The credit derivatives market continues to soar - the International Swaps and Derivatives Association's (ISDA, New York) midyear survey puts the notional amount at $12.43 trillion as of June, up nearly 48 percent in the first six months of the year and 128 percent over 2004. But such front-office trading success has its back-office price, along with the potential to cause the market to implode. A mass of outstanding trade confirmations is swamping firms' operations departments, which are ill-equipped to deal with the surge in volumes. And that has regulators worried.
In a letter sent to major U.K. market participants in February, the U.K.'s Financial Services Authority highlighted its concern about the level of unsigned confirmations - and the risk posed to market efficiency and confidence. Similar apprehensions spurred the Federal Reserve Bank of New York to host a meeting in September with 14 of the largest dealers, as well as a number of domestic and international supervisors. "Regulators wanted to make it clear they think the market is very important, and they don't want to see the market getting into issues that would keep it from growing," says Karel Engelen, ISDA's policy director.
Even though ISDA's 2005 Operations Benchmarking Survey recorded a significant drop in trade capture error rates, failures in accurately capturing transaction details remain a major cause of trade fails. The No. 1 reason confirmations are not settled lies with difficulties in "processing assignments," according to Engelen. Assignments (also called novations) occur when a customer wants to exit a deal prior to maturity. It has become a very active - and rapidly expanding - secondary market popular with hedge funds and, to a lesser extent, traditional investment managers, insurance companies and even pension funds.
Automating the Back Office
To allay the Fed's concerns, the 14 major dealers developed a five-point proposal. One part of that proposal is to adhere to the ISDA 2005 Novation Protocol. The protocol, which went into effect on Oct. 24, standardizes the process by which participants to a novation - transferor, transferee and the original dealer in the trade (known as the remaining party) - obtain/provide consent to that transfer, including the exchange of a novation confirmation. "The idea of a protocol came up because, if you are trying to institutionalize a better process around novations, it is much better to do that on a multilateral basis than negotiating bilaterally," says an industry insider.
The crux of the major dealers' proposal is a commitment to reduce the confirmations backlog. They have pledged that by Jan. 31, 2006, the number of confirmations outstanding more than 30 days will be reduced by 30 percent compared to the levels on Sept. 30. Further cuts - levels for which will be set by Dec. 15 - will be made by the end of March 2006. To monitor progress, the dealers will provide monthly metrics on trade volumes, confirmations, settlements and fails. Central to achieving these targets has been a commitment by the major dealers to make full use of all the Depository Trust & Clearing Corp.'s (DTCC, New York) automation capabilities by Oct. 31, 2005, with their active clients to follow suit by Jan. 15, 2006, and less active clients by March 31, 2006.
Most industry participants agree that automation is the only way the industry can tackle its current processing issues and support anticipated future volume growth. To that end, the DTCC launched Deriv/SERV, its automated matching and confirmation platform, in November 2003. To date, customers have been held back from using the service with the dealers because of the lack of master confirmation agreements. According to Peter Axilrod, managing director, new business development in the DTCC's Deriv/SERV business, the focus now is on getting more participants involved.
"DTCC has, therefore, agreed with the dealing community to incorporate the standard terms of these master confirmation agreements into its operating procedures, which means firms will not have to have bilaterally executed master confirmation agreements to trade and confirm through DTCC," explains Axilrod. "In addition, ISDA has promulgated its own set of standard terms for single name trades - the ISDA Physical Settlement Matrix - and the dealing community and DTCC will be supporting that on a fully automated basis next January."
Essentially, then, the DTCC is becoming the de facto service for automated trade confirmations and payments, according to Harrell Smith, manager of the securities and investment practice at Celent Communications. As a result, electronic trading platforms want to work with the DTCC, as it enhances the value of their offering.
Trading by Phone
When it comes to trading, the electronic platforms traditionally have been interdealer affairs, such as Creditex's (New York) RealTime and GFI Group's (London) CreditMatch, while phone trading remained the norm in the dealer-to-client space. But that is changing. MarketAxess (New York) was the first to launch a client-to-multidealer electronic credit default swap index trading system, which went live in September and was followed in October by the launch of Thomson TradeWeb's (Jersey City, N.J.) TradeWeb CDS. Both have the functionality to support the ISDA Novation Protocol, and both link to Deriv/SERV.
On the pre-trade side, MarketAxess has incorporated the Markit Group's (London) Markit RED database to ensure users know the correct reference entity and obligations, as well as functionality that enables counterparties to check that sufficient credit lines and documentation are in place, says Stephen Davidson, head of corporate communications with MarketAxess. Trades then are sent to the DTCC for matching. But, while such capabilities tackle the trade capture issues, assignments still are the really important issue, notes Davidson. So, "When a client wants to assign a trade to Dealer B, MarketAxess will help meet the Novation Protocol requirements by sending an e-mail on behalf of the client to Dealer A, notifying it that an assignment request has been put through," he says.
Meanwhile, in the post-trade space, Creditex sister company T-Zero (Toronto) launched its offering this summer. "T-Zero is a flexible derivatives affirmation tool," says Mark Beeston, the firm's president. "We take trade details from our clients via an API [application programming interface], serve those up to their counterparties on a deal and allow their counterparties to affirm the economic details, add any allocations or deal splits, and point out any errors." Because T-Zero is not providing the legal execution, the workflow process is applicable across both electronically documented trades and also deals done on paper, he adds.
By contrast, ebusinessware (New York) is attacking the workload in the front office as it pertains to the risk management and support of the book itself, according to Ed Hoofnagle, the firm's CEO. "A lot of the reason you get these backups in trade reconciliation is because everyone is busy doing other things, including price testing and marking the book to market," he says. "What we're doing is easing the administration load by automating the mark-to-market process."
Such automation will be crucial if the industry is to reduce outstanding trade confirmations. "Ultimately, what people will be looking at is to have credit derivatives very much in line with the other asset classes," ISDA's Engelen says.
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