Lemonade From Lemons—Analytics Benefits of Dodd-Frank Compliance

by Patrick Woody, RiskAdvisory

No matter what twists and turns the Commodities Futures Trading Commission (CFTC) might take in deciding its final definitions for Dodd-Frank Act Title VII implementation in the run-up to June, one thing is certain: Compliance is compulsory and imminent.

Think what you will about the Dodd-Frank Act, but don’t expect regulators to back down from their insistence on implementing measures they say will add transparency and safety to swaps markets.

Any final heel dragging that energy sector players muster during the next few months likely won’t work. Regulators have done this before with the financial services sector’s implementation of real-time, high-volume transaction surveillance in the foreign exchange and cash-clearing markets. The reporting burdens of the Patriot Act, anti-money laundering and the Office of Foreign Asset Controls regulations were deemed draconian and “un-practicable” when first prescribed. It took only 18-36 months for the technology to catch up and spawn a line of vendor solutions that automated the un-practicable aspects of regulatory reporting. Regulators know this, hence their apparent lack of sympathy for implementation hurdles that industry has expressed about Dodd-Frank compliance.

Energy companies must accept regulatory reality—admitting the inevitability of Dodd-Frank reporting and focusing on streamlining compliance activities and deriving business upside where possible. Facing mandatory expenditure and systems alterations, they must harness the opportunity afforded by these compliance requirements to improve day-to-day business operations, bringing useful metrics and analysis to their legacy environments through business analytics. When investment is inevitable, monetize it. The outcomes of new automation and post-trade efficiency will provide quantifiable benefits for energy and commodities traders in ways that financial services trading floors have enjoyed for years.

Dealing in the Known, Unknown

The CFTC’s delayed rulemaking has provided utilities with buffer time to mobilize teams and evaluate systems. The uncertainty in the rulemaking, however, and particularly the critical definitions of a swap dealer, major swap participant and what defines a reportable swap, has provided a reason to delay making necessary investments and directional decisions. But given what is known, what can utilities do to comply and thrive using the compliance-driven transformation upon them?

Some observers viewed the Feb. 23 CFTC postponement of defining swap dealer as a sign that their advocacy for end user status is persuading the CFTC to adopt a narrower definition of swap dealer, major swap participant or both and consequently a more generous definition of end user. But don’t get too excited. The rules for end users still will present problems in determining which party will do the reporting and who will transmit data to the swap data repository. Data-reporting responsibilities will be unavoidable for end users, as they are for swap dealers and major swap participants. Why are utilities waiting to decide how and when to move toward real-time reporting and recordkeeping? The minimum requirements for recordkeeping and reporting are in place for swap dealers, major swap participants and end users alike. Whichever classification, the minimum requirement is the same.

As seen in the financial services industry’s experience with foreign exchange and cash-trading regulations, Dodd-Frank includes four key areas where more operational efficiencies and benefits can be gleaned beyond meeting mandatory compliance requirements: real-time work flows; data aggregation; activity-based costing; and trade surveillance. All require greater collaboration among managers in the front, middle and back offices, as well as equally critical collaboration with the information technology organization.

Real-time Work Flows

Trading in a real-time reporting environment will require many new system changes for firms that must comply with Dodd-Frank. Many confirmations created in the bilateral over-the-counter (OTC) market are exchanged in an end-of-day process and verified the next day. Some systems create the confirmation as a byproduct of accounting batch entries that post in overnight general ledger processes.

That time delay creates an unnecessary risk when a trade is booked incorrectly and not detected until confirmations are exchanged and checked by both parties. Its inefficiency is apparent, but many firms operate every day with this time-delayed work flow of checks and balances. If they have not suffered trading losses or decreased profit from trade-entry errors, they are lucky gamblers.

Real-time CFTC reporting will put stress on that operating model and expose it for its operational risk. Complying with Dodd-Frank will compel a trading organization or its technology vendors to create a real-time confirmation work flow that enables concurrent real-time reporting, bilateral confirmations and broker checkouts. Moving this operational event from an end-of-day to a real-time process will benefit the business beyond the compliance requirement by speeding the back-office process for detecting trade-entry errors and mitigating human errors that cause trading losses.

Here’s another benefit to real-time reporting: The longer a trade error remains undetected, the longer the firm’s position is represented incorrectly to others on the trade floor, where trading decisions are being made against this faulty position information. Giving traders more time to react in the market is critical to preventing a human error from becoming a trade loss.

Removing Silo Barriers to Aggregation

Most utility and energy firms have trading data spread across disparate systems that have become entrenched silos. Failure to aggregate the data from these silos means duplicating compliance costs by solving the same Dodd-Frank reporting problem in each silo. A trading organization with separate energy trading and risk management (ETRM) systems for power, natural gas or fuels would need to retrofit each system to report swaps in real time. Such duplication adds compliance costs and diverts already scarce resource bandwidth and capital.

A more practical approach is the aggregation of the disparate data into a centralized regulatory data model—one with minimal intrusion to incumbent ETRM systems and silos of data. Such aggregation optimizes compliance investments, but it also provides a data framework foundation that can be used to create additional business intelligence by capturing overall gross and net positions based on a singular, aggregated view of the truth across all asset classes.

Endeavoring to aggregate data becomes even more critical when considering the new trade-level data required by Dodd-Frank: unique product identifiers (UPIs), unique counterparty legal entity identifiers (LEIs) and unique swap identifiers (USIs), to name a few. Each must link to individual swap records, which impose a new reporting burden and create opportunity to optimize the use of regulatory capital.

Activity-based Costing

The Dodd-Frank Act is forcing organizations to rethink their portfolio mixes based on whether trades are bilateral OTC or exchange-based. New costs of maintaining margin and securing credit lines, as well as the added regulatory transaction fees associated with reporting, might turn marginally profitable deals into losses after all the costs are allocated. The industry makes a standard practice of tracking transportation costs, storage fees, transmission costs and even broker fees at the deal level for invoicing and profit and loss accounting. In the new regulatory climate, it will become prudent to do the same for regulatory costs.

Before Dodd-Frank, compliance and reporting were viewed as infrastructure and administration overhead. Now that this cost is increasing, it must be measured, monitored and allocated at the deal level to assess trade profitability.

Activity-based costing (ABC) can capture these costs using financial business intelligence at an operational level. ABC provides a more accurate account of the regulatory costs by trade and trade type and empowers management with both the information to determine which trades are profitable and the means to optimize the use of margin and capital lines.

Harnessing Investments to Mitigate Whistle-blower Risk

Through many new whistle-blower incentives, the Dodd-Frank Act adds another compliance stricture to the trading environment that firms can turn to their benefit.

Dodd-Frank offers generous monetary rewards to eligible whistle-blowers: a lucrative bounty that ranges from 10 to 30 percent of the sanctions regulators collect. Newedge recently was fined twice for a total of $900,000 for late and inaccurate reporting, which punctuates that whistle-blowing is not limited to malfeasance; it can apply to other forms of noncompliance. Market participants must shore up existing efforts and be more proactive. Firms must do much more than maintaining a paper file of ethical conduct signatures and schedule awareness training. This whistle-blower risk can be mitigated only by implementing real-time surveillance, alerts and reporting.

Trade information housed in a centralized regulatory data model for reporting purposes also can be tapped for surveillance analytics designed to root out malfeasance, manipulation and errors. This confluence of deal data allows analytical models to perform surveillance and detect patterns of trading behavior that expose noncompliance.

For example, real-time surveillance can prevent against some common market-manipulation techniques such as banging or marking the close with block trades, or trades at settlement, in an attempt to affect settlement prices or washing fictitious sales prearranged between buyer and seller to negate price discovery and competition.

Tax or Opportunity?

Dodd-Frank compliance requires a significant investment of funds and resources. But if your organization’s reaction to the burdens of Dodd-Frank are similar to its reaction to new taxes, you might be missing an opportunity to derive greater business benefit through some of these compliance investments. Firms that fail to take advantage of the business improvements enabled by the capital expenditure mandated by Dodd-Frank overlook a powerful opportunity to make business lemonade from regulatory lemons by bringing added efficiency and risk control to their trading operations. 


Patrick Woody is senior strategist for regulatory risk compliance at RiskAdvisory, a division of SAS. Woody has extensive experience working with trading and clearing operations implementing regulations and controls.

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