Michael Shashoua: Mind the Gaps

Identifying ways to manage systemic risk by deploying standards was high on the industry’s agenda as it headed into the Sifma conference last month.

Using standards to better manage risk is being pursued under the direction of the Office of Financial Research, as well as by the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC). Among the standards in place, being considered or in need of upgrade or wider adoption, are legal entity identifiers, FpML, ISO 20022 and FIX. Since the financial crisis highlighted the risk of over-the-counter (OTC) derivatives trading, concern and attention is focused on how to use standards to address risk in that asset class.

Exploring Ways
The industry is now exploring ways to use FpML data representation for OTC derivatives. The International Swaps and Derivatives Association (ISDA) has proposed a derivatives product registry that would maintain a reference data representation for standardized derivatives, issue product identifiers for those derivatives, and distribute this reference data to market participants. ISDA says a normalized product representation, produced through FpML, can facilitate transparency reporting, simplify trade-processing flows, increase flexibility among participants, and increase interoperability with other protocols.

But FpML will have to work in tandem with other industry standards, particularly FIX and ISO 20022, which address messaging.

The FpML reference list of firms integrates with ISDA master agreements and interacts with FIX, says Jim Northey, co-chair of the FIX Protocol Ltd. (FPL) Americas Regional Committee and a partner in the LaSalle Technology Group. “That can serve as a base while we’re building version 1.5 of the ISO 20022 platform,” he says. Ultimately, the derivatives data must be transmitted to the CFTC in a compliant format, and so FIX messages have to carry FpML information to the regulator, Northey says. “By having a warehouse and a standard product identifier, we can do even more because we can carry it as part of our business messages that disseminate reference data information, report trades and do all the pre-trade activity,” he says.

Although FPL, FpML, ISITC, FISD, Swift and XBRL have been working together since last year under what they call the “Investment Roadmap,” to include different business process and data standards under the ISO 20022 model for coordination and compatibility, the burning question, as Northey sees it, will be whether to adopt something that will be exactly the same and completely correct for every user, or to get agreement to adopt a standard with some differences depending on where it is being used.

Even if there were only one standard to be concerned with, nothing’s perfect and there are bound to be holes in what financial instruments it covers or glitches in how it treats different instruments. That logic supports the evolutionary approach to the issue of choosing a standard for OTC data, because the data has to work with so many other functions, like trade messaging, that have other sets of standards. A mix-and-match approach is inevitable, says Eric Cohen, director of corporate risk and treasury at Pricewaterhousecoopers.

“We focus on defining the common language associated with all financial instruments, all their facts about the instruments, and all the relationships with the instruments,” he says. “We make sure there is a formal and factual representation of the reality of that derivative. From that structure, you can then mix and match, and understand what you have seen and how you behaved in the market.”

With different standards bodies creating the system everyone has to work within, the industry must avoid creating gaps that leave it susceptible to the risk the standards intend to prevent. The Investment Roadmap is a start, but each member of that group will have to mind the gaps.