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Regulation, risk and the rise of negative affirmation
As far back as 2003, the Federal Reserve Bank of New York began to focus on growing operational and legal risk in OTC derivatives. OTC derivatives volumes had been increasing significantly year-on-year and the operations departments of the major G14 banks, hampered by a lack of standardisation and manual processes, faced a dangerous backlog of unconfirmed trades, meaning banks had assets at risk.
Alarmed at the risk associated with the backlog, the Fed worked with the industry to reduce the backlog and achieve a sustainable future by promoting standardisation and increasing the use of electronic trade confirmation. Over the years, progress was profound, particularly in credit and interest rates derivatives where today approximately 99% and 90% of trades, respectively, are electronically confirmed using MarkitSERV.
Progress has also been made in equity derivatives, but diversity in the product set, regionalisation and limited standardisation in the Master Confirmation Agreements complicate efforts to make a larger part of the market eligible for electronic confirmation. Today, around 36% of equity derivatives are electronically confirmed.
The goals of regulation
After the financial crisis, regulatory bodies around the world implemented rules intended to make the global derivatives market even safer and more transparent. Beyond requirements for trade reporting, central clearing and trading on venues, there are rules for mitigating risk in non-cleared derivatives. These include deadlines (which vary from one to five business days) for confirming trades.
For electronically confirmable trades these targets are achievable for the vast majority of transactions. However, exceptions do occur and participants face a dilemma in how to ensure 100% compliance with a regulatory obligation subject to potential enforcement action. The challenge is particularly acute for products that are not yet electronically confirmed, such as many equity derivatives, which require a manual process. Rather than risk non-compliance, some firms have turned to the thus far little used practice of negative affirmation and have even withdrawn certain types of trades from electronic confirmation in favour of negative affirmation.
Solution or added risk?
With negative affirmation, if the recipient of a trade notice does not dispute the terms of the contract within a defined period, typically 24 hours, the trade is deemed "confirmed" and the regulatory obligation has been met. However, the lack of true bilateral confirmation reintroduces or perpetuates the very risks which the industry and regulators have worked so hard to mitigate.
The confirmation process, whether electronic or paper, creates a positive feedback loop. I agree with your view of the trade and importantly you know that I agree with your view. Simultaneously, you agree with my view of the trade and I know you agree with my view. However, there is no feedback loop in the negative affirmation process. The sender has no way of knowing if the recipient has received a trade confirmation or agrees to the details provided by the sender. The recipient might not even know the trade exists, as no one would chase for a missing confirmation without knowing about the trade in the first place. Similarly, even if the recipient had replied, the sender might not have received the reply and might not be aware that there is disagreement over trade terms. In short, negative affirmation can easily give a false sense of security, while leaving risk unchecked. This is certainly not progress.
What do regulators think?
While the CFTC does not explicitly prohibit negative affirmation and while final Trade Acknowledgement and Verification of Security-Based Swap Transactions rules from the SEC permit it in certain situations, the practice seems inconsistent with their respective statutes as amended by Dodd-Frank. Both the Commodity Exchange Act and the Exchange Act require that swaps data repositories "confirm with both counterparties to the [swap or security-based swap respectively] the accuracy of the data that was submitted."
Meanwhile, ESMA permits negative affirmation as long as "both counterparties have agreed in advance to confirm by this process."
After nearly 15 years of both voluntary efforts and mandates to reduce risk in OTC derivatives, risk is once again creeping back into the system. Some might accept it as an unintended consequence of aggressive regulation. That would be short sighted. We must view negative affirmation as an inherently risky practice which has the potential to reverse a decade of progress in electronification, standardisation and the reduction of financial and operational risk. The industry must utilise electronic trade confirmation wherever available. It must also redouble its efforts to expand electronic confirmation in equity derivatives in order to elevate the trade certainty in that market to the levels already achieved in credit derivatives and interest rate derivatives.
Kirston Winters, managing director at Markit, is co-head of product management for MarkitSERV
Tel: +44 20 3367 0500
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