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Automating RegTech

There are a number of highly regulated industries that must adhere to complex regulations from various regulatory bodies. These often come in the form of lengthy documents that can be arcane, ambiguous, and expensive to interpret into computer code. It's even more expensive to adapt these regulations to a firm's internal systems. There is no competitive advantage for firms in processing these regulations separately, so it would be mutually beneficial to codify and test the rules once across all firms.

There have been attempts to do so using shared libraries. The challenge with this approach is that these libraries don't work natively across the complexities of each firm's existing systems. In order to use them, they would need to invest significantly to build new systems that use the shared libraries. Another issue is that technology advances quickly, and an optimal solution at any point in time is not likely to be the best solution in a short time.

There is an alternative. If regulations were codified in a declarative model that could be cross-compiled to run in different execution contexts, then that would enable firms to create their own processors to translate the model to work in their systems. In that way they get the advantage of a codified, unambiguous, and verifiable model while still retaining their existing systems. Morphir provides exactly this capability by providing tools to project a unified model into various execution contexts.

Use case: US LCR

The US Liquidity Coverage Ratio is a required report for certain banks and systemically important financial institutions. Its definition can be found at https://www.govinfo.gov/content/pkg/FR-2014-10-10/pdf/2014-22520.pdf. It's complex enough that there are accompanying documents and samples that attempt to clarify it. Ultimately it's a set of calculations that can be defined concisely and unambiguously in a concise and unambiguous programming language.

We'll step through how we can define such a regulation using Morphir with the LCR as an example.

Getting started

If you've not already done so, install Morphir as per the getting started instructions. Create a project called "lcr":

morphir init lcr
cd lcr

In this example, we'll use Elm as the Morphir modeling language. If you've not done so, install elm.

Modeling the LCR

Let's define the core of the calculation for Morphir. The full LCR is quite extensive, so we'll focus on a few examples that highlight different aspects of modeling.

Modeling calculations​

At a high level, the LCR is a calculation. In fact if you look it up, the first thing you'll run into is probably this calculation: LCR = High quality liquid asset amount (HQLA) / Total net cash flow amount ​. In modeling terms, it's not actually that simple since the LCR is calculated using a window from a given date. It also needs to run on a set of data. So in our model, we'll define it as a function:

lcr toCounterparty product t flowsForDate reserveBalanceRequirement =
    let
        hqla                = hqlaAmount product (flowsForDate t) reserveBalanceRequirement
        totalNetCashOutflow = totalNetCashOutflowAmount toCounterparty t flowsForDate
    in
        hqla / totalNetCashOutflow

As you can see, that's pretty expressive, and the last line matches the calculation. For anyone new to Elm, the first line declares the function. Elm uses spaces rather than (,) to itemize parameters. You might be wondering what some of these extra parameters are all about. These are the points where the logical model meets the physical context that it will be run in. They are parameters at the top level so that individual firms can specify them as needed. The parameter named product is a good example. It's a function that takes a product key and returns the product structure. It's up to the model user to determine how product identification and lookup will be supplied by their system.

If you read the specification, you'll see a fair amount of space used to describe something called the adjusted excess HQLA amount. This happens to be a nice calculation to demonstrate mathematical modeling:

adjustedExcessHQLAAmount =
    let
        adjustedLevel1LiquidAssetAmount = level1LiquidAssetAmount

        adjustedlevel2aLiquidAssetAmount = level2aLiquidAssetAmount * 0.85

        adjustedlevel2bLiquidAssetAmount = level2bLiquidAssetAmount * 0.50

        adjustedLevel2CapExcessAmount =
            max (adjustedlevel2aLiquidAssetAmount + adjustedlevel2bLiquidAssetAmount - 0.6667 * adjustedLevel1LiquidAssetAmount) 0.0

        adjustedlevel2bCapExcessAmount =
            max (adjustedlevel2bLiquidAssetAmount - adjustedLevel2CapExcessAmount - 0.1765 * (adjustedLevel1LiquidAssetAmount + adjustedlevel2aLiquidAssetAmount)) 0.0
    in
        adjustedLevel2CapExcessAmount + adjustedlevel2bCapExcessAmount

It's included here just to show how much easier it is to understand a model than the written description:

There are two categories of assets that can be included in the stock. Assets to be included in each category are those
that the bank is holding on the first day of the stress period, irrespective of their residual maturity. “Level 1”
assets can be included without limit, while “Level 2” assets can only comprise up to 40% of the stock.

Modeling collection operations​

The LCR spec is peppered with operations of collections of data. For example:

level2aLiquidAssetsThatAreEligibleHQLA =
    t0Flows
        |> List.filter (\flow -> flow.assetType == Level2aAssets && isHQLA product flow)
        |> List.map .amount
        |> List.sum

It's pretty easy to see that this takes a collection, filters it, then sums the "amount" of the remaining. The important point to note here is that we're letting the model know of a collection while also leaving the implementation entirely undefined. This allows us to process this model into a variety of execution contexts.

Modeling structures​

The previous example contained a collection name t0Flows. We can see from the example that it has assetType and amount fields. In fact, this is defined in the spec as a cash flow, which contains a few other fields. At this point in our modeling, we have a couple of options. We can either use a single common structure throughout the model, even when large portions of the app don't require all of those fields, or we can create multiple structures that are more aligned with the usage. Since the LCR actually defines a cash flow, we'll go with the first option since it matches the language of the business. The cash flow is defined as:

type alias BusinessDate = Date


type alias ReportingEntity = Entity


type alias Flow =
    { amount : Amount
    , assetType : AssetCategoryCodes
    , businessDate : BusinessDate
    , collateralClass : AssetCategoryCodes
    , counterpartyId : CounterpartyId
    , currency : Currency
    , fed5GCode : Fed5GCode
    , insured : InsuranceType
    , isTreasuryControl : Bool
    , isUnencumbered : Bool
    , maturityDate : BusinessDate
    , effectiveMaturityDate : BusinessDate
    , productId : ProductId
    }

Notice that most of the types are named using the language of the business. This is an aspect of domain modeling, the ubiquitous language, that helps all the stakeholders to reduce misunderstandings.

Verifying the model

This is just a small sampling of what's required to turn a full specification into functioning code. It's enough to see that it's not a trivial task, and there's a significant advantage if someone else could do it for you and prove that it's correct. This is where the use of a pure functional programming language for business modeling really shines. The common statement that "if it compiles, it's guaranteed to run without errors" really applies well to RegTech. The Elm compiler catches a huge number of potential errors that would otherwise be impossible in non-FP languages.

It's worth noting that there are languages that provide even more guarantees, like Coq and Microsoft's Bosque. In creating Morphir, we were careful not to write our own or locking on a particular language. This leaves the option of using the best language for the job, as long as that language can be co-compiled into the Morphir IR.

[TODO] show examples of catching errors

The OCC helpfully provided some test examples that we can also use to verify our models. We've done so in the form of unit tests on our Elm code. These tests demonstrate how the OCC's tests, which were provided in a document, could actually be codified into the modeled rules.

Using automation to adapt the model to your systems

Now that we've ensured that our model of the LCR is correct, we want to turn it into code that can execute in our systems. For this purpose, we'll assume that the regulatory reporting data is currently housed in a SQL data warehouse. Let's take a look at how the sample above translates to SQL:

select sum amount
from t0_flows tf
where tf.assetType = 'Level 2a Assets' and tf.isHQLA = 'T'

You can see in the example that the generated code makes some assumptions about the physical environment. These are the things that are likely to be very different across firms. The value of modeling is that each firm can customize the code generation to match their own environments.

Of course, it's naive to think that the full LCR calculation would be able to execute entirely in a data warehouse. In fact, many firms are migrating these calculations to new technologies like Spark. Doing a large scale migration of a report like the LCR to a new technology is usually a significant and risky effort. On the other hand, if you're running from a model, it's just a matter of switching to a new backend generator. While that's not trivial, it sure is a good deal easier, cheaper, and less risky that rewriting the entire calculation from scratch. Let's take a look at the Spark version of our sample:

Spark Scala

t0Flows
    .filter {flow => flow.assetType == Level2aAssets && isHQLA(product, flow)}
    .map (_.amount)
    .sum

Summing up​

We've seen how using an industry standard RegTech can save an industry valuable time, effort, and risk. We've also seen that doing so with a shared model allows firms to adopt RegTech without the costly exercise of rewriting their systems. Finally, we've seen how capturing regulations in a technology-agnostic model can ease migration to new technologies.

To view the entire LCR example, take a look at the Morphir Examples project. For generating SQL and Spark from Morphir models, be sure to keep an eye out for the upcoming morphir-sql and morphir-spark projects.

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