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OTC structured products, Mifid ii transaction reporting, Mifid ii reporting, Mifid ii costs

OTC structured products – the tip of a MiFID II iceberg?

Without any small hint of poetic justice, The Titanic was famously described as “unsinkable”. Similarly, in the run up to MiFID II, financial institutions have pulled together their own flawless compliance models as they come up for air following the scramble to be ready for January 3rd. While the broad feeling amongst the industry may currently be one of relief, there is a post-MiFID II iceberg lying submerged ahead in the form of OTC structured products. In their simplest form, these products are comprised of securities, such as corporate bonds, and are then valued based on the performance of one or more underlying derivatives contracts.

OTC structured products

These highly exotic securities have multiple cash flow branches attached to them – which often makes them far harder to value than a standard security. Traditionally, banks and brokers have stored these products as trading positions in their execution and order management systems. Until now, this has been all well and good, as these products have been traded fairly infrequently and have been done ‘over the counter’ (OTC).

The challenges

But then along comes, you guessed it, the iceberg. Suddenly, all these products, which banks previously traded with each other, need to go through a central clearing counterparty (CCP). This creates a couple of immediate challenges. Not only does this mean that firms now have to explicitly show how they value these products, but they also have to attach an ISIN code to them which adds a significant administrative burden. As a result, they become costlier to manage.

Firms will need to work out a way to store these products – even the ones that don’t trade often. If this wasn’t enough, they will need to accurately update information relating to their valuation. But in order to achieve this, banks and brokers need to shift from looking at certain products as trading positions, to seeing them as part of the wider securities universe.

The problem is that firms can only have a broader view of securities if they have recorded all their derivatives in a single database. An interest rate swap (IRS) contract, for example, could have a number of bonds underpinning it. Traditionally, a bank would retain the information relating to these bonds in a standard securities database. This is fine, but in a MiFID II world, it makes more sense to link the bonds to the derivative contracts, to ensure the most accurate valuation.

This way, a bank can start to build intelligence around how the characteristics of the underlying bonds change, and as a result, how the value of the contract changes. This would involve getting market data feeds from the securities into the trading systems. The challenge lies in the fact that information relating to the securities would not be included as part of the trading system database, and therefore a trade may be executed without corresponding data sets. A significant problem for when the regulator comes knocking.

In the same way that The Titanic was not unsinkable, no execution or order management system is full proof when it comes to highly complicated structured products. As the compliance ship moves ever closer to this particular MiFID II iceberg over the coming months, firms will be seeking a way to link the data that connects securities with the underlying derivative contracts. With local regulators sharpening their pencils ready to assess the market’s compliance efforts, those who fail to address this particularly nuanced difficulty could be left sinking without trace.

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