Hedge Fund Intelligence Navigating Derivative Regulations | Page 2

SOME ALIGNMENT IN RULES IS EMERGING

The industry may see a measure of simplification in the future, thanks to efforts to align the different
regimes. In particular, the OTC Derivatives Regulators Group (ODRG), which is composed of regulators
within the G20, is working toward aligning the differing rules of the members’ respective regulatory
regimes and areas of oversight. A good example of efforts to create consistency is the standardization of
trade identifiers. For the regulations to function effectively, each trade must have a standardized identifier.
Right now, each regime has its own conventions – the most popular example is where the CFTC’s
Dodd-Frank Act mandates the creation of Universal Swap Identifiers (USIs), while EMIR (European
Market Infrastructure Regulation) created rules requiring Universal Trade Identifiers (UTIs) for
ESMA-member nations. USIs and UTIs differ in format, use, and time of origination, but efforts at
reconciliation are underway to bring about a more globally recognized standard, akin to how an ISIN
is used for securities, but at the transactional level.
We also are seeing a move toward cross-jurisdictional recognition, and the idea “if you’re compliant
with derivatives regulation in a country we deem to have appropriate regulatory requirements, we’ll
consider you compliant here.” For example, Europe recently approved equivalency for five Asia-Pacific
countries, including Singapore and Hong Kong, effectively stating that if a given entity were compliant
with the rules of one of these countries, specific to centralized clearing and/or trade repository reporting,
the EMIR-equivalent provisions would be “disapplied.”
MEETING THE CHALLENGES IMPOSED BY REGULATION

Compliance with these regulations incurs an operational cost, but in the long view, complexity and
preparation are more significant issues than expense. Additionally, the potential fines and sanctions firms
could face for non-compliance could be far more expensive than the relatively modest investment in
compliance capabilities. Northern Trust and other firms are developing services aimed at providing
anticipatory guidance and helping lessen the operational challenges associated with regulatory compliance.
That said, the greater challenge is preparing for the future; building solutions to meet the demands of a
fund’s current situation, while also taking potential future obligations into account as new regulations
take effect or as the manager expands into new markets and products.
The other challenge lies in accommodating how regulations affect strategy: hedge funds historically
have been known for opportunistic trading – capitalizing on investments quickly in response to market
behavior. Some strategies, such as relative value, arbitrage, and special situations, are almost entirely
predicated on this concept. In the future, these funds will not only need to obtain the typical sign-offs
from their investment and risk committees, but they will also need to address legal and operational
requirements related to any country they intend to trade within or counterparty they intend to trade
with. The result is that operational and compliance activities, traditionally the reactive purview of the
middle- and back-office teams, have a more direct impact on front office decision-making and behavior
and are becoming required considerations prior to trade execution.
Within the new regulatory environment, central clearing poses its own challenges. The different
clearing houses, privately run and mostly domicile-specific, each offer different products, positional and
transactional IDs, middleware support, compression methodologies, opportunities for cross-margining,
collateral requirements, etc. This creates a kaleidoscope of divergent operational demands – everything
from trade capture to lifecycle event processing to pricing to collateral management – and those functions
must be able to adapt to the specifics of each market in which the manager is executing/clearing trades.
This complexity is magnified with regulators working to standardize electronic swap execution in parallel,
but doing so a little differently in each market and on differing timelines.

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