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MiFID 2 Timestamps

Time is yet another example of how MiFID 2’s range makes a simple concept fiendishly complicated.  Activities like high frequency trading (HFT) measure time in micro seconds and smaller intervals whilst a structured transaction that’s taken six months to negotiate often appears to be executed over several days as the final terms are specified.  The new rules attempt to cover both of these extremes and also define what is the benchmark for time, it’s UTC and where can you find it.

MiFID 2 sets higher standards for HFT venues and traders whilst still setting a minimum precision of a second for more traditional dealing methods.  One second may sound fairly easy to match but remember every few years the physicists decide to add a second to UTC (usually at year end) to keep this measure in time with the way the Earth and the Solar System currently operate.  This gives system architects a headache.  Every computer ships with an on-board clock chip running the mother board.  But I’ve never heard of one of these clocks being set up for leap seconds so software clocks over the network might be better, but then how fast is your network, if the server is in Europe and the trader is in Tokyo what time is it actually telling?   Lots of practical issues for the very large firms with global operations affected by MiFID 2.  Here’s a quick summary of the MiFID 2 rules.

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The Good Cleanup Guide

Apologies for the break in updates, I’ve been busy moving from Singapore back to London.

Anyway with year-end approaching fast the need to have a clean balance sheet is rising in controllers’ agendas and the reality that some areas have not had effective controls needs addressing.  I once spent a complete year on cleanups and learned a lot about how to tackle them as they are projects unlike the normal systems and business development.  They are a little like the now notorious Fatburgs that are blocking London’s sewers.  Like the Fatburgs their causes are simple, management didn’t want to ensure that what they sent downstream could be handled and sent it anyway.

  • Trading products for which downstream systems cannot support.
  • Giving operational and accounting responsibility to under resourced departments.
  • Failing to ensure staff have adequate knowledge and training in their duties.
  • Failing to upgrade downstream resources for changes in industry practices (like margin reform).

For those being tasked with a cleanup, here’s a guide to the best way to go about it.  The Good Cleanup Guide

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EU Updates Financial Reporting Templates for IFRS9

This isn’t earth shattering, the main provisions of IFRS 9 are coming into force in January 2018 and naturally there will be changes to the format of published financial statements.  The EU uses this as the basis for statutory returns that firms must make under CRR.  The original delegated regulation for this is 2014/680 and parts of this are now being updated by 2017/1443.  But the size of these technical rules is illustrative of the costs of regulation.  2014/680 is 1,861 pages long with hundreds of reporting items defined and referenced for inclusion in an electronic submission framework.  The update is a mere 527 pages and all firms will need to update their reporting to comply for the first reports which will be for Q1 2018.  That said once the update is complete the compliance should be fairly automatic for a firm that already has its IFRS lines produced at a detailed level.

On this subject there are firms that email MIS spreadsheets daily to their regulators which is considerably more primitive and time-consuming for both sides.  If the EU was serious about promoting efficiency it ought to put a time bar on how long these solutions should permitted before electronic submission is required.  Or perhaps make it part of a scorecard which leads to a capital add-on reflecting the higher risks a firm carries when it tolerates weak reporting infrastructure.

 

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The FRTB will tighten Desk Management Standards, Trading/Banking book Position Transfers and Banking Book hedging

As well as upgrading the market risk capital rules the FRTB will set much higher standards over the governance, management and operation of trading desks.  Desks must be defined in detail with traders assigned to a single desk which must have a designated desk head.  As previously covered the FRTB is prescriptive about what instruments and activities should be part of the trading book and what should not.  Further moving positions from trading book to banking book will be much harder, banks need to document the reason, receive senior management and regulatory approval and then publish the fact and adjust their capital calculations  to prevent any capital benefit.

Using the trading book to hedge banking book risks will still be possible but different risks require different approaches;
1) Equity and Credit risk need an external trade that exactly matches the internal risk transfer trade.
2) Interest rate risk needs the internal risk transfer trade to be dealt by a specific desk set up for that process, this desk can then trade hedges with third parties.
3) FX and Commodity risk will only require an internal risk transfer to a standard trading desk.

Trading book risks cannot be moved to the banking book for regulatory capital purposes.

The EU published a proposal to amend the existing CRR rules to meet the new BCBS standard in November 2016.  Here is an analysis of the governance, position transfer and risk transfer provisions, comparing the existing EU rules with the BCBS standard and EU’s proposal.  As one would expect the proposal follows the BCBS standard very closely and at this stage the EU does not seem to be intending to “gold plate” or add any extra rules.

 

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MiFID2 Pre and Post Trade Transparency

The upgrade to the trading transparency regime is one of the largest components of MiFID2.  MiFID1 was very equity focused while MiFID2 has a vast scope across financial markets.  The regime focuses on three areas;

  1. Pre-Trade – When should orders be public?
  2. Pre-Trade – When should quotes and expressions of interest be public?
  3. Post-Trade – When should executed trade details be made public?

Financial instruments are divided into asset classes, sub asset classes and sub classes and their liquidity assessed.  Asset classes include bonds, interest rate derivatives while the sub classes cover areas like the maturity and underlyings of derivatives.  The liquidity assessment uses several methods and some of the levels are initially more relaxed being tightened over the next few years.

More liquid products (like equity shares) will be required to make more activity public while illiquid products will have waivers to allow participants to disclose less pre trade information and to defer publication of trades executed.  Generally, the rules are split between those for equity like instruments (shares, depositary receipts, ETFs, certificates) and non-equity-like (bonds, structured finance products, emission  allowances and derivatives).  Equity publication may be deferred one or two hours or until the end of day while non-equity-like publication may be deferred for two business days.  There are also provisions for regulators to effectively suspend the whole non-equity regime for months where a liquidity crisis occurs (MiFID2 is peppered with special rules covering government debt markets).

The detailed analysis can be found here.  These rules should also be viewed with the new requirements over the provision of best execution and the evidence that investment firms will need to keep to prove their compliance.

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An Overview of IFRS 9, Accounting for Financial Assets and Liabilities

IFRS 9 is a major upgrade to the accounting rules for financial instruments coming into force in 2018.  It has four main areas described in more detail here

  • There are new rules covering the classification and recognition of revenue/losses from financial instruments.
  • Impairment is to be measured on an Expected Credit Loss rather than the previous incurred loss method.
  • Own Credit Adjustments are to shown only through Other Comprehensive Income.
  • Hedge Accounting is to allow broader types of hedges and instruments to be hedges better following commercial practice.

Most of the excitement is on the second bullet above as this is requiring a major re-engineering of banks’ financial assessment of their expected credit risk losses.  Banks that already use their internal models to estimate expected losses for their regulatory  capital are better placed than those who have just used Standard Rules calculations.

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A Guide to Fed Watching

US Dollar interest rates dominate domestic and international finance.  The overnight Fed Funds rate generally follows a target set by the Fed Open Markets Committee chaired by Janet Yellen.  From the outside this committee can seem rather obscure and difficult to read, which has lead to a pocket industry of economists and analysts reading the tea leaves of officials’ statements and the economic statistics published.  My explanation of the process and things to watch out for is here.  I think the most important element is spotting when a voting member of the committee makes a comment which shows a change in stance on rate setting, i.e. if a more conservative (hawk) member views cutting rates favourably or a more liberal (dove) thinks that rates need to rise.  These terms are relative, in reality the US economy is not guided by Chávestas.

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The Strengths and Weaknesses of ORFs

ORFs (Operational Risk Frameworks) are now part most big banks’ management of their operational risk.  But they’re not the panacea for all a firm’s operational risk, mostly because they are far too subjective and also struggle to predict the magnitude of a potential loss, for much of the same reasons that operational loss models have lost credibility in the last few years.  But having said all that, they’re better than having not structured framework to assess the operation of process and controls.  Here’s a paper on the topic.

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The Challenges of Operational Risk

Operational Risk like much of banking has just come through a tough time where despite serious improvements in the structure of its risk management the Basel Committee is recommending the removal of internal model approval (mostly due I think to their failure to estimate the enormous losses of the last few years as conduct related fines have hit the industry).  Here’s a short article comparing Operational risk to Market and Credit risk to show the gaps and challenges facing it.

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Banking Interviewers’ Guide

I think most of us at some time or other end up rushing to an interview, not having reviewed the candidate’s CV properly and with no real idea of what appropriate questions to ask.  Well I can only advise, do read the CV before the interview but in terms of the questions here’s a little app for those on Android phones to help you out on the questions.  If you’ve got some good questions of your own you’d like to donate please email me.