Markit's Moving Fast Into Derivatives Processing

London-based data provider Markit has bought Communicator, Swapswire and BOAT. What's next for the fast-moving derivatives player?

When we saw Markit Group buy SwapsWire and then BOAT in quick succession, we knew it was time to take a closer look at the aggressive British entrant into the U.S. derivatives processing market.

Founded in 2001, Markit started out as a provider of independent credit derivatives pricing. Its derivatives indices, such as ABX and CDX, have become critical in firms' struggle to accurately determine the value of outstanding derivatives contracts whose underlying assets may be murky. ABX, for instance, tracks the performance of a set of credit default swaps based on U.S. subprime home loans (the derivatives prices themselves are provided by a consortium of 16 investment banks).

It is widely understood that Markit's indices effectively are the only independent means (other than complex mathematical models that cannot take into account factors such as underwriting quality) available to estimate the value of certain types of derivatives. But not everyone is a fan of the indices.

"They're fallacious because they reflect an environment that doesn't exist," contends Dick Bove, analyst at Punk Ziegel. For instance, Markit's CMBX index of commercial mortgage-backed securities recently reflected a 6 percent to 8 percent imputed loss in U.S. commercial real estate when the actual loss was a quarter of 1 percent, according to Bove. "People buying the securities are estimating a far worse disaster than is actually occurring," he says. Accounting rule FAS 157 requires banks to mark certain products down to the implied value of the indices, even if they still are performing well, Bove notes. What firms should do, he believes, is value securities according to how well they actually are performing, rather than based on indices that reflect only what securities buyers think.

Markit concedes that its indices are not perfect. "What an index tells you is where the derivative category is moving; to some extent, that's a symptom rather than a cause," responds Jeff Gooch, EVP and head of trade processing and valuations at Markit. "It helps, because it gives you something to watch. And it does, to a certain extent, reflect some liquidity issues as well as everything else that goes into valuing these products."

Markit also provides a Reference Entity Database (RED) Service -- a set of business entity identifiers to which dealers can refer in order to standardize documentation and avoid mistakes. RED has become so essential to the credit derivatives market that the DTCC has said it will soon start rejecting contracts coming into its Trade Information Warehouse that lack RED coding.

A Thirst for Operations

Markit began its foray into derivatives automation in May 2006, when it acquired White Plains, N.Y.-based Communicator, which offered an OTC derivatives processing platform for trade confirmation, pricing, valuation and trade lifecycle events (the product has been renamed Markit Trade Processing). "We made a very definite decision to get into the processing space," recalls Gooch, who previously ran global OTC derivatives operations at Morgan Stanley.

"The general health of the OTC markets is very dependent on processing efficiency," he continues. "If the industry collectively is going to sort out the problems in derivatives processing, it's going to need to move the bulk of the volume for confirmation in those markets over to electronic platforms."