The future of derivatives, securities lending and repo contract flows

Putting it all together – ISDA Collateral toolkit, Common Domain Model, Clause Library, Smart Contracts.

Back in 2013, Paul Kelly and I documented the state of negotiated ISDA documentation and the challenges it posed for the negotiation and onboarding processes as well as the high cost to derivatives participants – see Million Dollar Spreadsheet.  

Winding the clock forward 8 years we revisit the state of the market to assess the changes and map out how the initiatives being championed by ISDA afford a way to realise significant operational cost benefits.

With ISLA and ICMA also progressing similar initiatives and with a real sense of cooperation can real change be effected?

Then

The full article is worth a read, but the summary is this:   

  • Trade documentation contains important terms for managing day to day operations, risk and pricing
  • The process to create, negotiate and manage this documentation has not changed since the advent of the word processor (MS Word), email, printed contracts, scanners and PDFs
  • The price of this is an expensive process, littered with poor quality data and poor connectivity between disparate systems. 

The million dollar spreadsheet title refers to the kind of money being spent capturing data from these contracts following the 2008 financial crisis, often into throw-away spreadsheets.

Now

Frustratingly, as we look at the market now, little has really changed:

  • Plenty of vendor solutions offer to fix parts of the process but in most cases when it’s come down to it, time constraints and regulatory pressure means that many firms continue to revert to what they know
  • Rather than using digital negotiation platforms and document generation tools, most have continued to negotiate in word and use email as the workflow.

Compounding a reluctance to change, there has been a lot of regulatory pressure in those intervening years:  uncleared margin reform (variation margin, initial margin), Brexit, record keeping (QFC, BRRD), benchmark reform and that’s ignoring the market pressures, not least an unforeseen global pandemic that forced a year of working from home.

Strategic change in financial services is hard.  

Knowing what you should do and actually making the change are two very different things.  Change initiatives with large stakeholder groups and fairly opaque return on investment are even harder to get started.  

The derivatives flow is one such area:  

  • Front office initiate change
  • Risk monitor and set levels
  • xVA desks price
  • Legal create and negotiate the documentation
  • Back office teams digitise the data
  • Operations teams manage margin and disputes
  • Compliance projects drive regulatory changes

All of these groups stand to benefit from a more efficient end to end process, but quantifying how much is difficult.  Then there’s the matter of who should pay for the changes.

Its not all negative – out of the key pillars: create, negotiate, capture and use, there have been some improvements.   Those that can be adopted gradually, using the regulatory programme budgets to be more efficient is a neat way of doing this.

For example few banks still hold paper based contracts – most are now held in scans and many are searchable, largely as a result of record keeping requirements. Contract analysis and digitisation solutions are available that can manage and digitise the data from these contracts accurately and efficiently, reducing throw away or duplicated effort.

Another change is within the industry bodies such as ISDA and ISLA, that have been working on defining standards.  To facilitate adoption it really has to be driven by the bodies that create the contract templates. 

These standards include a Clause Library to simplify and standardise negotiation, but also to help the contract analysis solutions with data extraction going forward and a Common Domain Model to provide a language that can be used to facilitate better mapping between contract data and target systems such as collateral management vendors.

Future

The challenges to adopt these new standards will remain – strategic projects in this space are going to struggle to get approval in this climate.  Tools such as ISDA Create are good templates for what is possible, but will rely on mass adoption to really make a big difference.   The same is true for the Common Domain Model – the model needs to become common to realise its benefits.  Of course for those in-house builds and vendor solutions just starting out that do not already have their own proprietary data models the Clause Library and CDM are both great building blocks, saving them time and money.

For those established vendors that have already developed their own models, the key will be the impetus to map to the common standard.  The Open Source nature of the Clause Library and CDM are great enablers as they allow vendors to easily adopt a common standard and facilitate simple interoperability, but this requires investment.  Knowing that a critical mass of vendors are all investing in exporting and importing data using the standard is key.  

Finally we come to Smart Contracts.  The idea that contracts can contain executable code.  All of these foundations need to be in place before Smart Contracts can really be contemplated.  

It feels different this time though.  The ISDA surveys indicate that market participants are aware they are wasting millions on archaic processes, so perhaps that elusive return on investment business case is becoming clearer.  

Just because a change is hard to initiate and the process will be slow, the biggest failing would be to not start the journey…