Politicians are often accused by practitioners of trying to close the stable door after the horse has bolted. Inevitably, many regulations address the problems that caused the last crisis, but the rules imposed on the financial markets since Lehman Brothers collapsed in 2008 are a pre-requisite to the prevention of future shocks. “Overall, the spirit of the rules is about restoring confidence,” says Walter Ferstand, compliance and regulatory expert, NICE Actimize, a specialist technology vendor.
In theory, greater price transparency – the aim of the reporting, clearing and trading reforms to the OTC derivatives markets, as well as several other post-crisis regulations – should encourage more frequent trading by a wider variety of actors, leading to greater liquidity and more effective risk transfer. But such is the range of abuses uncovered in the past seven years – from insider trading to benchmark manipulation and beyond – that the post-crisis regulatory environment also requires significant levels of monitoring by market participants, both to demonstrate compliance to regulators and to deliver best execution to clients. And in this new, more transparent, world, investment managers are taking an increasing share of responsibility. “The buy-side has realised they need direct access to trade monitoring tools, rather than relying on banks and brokers. They must also realise that compliance must be automated, not manual, and that lack of size is no longer an excuse for lower levels of compliance. Claiming you have little or no budget for compliance won’t fly with the regulator,” says Ferstand.
For derivatives-focused traders at asset management firms in Europe, there are perhaps three main strands to the legal and compliance context within which they ply their craft. First, the G20 mandated introduction of trade repositories, central counterparties and electronic trading venues to the OTC derivatives markets has created a whole new regulatory framework – mapped out by the European Market Infrastructure Regulation (EMIR) and as-yet-incomplete MiFID II – leading to new workflows and new expectations for best execution. But it also offers the prospect of new data sources that will assist trade benchmarking and monitoring (as well as regulatory oversight). Second is the regulatory response to London-based rate-fixing scandals, which reverberated across the derivatives markets due to LIBOR’s widespread use as a reference rate in swaps contracts. The second Market Abuse Directive imposes criminal sanctions for insider dealing and benchmark manipulation and – in combination with MiFID II – expands the instrument scope and data fields required for transaction reporting rules. The final, but least tangible, change is in the attitude and expectations of regulators, who are no longer satisfied with proof of box-ticking by asset management firms as they increase their vigilance on systemic risk and investor protection.
The increase in regulatory scrutiny of buy-side trading operations is very evident to Amandine Garcia Villar, deputy head of investment compliance, Europe, Allianz Global Investors. Her job was created just under four years ago in direct response to post-crisis regulatory change. Previously operated along multi-boutique lines, Allianz GI has been run as a single investment manager since 2012 and identified strategic and operational benefits in creating a more uniform, harmonised compliance culture across its investment function globally.
Although remaining vigilant for evidence of abusive or illegal practices by other market participants, the number one priority of the Allianz GI compliance team is to ensure that the firm’s own trading activity remains fully compliant with the relevant regulations. This involves a lot of trade-by-trade monitoring, but Garcia Villar says regulators are increasingly keen on asset managers displaying a holistic compliance culture underpinned by sound processes and clear understanding of regulatory requirements on the part of trading professionals. “It’s not just about having the right controls in place. Regulators would rather that regulated firms prevent non-compliance rather than detect it,” she says. To this end, Allianz GI is using training technology to help to provide consistent compliance training for traders based in different jurisdictions.
A holistic approach to compliance demands a high level of collaboration between trading and compliance staff, says Garcia Villar. “Historically, the front office was not really expected to flag issues to the compliance team, but that has changed. They alert us to issues that may need investigation and there are certain decisions for which they are obliged to seek our approval. These days, traders are the front line of the compliance effort,” she explains. “We have daily interaction with the traders, not just about trade monitoring issues, but also to discuss how to handle upcoming regulatory issues. Being a trader is an exposed role in today’s fast-evolving regulatory environment, so they are grateful for support from compliance.”
The buy-side has witnessed a professionalisation of OTC derivatives trading in recent years. Pre-crisis, deals were typically struck by PMs with a very precise idea of the terms they required from brokers, but often with little reference to best execution or risk management. “Greater awareness of the risks of OTC derivatives trading at a senior level has led to the introduction of new controls,” says Oliver Allwood, consultant at Investit. And as centralised multi-asset dealing desks were increasingly expected to take over OTC trading duties, new utility-like services became available to support post-trade processes, such as confirmation and reconciliation. These were targeted primarily at the sell-side but are also used by buy-side firms with higher derivatives volumes.
While the reporting and monitoring obligations of the buy-side have increased, regulatory expectations are still lower than for brokers and exchanges. Nevertheless, larger buy-side firms have voluntarily increased investment in compliance, for reasons including supplier due diligence, brand reputation and best execution.
Michael O’Brien, global head of sales at SMARTS, the trade surveillance solutions firm bought by exchange operator Nasdaq in 2010, traces increased buy-side interest initially to due diligence on their brokers’ market abuse and monitoring capabilities when using DMA services. Since then, OTC derivatives reforms have led to a broad-based uptick in demand for surveillance tools. “Fixed income derivatives are very much in focus across the buy- and sell-side. Trade monitoring has to move away from spreadsheets and become more systematic,” says O’Brien. Historically, the voice-broked nature of the OTC derivatives markets made it hard to monitor trades or prove best execution. But rate-fixing scandals and OTC derivatives reforms have prompted further innovation, according to O’Brien, including feeds that combine newly available market and reference data to form the basis of meaningful comparison between transactions.
NICE Actimize’s Ferstand agrees that the automation required by new OTC derivatives rules will improve surveillance of the more liquid swaps over time. “To monitor on-SEF derivatives trades effectively, market participants must first have access to standardised data. For more complex, exotic derivatives and structured products, the challenge is even steeper. But once you have the data, you can begin to model,” he notes.
At Allianz GI, Garcia Villar confirms the buy-side’s appetite for automated surveillance solutions, but acknowledges the pace of regulatory change makes it hard for vendors to keep up. In a crowded market, few if any are able to provide a comprehensive trading compliance solution. For the time being, Allianz GI relies on a combination of in-house developed technology and human resources. “We have seen no off-the-shelf product that can meet the complex compliance requirements of a global asset manager with trading operations in multiple jurisdictions,” she says.