The Indian summer for product classifications

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The Indian summer for product classifications

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Thursday 17 November 2011 – by Martin Sexton

Protesters outside exchanges have the belief that institutions use black magic in the form of derivative products to attempt to boost profits, says Martin Sexton, Europe standards representative of the International Securities Association for Institutional Trade Communication.

From an industry standards perspective the classification of financial products has been on the back burner for a number of years and the rejection of the draft ISO Standard, 10962 Classification of Financial Instruments (or ISO CFI) in 2011 emphasised the need for action. With the regulators taking a tighter reign on the markets, there has been a realisation that effort needs to focus on identifying a usable product classification.

Though the protesters outside the world’s stock exchanges are probably a little misguided, they do have the belief that financial institutions use black magic in the form of derivative products to attempt to boost profits. Of course, if one cannot classify a product properly and consistently across the enterprise, it could be argued that some form of dark arts are being practiced. Since the rejection of the draft ISO CFI, due to its complexity and more importantly, its lack of product coverage, we have seen an Indian summer in the area of financial product classifications with the formation of a number of initiatives.

ISO, under TC 68, set up a study group to examine the needs of the markets for identifiers. As part of this analysis, the use and scope of the ISO CFI is being re-investigated. Meanwhile, to meet the OTC derivative products reporting requirements of Dodd-Frank and EMIR, the FpML reporting working group took up the gauntlet to analyse the OTC classifications in use and proposed by authorities.

Once this analysis was complete, the working group developed a scheme based on an asset class and product type hierarchy. This proposal was supplied to the ISDA Universal Product Identifier (UPI) Steering Committee responsible for defining a unique product identifier and mechanism for OTC products. Subject matter expert working groups were subsequently created to focus on each specific asset class. All were working on the premise that a three/four tier hierarchy was to be developed, comprising of the following terms: asset class, base product, sub-product and optionally, transaction-type.

The EDM Council has entered the fray by examining the semantics of OTC products; this initiative has taken the form of a proof of concept, which analyses the semantic building blocks of a couple of swap products, namely an interest rate and a credit default swap. Given that the ISO standard focuses primarily on cash and exchange traded instruments, a new working group has been constructed to examine the creation of a workable classification across all asset classes.Participants include International Securities Association for Institutional Trade Communication (ISITC), FIX Protocol Limited (FPL), DTCC and X.9. Using a consistent product classification should not only be considered a regulatory requirement, it can also have benefits across the enterprise as a whole.

Most applications have their own method of classifying financial products; some extremely granular, others not so. Each is used to meet a specific business requirement, be that for simply identifying whether manual intervention is required at a specific point in the trading lifecycle or for more complex requirements such as position valuations, credit risk analysis or identifying the appropriate nominal ledger entry code.

The creation of an all-encompassing classification scheme is, and should be, a goal of anyone responsible for compliance. Examining the use of classifications across all assets, including cash equities and debt, one can see the need for different hierarchical paths in a product topology; one for standardised products and the other to support non-standard (OTC) products.

From an OTC perspective, there is consensus regarding the main asset class groupings, namely commodities, credit, equities, foreign exchange (FX) and rates. Nonetheless, some believe that an additional asset class of hybrid is needed to capture products such as multi-asset return swaps, exotic and structured derivatives. At the base product level too, there is some agreement on the appropriate categories, though the majority tend to descend into a granular product type level, immediately avoiding any form of hierarchical structure.

Underlying the two dimensions of an OTC classification scheme, a pool of key characteristics is required to be able to meet the various business requirements. In some instances, this may comprise fewer than five attributes, along the lines of the ISO CFI. Other times when classifying complex hybrid instruments a large number of characteristics are required. When defining a classification, there are a number of points to consider. What product classifications are already in use across the enterprise and for what purpose? Does any industry scheme seem appropriate to use as the basis of an enterprise-wide classification? And as a final point, it is important to ensure that any scheme has a firm semantic understanding and that each attribute contains only one discrete piece of information.