That is the question that compliance and regulatory reporting managers will face when it comes to deciding which trades to include in their transaction reports the day after trades are executed. The wrong answer could cost them hefty fines but finding the right answer will be costly as well, particularly when it comes to over-the-counter derivatives. There is no definitive source of information; therefore, financial firms will have to rely on whatever is available as well as a bit of their own judgement.
The requirement for transaction reporting on the day after trades are executed is the last in a series of required reports under the second incarnation of the Markets in Financial Instruments Directive (MiFID II) which is effective in January 2018. Financial firms may have to make public some pre-trade reporting of price quotes. Trading venues, including systematic integrators (SIs), which are typically banks or broker-dealers, must report individual trades several minutes after the trade is executed. In addition, trading venues — such as exchanges, multilateral trading facilities, and SIs — must also report to ESMA all the day’s trades on the evening they are executed. The evening’s reporting data is published by ESMA at 9 AM CET the following morning.
At issue with reporting trades in OTC derivatives is that there are far more contracts to worry about than with equities or fixed-income instruments. Not all of those OTC contracts have to be reported. The guidance from the securities watchdog European Securities and Markets Authority is a bit unclear when it comes to OTC derivatives. ESMA says that all trades executed on a trading venue must be reported. That isn’t too hard to figure out when it comes to equities and fixed-income instruments. Not so for OTC derivatives.
The regulatory agency says that when an OTC derivative shares the “same reference data” as another that is traded on a trading venue then reporting requirements apply. Legal and operations experts tell FinOps Report that ESMA’s guidance is muddled because ESMA has not clearly defined what it means by “same reference data.” Making the task of deciding which OTC derivative trades to report even more difficult is that ESMA also wants the reporting requirement to apply to OTC trades where the underlying instrument is traded on a trading venue.
So what can financial firms do to find out if an OTC derivative or the underlying instrument of an OTC derivative is subject to reporting requirements? Operations and regulatory reporting managers can try to figure out the answer by analyzing loads of data from, multiple trading venues. Alternatively, they can cut down their workload by relying on two centralized sources of information.
One source is ESMA’s own Financial Instruments Reference Data. System (FIRDS) database, which has been designed to standardize reporting across multiple regulations and take into account future regulatory measures. Another source is s service under development by the new Derivatives Service Bureau, a subsidiary of the Association of National Numbering Agencies, the umbrella organization for national numbering agencies. The DSB’s primary job is to generate ISINs for OTC derivatives for firms to meet MiFID II and other European reporting requirements.
The reference data on FIRDS includes International Securities Identification Numbers (ISINs) and reference data on transactions reported by trading venues on the evening of the day they are traded. “The ToTV service from the Derivatives Service Bureau will download the information from the FIRDS database as soon as it is made available at 9 a.m. CET, tagging those ISINs in the DSB archive as being traded on a trading venue,” says Sassan Danesh, managing director of eTrading Software in London. The firm serves as the DSB’s technical and management partner.
The DSB’s new ToTV service, which will tag ISINs as being ToTV or not ToTV, is set to be launched on December 18 after user testing is completed. Users of the DSB will not be charged additional specific fees for inquiring whether or not an OTC derivative or its underlier is ToTV. However, because it operates on a cost-recovery model, the DSB will include the cost of the ToTV service as part of its development and operational expenses when calculating how much to charge users for core numbering-agency services.
The good news: if operations, compliance or regulatory reporting managers look up an ISIN in the FIRDS database and find it, they can rest assured the trade is considered ToTV and must report it. The bad news: ESMA has repeatedly said that it does not consider the FIRDS database to be a golden copy. That means firms might need to worry that they have missed a reportable transaction.
ESMA has not commented specifically on the DSB’s ToTV service, but Danesh acknowledges that it will also not be an authoritative source. Still, it offers ease of use. “ISINs appearing in FIRDS are automatically tagged in the DSB as ToTV. If a query based on trade details doesn’t turn up an instrument with its ISIN in the DSB database, it is not ToTV,” he explains.
However, the DSB’s ToTV service has some shortcomings. When it comes to ISINs for OTC derivatives tagged as ToTV, operational glitches such as errors in trading venue reporting or subtleties related to what time during the day a contract became ToTV could result in gaps in the FIRDS update each morning. Because the DSB’s service is fed from the FIRDS daily update, any gaps in the FIRDS update could potentially affect the reporting by financial firms of their previous day’s transactions.
What happens when the DSB’s ToTV service says that ISINs are not ToTV? Again, its interpretation isn’t foolproof. Due to the greater granularity of reference data that the DSB provides on any ISIN than FIRDS, any query a financial firm makes about the ToTV status of an ISIN using FIRDS data alone could give the financial firm a group of ISINs, rather than only the derivatives product that was actually traded and reported by a trading venue. Therefore, as Danesh cautions, financial firms must decide for themselves what additional work they want to do to verify the ToTV status of an ISIN that the DSB has marked as not ToTV.
Given the degree of uncertainty, why use the DSB’s service instead of ESMA’s? Danesh cites operational efficiency as one reason. “Instead of linking to two databases to match up the ISIN with its ToTV status, financial firms can do so for only one,” he says. “The DSB’s database will also include more reference data than ESMA’s.” The additional information can be used by the front-offices of systematic internalizers to determine pre-trade reporting obligations and by counterparties of OTC derivative transactions to determine the ISIN for the derivative during their pre-trade negotiations.
When it comes to finding out which derivative underliers are ToTV, compliance and regulatory reporting managers will have a far easier time using the DSB’s service than ESMA’s FIRDS, contends Danesh. “The OTC-ISIN database will also contain a flag that will mark all instruments whose underliers are ToTV,” he says. “This information can be derived from data on FIRDS, but requires more work for participants to decipher.” Because the DSB will provide the ToTV status as an explicit additional attribute, middle and back office managers don’t need to do any additional analysis of their own.
What happens if a financial firm has all of the details of a trade, but not the ISIN? Danesh says that, based on the DSB’s current presumptions about ESMA’s criteria for ToTV determination, only the DSB’s service will be able to determine whether the OTC instrument is ToTV. “One of the FIRDS data elements is the ISIN itself,” he explains. “Therefore, assuming ESMA intends the ISIN to be part of the ToTV determination, market participants can access the DSB’s OTC-ISIN database in order to determine ToTV status.” When compliance and regulatory reporting managers search the DSB’s database based on the attributes of the trade, they will receive all of the other reference data attributes that are required for ToTV determination as well as the ToTV flag.
Although financial firms required to complete transaction reporting under MiFID II do have two choices of where to search for the eligibility of their OTC derivatives, it will still be difficult for them to be absolutely certain they have reported all covered transactions. Until ESMA further clarifies its guidance to take into account the complexities of the OTC derivatives market, financial firms could still be scratching their heads on what to report. As a result, say legal experts, they could either report far more or far fewer OTC derivative transactions than they should.
ESMA is reportedly refining the reporting standards that support the FIRDS database. Representatives of the DSB and ESMA will be speaking at a webinar about the DSB’s ToTV service at 3 p.m. UTC on Friday, November 17. (Registration requests should be sent to the firstname.lastname@example.org).