Affirmative Action
Even though the credit-derivatives market barely existed before the mid-1990s, more than $10 billion in credit derivatives products now are traded in the United States each day, according to Celent. With unprecedented growth, however, has come an uncomfortable degree of risk in the form of outstanding confirmations. The market neared $17 trillion in notional outstanding contracts last year.
In response, The Federal Reserve Bank of New York summoned 14 leading major dealer banks last October to discuss ways to reduce the backlogged paperwork. "The concern is that the confirmation process was taking too long and therefore generating a large backlog of information," says Peter Delano, senior analyst, TowerGroup. "If someone defaulted on an original arrangement, it could cause a ripple effect and potentially a lot of damage to the industry."
By June 30, 2006, the major dealers had achieved a 70 percent reduction on September 2005 levels in each market participant's number of confirmations outstanding for more than 30 days, a commitment they made to the Fed in March. To build on this reduction, both the Fed and the major dealers agree that the creation of a largely electronic marketplace in which all trades are processed through an industry-accepted platform is the most logical step.
Quest for Solutions
As a result of this quest for automation, tech providers are ramping up their affirmation offerings. Gaining the most attention is AffirmExpress from New York-based Depository Trust & Clearing Corp. (DTCC). Designed to help traders check, and if necessary correct, the terms of a deal immediately after it is agreed upon, AffirmExpress currently is being tested by interdealers GFI Group, Icap and Tullett Prebon.
"This is new for DTCC since they are typically a back-office operation, focused on matching and affirming on the back end," says Michael Fuhrman, GFI's head of e-trading, North America. AffirmExpress is "trying to capture the trade as quickly as possible on the front end and find any errors," he adds. "We thought it would be great for the industry."
Here's how it works: As GFI, for example, brokers a trade, its existing confirmation engines transform the trade data into FpML (Financial products Markup Language, the industry-standard protocol for complex financial products that is based on XML). The message then is routed over a secure connection to DTCC, where all trades are captured in a database via an application program interface (API). Traders simply access their blotters to review the details of the trade as provided by the brokers. A queried trade is sent back to the broker that submitted it. The interdealer broker speaks with the trader, amends the trade if it is incorrect and resubmits it, and the trader then can accept the trade.
Fuhrman stresses that an important aspect of AffirmExpress is that the brokers submit the details on behalf of traders. Currently, traders access DTCC and input the details themselves. In addition to saving the traders time, the extra set of eyes reduces the chance for error, Fuhrman contends. "If you notice an error early, before the trade has become a contract, this system allows you to remove that error very quickly," he says. "By eliminating errors before the trade occurs, unnecessary time, money and paperwork is saved."
After the trade is confirmed, it moves through the DTCC's matching service, Deriv/SERV, where it becomes a legally binding contract with no signature. "The demand for the [affirmation service], extended to the buy side, is actually bubbling at some of the banks when they see how important this is" for improving processing, says Fuhrman.
Early Elimination of Risk
To extend affirmation services to the buy side, vendors such as Omgeo, T-Zero and TradeWeb are offering their own solutions that electronically transmit confirmed transactions to the DTCC's Deriv/SERV platform. The spike in new vendor offerings reflects just how much of a concern operational risk issues have become for buy-side firms.
According to Mark Beeston, president of T-Zero, the cost of operational risk on the buy side has become "acutely transparent," thus driving up demand for automation. "Financial services firms are in the business of managing market risk -- not managing operational risk," he says. "They want to make the elimination of that risk as easy as possible," adds Beeston, the former COO for credit trading at Deutsche Bank.
"Documentation is obviously one of many risks to surmount as financial institutions document these transactions," Beeston continues. "The fund community sees the value in removing these risks as early as possible in the lifecycle, because one error can cause multiple pain points."
JPMorgan was one of the first Wall Street firms to go live with T-Zero's post-trade straight-through processing (STP) platform for credit derivatives. The T-Zero system electronically captures all trade details, assignments, allocations and other relevant details in the processing of credit derivatives, and allows counterparties to send affirmed trades to the DTCC automatically for same-day, or T+0, legal execution.
JPMorgan leverages the T-Zero solution to process live trades between Goldman Sachs and hedge fund KBC Alternative Investment Management. "The platform is precisely what the market needs to underpin its growth, and we look forward to continuing to work with T-Zero to bring further benefits to our broad client base," said Guy America, head of European credit trading at JPMorgan, in a news release.
T-Zero's Beeston says his firm connects agnostically both to an array of broker trading platforms as well as other electronic execution platforms to allow clients to leverage data where they see fit. "It's not up to us to prescribe where they can or cannot go with it," he notes. T-Zero recently bolstered its connection strategy by partnering with Calypso Technology, a provider of capital markets trading software, to develop an interface between Calypso and T-Zero and assist Calypso's clients in improving STP of credit derivatives trades through DTCC and T-Zero.
Buy Side Leads the Pack
One area of credit derivatives processing in particular for which firms are seeking solutions is the handling of multi-asset classes. According to John Burchenal, managing director, asset class expansion, Omgeo, buy-side firms are leading the charge. "The buy side is way ahead of the industry in terms of how they're processing their asset classes," he asserts. "They're creating single systems to do their processing for all of these asset classes, where dealers, while they are moving in that direction, are still siloed in terms of the systems that they use."
Back-office and settlement systems "typically don't talk and play well with each other," Burchenal continues. "Where the sell side is focused on managing risk, the buy side has broken down those barriers while looking for ways to process activity in a single place."
To meet the growing demand for a single STP offering, Omgeo recently announced that it is linking its newest offering, Omgeo Connect, with the DTCC's Deriv/SERV. The link will enable multi-asset class investment managers to integrate, under a single point of access, their domestic and cross-border trade processing for over-the-counter derivatives for fixed income, equities and other instruments. The connection between the two services is expected to go live this quarter.
"We have relationships with thousands of buy-side customers and hundreds of dealers," says Burchenal. "They look to us for STP of their cash instruments. They've also been asking us what we can do for derivatives, too. They want to do all of their STP in one place."
Omgeo Connect allows investment managers and investment manager outsourcers to interact with both Omgeo services and other third-party post-trade solutions, Burchenal says. Users will benefit from streamlined trade and settlement management of multiple asset classes via an application service provider (ASP) environment, eliminating the need to maintain multiple systems and services, he asserts. <<<
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