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Capital And Credit Management: Broker-Dealers Coping With The Pace And Change Of Regulation: Thought Piece From Andrew Powell, Chief Operating Officer, Softek

Date 23/11/2016

In this second instalment of the three part article series focusing on capital and credit management, we explore how broker-dealers are coping with the changes in regulation, the operating models they are having to implement, key trends and future changes.

Andrew Powell

Andrew Powell, Chief Operating Officer, Softek

As with all financial market participants, both broker-dealers and clearing firms are experiencing significant regulatory change.  For one, reporting requirements have increased in both frequency and detail.  Add restrictions on capital and firms now must rethink their processes and, in many cases, restructure their businesses to ensure compliance. At present, the community’s attention is fixed on the SEC mandated rulebook reporting changes, which affect three key areas, the Net Capital, Customer Protection and Books & Records rules. Combined, these changes serve to increase transparency in derivative positions, add further protection to investors and ensure that stringent risk management processes are followed.

From an operational perspective, this raises the question “What must broker-dealers implement in order to be compliant?” The answer, however, is not a straightforward one and there are many challenges to overcome. For example, any third party liabilities must be accounted for in the net capital calculation; any “carrying broker-dealers”, who maintain customer securities and funds, must deploy a new segregated reserve account for broker-dealer clients; and firms must document their market, credit and liquidity risk management controls via FINRA Rule 15-33.

Naturally, maintaining market integrity is an objective and regulators must have confidence in the accuracy of information reported by the participants. In order to achieve this, broker-dealers and clearing firms are required to record transactions and send them to a central location. This is a crucial step in the process of proving regulatory compliance. Additionally, broker-dealers must meet the minimum regulatory reporting for all customer portfolio, OCC options and haircut margin requirements in order to ensure any trading activity is appropriately capitalised.

To meet these challenges, a growing number of broker-dealer firms are seeking external advice from experts in industry best practices, regulatory compliance and data management processes. The last point is of vital importance, as data forms a critical component in any robust reporting environment.

The regulators demand that market participants improve how they report, track, share, combine and analyse information. Recently, we were asked to implement a customer facing “trading risk policy” for a clearing firm. Their need was for a more conservative risk policy which would exceed the minimum regulatory requirements. For another broker-dealer client, we developed a bespoke process to sequence “day trades” so they can track the “High Water Mark” of an account at any time of the day. This enables the firm to monitor client margin requirements on an intraday basis and aids them to more effectively manage their capital – something the regulators are keen to see.  And yet another client was asked by the regulators during an audit to show historical transactions from three years ago.

As I mentioned, regulators are pushing towards intraday monitoring. Looking at the end of day health of your trading operation is no longer adequate. The regulators want participants to know that they are sufficiently capitalised and that client credit is monitored during the day. The aim is to make sure participants survive market events or extreme volatility and that the impact on the market is more controlled. Given the current economic and political events, this is how the regulators are ensuring the events of 2008 do not repeat themselves.

However, all this comes at a cost. This squeeze on the profit margin is forcing firms to take a closer look at their cost base - none more so than the smaller broker-dealers. As such, this has given rise to an increased uptake of outsourced services and the adoption of cloud based solutions. Furthermore, broker-dealers are utilizing vendors that can aggregate data from multiple venues, platforms and internal systems both on a start of day and intraday basis. From a reporting perspective, whether regulatory or for use as customer record keeping, a near real-time aggregate view is necessary to satisfy both capital and margin requirements of the customer, as well as all compliance related inquiries. 

So, what does the future hold for this industry, in summary – more change! The U.S. election result is very likely to signal a review of the regulatory framework. The Trump campaign has talked about the repeal of Dodd Frank, specifically in derivative oversight, which would serve to increase the volumes and be a plus for all trading participants. If this happens, we expect it to impact trading volumes and the capital commitment required to run a trading desk. On the flip side, the OCC is maintaining that current leverage rules in the listed option market will lead to a weakening of liquidity.

In conclusion, as low interest rates seem to be a reality for the foreseeable future, to fund the cost of today’s regulatory compliance, broker-dealers are looking at creative ways to increase trading volumes and cut costs. This environment has forced several broker-dealers to exit the business, but the more innovative firms are looking at outsourcing whilst embracing technology and education on regulatory issues.  These broker-dealers are planning to survive and profit. It’s no easy task, but making an educated decision, is now an easier process in a more connected world.

Part 1: Capital And Credit Management: The Changing Face Of The Regulatory Environment: Thought Piece From Andrew Powell, Chief Operating Officer, Softek