

While it might be argued that depositories have resigned themselves to taking it on the chin with respect to liability arising within its own global sub-custodial network, the issue becomes somewhat more fraught when a depository is appointed to an alternative investment fund which uses a prime broker, and therefore becomes exposed to losses arising out of the use of the prime broker’s network of sub-custodians.

Depository liability standards for loss of custody assets

To take it a couple of steps back, the directive pro-vides that the depositary shall be liable to the alter-native investments fundsor to its investors for the loss of custody assets by the depository or by a third party to which the custody of financial instruments held in custody has been delegated, unless it can prove that the loss of custody assets is a result of an external event beyond its reasonable control, the consequences of which would have been unavoid-able despite all reasonable efforts to the contrary.

In the case of loss of custody assets, the deposi-tory must return a financial instrument of identical type or the corresponding amount to the alternative investment fund or the manager acting on behalf of the fund without undue delay.

Importantly, in addition to the external event defence in the case of liability for loss of custody assets, the

directive includes a device to enable a depository to discharge its liability for loss of assets to third parties appointed by it, subject to certain conditions.

They are: (i) all of the delegation requirements of the directive having been met; (ii) there is a written con-tractual agreement to give effect to the discharge and which provides that a claim can be made di-rectly against the third party delegate; and (iii) the fund/fund manager has agreed to the discharge in a written contract which also establishes an objective reason for the discharge.

Discharge to prime brokers

The directive expressly recognises and contem-plates the continued use of prime brokers in the pro-vision of services to alternative investment funds, particularly hedge funds.

However, the directive equally contemplates that to the extent that any such prime broker is holding assets of an alternative investment fund in custody, it must do so as a delegate of the depository, in which case the provisions of the directive as to delegation apply.

Prior to AIFMD, the standard operating model for prime brokers operating in both the UK and the US prime brokerage markets was such that such prime brokers used their own network of sub-custodians for the custody of their prime brokerage clients’ assets, with the liability of the prime broker for losses being governed solely by the terms of the contract appointing that prime broker to custody the assets.

Post-AIFMD, this operating model leaves the depos-itary somewhat exposed in the context of the near strict liability for loss of custody assets, bearing in mind that it is now a step removed from the man-agement of that global network of sub-custodians.

In order to address the change to the liability landscape, two variations on the existing model have emerged:• The depository discharges its strict liability for

loss of a financial instrument to the prime bro-ker in accordance with AIFMD; and

• The depository retains strict liability but is pro-vided with an indemnity from the prime broker in respect of the loss of a financial instrument held in its custody.Etain de Valera breaks down AIFMD depository liability and discharge to prime brokers

Who’s to blame? Who’s to blame?

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38

The alternative to the discharge of liabil-ity solution is an indemnity from the prime broker. While this might seem like a simpler solution, the negotiation of indemnities is of-ten difficult and time consuming.

Typically a prime broker will seek to narrow the scope of the indemnity so as to ensure that it is only required to return the financial instrument, or pay out the cash value thereof.

However, a depository may also seek to include within the scope of any indemni-ty indirect or consequential losses of any type or perhaps distributions paid on the assets lost.

Irrespective of whether or not the discharge of liability or indemnity solution is to be used, de-positories and prime brokers will also need to agree upon the treatment of re-hypothecated assets and the extent to which such assets will fall within the scope of the discharged liability or indemnity.

The outcome of this aspect of any negotiation will likely depend on the law governing the prime brokerage agreement and whether or not such re-hypothecation gives effect to a title transfer of assets (thus bringing them outside of the depository’s safekeeping responsibilities).

Equally, both parties will need to consider and agree upon the procedure for any conduct of claims which may be made as against either of them for any loss of custody assets and liability for the costs associated with running such claims.

Depositories and prime brokers undoubtedly face challenges as they navigate the intrica-cies of the directive as to liability for loss of custody assets.

Ultimately, the industry may need to wait for a court of competent jurisdiction to pronounce on the effectiveness of any discharge of liabil-ity in accordance with AIFMD, so as to obtain a clearer picture as to how the depository and prime broker can address their respective ex-posures and concerns. AST

The question as to which potential solution might be used is not always an easy one for depositories or prime brokers to agree upon.

From a depository’s point of view, while the dis-charge of liability might seem like the obvious solu-tion, the directive has been crafted in such a way so that the onus is on the depository to demonstrate that the discharge has been effective.

This will require it to demonstrate, that all of the requirements of the directive for the delegation of its custody tasks have been met, including those as to due diligence in the selection and on-going monitoring of the prime broker as its sub-custodian and—perhaps more critically—being able to demonstrate an objective reason for that discharge.

In the context of its selection and monitoring obli-gations, a depository will seek to employ rigorous initial and on-going due diligence procedures to comply with its obligations, but it may not always

be possible to access the type of information that it requires.

Contractual provisions as to rights of access to and provision of information by the prime should form key provisions of any agreement pursuant to which a prime broker might be appointed as sub-custodian.

Furthermore, the objective reason for discharge is also key and—notwithstanding the guidance provided in Article 102 of the Level II Regulation as what will constitute an objective reason for dis-charge—it is incumbent upon each depository to look to its own operating model and the circum-stances in which the discharge is made to ensure that such an objective reason exists.

While a depository may seek to rely on being in-structed by its client to appoint the prime broker as an objective reason, it would seem prudent for it to ensure that a more rigorous assessment of such a reason be undertaken. Et

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“ The industry may need to wait for a court of competent jurisdiction to pronounce on the effectiveness of any discharge of liability in accordance with AIFMD, so as to obtain a clearer picture as to how the depository and prime broker can address their respective exposures and concerns

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CENTRAL SECURITIES DEPOSITORY REGULATIONMay 2014: Eurosystem lifts ‘repatriation rule’ for collateral

October 2014: Move to a T+2 settlement cycle

Summer 2014: Central Securities Depository Regulation (CSDR) enters into force

Mid-2015: CSDR secondary legislation enters into force

June 2015: First CSDs migrate to the T2S platform

Early 2016: CSDs to be officially authorised under CSDR

September 2016: Third wave of CSDs migrate to T2S

February 2017: Fourth wave of CSDs migrate to T2S

CSDR: key events

On 15 April 2014, the European Parliament adopt-ed the first European regulation on central securi-ties depositories (CSDs) nicknamed ‘CSDR’. The text, which is expected to enter into force in the late summer, will be complemented by secondary legis-lation (technical standards) by mid-2015. At around the same time, TARGET2-Securities (T2S), the eurosystem single IT platform for the settlement of European securities in central bank money, will offi-cially kick off. What does this mean for CSDs, custo-dians, sub-custodians and their clients? What will be the combined impact of these changes in regulation and IT infrastructure?

Ten years ago, the implementation of the Markets in Financial Instruments Directive (MiFID) resulted in increased competition in the trading space, with new trading platforms taking significant market share from incumbent exchanges. More recently, the adoption of the European Market Infrastruc-ture Regulation (EMIR) has led to more centralisa-tion of risk (in central counterparties) and data (in trade repositories) in the OTC derivatives market. Now, two major initiatives are about to affect the last layer of the securities chain, settlement and custody. So what should we expect?

First, let’s look at the expected benefits of the ongoing reforms from the point of view of market participants:

Less fragmentation

Both the CSDR and T2S aim to facilitate the cross-border settlement of securities transac-tions and, in the case of T2S, to remove the distinction between ‘domestic’ and ‘cross-border’ settlement. The use of the single T2S platform by 24 CSDs in 21 countries will undoubtedly contribute to a more integrated market, and will benefit custodians active in multiple jurisdictions across Europe, allowing them among others to centralise their holdings with a single CSD in the T2S zone and to reap the benefits of more centralised collateral and liquidity management.

By establishing harmonised authorisation and su-pervision requirements for CSDs, the CSDR will also contribute to reduce national specificities, al-though country-specific attributes will remain, for example, due to differences in the law applicable to securities.

Enhanced competition

Harmonised rules in the CSDR will also contribute to enhance competition among CSDs, putting further downward pressure on CSD prices. For the first time, CSDs in the EU will be able to ‘pass-port’ their services in other member states once they have been authorised by their home

The CSDR and T2S will fundamentally reshape the European settlement and custody landscape for years to come, says Soraya Belghazi

The evolving landscape for settlement and custody

regulator. They will compete, not only for settlement and custody, but also for new issues and issuer registration services.

More transparency

Several provisions of the CSDR aim at enhancing transparency, whether at the CSD or market level. At the CSD level, strict rules will govern the publica-tion of prices, the disclosure of potential conflicts of interest and internal governance arrangements. All CSDs will have to appoint at least two independent directors in their board, and they will have to establish, if it does not already exist, a user committee composed of CSD participants and issuers.

At the market level, the dissemination of data on settlement fails, ie, the proportion of settle-ment instructions that do not settle on the in-tended date, will be harmonised and will make it easier to benchmark the performance of indi-vidual markets against the European average. The CSDR also creates a new reporting obliga-tion for custodians settling transactions in their own books (without a corresponding movement in the CSD). Although the quarterly reports of these ‘settlement internalisers’ will not be pub-lic, they will allow regulators to better assess the importance and evolution of transactions settled outside CSDs.

Rock-solid safety standards

The fourth, but not least important, benefit of the regulatory reform is that it will ensure that the settlement and custody infrastructure remains re-silient to future shocks. Strict prudential require-ments, including capital requirements, standards on the management of operational risks and re-covery, will apply to all authorised CSDs in the EU. Links among CSDs and between CSDs and other infrastructures will also be strictly super-vised, as well as the provision of commercial bank money settlement.

All in al l , the replacement of fragmented national rules by harmonised safety standards should benefit market participants by giving them extra assurance that the infrastructures they use for settling transactions and safekeeping their assets abide by very strict standards.

Now, these changes will not come about without difficulties, and important challenges remain to be addressed. CSDs, first, will have to undertake a major compliance effort. Even for those not mi-grating to the T2S platform, technical adaptations in existing systems will very often be required to ensure full compliance with the new rules.

Yet, beyond these compliance costs, the largest challenges are to be found in those developments that will have a market-wide impact. From the per-spective of custodians and their clients, I can see at least three major challenges:

Getting ready for T2S

CSDs are not the only ones having to overhaul their systems prior to connecting to the T2S platform, starting in June 2015. CSD partici-pants, even when they do not intend to be “directly connected participants” in T2S, also have to make technical adaptations and review their back-office processes.

More generally, custodians and sub-custodians need to determine how they can make the most of the new opportunities offered by T2S, especial-ly in terms of collateral and liquidity savings. In order to succeed in the post-T2S world, all market actors must ensure they are sufficiently prepared and have a clear strategy and communication towards their customers.

Settlement discipline

By 2015 (and in exceptional cases 2016), the CSDR foresees that EU markets will have moved to a shorter settlement cycle, ie, two business days instead of three after trade date (T+2). This, together with the imposition of penalty fees on CSD participants failing to deliver securities on the intended settlement date, will create new op-erational challenges.

The transition to T+2 is now underway, with most EU markets having confirmed their intention to ef-fect the move on 6 October 2014. The number of markets (more than 20) affected simultaneously by this switch is unprecedented and will thus require a close coordination between infrastructures, market participants and their underlying clients.

The evolving landscape for settlement and custody

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In addition to T+2, the CSDR foresees the imple-mentation of a harmonised settlement discipline regime in the course of 2015, including mandato-ry buy-ins and penalties for late settlement. The details of these measures are still to be defined in secondary legislation, but market participants expect the penalties to be much heavier than what exists today, despite an already high level of settlement efficiency across EU markets (on aver-age, 97 to 98 percent of instructions processed by European CSDs settle on the intended settlement date, according to ECSDA 2012 data).

Important questions will have to be answered: will penalties be imposed on all parties in a chain of fails, or only on the original failing party? Will custo-dians be able to pass on the penalties to their clients and how? Who will execute buy-ins for transactions that are not CCP-cleared? In any case, market par-ticipants will have to take into account the potential cost of the new discipline rules and might need to re-examine their relations with customers who repeatedly fail to deliver securities on time.

Account segregation

The CSDR will also affect the relationship be-tween custodians and their clients in other ways. Following the financial crisis, EU decision-makers have sought to promote the use of segregated accounts at infrastructure level, considering that such accounts offer a higher protection for inves-tors in case of a custodian failure.

Without imposing a given account structure, Arti-cle 38 of the CSDR requires CSD participants to

offer their clients “at least the choice between omnibus client segregation and individual client segregation”, as well as to “inform them of the costs and risks associated with each option”. This means that custodians working with omni-bus accounts will have to offer their clients the possibility to maintain segregated accounts at the CSD level, and that they will need to have a clear policy to disclose the associated costs and risks.

A fourth challenge worth mentioning relates to the new CSDR rules on the provision of cash and credit to CSD participants when central bank money is “not practical or available”. These rules will apply to both CSDs operating under a banking licence and to banks acting as cash settlement agents for CSDs.

They involve strict limitations on the type of ac-tivities that can be performed by the bank as well as special requirements on credit and liquidity risks, including an additional capital surcharge. This aspect of the CSDR, which had generated some controversy during the legislative debate, aims at limiting potential systemic risks result-ing from the failure of a cash settlement bank, whether or not it is part of a CSD.

As these changes unfold in the coming months, it will be interesting to see what solutions are de-veloped by CSDs, their users, as well as regula-tors, in response to the new challenges. There is no doubt that the CSDR and T2S will funda-mentally reshape the European settlement and custody landscape for years to come. AST

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The views expressed in this paper are those of the author alone and do not represent an official position of ECSDA

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“ Important questions will have to be answered: will penalties be imposed on all parties in a chain of fails, or only on the original failing party? Will custodians be able to pass on the penalties to their clients and how? Who will execute buy-ins for transactions that are not CCP-cleared?

”

FOREIGN ACCOUNT TAX COMPLIANCE ACT2010: The Foreign Account Tax Compliance Act (FATCA) is signed into law by President Barack Obama

2011: Start-date is postponed to January 2014

February 2012: The Internal Revenue Service (IRS) publishes draft FATCA regulations, in which foreign banks are required to hand over details of American account holders with more than $50,000 in deposit

July 2012: Draft model I Inter-Governmental Agreement is released

January 2013: Final regulations for FATCA are supposed to take effect

July 2013: The IRS and the Treasury Department delay certain provisions yet again. Start-date is pushed back to July 2014

January 2014: Banks clamour for more time, but the IRS refuses to budge

FATCA: key events

The Foreign Account Tax Compliance Act (FAT-CA) has been part of the background for a while (since 2010’s HIRE act). Registration is underway, and the customer onboarding deadline of 1 July 2014 is just around the corner at the time of writ-ing. Despite some continuing areas of uncertain-ty, including the Inter-Governmental Agreement (IGA) status of various major jurisdictions, many businesses are breathing a sigh of relief at having processes largely in place.

FATCA onboarding

A key area often remaining outstanding is gath-ering tax residence self-certifications for both in-dividuals and entities. The collection of electronic W-8s is an emerging trend and automating what would otherwise be a manual process brings great efficiency—a comprehensive study by the Internal Revenue Service (IRS) pointed to an eight-fold reduction in the processing cost of electronic versus paper tax forms. For businesses looking for a silver lining to FATCA compliance, electronic self-certification speeds up the customer on-board-ing process, and forms are verified in real time, with more than 90 percent validated at point of submis-sion, rather than being dependent on the postal service and manual review.

While aspects of onboarding for FATCA may re-main outstanding, there have been encouraging signs from the IRS as to how they will treat busi-nesses that are running programmes very close to the wire. Commissioner John Koskinen, speak-ing on 24 March 2014, said that the IRS would be “understanding” when coming across businesses

that were “making reasonable, good faith efforts to comply” when building new processes and systems, even when they may experience problems “getting it exactly right”.

FATCA reporting, existing book of business

Any sense of relief, however, may be premature. The FATCA endgame—reporting to the IRS and to the IGA authorities—comes in 2015. The IRS and the IGA partner countries have been slow to release reporting schemas and guidance, which means that businesses will experience the familiar FATCA pres-sures of uncertain requirements and tight deadlines all over again.

The proliferation of IGAs in the last year has cre-ated more complexity in FATCA reporting. In 2012, reporting was solely to the IRS. The IGAs mean that a financial institution with branches in various coun-tries will have to report to multiple tax authorities, us-ing different electronic submission methods with the reporting format also likely to be different. For exam-ple, HMRC (the UK tax authority) has indicated that they will include check boxes for threshold elections and nil returns as part of the submission. The differ-ent submission formats and business requirements to reconcile back to source data and to other reports mean that working with a solution provider rather than an in-house build may be the best option.

On-boarding new customers is only half of the issue. There is little time to draw breath before the deadlines for reviewing and remediating the existing book of business kick in. In many ways remediation may be a more challenging process

The FATCA onboarding deadline is not the end of the road, says Laurence KiddleDown to the wire

than onboarding—it requires businesses to hold adequate data on their customers and crucially, to have the ability to efficiently interrogate this data. One business took the view that as they captured ‘nationality’ in their private banking operations, they were largely covered—only to discover that over 50 percent of their records had ‘unknown’ in that field. Sizing and segmenting the data and having the ability to gather further information such as W-8s or other self-certifications from their customers will be imperative—and leveraging the FATCA client on-boarding process, while being aware of the subtle differences between the two, is critical.

And of course, once new client onboarding process-es are in place and pre-existing customers have been reviewed and remediated, there is a further change in process as a business moves into the world of moni-toring for change in circumstance—again with appro-priate processes in place for remediation.

For other similar processes, this transition to busi-ness as usual would mean an opportunity to relax. FATCA, however, is no longer the only gig in town.

OECD, and an automatic exchange of information

FATCA has spawned huge international interest in tax information reporting—so much so that in 2016, the Organisation for Economic Co-operation and Development (OECD) Automatic Exchange of Information (AEOI) programme will introduce mul-ti-lateral information sharing with over 40 countries already signed up. So what was for many busi-nesses a headache—identifying and reporting on American customers—has the potential to become a fully fledged migraine when tracking multiple tax residences in multiple jurisdictions.

At a recent Thomson Reuters webcast, a polling question asked how easy it would be to future-proof their existing programme to cover the OECD AEOI. Just 4 percent of respondents thought the process would be ‘straightforward’; 56 percent flagged addi-tional rework requirements, while over a third would require either fundamental change or a new system.

Despite the surface similarities, there are pro-found differences between FATCA and the OECD proposals. Categories are different, which means that businesses may need to classify their cus-tomers differently for FATCA and AEOI purpos-es. While FATCA applies minimum account level thresholds, the AEOI does not—which brings many more customers into scope. The AEOI focuses on tax residence(s), rather than the binary American/non-American FATCA approach.

But, by considering these aspects while rolling out FATCA compliance programmes, a little short-term effort can bring considerable long term benefit.

With all this in mind, it would be a mistake to think of the FATCA onboarding deadline as being the end of a FATCA compliance programme. “But it can be seen as the end of the beginning”. While (mis) quoting Winston Churchill may be out of context in a FATCA discussion, keep in mind that Church-ill himself—voted “greatest Briton of all time” in a 2002 BBC poll—would probably have been picked up by FATCA as a US person (with an American mother, and as an honorary citizen). And at various stages in his life may have been reportable under AEOI as resident in Ireland, India and South Africa. This further underlines the inherent complexity in designing a programme to track tax residence and information reporting. AST

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“ What was for many businesses a headache—identifying and reporting on American customers—has the potential to become a fully fledged migraine when tracking multiple tax residences in multiple jurisdictions

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Collateral is viewed as both a solution to, and trigger of, the massive financial losses that occurred as a result of the financial crisis of 2008.

In response, policymakers around the world have enacted new rules and legislation, including the US Dodd-Frank Act in the US, European Market Infra-structure Regulation (EMIR) and Basel III standards, to increase market stability and resiliency, enhance transparency and reduce risk. As a result, these rap-id and significant changes in the financial markets are impacting the management, mobilisation and transformation of collateral.

But despite the regulatory reform of the derivatives markets on both sides of the Atlantic, concerns over an anticipated collateral shortage continue to abound. Phased implementation of mandated clearing for swaps is now underway, while the final agreements over the introduction of operational controls and cap-ital requirements for non-cleared OTC derivatives trades are being made. It is expected that these two initiatives will have the biggest impact on the demand for collateral. As such, market participants, in particu-lar those operating in the buy side, need to consider how best to manage their own collateral in order to prepare for any potential shortage in supply.

So what are the main drivers behind the changes to the collateral market and what opportunities exist

for buy-side market participants responding to new regulatory and industry agendas?

To begin with, it is helpful to draw a distinction be-tween what we mean by collateral and what we refer to as collateral management. Collateral is the security provided by one party to another to mitigate counterparty risk for any extension of credit or fi-nancial exposure. In financial markets, collateral is broadly interpreted but typically includes cash, secu-rities and, at times, commodities such as gold.

Collateral management, on the other hand, refers to the efficient and effective allocation of collateral to reduce risk and encompasses both supply and demand components. The former includes the rec-onciliation of deal/trade portfolios and the daily cal-culation of exposures based on price movements of both the trade/deal itself and any existing collateral, while the latter includes the efficient identification, aggregation, management and allocation of collat-eral to meet various exposures.

Is there sufficient collateral to meet demand?

As a result of new derivatives legislation, liquidity requirements and regulatory mandates, organisa-tions have attempted to calculate the amount of collateral that will be needed by financial firms. Driving the increase in collateral requirements are

The buy side needs to consider how best to manage collateral in order to prepare for any potential shortage in supply, says Mark Jennis

Collateral: the double-edged sword?Liquidity lessons: Dodd-Frank, Basel IIIand more

Collateral: the double-edged sword?

Collateral

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in underlying margin activity, is expected to have an impact on costs and risk in a number of areas including funding costs; operational capabilities and settlement expectations management; and report-ing and recordkeeping. Furthermore, the segregation of accounts required by new regulations, while improving the safekeep-ing of collateral, will add complexity to the collateral management process that existing technology will find challenging to manage.

Transparency is key

During periods of extreme market stress, the volume and value of margin calls increase exponentially.

The inability of firms to seamlessly connect collat-eral obligations and their ensuing settlements cre-ates opacity in the market. This has the potential to cause destabilising market reactions and impact the decision-making of policymakers responsible for managing the crisis. In response to the need for transparency, regulators are becoming more interested in collateral reporting. This is evident in exposure reporting to trade repositories, margin dispute reporting and recovery and resolution reporting needs.

Multiple solutions to the collateral challenge

There are currently multiple collateral manage-ment solutions encompassing anything from port-folio margining to collateral optimisation trying to address the different segments of the collateral challenge. However, the situation requires a solu-tion that can address both the scale and the ef-ficiency of collateral management challenges, as well as the gap between the supply and demand

of collateral. Without it, hedging risks will become more expensive, profit margins will continue to be squeezed and investment returns will become more challenging.

The evolving regulatory environment will continue to place significant pressures on financial firms and create multiple challenges for managing collateral. With margin call activity expected to increase by as much as 1000 percent and given the increasing de-mand for collateral, this will have a major impact on both liquidity and risk—the operational nightmare scenarios are endlessly identifiable.

In an environment where cost benefit analysis rules the day, the industry is looking to harness market

infrastructures to help solve this issue. Firms are growing wary of fragmented approaches that may deliver limited operational cost and risk benefits.

The reality is that collateral challenges will be far more extensive than envisaged to date, and in many cases, fragmented solutions will only address certain parts of the problem.

This will leave firms struggling to cope with the enor-mity of the situation in years to come.

In conclusion, it is essential that strategic collabora-tive solutions are employed to leverage the exper-tise and knowledge of multiple providers as well as address the issue in a more holistic manner.

With this in mind, DTCC is continuing to col-laborate with industry partners to develop solu-tions that address the operational costs and risks associated with the increased demand for collateral. AST

new rules that mandate central clearing for the ma-jority of OTC derivatives trading and the introduction of operational controls and capital requirements for non-cleared, OTC derivatives trades. In practice, clearinghouses will have to impose initial margin requirements as well as reduce or eliminate thresh-olds for variation margin, which will dramatically in-crease the demand for high-quality collateral.

The extent of the problem has been highlighted in a number of studies. The Bank of England estimat-ed in September 2012 that the amount of collateral needed to meet requirements posed by new regula-tions globally could reach as high as $800 billion. A more recent study by the Bank of International Set-tlements estimated this to be around $4 trillion.

Despite the anticipated increase in demand for collateral, many market participants are either not fully cognisant of their eligible collateral or unable to efficiently mobilise collateral to allocate it against specific exposures. As much as 15 percent of the collateral available to financial institutions is current-ly left idle, costing the global industry more than €4 billion a year, according to a recent joint study by Clearstream and Accenture.

In addition, many firms are not optimising their col-lateral, which could create a gap between supply and demand. Optimising collateral not only requires reviewing the eligibility criteria and understanding the terms of the collateral agreement, but also cal-culating the costs of putting that collateral to differ-ent uses and moving the collateral and following its settlement status across the extensive network of depositories and custodian banks.

Margin calls expected to grow

A number of drivers are expected to dramatically increase margin call activity, which will likely have a significant impact on liquidity and risk. Discus-sions with participants in the OTC derivatives mar-kets indicate that this activity could jump 500-1000 percent. There are a number of factors behind this likely increase:

Regulatory changes: Dodd-Frank and EMIR could require initial margin for both counterparties and a reduction or removal of thresholds for variation mar-gin. The inclusion of initial margin will significantly

increase the amount of collateral required, and will create additional margin calls. The removal or reduc-tion of thresholds for variation margin will mean any change in valuation may trigger daily margin calls. In the past, thresholds limited these calls to times of significant changes in underlying valuations.

Regionalisation: The potential creation of multiple regional clearing venues per product may have a splintering effect on collateral, increase the number of margin calls, and alter the mix of acceptable collateral globally. If this occurs, it could also lead to a dra-matic rise in collateral requirements as the benefits of offsetting exposures experienced in today’s portfolio exposure calculation are removed and margin reverts to being calculated on regional or gross basis.

Clearing fragmentation: With new clearing re-quirements for OTC derivatives transactions, credit support annexes (CSAs), which have historically covered an entire portfolio of deals with one margin call now may exclude products offered by different clearing houses—which may drive individual daily or even intraday margin calls for each clearing-house. This clearing fragmentation reduces the historical advantage of calculating margin across a multi-product portfolio. This fragmentation effect may be exacerbated in the US by the regulatory requirement that creates multiple collateral accounts for specific types of underlying trans-action being collateralised: security-based swap, non-security based swap, future and option, or cleared/non-cleared (bilateral) activity.

New standard credit support annexes (SCSA): CSAs establish rules that govern the posting of collateral for OTC derivatives. Historically, margin calls have primarily been met in EUR or US dollars. The International Swaps and Derivatives Associa-tion’s (ISDA) new SCSA looks to encourage better risk mitigation through matching the currency of the collateral with the currency of the underlying trade.

The combined impact of new collateral require-ments and margin activity

Regulatory changes are making it difficult for market participants to keep their internal systems and pro-cedures responsive to meet new challenges. Firms are concerned because the increase in collateral requirements, along with the subsequent increase

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proposal is considered more stringent in a number of areas than the global framework.

The US proposal includes more specific crite-ria, enumerating eight requirements which must be met to classify a deposit as operational. The criteria includes qualitative components (types of products used, contractual terms, account types), specifically excludes deposits from certain finan-cial companies and mandates quantitative proof that deposit levels are related to custody, clearing or cash management activities. All eight criteria must be met in their entirety for an operational deposit to be recognised by regulators for LCR purposes. Banks will need to build a system that enables monitoring of all eight—for all their clients—on an ongoing basis.

The US proposal also calls for an accelerated timeframe, with 80 percent compliance in 2015, while the Basel Committee calls for 60 percent compliance in the first year. Reaching the US compliance threshold means information systems must be 100 percent capable of calculating all specified measurements by the 2015 deadline. Banks must immediately invest, test and plan for adoption of the US LCR to meet the demands of this rigorous timetable.

Effect on profitability

Both versions of the LCR offer definitions of as-sets that can be defined as HQLA, which must be held against assumed outflows in a 30-day liquidity stress scenario. However, the US proposal applies a more stringent definition excluding instruments like residential mortgage-backed securities (RMBS) and covered bonds. As a result, the carrying costs of the deposits, particularly for those that require higher HQLA requirements, will be impacted. Both requirements are expected to affect FI flexibility and profitability.

Costs associated with the HQLA requirements and other aspects of the US LCR may have implica-tions, sometimes material, for FI business models in relation to internal and external pricing. Internal pricing policies and guidelines for banks may have to change in order to secure business that will be profitable under the new regulation. There may also be a broad impact on both revenue and profit due

to costs associated with the HQLA requirements. These challenges could prompt banks to change their product mix and create new products that are more profitable under LCR guidelines.

Guidance for asset managers

AIFMD and the US LCR are part of a worldwide reg-ulatory overhaul. The goal is to improve the global banking sector’s ability to absorb economic shocks, contain liquidity risk and prevent financial spillover into the real economy.

A major effect of regulation will be an increase in credit and deposit costs, and may result in fee-based services being more sought after by FIs.

Asset managers that analyse their banking relationships holistically rather than on a transac-tion-by-transaction basis can adapt more quickly to the evolving financial system. Engaging in an extended dialogue with their banks and prime brokers can help redefine these critical financial relationships with actionable insights: such as the total value of services they purchase and how FIs value their business relationships. Fund managers can also gain the benefits of scale by identifying ser-vice providers that offer end-to-end solutions, such as securities financing, cash-flow monitoring, custody of assets, and more.

Early adopters will be better positioned to manage client expectations and attract new investors. And as balance sheets gain strength across the globe, fund managers and investors alike will benefit from a less risky financial system with better capitalised banks and more resilient counterparties. AST

New financial regulatory reform initiatives, such as the Alternative Investment Fund Managers Directive (AIFMD1) and the Basel III liquidity coverage ratio (LCR2), are redefining relationships between asset managers and their financial institutions (FIs). The depository requirement of AIFMD has the potential to raise costs for investment funds and investors, while LCR will likely raise the cost of using banks’ balance sheets. Asset managers that assess their banking and prime brokers holistically, instead of on a transaction-by-transaction basis, may benefit from counterparty relationships that are better capitalised, have greater credit quality and offer more robust financing.

The AIFMD regulatory milestone

As a result of AIFMD, alternative investment funds that seek to raise capital in Europe will now require the services of a depository if they are registered or operating in EU member states. Essentially a custodian with expanded responsibilities, a depository will provide cash-flow monitoring, safe custody and oversight services.

In the past, depository liability has been limited, and in some cases, transferred to a third party. Proposals within AIFMD may result in this changing as a result of the work being undertaken by the European Securities and Markets Authority (ESMA). Working as an independent provider, the depository will assume full liability of assets in each fund under management.

If the depository or appointed custodian loses a finan-cial asset, the depository must provide an identical replacement or an equivalent monetary amount. With full liability, the depository will assume the credit risk of its counterparty, which enhances investor protec-tion, but also has the potential to raise fees.

Global implications

The AIFMD requirements are a part of the European Commission’s objectives to harmonise the regulato-ry standards, level the EU playing field and improve the stability of the financial system.

Although the directive is aimed at alternative invest-ment fund managers who have registered offices in EU member states, its scope has global implications since it also includes funds with registered offices in a third country.

LCR’s impact on deposits

The global framework in Basel III lays out new liquidity standards that will change how banks value certain deposits and commitments as banks must make standardised assumptions about the stability, as well as acceptable liquidity sources and levels, for each.

A principal feature of LCR is the requirement that banks classify most wholesale deposits as either operational or non-operational based on specific criteria. Operational deposits would generally receive more favourable treatments. Achieving compliance will require banks to build and operate information systems that monitor all criteria for each client on an ongoing basis. The LCR also specifies assumed outflow rates for credit and liquidity facilities, and defines high-quality liquid assets (HQLA) that can be converted into cash easily to meet a 30-day liquidity stress scenario.

Proposed US LCR rules

In October 2013, US financial regulatory bodies published proposals for implementing the LCR. While the final version is not yet published, the US

Morgan Downey, head of global custody and agency services at Bank of America Merrill Lynch, outlines the changing relationship between asset managers and their financial institutions

Regulatory reform: redefining the FI relationship

1 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010

2 Basel III (or the Third Basel Accord) is a global regulatory framework to strengthen bank capital requirements, agreed upon by the members of the Basel Committee on Banking Supervision in 2010-11

Bank of America Merrill Lynch (including Global Custody and Agency Services) does not render any opinion or provide advice regarding legal, compliance, account-ing, regulatory, tax or investment matters and it is your responsibility to seek such legal, compliance, accounting, regulatory, tax or investment advice as you deem necessary. The information in this article does not constitute investment advice or an offer to invest or to provide management services or any other services. “Bank of America Merrill Lynch” is the marketing name for the global banking and global markets businesses of Bank of America Corporation. Lending, derivatives, and other commercial banking activities are performed globally by banking affiliates of Bank of America Corporation, including Bank of America, N.A., member FDIC. Securities, strategic advisory and other investment banking activities are performed globally by investment banking affiliates of Bank of America Corporation(“Investment Banking Affiliates”), including, in the United States, Merrill Lynch, Pierce, Fenner & Smith Incorporatedand Merrill Lynch Professional Clearing Corp., all of which are registered broker dealers and members of SIPC, and, in other jurisdictions, by locally registered en-tities. Merrill Lynch, Pierce, Fenner & Smith Incorporated and Merrill Lynch Pro-fessional Clearing Corp. are registered as futures commission merchants with the CFTC and are members of the NFA. Investment products offered by Investment Banking Affiliates: Are Not FDIC Insured • May Lose Value • Are Not Bank Guaran-teed. ©2014 Bank of America Corporation.

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trade. Now, banks are reconciling the confirmation, the advice of payment, and reconciling the actual settlement. It is multiple changes. When there is an exception, banks are now expecting to see the whole of that lifecycle. The vendors like ourselves have been responding by providing technology solu-tions that enable transactions to be processed in re-al-time, to be able to link lifecycles to each other for a trade, to link related holdings to a trade, so you get a more holistic picture to understand what risk is.

That is for me what really underpins regulations from Dodd-Frank, EMIR, Basel III, the Bank for Interna-tional Settlements paper published last year—it’s all about whether a bank can fund a transaction. And if you can fund that transaction, then you have confi-dence that your counterparty is going to settle and then it just eases the whole confidence game.

How are banks reacting to increasing regulatory and operational pressures to actively monitor and manage their intraday liquidity positions?

I think there is a very mixed approach. In talking to a number of organisations over the year, there was an initial, I wouldn’t say enthusiasm, but there was a increased interest in interpretation of the regulations such as Basel III and EMIR, which were clouded in many ways. These were high-level requirements, but they didn’t really details how those requirements were to be implemented, monitored or reported. A lot has been left with local regulators. What we are finding now is multinationals are tending to play off one regulator against each other.

Also, I don’t think the banks have looked at this from a strategic benefit. If you and I were looking after our own bank accounts, we would make sure we had enough to pay, otherwise it would be rather embar-rassing at the petrol pump.

The banks are currently putting tactical solutions in place—they may employ staff to do more reporting, gathering information from a multitude of different systems, rather than a strategic tool that will ac-tively monitor their positions and balances. I think their first step has always been one of tactics—lets throw some more bodies at it and tick the box. But what they should be really doing is looking at the

strategic benefit of the regulation. If you are funding at a transaction level that means you know exactly much collateral you have to hold to meet your fund-ing commitments.

Today, what they are doing is put a guess in place, and then adding £50 million on top just to make sure. There is a lot of opportunity for investment and, ulti-mately, profit that is being missed by not looking at strategic benefit. AST

How do you approach Dodd-Frank Act and EMIR, and what effect you think the regulations will have on liquidity?

It has had a massive effect. If you step back and look what has happened over the past four to five years, the industry through regulation—unfortunate-ly, rather than doing it themselves—has focused on managing risk, and in order to manage risk, the whole back and middle offices, the way transactions are processed and accounts are managed within a bank, have had to change.

There has been a paradigm change. Traditional pro-cessing from years ago was back to basics: there was overnight settlement, and we were talking about T+3 as being achievable. Today, everything is about intraday transaction processing, and managing funding of transactions by a transaction-by-transac-tion basis. The US Dodd-Frank Act and European Market Infrastructure Regulation (EMIR) are really focused on the OTC exposure, quite rightly so.

So there’s those regulations. Also, the trade report-ing came into force on 12 February 2014, and a lot of organisations have been able to respond to that. There are trade repositories that have been estab-lished and those reporting requirements going on, in terms of new reconciliation requirements based

on frequency and on the quality of the information within the trade—which we have responded to by providing specific reconciliation packages.

On the basis of intraday, technology is providing ca-pabilities now whereby banks are able to process the trades through their whole lifecycle within the day, so they are transaction-based processing now, which is fundamental to intraday liquidity.

So first of all we’ve moved from batch processing, where traders were saying that they had positions in different currencies and they were quite hap-py—of course that would then lead to an exposure during the day, or a lack of opportunity to take part in favourable market conditions. There is also an exposure that banks don’t have confidence in their counterparty institutions that they are actually going to settle.

Then throttling starts to take place and that confi-dence question comes into play. What we’ve been seeing is a drive, coming through regulation, from responding to regulation, to changing technology, to a move to transaction-based processing to be able to move a better understanding of the lifecycle of a trade.

In the bad old days what would happen is you would accept the trade and look for the settlement of that

Opportunities for investment and ultimately profit are being missed because strategic benefits are not being considered, says Darryl Twiggs

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“ The vendors like ourselves have been responding by providing technology solutions that enable transactions to be processed in real-time, to be able to link lifecycles to each other for a trade, to link related holdings to a trade, so you get a more holistic picture to understand what risk is

”

Lombard Capital MarketsBen ColeCEOTel: +44 0 7880 733437info@lombardcapitalmarkets.comwww.lombardcapitalmarkets.com

Lombard Capital Markets provides consultancy services, specialised in delivering change consultants within investment banks and financial institutions. We have a proven track record in derivatives, prime brokerage, securities finance and global custody. Our consultants are subject matter experts ensuring your strategic goals are delivered

We specialise in:• Business case definition• Target operating model definition• Develop and manage RFI/RFPs

Financial Regulation

Lombard Capital Markets is fully aware of how the changing regulatory landscape will impact your business. We have experience of delivering changes in order to comply with the following:

• EMIR• AIFMD• BASEL

KDPW GroupIwona Sroka+48 537 93 43kdpw@kdpw.plwww.kdpw.pl

KDPW Group, including the CSD and CCP clearinghouse, is the most important infrastructure institution on the Polish capital market.

The group offers a competitive, integrated and complementary package of depository, clearing, settlement and add-ed-value services. Thanks to synergies between KDPW and KDPW_CCP, the KDPW Group provides its clients with the highest international standard services.

KDPW—the central securities depository of Poland—is responsible for the settlement of transactions concluded on the regulated market and in alternative trading systems and for the operation of the CSD. In addition, KDPW provides many services to issuers including dividend payments to shareholders, assimilation, exchange, conversion and split of shares, and execution of subscription rights.

KDPW also offers trade repository services under EMIR requirements. KDPW_TR covers the reporting of all types of contracts subject to the reporting obligations (including exchange-traded and OTC derivatives).

KDPW_CCP is a clearinghouse responsible for the clearing of transactions on the regulated market and in the alterna-tive trading system and the operation of a clearing guarantee system. KDPW_CCP began its operations on 1 July 2011.

BNY MellonHani KablawiExecutive vice presidentHead of EMEA asset servicingwww.bnymellon.com

BNY Mellon is a global investments company dedicated to helping its clients manage and service their financial assets throughout the investment lifecycle. Whether providing financial services for institutions, corporations or individual investors, BNY Mellon delivers informed investment management and investment services in 35 countries and more than 100 markets. As of December 31, 2013, BNY Mellon had $27.6 trillion in assets under custody and/or administration and $1.6 trillion in assets under management. BNY Mellon can act as a single point of contact for clients looking to create, trade, hold, manage, service, distribute or restructure investments. BNY Mellon is the corporate brand of The Bank of New York Mellon Corpora-tion (NYSE: BK). Additional information is available on www.bnymellon.com or follow us on Twitter @BNYMellon.

BNY Mellon’s Investment Services business provides global custody and related services, broker-dealer services, collateral services, alternative investment services, corporate trust and depositary receipt services, as well as clearing services and global payment/working capital solutions to institutional clients.

We touch all points across the investment lifecycle: from the creation of assets through the trading, clearing, settlement, servicing, management, distribution and restructuring of those assets:• We help create assets, working with clients to issue debt or DRs, for example.• We facilitate the trading and settlement of assets through our broker-dealer, global markets and treasury services activities.• We hold and service assets for beneficial owners through asset servicing.• We provide a distribution channel for those assets through our Pershing platform• We can restructure those assets, as in the case of debt restructurings, through corporate trust. • We support the rapidly expanding collateral management needs of both the buy and sell-sides through our global

collateral services business.

• Programme and portfolio management• Vendor management• Business analysis expertise

• FATCA• Dodd-Frank• Delivering changes as a result of

structural reform

• CASS• SEPA

Oesa Partners Kate WormaldFounderTel: +44 0 20 3693 6085Kate.wormald@oesa.co.ukwww.oesa.co.uk

Oesa Partners is a well-established and highly respected specialist consultancy providing legal and regulatory services to the alternative investment management industry and corporates and pension plans who are users of derivatives.

Our services cover advisory, project management and trading documentation, which includes amongst other documents;• Prime brokerage agreements• ISDA agreements• Master confirmations• GMRA agreements• GMSLA• Give up agreements/compensation agreements

As specialists we do not have the distractions of a wider portfolio and therefore offer, what we believe, is an unrivalled level of service and understanding in the hedge fund arena. We are also active participants in the hedge fund industry, being closely involved in key industry developments.

We pride ourselves on working in the most commercial and effective ways that best fit with our client’s strategies and objec-tives. As a niche consultancy we are able to offer a fresh and flexible approach to fees. We are not constrained by billing at hourly rates and in increments of minutes, whether used or not. We can offer retainers, fixed fees, project fees or an hourly rate to meet individual needs and budgetary requirements.

• Administration agreements• Master netting agreements• Central counterparty clearing • Custody arrangements• Electronic access agreements

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©2014 The Bank of New York Mellon Corporation.

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It’s as simple as this:BNY Mellon’s business is investments.Managing them, moving them, making them work.We bring their power to people’s lives.

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