The bullish surges and the nose dives, the bursting bubbles and the depression fears……if the system could contain itself with some grace at all, there would have been no policing. Every time we see the market crash, be it the black Friday , the great depression or the 2008 Credit Crunch, it brings out the need to put in place some sort of discipline in the market.
The market place has learnt constantly from mistakes of the past, but how much can the learning be trusted? This is where regulations come in, to bring down the risk taken on investments due to unprecedented market crashes. In the past we saw Surbanes - Oxley stepping in, and now we see Dodd – Frank standing tall. Law making however is a continuous process and everyone should expect it to keep coming up in waves rather than being a one-time fixture. Down this article, I wish to discuss the expectations set by the law, the response of the market players, the challenges faced by firms to put the legislations in practice and the need to blend compliance to the law into a firm’s work culture.
The Energy Policy Act – 2005 and Commodity Futures Modernization Act – 2000 enabled regulatory authorities like SEC, CFTC and FERC to impose severe penalties in case a firm is not in line with the regulations. Apart from the penalties, a charge under the law is also harmful for the reputation of a firm. All the market players are doing their own research so as to understand the expectations set by the law and practical ways to effectively and efficiently blend these into their work routine. This includes an increase in working costs and therefore a shift in profit margins and hence investment strategies. The key focus areas of the legislator are:
2. Clearing, execution, margining, and reporting requirements for all swaps.
3. Record retention, data accuracy, and trade confirmation capabilities and requirements for all swaps
4. Real-time reporting for all swaps
5. Identification codes, to uniquely identify counterparties (UCI), the swap (USI) and product (UPI).
The authorities will also have a hand in determining which contract to be traded on the exchange, which ones to be subject to clearing and which ones to be deemed as clearable. Also, they can now set standards for capital, margins and position limits for all transactions.
If you’re wondering why swaps steal the show in the picture, it is because swaps are largely OTC and hence are the most un-regulated and are usually not reported in a standard fashion. The rest of the lot are mostly standardized to a great degree and adequately monitored.
It usually takes up to a year for the rules to come up which support a passed legislation and the industry is usually given another year to adjust itself to the new legal setup. This means that the companies would be expected to be compliant with the Dodd-Frank act by mid of 2012.
As the company audits proceed, the firms are under a constant pressure to put a process in place in order to adapt to the law. Many firms are analysing the impact and opportunities resulting from it. The costs will definitely go up as compliance programs will have to be run as an add-on. Also new standards of data management and reporting are expected now. This might require a firm to re-think on the markets it trades in, the composition of its trading portfolio, and the profit margin it targets. The need is therefore to put an efficient compliance program in place which makes the new laws blend seamlessly into the corporate culture, as well as give a competitive edge. The change must be handled with flexibility and disruptive effects like changes in level of innovation, reduced liquidity and increased costs should be minimised.
The challenges which stand in the face of a swift adaptation are many. Most companies lack a compliance culture. It requires having a strong leadership structure, a sustainable investment model and commitment from every single employee. It also requires the culture to be put uniformly in all levels of the firm. Also the practices and processes have not fully developed which realize the compliance effectively. These have to evolve over time.
Another major issue is to simplify and improve the data processes for more quality and consistency along all sections of the company. Sometimes even if the data capture capability is sound, the meaningful consolidation of data to make the overall picture appear is an issue to cope with. Firms have to look at putting robust systems in place to get accurate trade data and to process it for effective real time reporting and consolidation.
Quantifying the risk a firm takes on account of being compliant with the law and facing penalties is a big issue in itself. To measure how much a company is exposed to violate legislation and to take quick trade decisions keeping compliance as well as profit in consideration is a tough job to handle. It requires analysis of data which needs to extremely accurate and consistent as well as reported in real time. This is a bigger challenge for firms which operate across numerous geographies and jurisdictions. The complexity also grows exponentially with increase in the types of instruments a firm trades in.
The standardization of processes and the new systems which come into place have increased the costs incurred to a good degree. The short term impact of this could be that the firm would re-think their trading strategies. In long term, this could also result in many firms exiting the US market to enter the less regulated Asian economies.
In the chaos, one thing that is clear is that a flexible and efficient compliance program will not only safeguard a firm’s interests but also provide a competitive edge over others. It is high time that companies all over the market wake up to address this need. This is not just a means to keep one’s hands clean, it’s a survival trait !
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