Derivatives boom ramps up operational pressure
Firms are required to raise the bar through the trade lifecycle, from order management through to post-trade confirmation, netting, settlement, and reconciliation.
February 20, 2023
This year looks to be uncertain as the last and regulatory changes, ESG scores and the blockchain are set to play pivotal roles in determining success or failure for some.
The pandemic brought us unprecedented levels of uncertainty for commodities trading resulting in the steepest one-month decline in prices on record. Mckinsey noted that more than 90 percent of executives expected the fallout from COVID-19 to fundamentally change the way they would do business over the next five years. Almost as many asserted that the crisis would have a lasting impact on their customers’ needs.
In times of upheaval, change may be required and with uncertainty still surrounding this coming year, more innovation is likely to be in store. The cloud, machine learning, blockchain and AI are all technologies being evaluated with no solid sense of exactly how they will be deployed or the impact they will have. Will any of them be the difference between success and failure? As the year gets underway, we have a look at three trends we expect to see in 2022.
1. Regulatory Change EMIR
The European Markets Infrastructure Regulation (EMIR) Refit Regulation purpose is to amend and simplify the EMIR and address disproportionate compliance costs, transparency issues and insufficient access to clearing for certain counterparties. The deadline to implement it has continually been extended but once again it is within sight. It’s likely to be a key topic in the regulatory reporting space in 2022.
Stakeholders need to understand and prepare for the upcoming changes, that are still being negotiated. These changes are forecast as being monumental to the industry and whilst most have a broad idea of what this will entail, the specific details remain unsubstantiated and undefined. The Devil is in the detail and with a lack of a definitive outline, regulatory reporting will take a pivotal role in moving forward and overcoming these new regulatory hurdles.
Regulations simply don’t disappear, and organisations will need to overcome further challenges surrounding enhanced surveillance, oversight, and regulations specifically around the flow of data. Add in AML regulations, expanding requirements for behavioural surveillance, greater enforcement of data security and ESG-related mandates, and it’s a lot to stay on top of.
With risk, there is reward though and these new regulations could lead to a host of new opportunities. Regulators are demanding more detail and real-time information, allowing the industry to gain efficiency by shifting from mechanical report production to cloud-based information management tools.
2. ESG (Environmental, Social and Governance)
The importance and impact of ESG has been exponentially increasing over the years and this year it could play a bigger role than ever. Almost all institutions now need an ESG score to attract investors and the higher the score the more favourable the investment tends to be. A lack of standards though has heightened the sense of uncertainty surrounding ESG and everyone is now trying to implement initiatives that will give them a more beneficial score.
The trend has led to many initiatives as each organisation tries to get the upper hand. New technology models are now introduced with an emphasis on improving their ESG score and the drive to remote working has opened up a range of possibilities in improving one’s environmental score.
3. Blockchain and other Digital Asset Classes
Some regulators have put significant barricades in the way of firms experimenting with blockchain technology. Blockchain is an entirely different proposition and there is still concern around the regulation of it. Especially how it differs from previously established operations and technology platforms.
The New York Times recently reported on how BlockFi, a fast-growing financial start-up, “claims to have more than $10 billion in assets, 850 employees and more than 450,000 retail clients who can obtain loans in minutes, without credit checks”. It’s able to offer these services without credit checks as rather than dealing primarily in dollars, it operates within the blockchain and digital currency space.
The technology has disrupted the traditional financial services world at such a rapid rate that regulators have fallen behind leaving consumers and the financial markets in a vulnerable position. Due to the lack of regulations, there are often instances of fraud, hacking and speculation which does not occur in the traditional previously established markets.
Despite these concerns, 2022 is expected to see more businesses invest in blockchain technology. This is likely to cause compliance challenges for regulators, particularly around fitting current blockchain innovations into contemporary regulatory structures, which are as yet unprepared to handle them.
With the blockchain, the increased interest around digital assets comes with it. As investor portfolios are increasingly including digital assets such as cryptocurrency in their portfolios, 2022 will see the creation of new and complex asset classes and additional challenges around reporting.
The acceleration of innovation, advanced technologies and regulatory change continues to bring challenges for the derivatives reconciliation industry. However, it’s not just about advancements in technology, developing in-house capability, adopting new innovations and applying them will what creates an advantage.
Our recent research report highlights some of the issues discussed above. The report commissioned by Kynetix and based on a survey and series of interviews with executives at over 60 sell-side firms, argues that through investment in technology, data normalisation or standardisation and automation, firms can navigate the ‘data jungle’ whilst achieving a new paradigm of risk reduction and efficiency.
In the report, we set out to benchmark approaches being taken by different parts of the industry, to understand the drivers for investment and get insights into how much automation is currently being deployed to mitigate risk versus sheer numbers of manual operators and processes in derivatives reconciliations.
Firms are required to raise the bar through the trade lifecycle, from order management through to post-trade confirmation, netting, settlement, and reconciliation.
The implementation of AI in post-trade operations could lead to increased accuracy, efficiency, and compliance, creating new opportunities for the industry.
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