Technology Upgrades Improve Derivatives Processing

Derivatives Processing picks up speed thanks to tech upgrades at DTCC, SwapWire, major broker-dealers and custodians.

What a difference two years make. In October 2005 at the Institute of International Bankers Luncheon in New York City, Timothy Geithner, president of the Federal Reserve Bank of New York, expressed grave concerns about "the growth in volume and complexity of new instruments for risk transfer, which has advanced, as it typically does, ahead of improvements in the trade-processing infrastructure and risk management and control practices." Among other problems, he cited "the degree of manual processing required for trade capture and settlement, ... and the slow adoption of market services for automated processing."

Fast-forward to summer 2007, and derivatives processing is a slightly more automated world, especially credit derivatives -- contracts that transfer the risk of the total return on a credit asset falling below an agreed level without transfer of the underlying asset. An April 2007 report from the International Swaps and Derivatives Association (ISDA) found that outstanding credit derivatives trades fell from 16.2 days worth of business in 2006 to 5.5 today; interest rate derivatives were down to 14 days from 50. The survey also found that among large firms, more than 70 percent of credit derivatives confirmations are sent out T+1, up from 50 percent a year ago.

"Last year there was a lot of attention to credit derivatives because of the fast growth in that market and outside pressure from the Fed and [British regulatory body] FSA," explains Brad Bailey, senior analyst at Aite Group. "There was a considerable spend on technology and innovation by different vendors," including Calypso, Markit, T-Zero, Thunderhead and Interwoven, and the major dealers invested heavily in these upgraded solutions, he adds.

Further, the Depository Trust and Clearing Corp., the broker-dealer-owned clearing utility, built a trade information warehouse that stores a "golden copy" of every trade record that passes through its DerivSERV engine for matching and confirming credit derivative trades electronically. About 80 percent of all credit default swaps are matched and confirmed through DerivSERV. And another major utility, SwapsWire, now has 15 dealers and 30 interdealer brokers using its electronic confirmation service for equity derivatives.

In other developments, the Financial products Markup Language (FpML) -- an XML message standard for the over-the-counter derivatives industry -- is gaining traction as a universal language for derivative transactions. A novation protocol has been agreed upon for handling the reassignment of trades to new counterparties. And large broker-dealers and custodians, such as State Street, are rebuilding their derivatives processing platforms to accommodate new derivatives products.

Yet there's work to do before derivatives processing is completely automated. "Utilities like SwapsWire and DTCC are not keeping pace with the growth in new types of derivatives products coming out," says State Street SVP Neil Wright, who along with fellow SVP Kevin Sullivan was hired by the firm at the end of April to oversee ongoing development of its derivative-processing capabilities. For instance, while the DTCC addresses credit derivatives, commodity and equity derivatives are growing quickly and are not yet addressed by the DTCC's matching service or trade information warehouse, Wright notes.

Equity derivatives are likely to be the next area of focus. "Last September the Fed announced it will look at the equity derivative market, which is a very big, client-facing global market," Aite's Bailey says. "The industry expected this, and there's been a lot of cooperation among the dealers and ISDA working groups."

State Street's New Platform

One of the major difficulties with automating derivatives, State Street's Sullivan says, is handling the many data fields each contract requires. "In the exchange-traded securities world, you might have five pieces of data on equity trades or bond trades, and it's always the same five or six pieces of data. So you can build a system around that assumption," he explains. "But in the derivatives world you might have over 100 pieces of data from a universe of about 10,000 that can exist. It's difficult to build a framework that can handle new products as they emerge quickly because the number of fields that are available is so much greater."

Sullivan and Wright are building a new asset-servicing platform to provide middle- and back-office accounting. They're constructing a service-oriented architecture into which they will plug third-party software and proprietary tools. "There's no one product on the market that can meet the needs of an asset-servicing organization the size of State Street," Sullivan notes.

The framework will accept data feeds from DTCC and SwapsWire and validate trades via the DTCC's trade information warehouse. "The industry has accepted that the DTCC's trade data warehouse view of the trade is, in fact, what they call the golden copy," Wright says. "If there's any dispute, those are the terms of the transaction that both parties have agreed to."

The new platform will make heavy use of FpML. "It provides a single dictionary for the 10,000 fields that are used in derivatives," Sullivan says. "Because everybody understands what those 10,000 fields mean, the confusion that can occur is reduced." The initial rollout of the platform -- which will accept trades in any format and convert them to FpML -- later this summer will cover all products that use FpML today, Sullivan adds, noting that the firm will be able to service new types of derivatives products as soon as they can be represented by an FpML message.

DTCC Update

DTCC launched its trade data warehouse for credit derivatives in November; all trades matched in DerivSERV are stored there automatically. These records should ease post-trade contract maintenance and result in fewer disputes, according to Janet Wynn, managing director of DTCC. All parties reconcile with the warehouse rather than with multiple dealers, which helps with portfolio margining and risk management, she explains.

The next step for the trade information warehouse is "backloading" -- getting pre-November 2006 portfolios into the warehouse. "The largest firms have the bulk of the portfolios," says Wynn. The so-called Fed 14 (the 14 major broker-dealers the Fed asked in 2005 to reduce credit derivatives backlogs) have backloaded most of their contracts; others have started. "We expect to be backloading through early next year," Wynn says.

The trade information warehouse will help DTCC automate quarterly settlements processing, Wynn continues. Credit derivatives contracts have payment obligations every quarter. In February, DTCC began work on automatically calculating these payments for single names and index trades, which Wynn says is 85 percent of the market. "We're going through a long trial period where we're showing people what the calculations would be, and they're comparing them to their own risk calculations," she says, adding that in November DTCC plans to offer straight-through processing for these quarterly payments.

DTCC also is testing and hopes to roll out by summer's end a trade information warehouse feature that lets users record a credit event, such as a company's bankruptcy or merger. "Right now if there is a credit event, people have to notify each other that an event has happened and which contracts are subject to it," Wynn reports. "Using our system, people will be able to flag an event and note which contracts are impacted." Not only would the noting of credit events help with calculating quarterly payments, it should help address the concern of regulators, such as the Fed, that the market may be ill-equipped to handle major credit events.

To use the new DTCC features, custodians and larger dealers are updating their systems. But, Wynn points out, small firms don't need to worry. "Folks that are small can just use spreadsheets for input and output," she says. "We're trying to work with them on getting an automated feed to their service provider."

Further down the road, the DTCC will work on automated processing and a warehouse for other types of derivatives, such as equity derivatives. "A small percentage of the equities market is confirmed electronically right now, so our focus at the moment is getting those transactions confirmed electronically," Wynn relates. "To drive forward automation here, we have to get a lot of participation from the buy side and across hundreds of second- and third-tier banks, because every bank in the world uses interest rate derivatives for asset/liability management."

Publish Date: Jun 18, 2007
Source URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=199903414

PolarLake releases OTC derivatives trade lifecycle package

PolarLake has today launched a fully packaged over-the-counter derivatives trade lifecycle solution.

The solution is ideal for sell-side, buy-side, custodians and fund administrators.

Features of the solution are:

• ISDA compatible portfolio reconciliation, matching and reporting service, including out of the box reports for business users
• Support for FpML 4.2 & 4.3 standards
• Out of the box FpML semantic validation of the business meaning of trade data
• Ability to take inputs in any format (Excel, pdf, CSV, XML, etc.)
• Out of the box BPM support for trade lifecycle and exception management
• Data Analyst driven user desktop for configuring business rules
• Support for all derivative classes
• Out of the box integration with WS-CDL for choreography of trade flows
• Integration platform for connecting to SwapsWire, T-Zero, DTCC
• Easy integration solution for FpML onto SWIFTNet
• Business rules defined in open standards rule language XQuery

The key benefits to financial institutions of adopting PolarLake's OTC derivatives trade lifecycle solution are:

• Decreased costs and lower operational risk through automation of existing manual portfolio reconciliation processes
• Increased revenue through tailored, differentiated OTC derivatives trade services to clients
• Lower cost of integration over traditional coding of transformations
• Lower cost of maintenance based on PolarLake's ability to manage the complexity of FpML in an intuitive data centric manner
• Quicker on-boarding of new services such as SwapsWire and T-Zero

Commenting on the release, PolarLake CEO John Randles said, "PolarLake has been involved in the integration, reconciliation and process management of FpML based trades for many years. Our core platform is more suited to this problem than any other on the market due to our patented XML pipelining technology. And, with our experience in many implementations with companies like JPMorgan, Société Générale, Pioneer Investments and Dimensional Fund Advisors, we have been able to package a complete integration, reconciliation, matching and BPM solution for the OTC Derivatives market. Companies new to these asset classes are looking for solutions, not a series of technical problems. Companies already working with these asset classes are well aware of the technical and operational problems, currently addressed by expensive manual processes. These are problems we have already solved."

Publish date:July 23, 2007

Source URL:http://www.finextra.com/fullpr.asp?id=16240

Barclays and BBH exchanges FpML messages over SwiftNet

Swift announced today that Barclays Global Investors and Brown Brothers Harriman were the first asset manager and custodian to exchange FpML (Financial products Markup Language) based Contract Notifications over SWIFNet.

The following week, State Street on behalf of PIMCO and other customers began testing FpML communication with Bank of New York, Mellon Bank, Northern Trust and State Street Corporation.
SWIFT has launched the SWIFTNet FpML programme, in cooperation with ISDA (the International Swaps and Derivatives Association) earlier this year. This initiative seeks to automate OTC derivative post-trade processing. By using SWIFTNet FpML the industry players will be able to manage the rapidly growing volumes in the OTC derivatives market in a more efficient way.

"Our successful test is evidence of Brown Brothers Harriman's commitment to improving STP and reducing risk for our clients' derivatives activity," said Cherie Graham, Head of Brown Brothers Harriman's Derivatives Product Group. "We are excited to play a key role in helping the industry move forward with making derivative trade automation a reality through the FpML format."

Steve Goswell, Director, Barclays Global Investors, a strong advocate for automation and standardisation in the asset management community, said, "Barclays Global Investors is building a strategic platform to support the growth in OTC derivative volumes. With the help of SWIFT we have a global, secure, and reliable transport mechanism."

"This industry initiative will become an additional vehicle for improving the STP handling of OTC derivatives and help to mitigate the settlement risk for these products," said Terry Randall, senior vice president of State Street Corporation.

The first phase of SWIFTNet FpML involves transporting contract notification messages between asset managers and custodians. Later phases involve additional market participants, such as dealers and additional services, including trade confirmations and portfolio statements.

"This initiative brings the industrial strength and reach of SWIFTNet to the OTC Derivatives processing area, complementing our existing post-trade messaging services for the FX, equities and fixed income spaces," said Fabian Vandenreydt, Acting Head, Securities Industry Division, SWIFT.

Source URL - http://finextra.com/fullpr.asp?id=16055
Published Date - July 07, 2007

Germany Jumps at Derivatives

New regulations open opportunities, but strict risk management rules force asset managers to overhaul their front offices.

For the first time, fund managers in Germany are taking on a wider variety of derivatives to boost investment returns, but stringent new risk management guidelines call for radically revamping front-office systems, which could delay the launch of funds that comply with the regulations.

Financial regulators in Germany have always viewed derivatives with a cautious eye. While securities regulator Bafin does not share the view of investment guru Warren Buffet—who famously described the instruments as "financial weapons of mass destruction"—it had until recently only allowed asset managers in Germany to invest in derivatives to hedge risk exposure within their portfolios.

This all changed with the introduction of the Derivatives Regulation (Derivateverordnung) in February 2004, which came into force in conjunction with the Investmentgesetz (InvG) legislation. The Derivatives Regulation allows fund managers to invest in the full spectrum of derivatives products. But to do so they must obey strict risk management rules, which place limits on market risk and counterparty risk and require fund managers to install management and control systems in the front office to monitor the increased risks associated with derivatives. The funds had an adjustment period, which lasted until February this year.

Philippe Carrel, global head of alternative investments at Reuters in New York, says asset managers in Germany have "jumped at the chance" to begin updating their front-office risk management systems to comply with the rules.

Carrel says increasing pan-European competition in the asset management industry has given German fund managers a strong incentive to offer their institutional clients the opportunity to invest in derivatives and structured products. The European Union's Undertakings for Collective Investment in Transferable Securities (Ucits) III directive has extended the range of financial instruments in which funds are able to invest and introduces a "European passport" system to facilitate cross-border activity within the European Union. This opens up opportunities for hedge funds and asset management firms based outside Germany to vie for market share with the country's leading fund managers.

"This [Ucits III] is a new deal," Carrel says. "You are going to see old business models going out of the window and new business models starting to flourish. A passport-free Europe is becoming a reality. If you are an asset management firm that does not offer German investors market-neutral funds [which contain derivatives], someone else will do it."

Risk Control

Frankfurt-based Metzler Investment built a new risk control department to comply with the Derivatives Regulation in early 2006, using a risk management system developed by RiskMetrics. The Frankfurt-based asset manager, which has €30 million ($40 million) under management in a variety of equity and corporate bond funds, took a year and a half to make the risk and control department fully operational.

"Before the derivatives rules we did not need to carry out value-at-risk (VaR) calculations. Now we have to monitor the quality of VaR calculations on a daily basis through back-testing," says Ruth Boettcher, head of risk management at Metzler Investment.
Metzler's risk control department is split into various teams. The original risk management team, which consists of three people, carries out VaR calculations and stress-tests the portfolio. This involves the use of historical simulations and Monte Carlo simulations. The risk team works alongside a data management team, which consists of three people, and a legal and compliance team comprising four people.

"You have to develop all the interfaces to internal systems—it was hard work," says Boettcher. "If you have a new product, you have to route it from the back to front office and into the risk management system to make sure [it is compliant with the regulations]. We have a big IT team and we are working every day on the interfaces because we need a lot of automation in order to avoid manual processes."

In addition to carrying out daily VaR calculations on investment portfolios, fund managers have to obey strict rules on pre- and post-trade transactions to ensure they do not fall outside the regulations. Front-office systems must monitor a fund's exposure to individual stocks and share-price indexes, currencies, and bond issuer and counterparty credit risk. Asset management software company Aquin Group and financial services software provider Charles River Development are among the vendors helping German fund managers comply with these rules.

Aquin Group has installed its MIG21 Global Investment Compliance system at several major asset management firms in Germany, including DWS, a subsidiary of Deutsche Bank, Union Investment, Allianz DIT and Com Invest.

Charles River has installed its Investment Management System (IMS) at six institutional and retail asset managers in Germany. Siegfried Huegemann, senior account implementation manager at Charles River, says the IMS—which incorporates n-tier service-oriented architecture to support front- and middle-office systems—enables vendors to meet three sets of compliance rules: legal and regulatory rules laid down by Bafin, contractual or mandate rules dictated by a client, and internal rules based on a fund manager's asset allocation models.

"The Derivatives Regulation sits between two components of risk—first and foremost the credit risk, and also market risk," Huegemann explains. "If you have a serious violation, you have to report it to Bafin. Quite often, asset managers have to manage as many as 25 different portfolios and they are not sure if they do comply with the regulations or not. Our system checks against a fund manager's account positions and lets the company know if an order violates the regulation's compliance rules."

Huegemann declines to name the asset management firms that have incorporated the IMS software into their systems, but he uses the example of a fund manager investing in exchangeable bonds to demonstrate how the system works. "Asset managers have to consider both market and credit risk. A fund could have a 10 percent limit on the value it can invest in a single issuer within its portfolio, such as Daimler Chrysler. This limit is dictated by the regulatory rules," he says..

"If the firm already has an 8 percent stake in Daimler Chrysler, it may wish to buy an exchangeable bond issued by BMW that can be exchanged against shares of Daimler Chrysler. The details of the BMW bond and the exchange rate can then be input into Charles River's IMS, enabling the asset management company to control the total issuer concentration of Daimler Chrysler. This enables it to avoid violating the InvG rules limiting exposure to a single issuer to 10 percent. The asset manager can increase the issuer concentration of Daimler Chrysler by an additional 2 percent only."

Huegemann says IMS can be adapted to meet the specific needs of an asset management firm, which may obtain trading data and instrument data from a variety of providers such as Reuters or Bloomberg. "We can adjust to the client's environment and integrate with it accordingly. To that end, we can also do pre- and post-trade compliance according to a predefined set of rules for particular security types, regardless of the data set. Without such an open system, it would be challenging to change predefined compliance rules when the regulatory landscape changes," he says.

However, Reuters' Carrel says German fund managers' primary challenge is integrating risk management processes into their internal and external systems. "Ensuring connectivity with order management systems, order routing, prime brokers and different execution venues is critical. Today, fund managers have systems for exchange-traded products that need to be updated to account for over-the-counter derivatives instruments as well. It is not just a case of buying a system and getting into a trade. You have to be able to aggregate risk and valuations. There is the control of static data. You have to change the workflow to have a single view of OTC and exchange trades in one place," he says.

Carrel expects these technical obstacles to hamper German firms' ability to launch funds containing derivatives. "It will be a struggle to start off with this year. Typically, firms get into a business, see the issues and then update systems and workflow. It is usually a much more reactive process," he says.

Source - http://www.watersonline.com/public/showPage.html?page=457147
Publish Date - July 1, 2007

Credit Markets Eye Automation

Industry leaders who attended a market summit on over-the-counter (OTC) derivatives operations in London are urging major credit derivatives dealers to band together and form a central clearing agent to clean up a market where regulators want to see transaction processing become more automated.

The service could be based upon a structure similar to SwapClear, which was launched in September 1999 by London-based clearinghouse LCH.Clearnet to provide clearing for plain vanilla OTC interest rate swaps, according to the panel of three senior representatives from the buy side and sell side and an industry clearing and settlement service.

"Any one of the major prime brokers [in the credit derivatives market] could take that leap of faith and suggest operating a clearing house," says Chris Bentley, head of operations at London-based hedge fund Cairn Capital, which manages portfolios worth $30 billion. "This could potentially be done just for their clients to start off with and if this started a precedent, others may join to form a consortium of banks operating the system. This will reduce the logistics of confirmation matching payments. You would give all your trades to the clearinghouse and match them off," he adds.

Major dealers in the credit derivatives market—which include Bank of America, Citi, Goldman Sachs and JPMorgan—have already taken steps to make transaction processing more automated, such as confirming a higher percentage of trades electronically and adopting new functionality from electronic clearing and settlement firms such as the New York-based Depository Trust & Clearing Corp. (DTCC).

The big backlog in unconfirmed trades in the credit derivatives market—which stemmed from manual processes at banks with some dealers still using pieces of paper to register trades—first fell under regulatory scrutiny in September 2005 when Timothy Geithner, president of the Federal Reserve Bank of New York, spearheaded a drive to clean up the backoffice processes of 14 of the largest dealers in the market. The 14 banks have since reduced backlogs on outstanding confirmations by more than 80 percent.

However, Val Wotton, vice president, equity derivative and structured products documentation at Citigroup, points out that investment firms will face further technical challenges if they are to integrate their trade processing systems with an external clearing agent.

"There are issues around matching workflow and your internal workflow management. How do you actually internally control your documents and your payments and then leading on from there, how do you then process them to an industry client solution such as one provided by SwapClear. There are also questions around how you link back into your internal systems and close the loop," says Wotton.

New York-based electronic brokerage Creditex's credit derivatives trade processing platform T-Zero—which offers market participants a messaging system for the electronic affirmation of credit default swap trades—was also suggested by the summit panel as a possible centralized clearing agent in the future.

However, Bill Hodgson, first vice president derivatives services at the DTCC, says the fragmented buy-side market presents a challenge to the development of "focused" buy-side services. "It is not hard to build a platform. Getting people to use it is a different matter," he says.

"An integrated approach needs 300 buy-side firms to come to the table. Unless there is some form of an industry forum for the buy side [to express their view] we are not going to have that," says Bentley.

Hodgson says the exchange and cash markets have taken decades to formulate integrated trade processing systems. "Generally, firms buy solutions that plug into their food chain. In derivatives, SwapClear and T-Zero have bits of the food chain. Even though we are working quickly on the trade information warehouse for credit, I think it will be quite some years before you see a mature and comprehensive global settlement solution that is integrated across all OTC asset classes by one provider," he says.

Meanwhile, global regulators continue to monitor the infrastructure used by major industry dealers to process equity, interest rate and commodity derivatives. The New York Fed announced in May that 18 major market participants in the equity derivatives market had made progress in automating post-trade processing infrastructure. Dealers have succeeded in reducing equity derivatives confirmation backlogs by 25 percent in the period from November 2006 to Jan. 31 of this year.

Source - http://www.watersonline.com/public/showPage.html?page=457137
Publish date - July 1, 2007