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
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