BULK NOVATIONS: addressing the five key challenges
With new, tighter regulations driving capital markets firms to fundamentally transform their business models, many have turned to bulk novations in response to the structural reorganization of their legal entities as their portfolios are repositioned. But several issues have emerged throughout the bulk novation lifecycle, leading to inefficient transfers and undesirable risk exposure. In this article, James Bakelmun, Nick Fry, Sarah McLellan and Nathan O’Reilly outline these challenges and explain what firms can do to migrate their portfolios more efficiently and mitigate their operational risk or potential reputational damage.
In the financial markets, novations—the act of legally replacing a party to an agreement with a new party (valid only with the consent of all parties in the original transaction)—or “bulk novations,” which involve trade portfolios in excess of 100 trades, are cropping up with greater frequency. Regulations such as Dodd-Frank and MiFID have put far more rules into place around the thresholds for the amount of notional outstanding, trade volume and open positions within large portfolios.
Despite the fact that some of these rules and regulations have been in place for a few years, the constantly evolving regulatory environment, coupled with the size, number and disparity of asset classes, regions, products, counterparties and systems involved are further complicating the bulk novations process. And it’s driving ongoing challenges to resurface and new obstacles to emerge among organizations that are looking to novate their portfolios.
Sapient Global Markets recently conducted interviews with the G15 and regional banks to identify the major problem areas, focusing primarily on three-way bilateral bulk novations. These discussions identified the key challenges banks are facing during the initial engagement, pre-novation, population lockdown, novation and post-novation periods. Specifically, the challenges span these five main areas:
- Pre-novation population management
- Counterparty engagement
- Vendor engagement
- Trade portfolio exchange
- Legal documentation
While banks noted they are grappling with these issues, the survey data also helped illuminate the necessary steps firms should take to help resolve size, engagement, exchange and documentation concerns.
OVERCOMING THE OBSTACLES
Most banks are finding challenges in some form or another during the bulk novation process given that novations require coordination both internally and externally. Even if an organization’s own process is in order, it’s likely that other firms aren’t quite there yet. In many cases, the primary challenge of a bulk novation is its sheer size.
Pre-novation Population Management
Greater novation population creates increased capacity issues for bulk action and larger notional outstanding, which in turn causes a greater risk impact. Larger portfolios are also more likely to span across varying geographies, time zones and resources, as well as tend to include multiple asset classes and product types.
These factors set the stage for a challenging bulk novation, with each jurisdiction, asset class and product type bringing their own unique set of rules
and regulations to the table.
However, this challenge begins to lessen when barriers are tackled one at a time, beginning with population management activities prior to population lockdown. Population management activities fall broadly into three categories: compression and clearing, which help to reduce the size of the trade population, and backloading, which lowers the amount of manually-intensive, paper-confirmed trades to novate.
Particularly over the last two years, compression, clearing and backloading have been utilized more than ever before, resulting in less manual work and smaller portfolios for bulk novation. Although many firms consider these activities business as usual (BAU), the seemingly most effective approach in today’s environment is to deploy compression, clearing and backloading iteratively at a higher frequency than BAU prior to the novation date. This can enable an easier path for bulk novation with a smaller and more electronic trade population.
Overcoming population management issues can certainly create the opportunity for a simpler process to kick off an efficient portfolio migration. But as with any transaction, external synchronization is needed for a smooth transition. That hasn’t exactly been the case when engaging counterparties due to conflicting counterparty preferences, industry events and respective internal dependencies.
Specifically, late responses to bulk novation requests and short notice (as little as one week) offered by buy-side firms are leaving insufficient time for industry participants to coordinate effectively.
As such, it is crucial for counterparties to collaborate and agree on a clear novation schedule to minimize timing deficiencies and ensure an effective flow of communication from the initial commitment stage through the post-novation clean-up discussions.
Initial communication with counterparties should be carried out approximately two months prior to the novation date. However, specific timing is contingent on the complexity of the population to be novated, as well as the volume and number of counterparties involved.
INITIATING PARTY CHECKLIST
- Initiating party’s rationale for bulk novation
- Relevant contact details and communication plan
- Key proposed timing, including novation date, novation effective date, population lockdown, weekend vs. weekday, documentation exchange and signing
- Bulk novation volume and scope, as well as required pre-population management activities
- Execution plan, method and approach (e.g., asset class schedule, big bang vs. individual), true novation vs. legal entity amend and use of vendors
- Trade reference identifier
Additionally, the initiating party needs to explicitly outline which tasks they require the participating counterparties to perform along with their associated timeline (e.g., sign and return of side letter and annexes). All parties to the novation must also ensure there are sufficient points of escalation identified. This is important for monitoring and managing any changes to the trade portfolio.
Firms should set expectations for subsequent ongoing communication (such as in the case of iterative portfolio reconciliations), dispute management and de-scoped trades. In addition, a single point of contact for each firm or per asset class is recommended, preferably through the front office or sales departments, who can then coordinate with the relevant internal resources.
Following the challenge of counterparty engagement is the task of partnering with the right third-party vendor to help streamline the bulk novation process. Successfully executing large bulk novations can be an onerous and difficult task, particularly when internal systems do not have bulk booking event functionality or if the novation involves multiple asset classes and systems.
Enlisting the services of third-party vendors can help reduce the burden of processing novations for electronically-confirmed transactions, as vendors can offer the following bulk processing options:
Custom processing — the vendor processes the bulk novation on behalf of all parties to the bulk novation
Bulk action tool — the transferor and the transferee upload a .csv file or manually update trade details into a bulk tool within the vendor platform to perform the bulk novation
Messaging — firms instruct the vendor through electronic messages, such as cancel and amend messages, which are then processed by the vendor
The initiating party needs to engage the vendor early on and ask the right questions to facilitate a comprehensive review of available options to suit not only their needs, but the needs of all parties to the novation. This will help alleviate any concerns the firms may have regarding the costs of these potentially one-off relationships. As such, the following considerations should be weighed for each participant:
- Connectivity (capacity for in-house systems to consume/suppress feeds from the vendor) and volume constraints
- Type of processing, such as custom processing vs. bulk action tools vs. BAU manual booking within the middleware and asset classes
- Cost of processing
- Product eligibility for bulk novation
- Proposed timing (weekend vs. weekday, availability for any testing required, novation date and novation effective date)
Vendor testing of the trade portfolio and corresponding vendor processing approach will go a long way in helping to mitigate processing issues in production. It’s important to assign a vendor engagement lead to effectively communicate and manage the participants’ dependency on the vendor’s services.
Trade Portfolio Exchange
Another key challenge is efficiently exchanging the portfolio. Whether a firm is the transferor or the remaining party, trade population exchange is a critical early event in a successful bulk novation and is important for ensuing population reconciliations.
Portfolio exchange is typically carried out using Microsoft Excel files. By providing this file, the initiating party gives other participating parties the opportunity to perform reconciliations against their own books and mobilize their internal functions more effectively. This seems somewhat straightforward, but unless firms extract trade population using middleware such as DS Match/DTCC, spreadsheets will reflect the firm’s internal booking systems in both structure and format, creating the need for manual workarounds once trade populations are received and before the data is available in a usable format.
Additionally, because the number of data points exchanged varies by firm, even if the formats are similar, the fields will not always match up. This can be problematic for non-vanilla products where more specific data points can be required. After these obstacles are overcome and the data is finalized in Excel, yet another challenge emerges. Since the trade portfolio file is typically exchanged via email communication, the lack of version control and data security become concerns.
Using a standardized format and set of data points (e.g., trade date, effective date, termination date, notional amount, transaction/product type, trade reference identifiers, legal agreement information, etc.) in an Excel file would be useful for exchanging the trade portfolio between parties.
However, due to the extensive range of products and data points, the complexity of standardizing the required fields and norms is quite significant and would require industry collaboration. Any such standardization would only work for vanilla products. For any structured products, attaching the original confirmation to the trade annex is recommended.
The generation and exchange of legal documentation is another component to the bulk novation process. Although generating and exchanging legal documentation for bulk novations does not present any issues, the challenge emerges when a standardized document format and template is developed.
Trades confirmed on paper typically require an ISDA side letter and trade annex, whereas third-party vendors often require their own templates to drive the legal documentation process for electronically-confirmed trades. But when the services of third-party vendors are not utilized, a standard template for the required legal documentation does not exist.
Until an industry standard is reached, the initiating party should define the templates to be used both internally and with the counterparty to facilitate consensus.
Moreover, the initiating party should ensure sufficient control and escalation points throughout the documentation process, including which party will be responsible for documenting the novation. This way, any amendments made to the trade can be updated in the legal documentation. Although ISDA does not specify which party to the novation should carry out the documentation, having the remaining party draft the agreement is widely preferred. And for any structured trades, it is preferable to attach the old confirmation to the trade annex.
Suppression of BAU electronic messaging also should be considered to avoid any operational risk (e.g., duplicate confirmations) and additional vendor processing charges. This could occur when a single novation confirmation has been automatically sent to a vendor platform per the existing BAU process.
In addition to the challenges related to population management, engagement and documentation, there are other factors to bear in mind for achieving a successful bulk novation.
First, firms should asses their internal readiness (e.g., internal front-to-back infrastructure) to identify and capture all process changes and development requirements.
Second, whether industry standards are adhered to for collateral (settlement of collateral made on N+2), or a bespoke collateral process (which needs to be communicated and agreed with all three parties to the novation) is used, firms should leverage existing market processes. This is particularly important if credit support annexes (CSAs) are changing.
Regulatory and transaction reporting will likely also be required for bulk novation, depending on the jurisdictions in scope. In most cases, the novation is treated as a full termination of the original transaction, replaced with a new transaction between the transferee and the remaining party. In this case, the reporting requirements generally follow BAU. But when a trade migration takes place across different reporting jurisdictions, consideration should be given
to whether the bulk novation will be compliant if carried out using a legal entity amend or if a true novation approach is required.
A fourth factor to consider is fees. In a standard three-way novation, a novation fee is transferred from the transferor to the transferee to account for the obligations undertaken. Typically, this fee is represented as the current present value (PV) of the portfolio being novated and includes any accrued interest. If the transferor and transferee belong to different entities within the same organization, the fee transfer may not be required, provided there are no regulatory obligations to include fees.
Last, the initiating party will need to ensure that all counterparties are correctly onboarded to trade with the new entity. This is particularly important if the initiating party belongs to a different legal entity or if it is in a different jurisdiction than the other counterparties.
The initiating party must also work with third-party vendors to ensure agreements between counterparties are up to date and inclusive of the entire product scope. In addition, they must ensure counterparties are onboarded onto third-party vendor platforms, if required.
The increasing array of regulations following the 2008 financial crisis continues to impact the way firms operate and conduct their businesses. This is only expected to continue as the rules and requirements evolve over time.
If banks and other bulk novation participants adopt the best practices described here, then they can mitigate operational risk and exposure by significantly decreasing the time it takes to complete these transactions. At the same time, they will be able to reduce reputational risk by becoming more efficient at participating, responding to and completing bulk novations.
This initial step can take the industry closer to establishing a long-term, industry standardized bulk novation process.
is a Business Consultant currently based in California. Specializing in large-scale change projects, James has experience delivering operational efficiency, risk management and regulatory-driven initiatives to buy-side and sell-side firms. His previous roles have focused on legal entity novations, MiFID II implementations, OTC clearing and target operating models.
is 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.
is a Business Consultant based in London with a background in capital markets regulatory change. She is currently working as a Business Analyst on a client-facing, centralized aggregation service, providing confirmation timeliness reports for the FED, CFTC and ESMA. Previous engagements have involved a bulk novation implementation project for a leading G15 investment bank as well as EMIR regulatory change initiatives.
is a Manager based in London and he has led several worldwide industry initiatives in derivatives of all asset classes. His six years of industry experience is diversified across investment banks, middleware, clearing, documentation and development, predominantly within the context of regulatory requirements.