The EMIR exposure reporting due to commence in August 2014 holds no terrors at first glance. The fields which you have been allowed to leave blank until that date simply need to be completed, with Mark to Market (or Mark to Model) revaluations of each trade’s Notional Amount, and Collateral details for any Margin or other collateral posted by the reporting firm.
When you start to explore the logistics of delivering this information, however, the scale of the exercise becomes apparent. The first thing to realise is that mark to market data needs to be updated daily, assuming that the underlying asset has had any price movement during the day. This means that every trade, which up until that point may have been reported on a “fire and forget” basis, needs to be revisited each day until it is explicitly closed out. Since CFDs are typically reported with no maturity date, this stream of revaluations per trade could go on indefinitely.
As an illustration, take a large forex client of Abide who reports up to 200,000 trades per day.
• On Day 1 they report 200,000 trades with an Activity Type of N (for New)
• On Day 2 they report 200,000 New trades and update the 200,000 from the previous day with the new valuation
• On Day 3 there are 200,000 New and 400,000 updates to report
• By the end of the week they are submitting 1 million messages
How long can high frequency trading firms continue to revalue every trade before the infrastructure grinds to a halt? The solution to this quandary requires a little background explanation.
Position Reporting Is Not An Obligation
The ability to report at position level was introduced as a concession to industry pressure in the December 2013 ESMA Q&A. The original intention of the technical standards was that trade records would be updated daily with the mark to market and collateral information, as illustrated above. A six-month delay was introduced to the population of these fields to allow time for further guidance to be given and additional preparations by the industry. However the default position is still that from August 12 reporting of trades continues at present but with the addition of exposure updates on a daily basis.
The default arrangement of updating individual trades will work perfectly well for certain market participants, namely those who are active in the high-value long-duration OTC derivatives which were the original target of the legislation, such as credit default swaps and interest rate swaps. For these products the low volumes of open trades means that the day one trade effectively becomes the position from day 2, and can be marked to market throughout its duration without complication. For all markets where multiple trades are undertaken in the same contract on the same day, this approach is more problematic. This includes high frequency and intermediate value markets such as exchange-traded futures and options and high frequency low-value markets such as retail CFDs, Spread Bets and rolling spot Forex . The result of applying the same approach here Leads to the explosion of reportable messages we saw in the illustration above.
Position Reporting Is A Practical Necessity
The Compression mechanism was originally designed to allow pairs of counterparties with large swap portfolios to net them down periodically to simplify their positions. This technique has been brought into service as a way of simplifying the treatment of high-frequency products. The basic approach is:
• Report each New trade (ie with Action Type set to N (for New) and Compression set to N (for No)
• Cancel each individual trade with an Action Type of Z (Cancellation due to Compression)
• Report the netted position as a New record, with Compression set to Y (for Yes)
All trades and modifications are reportable by T+1, so each of the above steps must take place in swift succession. The order in which the first two steps take place is also crucial as Trade Repositories may reject a Type Z submission for which they have not yet seen the New record.
It is not possible, per ESMA advice, to avoid the reporting of individual trades, and in the UK the FCA has advised that it is not possible to skip any steps in the lifecycle process (eg by reporting only the cancel). Therefore the above reporting pattern, ungainly and wasteful as it is, achieves compliance with the rules and guidance while avoiding a geometric growth of submitted messages.
Other Approaches Possible
Some Abide clients have already implemented a routine clean-up process whereby trades in the same contract with the same counterparty are aggregated and, wherever the buy and sell quantities net to zero – the trades are cancelled. This has reduced the number of trades to be cancelled and rolled into positions once mark to market starts. It would also be possible to program a LIFO or FIFO accounting-style system whereby incoming trades which wholly or partially offset previous trades in the opposite direction would result in the original trades being cancelled or modified. Firms that have considered this approach have generally found it to be too demanding in terms of analysis and systems development effort.
Abide is consulting with its Retail Derivatives User Group to refine our recommended approach to marking to market, but it is most likely to follow the Report/Cancel/Position pattern described above. Do you know of a better approach? Feel free to share it via the comments section or by contacting me at mark.kelly@abide-financial.com
