Market participants have been slow to embrace fundamental changes to their trading processes, leaving the front office to rely on ad hoc technology solutions and their own judgment to enforce increasingly complicated trading policies and rules. The need for robust, consistent and auditable pre-trade and post-trade compliance implies a matching need for automated solutions to enable compliant trading within the new regulatory framework.
It is essential to know whether a prospective trade complies with relevant regulations and internal policies prior to execution.
This can be challenging to implement for high volume electronic markets, given their intrinsic need for low latency execution. Although many regulators specifically exempt liquid FX spot markets from the most onerous pre-trade controls, a host of rules apply to electronic and voice trading for the majority of traded FX derivatives. In particular, these include rules for business conduct when trading with customers.
Business conduct rules aim to ensure market participants have access to transparent pricing, are constrained to trade products appropriate for their level of sophistication and risk tolerance, and have been fully informed of the relevant risks. In their DoddFrank rulemaking, the CFTC was among the first regulators to impose rigorous standards for business conduct. Swap dealers are required to perform legal entity due diligence checks prior to execution. These include explicit risk disclosures to the client, verification of execution agreements, and representations of eligible contract participant status. Price transparency is achieved via mandatory pre-trade disclosure of mid-market pricing.
ESMA’s implementation of MiFID II will have even greater impact on the front office process for European market participants. Scheduled to take effect in January of 2018, rules governing suitability and appropriateness require investment firms to assess client sophistication and risk tolerance based on client characteristics and the nature of the service or transaction under consideration. Best execution and pre-trade transparency rules require real time disclosure of prices prior to execution. Perhaps most significantly, MiFID II requires the interaction between traders, salespeople and clients to be monitored and subject to controls at each step of the front office workflow.
Although no OTC FX derivatives are currently mandated to clear, the CFTC and ESMA have both publically considered mandating the clearing of liquid NDF products, which are eligible for clearing at a number of CCP’s today. Understanding whether a trade is eligible for and subject to mandatory clearing is an essential part of the pre-trade regulatory control framework. For trades that are not cleared, BCBS / IOSCO margin rules are currently being implemented by global regulators in phases. By March of 2017 both VM and IM control requirements will be in place for financial institutions regulated by the US, Europe and Canada. The industry is undergoing a significant update of CSA documentation to support the introduction of these rules, and FX derivatives are directly affected by these changes. It is mandatory to understand pre-trade whether updated CSA documentation is in place to support uncleared trading with a counterparty.
Another developing area of pre-trade regulatory compliance involves electronic execution. CFTC rules govern electronic execution on a Swap Execution Facility (SEF), including allowed price methodology, and requirements for clearing. Many FX products trade on SEF today. MiFID II imposes detailed controls for transactions on Trading Venue (TV). MiFID II rules governing products mandated for execution on TV are yet to be finalized, but are expected to be comparable to the CFTC rules for SEF execution. In all cases, market participants need to know their options for electronic venue execution prior to trading.
Regulators have started to introduce rules to monitor and control algorithmic and highfrequency trading. The intent of these rules is to prevent price manipulation and to protect against “flash crash” events that may be introduced by volatility in algorithmic trading patterns. Order management systems for liquid products require responsive behavioral controls and detailed audit records to support the imposition of these controls.
Post-trade compliance primarily takes the form of transaction reporting, portfolio reconciliation and monitoring to ensure pre-trade compliance requirements were met. Transaction reporting involves examining each executed trade to determine whether there is an obligation to report under a given regime (e.g. CFTC part 43 and part 45 reporting, ESMA reporting rules under EMIR, etc.). The obligation to report may fall on one or more counterparties to the trade, or an external venue such as a CCP. The relevant reporting rules will specify a set of possible reporting venues, and reporting of trade facts to one of those venues must be done within a specific interval of time. Portfolio reconciliation is required to ensure counterparties to trades have the same view of the risk and nature of their obligations. Given the volume of FX transactions subject to these rules, inaccuracy in reporting can create significant problems in trade reconciliation.
Transaction reporting is the most widely implemented component of the G20 regulatory consensus, with mandates in place across more than a dozen jurisdictions.
The global nature of FX trading ensures that many transactions are subject to more than one regulatory jurisdiction. Substituted compliance and “third country equivalency” determinations are still being actively negotiated across many jurisdictions (including the US and Europe), so it is not safe to rely on the primacy of a single regulator for compliance. Jurisdiction must be determined dynamically for each transaction, based on facts about the product, counterparties and front office participants.
Consider the example of an NDF traded between the European branch of a US swap dealer and a French hedge fund after January 3, 2018. Prior to trading, this transaction will be subject to suitability and appropriateness checks under MiFID II, and external business conduct obligations under Dodd-Frank.
If the trade is not intended to clear, the bilateral CSA must be validated to ensure it’s permissible to trade this product without clearing. Moreover, if either the CFTC or ESMA has mandated NDF products for clearing by this date, the trade will be subject to a mandatory clearing requirement at a designated CCP. Post-trade, the transaction will need to be reported under separate obligations introduced by Dodd-Frank, EMIR and MIFID II rules. It’s possible to introduce additional regulatory nexus if the trader is based in a third regulatory jurisdiction, e.g. Singapore or Hong Kong.
STATE OF PLAY
For the most part, the industry has approached technological solutions for regulatory compliance as a series of tactical projects where the goal is to implement the minimally viable solution in the shortest possible timeframe. Given the rapid pace of regulatory change in the past four years, it is easy to see why many institutions have built infrastructure that is regional, siloed by asset class and product, reliant on manual processes, and expensive to update. Most institutions have implemented pre-trade controls in one of three ways:
1. As a spreadsheet with compliance instructions (e.g. “permitted under Dodd-Frank”, “not allowed under EMIR”) indexed by counterparty account and product. Front office staff are expected to consult the sheet prior to trading.
2. As a reference application where front office staff enter prospective trades, and compliance instructions are returned based on the captured information. This is often regulator and asset-class specific (e.g. CFTC business conduct for FX products, or EMIR clearing controls for Rates and Credit products).
3. As business logic separately implemented in many systems, e.g. FX spot/forward OMS, FX option pricing tools, sales trade capture, etc.
All three approaches may be encountered in a single institution. Very few market participants have implemented systematic controls for electronic trading outside their client onboarding process. Keeping disparate implementations current with the latest market infrastructure rules and regulatory obligations is a daunting task, and most institutions lack central ownership of this critical maintenance.
Post-trade, transaction reporting is usually implemented consistently across FX products, i.e. there is a single transaction warehouse that feeds multiple reporting gateways. However, there will be inconsistently implemented decision logic and workflow for each regulatory jurisdiction, often relying on the manual upload of trades from spreadsheets to reporting repositories.
Swap regulatory surveillance is in its infancy. Pre-trade regulatory rule avoidance is usually audited by manual review of a sample of executed trades, requiring the aggregation of information from dozens of systems to create a proper trace of trade record of decision activity.
IMPLEMENTING A CONSOLIDATED SOLUTION
A successful compliance solution for FX derivative trading will eliminate manual and inconsistent processes around client onboarding, regulatory decisions and internal business processes. Compliance should be deeply integrated with sales and trading workflow, allowing the front office to focus on client relationships, revenue generation and risk management. At the same time, the solution should provide traders and salespeople real-time insight to enhance conversations around regulatory mandates, clearing options, and optimal execution.
Achieving this will require routing all decisions through a single logical implementation of the global regulatory framework. Compliant trading demands systematic, auditable answers implemented consistently and globally across all products. FX should use the same framework as that used for rates, credit, equity, and commodity products.
The output of every regulatory decision for a prospective trade should be stored to a consolidated audit record, providing the basis for a robust violation analysis and remediation framework. This record must contain sufficient information to conduct a detailed review of the regulatory decisions taken, including a visual record for each decision path. Legal and compliance should be able to trace decisions back to the originating legislative text, allowing verification that the decision implementation is comprehensive and correct.
It must be possible to rapidly deploy updates to regulatory and market infrastructure rules, with clear ownership of rule testing and maintenance. To support rapid deployment, it is essential that updates take the form of structured data, not logic implemented in code. For electronic FX trading, any pretrade regulatory solution must be highly performing and lowlatency. Products that trade on RFQ can be processed at point of inquiry, and the decision response routed to the trader’s electronic quote infrastructure to inform their decision to trade. Products that trade on streaming markets or order books have more stringent requirements. Regulatory decisions for these trades should be pre-calculated and cached by product, counterparty and key transaction facts.
Dealers with well-funded, multi-year technology programs have struggled to build dynamic, global, cross-asset regulatory decision services. The task is complex, requiring detailed business and product knowledge. The most significant challenge is in execution. Inhouse development demands coordinated effort across technology, cross-asset front office and legal & compliance. The implementation of vendor solutions will need careful definition and planning to successfully replace a variety of inconsistent internal builds.
Over the next 18 months, a host of new rules affecting FX derivative trading will come into effect. BCBS / IOSCO uncleared margin regulations and the introduction of MiFID II will have profound impact on market participants. The window of opportunity for implementing a comprehensive automated solution is open, but remains narrow.