THE NOVATION CHALLENGE: how to ensure a successful outcome

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    THE NOVATION CHALLENGE: how to ensure a successful outcome

    Organizations within the financial markets are undergoing a period of incomparable change. The financial crisis has prompted a reevaluation of how risk is managed within firms, and as a result, many have been either forced to, or have elected to, fundamentally transform their business models. This has prompted an unprecedented amount of change in legal entity structures, often leading to large-scale migrations of trade portfolios. As firms migrate positions between legal entities, the need in the market for novation expertise is growing as never before to avoid reputational damage with counterparties, spiraling costs and increased operational risk. In this article, Nick Fry and Mark Thompson explore the main drivers behind this wave of novations, the key challenges firms have when faced with conducting this exercise and the guiding principles for a successful outcome.

    WHAT IS A NOVATION?

    A novation is defined as the act of legally replacing a party to an agreement with a new party. It is only valid with the consent of all parties to the original agreement: the remaining party must consent to the replacement of the transferor with the transferee. The transferee steps into each of the in-scope transactions in place of the transferor and assumes its obligations to the remaining party. A number of drivers can cause a firm to perform a novation of its externally facing position to another legal entity. Most are ultimately driven by regulatory change, but some have been projects that were the result of business transformation.

    THE KEY DRIVERS

    The first driver is a general theme among regulators for their own jurisdictions to be protected, meaning foreign banking organizations need to ensure that only risk originated in that country is held there. This could result in a stream of inter-entity novations, or risk transfers, as banks move risk to more appropriate jurisdictions. A specific example of this is the Dodd-Frank Act’s enhanced prudential standards, the final rule of which was recently released. This states that foreign banks of a certain size must place all of their US assets under the control of a US Intermediate Holding Company (IHC). This can then be appropriately regulated by US authorities and be governed according to domestic legal, capital, liquidity and governance rules. This segregation of US assets and regulatory control over the new US parent entity have the clear intention of ringfencing the effects of foreign banks on the local capital markets. The intention is that after this is implemented a non-US bank in distress could no longer threaten the US capital markets. The timeline starts in January 2015 with submission of plans to the Federal Reserve and extends into 2018. It is clear that this regulation will create considerable work for any non-US bank with significant US operations.

    The second driver is a little bit “looser” and broad based. It is the concept of jurisdictional or regulatory shopping—the idea of placing assets and operations in the most favorable regulatory environment. With the uneven rate of worldwide regulatory change and the rolling out and enforcement of new regulations comes the prospect for banks to take advantage of the shifting landscape and move their main legal entity into the location that provides them with the most efficient capital, tax and legal rules. There are also some jurisdictions that adopt a more advantageous regulatory position than their global hub competition. In other words, banking operations in that country will always be more favorably treated. In a global banking environment where margins are tight and profits can prove scarce, or at the very least highly fought over, any improvement on margins or the bottom line could prove decisive in a competitive battle.

    Thirdly, there are specific regulations that force banks to change their structure to some extent by spinning off entities or closing them down completely. Whether it’s the same entity but it now falls out of the legal structure of the original parent bank, or if the entity has been forced to close out completely, a novation project will be required to enact the policy decided upon by the bank’s senior executives. One obvious example is the proprietary trading desks of banks. Under the Volcker rule in the United States, a bank is explicitly no longer allowed to risk its own capital in any trading activity. Some banks have decided to close their desks, while some have spun them off into hedge funds where they have further explicit rules about if and how they are allowed to retain any form of ownership in those funds. In either scenario, there is a likelihood that a novation exercise will occur.

    There are other drivers that are not directly the result of regulatory considerations. The traditional reason for bulk novations, company mergers and acquisitions is still as prevalent today as ever. Firms may also embark on a novation to fulfill a new business strategy around a particular market. Finally, there may also be non-regulatory drivers for firms to migrate to other legal entities to reduce capital or funding requirements.

    THE KEY CHALLENGES

    Novation projects are often complex affairs, involving multiple business units across each of the impacted institutions. As a result, the challenges involved in such large-scale projects are numerous.

    Engaging the counterparties
    The first challenge is counterparty engagement. In order to facilitate as smooth a novation process as possible, each counterparty will need to be bought into every step and be on board with the whole process. The challenge will differ dramatically depending on the type of counterparty involved. Large broker dealers will generally be familiar with the process; however, the challenges here are twofold. First, ensuring that the required resources are allocated can be difficult as competing requirements typically mean this can be a stretch for many counterparties.

    Resource mix
    Secondly, it’s important to ensure that the novating firm’s resource mix is optimal to mirror the globally distributed nature of these counterparties and therefore maximize the potential for engagement. For less sophisticated clients, the initial challenge is often successfully educating them on the reasons for the exercise and why it is happening, followed by ensuring the requisite tasks are carried out through to novation execution.

    Internal resourcing can also be an issue. Identifying the right number and mix of resources for each stage of the process is problematic, particularly when juggling the requirements of the bulk novation with business as usual (BAU). Plus, there are potential complications and resourcing impacts from performing the actual novation outside of market hours (novations typically are processed over weekends, although we are seeing a trend towards midweek novations to limit this resourcing impact and as a function of process improvements).

    The role of intermediaries
    When firms undertake a novation exercise, there are multiple challenges linked to financial market intermediaries (FMIs). The landscape for over-thecounter (OTC) derivatives has changed dramatically since the financial crisis began, with swap execution facilities (SEFs), trade repositories, clearing houses, portfolio compression and portfolio reconciliation tools changing the way that these instruments are processed. This new industry landscape has complicated the novation process considerably. In the past, the only major difference in how OTC derivatives were processed was either via electronic matching platforms (e.g., DS Match) or via paper for confirmations. However in the new world, there is a multitude of possible process flows resulting from the various combinations of different industry systems and processing methods. Is trade execution via SEF or voice or electronic? Is a trade bilateral or cleared? Is a trade confirmed electronically or on paper?

    The landscape for over-the-counter (OTC) derivatives has changed dramatically since the financial crisis began, with swap execution facilities (SEFs), trade repositories, clearing houses, portfolio compression and portfolio reconciliation tools changing the way that these instruments are processed. This new industry landscape has complicated the novation process considerably.

    Understanding the process
    The initial challenge for firms is ensuring they have a deep understanding of these flows, the associated vendors and their capabilities, and how this translates into potential process or technology changes internally. This is absolutely paramount as some of these tools can dramatically simplify the novation process if used optimally. Similar to the challenge around counterparties, firms also have to ensure that FMIs have the resources available to process bulk novations if they are to be leveraged. Companies must also be cognizant of the fact that there can be a significant financial cost to being the initiator of a bulk novation via an industry platform. For example, novating parties often pay both the costs for their side and the counterparty’s side when processing trades via MarkitWire.

    Internal and external coordination
    Coordination, both internally and externally, is a significant challenge. Often, the novation exercise is the final piece of the puzzle following internal risk migrations and such ready-to-trade activities as legal master agreement execution and internal and external system set-up. To address this challenge, a firm’s planning must take into account these dependent projects while also ensuring that engagement with external parties is not compromised or delayed. Externally, the project planning needs to take into account not only the considerations of counterparties and FMIs, but also industry-wide events, such as quarterly credit rolls and equity expiry weekends, as there will be no appetite to novate on weekends where these events occur.

    Agreeing upon the portfolio to be novated
    Relying upon the in-scope products and counterparties, reconciliation of the novation portfolios can be an issue. Nowadays, large brokerdealers are directed to reconcile portfolios on a regular basis either via the traditional spreadsheet method or via tools such as TriResolve. Because this process is not completed for all trade and counterparty types, the task to reconcile portfolios can still be resource-intensive and time-consuming. In addition, the plethora of new FMIs that have evolved in recent years often contains unconnected data records of the same transaction. It makes sense then for firms to use the novation exercise as an opportunity to ensure that these records are consistent. However, the challenge lies in ensuring that this worthwhile task is completed in the most efficient manner possible and without distracting from the main goal of the novation.

    PRINCIPLES FOR SUCCESS

    Firms must consider a number of critical success factors as part of a strategy to execute an effective mass novation.

    Strategy and Roadmap
    The key to any successful novation exercise is first devising an effective strategy and roadmap based on certain fundamental tenets:

    • Effectively engaging impacted internal and external stakeholders with appropriate notice is a vital activity to clearly define and agree upon the scope; understand the associated trade/client populations, priorities and measures of success; develop an informed approach that is cognizant of constraints and considerate of opportunities; and create an escalation and decision-making mechanism as part of the communications and governance framework
    • Creating a meaningful decomposition of the eligible trade population enables firms to make informed decisions around scheduling based on complexity and impact, factoring in product and client variables. This should lead to a clearly defined and controlled management of the novation portfolio data set, as trade data needs to be complemented with additional attributes to enable the effective planning and tracking of execution activities while preventing the need for manually intensive reconciliation processes
    • Designing and agreeing upon a pragmatic and controlled approach supplemented by the requisite tools and interactions will provide an organization with a greater assurance of success
    • Synthesizing the population decomposition and the project approach into a clear project plan that provides tangible milestones and an understanding of required resources will help firms more effectively transition into the later phases, with a clear understanding of a tracking and monitoring mechanism

    Mobilization and Readiness
    When preparing for novation execution, several elements are critical for success. Firms should establish a detailed and cohesive run-book for the novation, while maintaining regular dialog with clients and any impacted FMI providers. This is to ensure the successful establishment of the requisite environment within which to execute the migration. Best practices should be adhered to with regard to the development and testing of the approach including any related tools and processes. If portfolio reconciliations are already undertaken, they should also include a reconciliation of the target novation population throughout this period to ensure this data remains clean. At this point, there is the potential to augment the existing team and build this process out to cover the entities involved in the migration. This would help firms better understand the portfolio being novated and allow the project team to drive the streamlining of the portfolio.

    Figure 1. Balancing the Components (Internal, Counterparty and Intermediary) is Critical for Success

    Execution and Management
    Firms must also perform the required outreach to counterparties and FMIs, the coordination of migration schedules and the production of the necessary artefacts and evidence for this process. The team will also be responsible for client and internal dispute resolution and producing clear reporting and metrics (internal and external) to reflect progress and any risks or issues. In order to complete the execution effectively, firms should consider the following factors:

    • Given that across all OTC asset classes the majority of trade confirmations are now processed via electronic matching platforms, it is imperative to manage the processing of the novation in each of these systems in a controlled and coordinated manner to avoid a multitude of post-novation reconciliation issues
    • A thorough and complete understanding of the tools available for processing bulk novations within each of the systems managed by the FMIs is essential to ensure that efficiencies are realized during the execution phase
    • Given the reliance on their platforms and solutions, effective management of FMIs is the key to a successful novation
    • Agreeing upon a common set of industry-defined processes and recommended tools is desired (e.g., a standard toolkit to facilitate bulk novations)
    • With regard to the processing of novation documentation, if the number of agreements to be processed is high, then it is worth considering automated generation tools, such as Thunderhead, to alleviate the load
    • Using standard agreements also improves turnaround times as clients struggle to understand bespoke documentation
    • As for the team tasked with processing and chasing agreements, aligning novation agreement production closely with the client service team creates single accountability
    • Using native language speakers to speak with clients where possible is a consideration when dealing with less sophisticated clients, such as small investors and corporates
    • Locating teams where there is critical client mass is a prudent approach (e.g., if the counterparties are primarily large broker dealers who have outsourced their operations to India, it makes sense to situate the novation client service team in the same locale)
    • As for metrics, turn-key reporting is a critical success factor. Teams should ensure client refusals are recorded and escalated accordingly

    CONCLUSION

    Just as the industry landscape for OTC derivatives has evolved over the past six years, so has the need for a far more sophisticated novation strategy. With so many factors now at play to complicate this exercise, it is absolutely vital that firms use a controlled approach. It should be developed with an understanding of how the target trade population connects with today’s industry tools. This will help firms realize efficiencies by leveraging established market infrastructure, ensure counterparty satisfaction with the process and, ultimately, achieve risk management objectives in a timely and cost-effective manner.

    The Authors
    Nick Fry

    Nick Fry
    iis a Director with over 20 years of experience in the capital markets industry, including investment banking operations and financial services consulting. He has extensive derivatives subject matter expertise and deep knowledge of the documentation domain. Nick also has firsthand experience in legal entity migrations and novations.

    Mark Thompson

    Mark Thompson
    is a Manager based in London with over 10 years of industry experience in a variety of areas, including structured products trade review, product control and regulatory reporting. Underlying these roles is Mark’s rigorous and practical approach to risk and control, operational risk management along with significant practical experience of the changing regulatory environment and updating processes and systems to match the latest requirements.

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