Chaos to Clarity - The CFTC STP 10 Minute Rule
In keeping with my passion and theme of 'Chaos to Clarity', I want to decode CFTC's Straight Through Processing (STP) 10 minutes rule which has gone into effect on August 1, 2016.
The STP Mandate
Starting August 1, The CFTC requires that all cleared swaps (mandatory or voluntary) executed on a Swap Execution Facility (SEF) should be sent to a Derivatives Clearing Organization (DCO) within 10 minutes, although a longer period is permissible in the event errors are discovered in the transaction and have to be corrected. The guidance also notes that the use of an affirmation hub or third party middleware platform i.e. MarkitWire or ICELink does not excuse compliance with this timing standard.
10 minutes is the new AQATP (As Quickly As Technologically Practicable) standard (if fully automated systems were used) per the CFTC letter dated December 21, 2015 - all in the spirit of providing certainty of execution and clearing.
Current Operating Models
Execution methods are broadly divided into "Electronic - order is electronically filled" and "Voice Executed - SEF voice broker facilitates the execution process". In both these scenarios, trades are eventually submitted to the DCO for clearing. In the case of voice trades, however, human intervention is involved in more than one step of the processing chain.
These two broad categories - Electronic and Voice - can be broken down into four execution-to-clearing workflows.
- First, when trades are directly submitted to a DCO. This is the true STP flow which ensures that trades are cleared within a few minutes if not seconds from execution.
- Second, trades are submitted to an affirmation hub before being released to a DCO for clearing. Although an affirmation platform is involved, in this case, trades are automatically processed without the need for counterparties to affirm the terms of the trade. So we have another STP flow ensuring timely clearing submission.
- Third, trades are submitted to an affirmation hub and both counterparties have the opportunity to review the terms of the trade before releasing for clearing. This allows for any error remediation at the SEF. This flow however, introduces minutes and oftentimes, hours of time delay in the clearing submission process.
- Fourth, trades are pre-arranged using an Inter-dealer broker and then submitted to the SEF. Given the non-electronic nature of these trades, they necessitate a control step of counterparty affirmation on the hub to allow for error remediation. Herein lies swap industry's biggest challenge. Additionally, any trades booked as a result of a multilateral electronic trade matching (aka services offered by RESET, TPMatch) fall into this category. Affirmation of voice trades can take hours (and in some cases days) due to manual nature of the flow and the incidence of operational errors.
What happens if an erroneous trade is accepted or rejected by the DCO? Addressing the errors after clearing will often prove to be difficult and costly. Additionally, counterparties may have to bear significant margin costs until the error is corrected. These concerns need to be addressed before this flow can be truly STP. Benefits offered by a post execution validation mechanism are significant enough for them to be not given up.
So what is the industry doing to facilitate 'prompt and efficient transaction processing within 10 minutes' as mandated by CFTC?
In cases where it is practically possible, market participants are moving in the direction of "auto-processing" which means trades will be automatically submitted to the DCO by the affirmation hub without requiring counterparties to review and affirm. This largely holds true for the third flow mentioned above and part of the fourth one related to matching reset runs. With these trades, there will be no need for post execution validation by counterparties since existing controls and checks at the point of the trade or pre-trade have largely proven effective.
For voice trades, post execution validation i.e. manual affirmation, will be a prudent approach to prevent errors from persisting downstream and hence causing direct cost impact to participants. A number of internal policy and behavioral adjustments need to be made by market participants to increase timeliness by accelerating the manual affirmation process. This might take the form of removing internal rules that prevent or delay trade submission to clearing or prioritizing action for SEF executed trades in the overall portfolio. SEFs are making continuous efforts to enhance robust error trade policies and will ensure that trades are delivered to participants immediately after execution of he transaction.
It is equally important to ensure that key metrics are measured and tracked by all participants to understand the points of failure and remediate them over next few months - either by using internal systems data or external service providers.
August 1 and Beyond
Submission to clearing within 10 minutes is a key industry move towards clearing certainty and prompt and efficient processing and is challenging the fundamental model of doing business which has been in existence for number of years.
Can we get there all the way? That's a million dollar question.
Do we know how to process a swap spread trade within a few minutes or determine its start of execution given its dependency on the treasury leg? Can we find alternative solutions to reduce potential operational errors and hence the need for manual touch? What are the longer term enforcement mechanisms for this rule? These are some of the key questions that the market participants are grappling with and have to jointly find answers to.
Interestingly enough on the other side of the Atlantic, MIFID II is introducing a similar obligation [RTS 26 Article 4(1)] that requires bilaterally executed cleared derivatives trades to be submitted to clearing within 30 minutes and requires clearing members to obtain evidence on the execution timeframe. Another flavor of the CFTC STP rule!
In whichever way we choose to get there, we are definitely one step closer to real time clearing in its race to zero!
Disclaimer: The views expressed in this blog are mine only and do not represent those of any employer, past or present with whom I have worked.