Regulation- A Surprising Catalyst for Innovation

Created in response to the global financial crisis, the Uncleared Margin Rules (UMR) are one of the most consequential regulatory events for the derivatives industry in recent years. While the rules were designed to reduce systemic risk, they have also led to a boom in technological innovation and standardization. Though not the original intention of the rules, the regulations have led firms to embrace technology and standardization. This technological explosion has unlocked efficiencies within the derivatives space, allowed pre-trade analytics to flourish, and optimized operations, helping firms reduce costs and capture more revenue.

As Phase 5 and 6 are set to go into scope in September 2020, and 2021, respectively, we continue to see how the UMR have compelled companies to use technology and standardization to streamline operations and reduce costs. For example, with estimates that over 400 firms will be in Phase 5 and over 700 will be in Phase 6, it is expected that over 10,000 new CSAs will need to be agreed between counterparties. This has led to a demand for increased CSA standardization in an effort to save time and cost for derivatives lawyers. In addition to making regulatory compliance easier, standardized CSA agreements provide better data to firms and help reduce operational risk by ensuring clarity among all parties involved in the agreement.

When I worked at ISDA overseeing the UMR implementation for the initial phases, I saw firsthand how the UMR have caused a knock-on effect regarding technology. Due to the regulations, firms began to embrace technology to ease the transition and make it easier to comply with the rules. As technology has been more widely embraced, it has improved standardization, streamlined processes and reduced costs. Now, firms have more data available to them, are spending less money on operations, and are well-positioned to benefit from the rise of emerging technologies. Technology and standardization have allowed firms to trade smarter, better and faster. While these knock-on benefits weren’t necessarily the goal of regulators, it has been a massive benefit to the derivatives industry that continues to accrue as more firms come into the scope of the UMR.

Almost any regulation has the effect of forcing an industry to become more efficient and serious about how they do business than they were before, and the UMR are no exception. Prior to the UMR and recent technological developments, most firms had their own bespoke processes and operations, leading to massive inefficiencies and costs within firms’ operations. However, these bespoke processes are woefully ill-suited for the increased requirements of the UMR, making the massive inefficiencies and costs brought on by these processes glaring issues. Much of the technology spurred by regulation within the industry has not only helped firms conform to the rules, but also helped them save costs on these processes while reducing operational risk. Previously cumbersome and disorganized pre-trade processes have been replaced by a robust pre-trade infrastructure that irons out inefficiencies and makes for smoother, faster operations.

In addition to freeing up time and money, standardization and technology have generated better data that yields valuable insights and analytics that can reduce operational risk in future trades. Pre-trade analytics has been one of the biggest beneficiaries of the technological boom of the 2010s. Firms are able to better analyze their trades, as standardization has made data more accurate and uniform and enhanced technology allow firms to access insights that previously may have gone unnoticed. Margin optimization and trade compression has become central to reducing counterparty risk and cost. Service providers today have eliminated trillions in gross notional through compression and billions in margin through collateral optimization. As the noncleared margin rules affect more and more firms in the coming years, margin optimization will play a key role in keeping business costs down in the OTC derivatives industry.

While technology is typically viewed as a means to reduce costs, over time it can play a critical part in generating alpha. Major banks have started to recognize this as they’ve seen how technology can free up more capital in other areas of finance and understand how the same principles can be applied to derivatives. There’s no real alternative to the derivatives industry for hedging risk, so it is imperative to keep this $600+ trillion industry robust and growing. Technology and standardization free up costs and help capture revenue that would otherwise be lost. Pre-trade analytics allow firms to have a better idea of the benefits and risk of a trade and when used wisely, resulting in bigger gains and fewer losses. Meanwhile, the costs saved can be redirected into more trades, leading to more profit and more revenue.

Lastly, a yet-to-be-realized benefit of the regulations is that the derivatives industry is far better positioned to take advantage of emerging technologies such as artificial intelligence and machine learning than it would otherwise be. It will be far easier to integrate these technologies into the existing technological infrastructure many firms now have than to integrate them into a firm with far more limited usage of technology and standardization. These technologies are often discussed as potential game-changers within financial services, and the embrace of technology that has already occurred means that there is a better idea of how these technologies can best be harnessed and possible pain points that could be solved.

The derivatives industry has reached a watershed moment, the effects of which will continue to ripple over the coming decade as more standards are adopted and further technological advances are made. The widespread embrace of technology has been one of the biggest positives resulting from UMR. By forcing firms to take a closer look at their processes, the UMR have unintentionally sparked a wave of innovation in a previously staid industry. The long-term effects of the UMR remain to be seen, but it’s evident now that the regulations have caused a shake-up in the industry in more ways than one.

John Pucciarelli is Director of Strategic Initiatives at AcadiaSoft. He advises firms on the impact of uncleared margin rules regulation on their processes. John was previously with The International Swaps and Derivatives Association (ISDA) as Director of Market Infrastructure and Technology.