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Central Clearing of FX Derivatives: Dodd-Frank Regulatory Effects


The Dodd-Frank Act is driving significant repurcussions in the FX derivatives market as the move to central clearing will require a host of changes in the industry.  The Act is requiring new hiring, new systems, new relationships and new data. 

The move to exchange trading of FX derivatives will have direct effects on Swap Execution Facilities (SEFs, or trade execution venues), Central Counterparties (CCPs, or clearing service providers) and Swap Data Repositories (SDRs, or data warehouse providers of full lifecycle trade details).

Standardization of FX Derivatives Static Data

Without standardized data in all of the related systems it is impossible to accurately match trades.  The primary efforts required is in standardization of counterparty identifiers, which has begun with the Unique Counterparty Identifiers (UCI) initiative among major OTC derivatives market participants.  The problem currently exists that each counterparty's system can have a different ID for the same counterparty on the same deal.  Even if two counterparties use industry-standard data providers like Bloomberg, Reuters, IDC or S&P, they often utilize two different data providers.  There are also challenges with interpretation of counterparty identifiers at the business unit level, which is a constant challenge as legal entities are formed, merged or closed down. 

The UCI initiative requires mass coordination of global counterparties and in some cases, significant expenditures to add translation and processing layers.  Adding data transformation layers reduces speed and efficiency, which must be taken into account in each organization's system investments.  Even if CCPs and SDRs arbitrarily define the eligible universe of counterparty IDs, the counterparties themselves must also adapt.

The data warehouses being built by Swap Data Repositories also require a large number of details, some of which do not currently exist in dealers' systems.  Ongoing reporting of each FX derivatives trade and its events will require timeline-driven transaction data, not just a notional value, a few terms and conditions and the two counterparties.  If a trade is split or allocated to customer accounts, this will further increase the data details.

Clearly, a comprehensive data model that captures all of the required FX derivatives transaction details is required.  Recent regulations have been implemented by the National Futures Association for additional trade, customer and entity relationship details, even down to the individual rate change ticks.  This is a substantial and long-dated industry project that should keep data providers and consultants busy for years.

FX Derivatives Deal Types

Dodd-Frank currently applies to FX options and FX non-deliverable forwards (NDFs), which fall under the "swap" designation of the Act.  These trade types must meet the full trade lifecycle requirements from trade execution, through clearing and reporting.

In April 2011 the U.S. Treasury proposed exclusion of FX swaps and FX forwards from the full Dodd-Frank "swap" requirements.  For these trade types, only the reporting requirements of the Act must be met.

Trade Lifecycle Requirements

FX options and NDFs are subject to the full trade lifecycle requirements of Dodd-Frank.  These include new workflows and processes for clearing these FX derivatives.  Full trade lifecycle reporting is required, including trade execution, terms and conditions, counterparties, counterparty relationships, events such as fees, cash payments, rate changes, calls or puts, and expirations. 

In some instances, large counterparties which acted independently previously for their own account must now take the role of Central Counterparty (CCP).  This is occurring for large broker-dealers and other market makers, which must now focus on building out their clearing infrastructure as opposed to dealing bilaterally.

Full review of end-to-end workflows and various connected systems is underway.  Replacement, enhancement or retirement of many systems will be required.  Even without complete regulatory requirements the transition and investment in IT infrastructure is underway to meet Dodd-Frank's timelines.

Staffing and Skills to Handle FX Derivatives Clearing

Back office staff will also need to learn new workflows, processes, operational procedures, and adapt to the new systems.  Where back office staffing was insufficient, this area will need beefing up to ensure full capabilities to execute the new FX derivatives central clearing regime. In particular, IT staff with core competencies in data processing and security, as well as back office analysts to design and implement counterparty and transaction data workflows are needed.

The slow-going nature of Dodd-Frank's implementation and rule-making is allowing market participants to adapt the new FX derivatives landscape.  Multiple rounds of regulatory proposals and industry commentary periods indicate where staffing enhancements and retraining need to occur. 

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