Best Practices for Vendor Management, IT Selection and the impact of Dodd-Frank on OTC Derivative Operations

Making Sense of Dodd-Frank’s Derivatives Central Clearing Model

Mike Parrinello | mparrinello@navigant.com | 617.748.8320
Brian Trojan | btrojan@navigant.com | 617.748.8333

As part of the fallout of the financial crisis of 2007-2010, Title VII of the Dodd-Frank Act (DFA) led to a sweeping overhaul of the Over-The-Counter (OTC) derivatives market. To increase transparency, DFA requires OTC transactions to be unbundled and includes rules for 1) daily clearing of trades, 2) daily margin and collateral requirements for most buyers and sellers and 3) new reporting and auditing regulations. While SEC and the Commodity Futures Trading Commission (CFTC) have not finalized the details of the regulations, asset managers need to start preparing for the impact that the regulations will have on their portfolio management, trading, operations, administration and compliance departments.

In This Issue

• Welcome
• Making Sense of Dodd-Frank’s Derivatives Central Clearing Model 
• Lessons Learned: Successful System Selection 
• Vendor Management: A Framework for Good Governance

New Derivative Parties Created by Dodd-Frank

The act introduces three new players to the OTC trading, clearing and settling processes including:

1. Swap Execution Facilities (SEFs) - SEFs are essentially electronic trading platforms that allow broker dealers to post bids and offers on products while subsequently permitting buy-side traders to either accept these offers or solicit new bids.
2. Central Counterparties (CCPs) - The CCPs will function as new clearinghouses for swap participants, facing both sides of the deal and will basically become the buyer and seller of the transaction.
3. Futures Clearing Members (FCMs) - FCMs will face the CCPs directly on behalf of the clients. If asset managers are currently trading derivative products, they will most likely have a relationship with listed derivatives clearers and can look to these providers as potential FCMs.

Differences Between Current and New OTC Trading and Clearing Process Trade Execution

Task	Current Environment	Post Regulation Environment
Trade Execution	Client and broker enter into swap transaction through voice negotiation or existing trade platforms	Voice execution replaced with electronic transaction platforms called SEFs Brokers can post bids and offers on products, buy-side traders accept offers or solicit new bids
Clearing and Settlement	Communication: Clients and dealers confirm details via term sheets and confirmation documents	Most trades will now have to be cleared via CCP CCP will face both sides of transactions and essentially act as both buyer and seller Asset managers will face CCP indirectly via a FCM
	Margin/Collateral: Clients and brokers agree to terms and transfer initial margin/collateral requirements	CCP will determine initial and variation margins for trades which will be posted directly to CCP on daily basis The FCM functions as central point of contact between asset managers and CCPs including collection of daily margin requirements and posting them to CCP
Reporting	No external reporting and audit regulations in place for OTC derivative trades	Reporting to the SEC, CFTC and investors on execution data, as well as audits The FCM most likely will provide clients with the material to satisfy the new reporting and auditing requirements but it is ultimately up to clients to validate this information
Counterparty Risk	Counterparty default risk present	FCMs pledge to CCPs the full performance of trade details by their clients

Please see the graphics below depicting the clearing of a swap trade before the new regulations are passed and the subsequent model after Title VII is finalized. As discussed above, the post regulation model introduces new parties to the clearing stage.

Pre-Dodd-Frank Model for Clearing a Trade

The asset manager executes directly with the dealer and faces the dealer as the counterparty.

New Regulation Model for Client Clearing

The asset manager faces the FCM, who faces the CCP as counterparty on the cleared trade.

Timeline for Proposed Changes

Although the final implementation timeline of Title VII rules continues to evolve, the anticipated details are stated below:

By the end of 2011	January – June 2012
More details surrounding the new clearinghouses (CCPs) Finalization of real-time reporting rules Updates to current position limits Final rules concerning the definitions of specific OTC products and participants to be determined	Further specifications of the capital and margin requirements for transactions will be defined Requirements of SEFs will be finalized and facilities registered Straight through trade processing for the new process of executing and clearing trades should be implemented Finalized details for CCPs and FCMs

Compliance and Change Management Program

While the industry waits for the final regulations to be defined and enacted, asset managers might instinctively lean toward delaying the development of a DFA compliance program and the planning of operational modifications in anticipation of the definitive regulations. However, there are many practical steps asset managers can and should take now to begin preparations for their firm specific approach to the Title VII requirements. From the information provided above, there will certainly be increased scrutiny surrounding margin, reporting and recordkeeping requirements as well as IT challenges related to connecting to the new counterparties. Asset managers should consider creating a dedicated task force to evaluate current systems and processes in light of the emerging rules with the goal of determining and testing future state best practices within their daily workflows as well as working directly with new counterparties. In addition to applying the appropriate rigor and discipline associated with good program management, a central clearing change management program will need to involve the additional wrinkle of following a somewhat moving target. By staying actively informed of the Title VII specifics as they are implemented, asset managers will be in an excellent position relative to their peers by implementing change incrementally into their business units ahead of the requirement.

For more information, please contact Mike Parrinello or Brian Trojan.

Lessons Learned: Successful System Selection

Tim Mueller | tmueller@navigant.com | 646.227.4402

Selecting a new vendor system to become the technology platform for a business area can be a process filled with either peril or opportunity. The right selection can stabilize operations for years and result in a productive partnership that is profitable and productive for both sides. The wrong selection can lead to lost opportunities, lost profits, and sometimes lost employment. The following are a few lessons our Navigant experts have learned from years of selection and implementation projects across a variety of business areas in financial services. They are based on a history of participating in selection projects both as a software vendor and a representative of multiple financial institutions, and can help you avoid a few common pitfalls.

In This Issue

• Welcome
• Making Sense of Dodd-Frank’s Derivatives Central Clearing Model 
• Lessons Learned: Successful System Selection 
• Vendor Management: A Framework for Good Governance

Business Simulation

Systems are often selected without a complete understanding of what it will be like to do business on a daily basis utilizing the selected system. It is critical that users experience a true business simulation exercise, and have actual users at the controls, before committing to a new system. Unfortunately, this step is often sacrificed in the interests of reaching a quick decision and the need to respond to a short time schedule, and then later regretted.

Business simulation can either be a multi-day, hands-on experience by the ultimate business users, or a one day session where the vendor uses client-provided data to demonstrate the capabilities of its product. Regardless of which approach is used, it needs to be crafted to meet the needs of the users, take into consideration the availability of time for the exercise, and the capabilities of the vendors under consideration. Skipping this step, however, leaves the business with no view of vendor system other than what the demonstration shows. All vendors know how to show their product in its best light, and that includes loading data that highlights strengths and minimizes weaknesses. The business simulation exercise, or proof of concept, is meant to show how the system looks with client-specific data to provide the buyer with a better idea of how the product will perform in their environment

Product, Performance & Customer Reviews

• One of the great surprises in performing reference checks is that you can often get very positive reviews on a product from senior management, even though there are serious known deficiencies. This may happen for a variety of reasons, but the end result is that reference checks should be conducted with individuals directly involved in the implementation and operation of a system, not those they work for, or worse, by senior management. That is the only way to be able to understand exactly what functionality is used and what isn’t.
• If the system interface seems confusing, it probably is. Don’t think it will be easier to understand once you spend time with the product. Business users today have spent a lot of time working with various computer systems and have an immediate feel for what is intuitive and understandable and what is not. Trust that instinct, it will not get any clearer, and you will most likely end up investing more money and time in training to compensate for the confusion.

Customer Service

• Underlying technology may not be important, especially in a hosted application, but the level of continuous investment is critical. Make sure you see clear evidence that the parent company is committed to investing in the product. Look for signs of recently added features and ask about the roadmap for enhancements. Gain an understanding of how customer feedback is incorporated into the budget for enhancements. The product you are implementing needs to be considered core to the future of the vendor company, or it will suffer from neglect in the future.
• The ability to develop a strong working relationship with vendor management can be more important than the base technology of the product. In the end you are selecting a business partner, not just a product. The only certainty in any implementation project is that there will be a few rough spots along the way. How the vendor responds to those challenges is often more important than any one area of functionality in the product. Having the right resources to problem solve, and consistently demonstrating a positive attitude is what will determine long-term success. If you don’t feel that strong client service culture from all levels of vendor interaction during the selection process, you can be sure you won’t experience it later.
• Related to commitment and partnership is the question of the level of support and depth of staff associated with a product. A good vendor should possess both a stable and qualified support team with enough staff members to provide each client with timely and quality support when issues arise. Over a long-term implementation, there are a variety of personal and professional events that can happen that impact key individuals in the implementation process. Having appropriate bench depth is critical in those situations, and also speaks to the level of importance the vendor places on the product you are evaluating.
• Always interview the proposed lead on the system implementation. The quality of that individual is perhaps the most critical element in a successful implementation. How often is it that vendor “employees aren’t as good as the product?” Inevitably a poor manager or team ends up in a troubled implementation, even if you are successful in replacing those individuals mid-stream. A strong implementation manager can overcome a limited product by helping you maximize the potential of that project. A weak one will cause budget overruns and a final implementation that does not take advantage of product functionality.

It is easy to get lost in the details of requirements, contracts and demonstrations when selecting a vendor application. As outlined above, once you get past some basic functionality requirements, most of the critical factors are “big picture” strengths and weaknesses. Focusing the selection process on those critical differentiators will help improve the chances of successful implementation.

For more information, please contact Tim Mueller.

Vendor Management: A Framework for Good Governance

Jordan Kuperschmid | jkuperschmid@navigant.com | 908.347.5610
Rochelle Edens | redens@navigant.com | 312.583.6825
Brian Dougherty | bdougherty@navigant.com | 646.227.4265

The motives for pursuing vendor arrangements are typically driven by the desire to achieve a high rate of satisfaction among customers, employees and/or agents at a reasonable cost. Successful relationships depend as much on the establishment of good governance by the contracting party as on the capability of the vendor. A representative case came to our attention recently when two subscription TV providers had sourced customer service to the same vendor yet the company with the comprehensive governance framework realized far greater customer satisfaction ratings than the other.

In This Issue

• Welcome
• Making Sense of Dodd-Frank’s Derivatives Central Clearing Model 
• Lessons Learned: Successful System Selection 
• Vendor Management: A Framework for Good Governance 

A governance framework that is thoughtfully planned, dutifully executed and consistently monitored promises to create value for the contracting party, vendor and customers. In an informal survey of Navigant clientele, vendor managers consistently acknowledge governance and three additional components as vital to any successful vendor relationship:

• A set of clear performance measures
• A “show me” style of monitoring
• A well-designed approach to communication

To align these critical aspects with vendors, we recommend that organizations minimally establish guidelines for the following:

• The creation and maintenance of policy and standards
• A risk management program
• A common set of tools (contract requirements, vendor evaluation tool kits, scorecards, technology)
• A methodology for performance management and monitoring
• Due diligence guidelines and research regarding a company’s financial strength, reputational standing and operational risk
• A council for facilitating best practice sharing internally and for obtaining external viewpoints

The implementation of these guidelines often leads to discussion of the aspects of vendor management to be governed at the enterprise level versus those that should reside within the business or corporate center directly using the vendor’s services. Navigant has found value in a hybrid model that positions certain components centrally while leaving room for individual units or relationship owners to tailor vendor guidelines based on the requirements of their specific business or clients. Regardless of which model you choose — hybrid, centralized or decentralized — the significance of governance, performance management, monitoring and communication remains.

Governance

In our experience, all successful vendor programs share the common theme of strong governance. Components of a governance framework for vendor management include:

1. A well-defined contract, which includes a detailed list of services, roles and responsibilities plus specific Service Level Agreements or Key Performance Indicators
2. Standards for quality, performance and acceptance of work-product
3. A system of robust measures and reporting along with relevant incentives and penalties
4. An escalation and problem-resolution program which may include customer complaint definition and handling
5. Requirements defining a controlled environment (operational, IT, financial, regulatory, legal, etc.)
6. A resource and capacity management plan including key resources to be assigned; skills/quantity of resources; and incentive/retention/hiring practices
7. Self and independent assessments/audits/evidence to confirm controls are operating and procedures are being followed
8. A risk management program which specifies the framework for identification, assessment, control, monitoring and response. Includes specifications for periodic and triggered assessments (new system, law, product, internal policy update, specific loss, etc.)
9. Documented and tested information management procedures including business continuity, records retention and privacy/information security
10. If the vendor is performing a function that relates to a regulatory obligation (Data Privacy, AML, FCPA), a sufficient supervisory structure must be in place
11. A strategy and approach to change management to influence people to accept change
12. Specifications for controls and governance in situations where a vendor may subcontract an affiliated or unaffiliated provider
13. Guidelines for submission and payment of invoices as well as change orders

Measuring and Monitoring Vendor Performance

Several of the key governance tenets above relate to defining expectations as well as to gauging actual performance against desired results. The means by which a vendor’s performance is measured and monitored will vary depending on the services provided, but a few overarching recommendations are broadly applicable.

Measuring

• Establish agreed-upon procedures regarding items to be measured, including a program for quality assurance
• Define a clear set of expected (baselined) results as well as incentives/consequences for performance
• Establish a balance of clearly defined measurements relating to accuracy, timeliness, completeness and compliance. Include variables that may be early-warning indicators (predictive monitoring)
• Develop a formal scorecard review process
• Utilize the measurements to identify trends, take action and drive improvement

Monitoring

• Establish criteria to identify transactions or processes to be monitored, indicating roles, procedures and escalation
• Establish frequency and focus of site visits (e.g., walk-through of printing and enclosing facility for a mailing operation)
• Set independent assessment requirements (e.g., type of SAS 70 required)
• Verify adherence to company policies (e.g., record retention and information security)
• Establish a “response ready” team to address any gap items identified. Many such issues will require the business and vendor to partner in problem resolution
• Continually review vendor’s business-focused profile such as commitment to the market, financial stability, reputational assessment and risks via review of financials and monitoring of filings
• Monitor news and have discussions with other companies utilizing the same vendor

Communication

Establishing a formal communication plan that provides channels for informal and timely interaction is critical to the success of the relationship. A majority of day-to-day issues and non-value-added activities by hiring entities and vendors are attributable to lack of communication. Effective practices include:

• Proactive communication and a defined escalation process
• Designated points of contact
• Participation in a customer advisory panel
• Scheduled checkpoints and status meetings
• Regular communications to address business execution issues
• Management meetings to consider lessons learned and ways to improve
• Review of performance monitoring mechanisms by leadership from both parties
• SWAT teams to address significant or timely matters
• Town Halls, newsletters and other mechanisms to broadcast mission and results

Evolving Measures of Success

In years past, successful vendor relationships were measured by the negotiation of long-term, low-cost contracts. Today, in the midst of uncertainty around regulations and a dynamic business environment, success also depends on the ability to weather change. A robust governance framework — employing an approach that continuously measures quality, monitors performance and maintains good communication — is critical to a vendor relationship that will in the long view prove enduring, productive and profitable.

For more information, please contact Jordan Kuperschmid, Rochelle Edens or Brian Dougherty.