The major dealers have committed themselves to increasing the proportion of credit derivatives trades confirmed electronically, while amending standard credit derivatives trade documentation to provide for cash settlement. But how is the buy side reacting to the tight deadline? By Ryan Davidson
Dealers are under pressure to sort out the problems that have plagued their back-offices once and for all. Progress has been made reducing the number of outstanding confirmations in the credit derivatives market since the Federal Reserve Bank of New York first demanded the top dealers tackle the problem in September 2005. But regulators want to see more done to increase the proportion of trades confirmed and settled electronically - and banks don't have much time to get their houses in order.
By July, the major credit derivatives dealers must meet ambitious submission, matching and accuracy targets, and use electronic confirmation platforms for the vast majority of eligible trades. On top of that, dealers have also promised the New York Fed they will automate novations by the end of the year, and incorporate the cash settlement process for credit derivatives into standardised documentation.
"The targets are ambitious but achievable," believes Theo Lubke, senior vice-president in the operational risk division at the Federal Reserve Bank of New York. "They are a step towards the processing performance in mature markets where matching is completely automated and happens on trade date or the day after. We expect market participants to increase the targets in the coming months to push further towards full automation."
The Fed isn't the only institution that will be watching over dealers' shoulders. Other regulatory bodies have also stressed the need to resolve shortcomings in operations within the various post mortems into the subprime crisis. The President's Working Group on Financial Markets, for instance, released a report on March 13 recommending dealers set standards for accuracy, timeliness of trade data and timeliness of resolutions of trade matching errors. It also called on the industry to amend standard credit derivatives trade documentation to allow for cash settlement, as well as maximise the efficiency of electronic processing platforms by promoting standardisation and interoperability.
Many of these points were echoed in the Financial Stability Report, published on April 12. However, the group, which comprises central banks, supervisors and treasury departments, also recommended the industry should push to automate trade novations, suggesting this be tackled in 2008. While no threat of intervention was made, the insinuation is clear - improve operational efficiencies, or else.
The push to clean up the back office began in September 2005, when the Fed met with the 14 largest credit derivatives dealers to agree targets to reduce backlogs. Back then, outstanding confirmations (calculated by dividing number of outstanding confirmations by daily volume of new trades) stood at an average 13.3 business days - although this increased to 23.5 days among large firms, according to the International Swaps and Derivatives Association 2005 Operations Benchmarking Survey. On top of that, only 33% of credit derivatives confirmations were sent within one day of trade, compared with 72% for interest rate swaps.
A month later, a series of reduction targets were agreed with the Fed - which were met. Further targets have been subsequently agreed and achieved by the major dealers, with confirmation backlogs falling to an average 4.9 days in the Isda 2007 survey, and 5.6 days for the largest 17 dealers.
Despite this, backlogs are now rising again. Outstanding confirmations spiked up to an average 6.6 days in 2007, partly due to a sharp rise in trading volumes at the end of 2007. The notional amount outstanding of credit default swaps (CDSs) reached $62.2 trillion at the end of last year - an 81% increase over December 2006.
In the latest letter to the Fed, the major dealers attempt to tackle this increase, this time joined by some large buy-side institutions. The letter was sent on March 27 by the Operations Management Group (OMG) - an assemblage of 18 dealers (including Bear Stearns, now part of JP Morgan, as one of the 18) and buy-side firms including AllianceBernstein, BlueMountain Capital Management, Citadel Investment Group, Moore Capital and Pacific Investment Management Company. The group pledges to submit 90% of trades eligible for electronic confirmation by one day after trade date and to match 92% within five days. Additionally, 90% of trades must be submitted accurately, matching without amendment, and dealers must provide nine-digit Reference Entity Database (Red) codes - a service run by London-based data provider Markit that assigns standardised identifiers for the credit derivatives market - on 100% of index trades and 90% of single-name CDS trades. All this must be done by July.
By September, the major dealers plan to be live with each other for central settlement, while novation requests are to be submitted via electronic platform rather than email by the end of the year. The auction process for the cash settlement of credit derivatives contracts will also be incorporated into Isda standard documentation.
Dealers say they are on track to make the improvements and should be ready to meet the targets. "The OMG believes the targets set out in the March 27 letter to the regulators are stretched but achievable," comments Stefan Bakunowicz, global head of fixed-income operations at UBS in London. "In addition to specific submission and match rate targets, the current commitments also address a couple of key processing bottlenecks."
In fact, major dealers are already close to meeting some of the targets. According to the latest Isda Operations Benchmarking Survey, 90% of the 79 respondents submit electronic confirmations for eligible credit derivatives trades within one day of trade date. Getting the buy-side on board and using electronic platforms is one of the final pieces of the jigsaw, say dealers.
"The amount of changes to systems and processes industry participants will need to make to meet the current set of commitments will vary. As we continue to set more aggressive targets, there will be a need for all participants to move to real-time connectivity between market utilities," adds Bakunowicz.
Many of the largest buy-side firms are already hooked up to electronic platforms, either directly to the New York-based Depository Trust and Clearing Corporation's (DTCC) Deriv/Serv matching and confirmation platform or via an electronic affirmation service that feeds into the DTCC, such as London-based T-Zero and Markit Trade Processing.
"We do not see the targets as being difficult to meet because we already have the back-office infrastructure in place to process credit derivatives to the required levels," says Paul Taylor, chief operating officer at London-based investment manager Solent Capital, which uses the T-Zero platform to access Deriv/Serv. "Another reason they are not a challenge for us is because we do not trade high volumes of OTC credit derivatives."
New York-based hedge fund BlueMountain Capital Management, meanwhile, uses the Markit Confirmation Service, part of its Trade Processing platform. This enables the firm to electronically review, approve and distribute confirmations with counterparties. "Our processes tend to be straight-through, from trade execution to confirmation, with systems and reporting designed to give us exceptionally granular detail to diagnose issues through the trade life-cycle," says Sam Cole, New York-based chief operating officer at BlueMountain.
Markit Trade Processing is also used by London-based hedge fund CQS - mainly because it covers all the asset classes, explains Scott Carpenter, head of operations at CQS in London: "We decided to use it because it was a cross-product platform that allows us to efficiently manage paper as well as electronic confirmation of trades."
However, the problem is less the handful of large, specialist credit investors - the main challenge lies in persuading the smaller buy-side firms to sign up to electronic platforms.
A plan is being drawn up by the OMG, along with Isda, the Managed Funds Association and Securities Industry and Financial Markets Association - due as Risk went to press - that will set out the steps banks must take to ensure clients are signed up to electronic platforms. The eventual aim is for the industry to match its trades on the day the deal takes place.
Despite the potential challenges of persuading small, occasional users of credit derivatives to pay subscription fees for electronic affirmation, confirmation and trade-processing services, dealers remain optimistic. "We have now on-boarded more than 90% of our clients to electronic trade matching platforms for credit derivatives," claims John Godfrey, global co-head of credit derivatives and equity derivatives operations at Goldman Sachs in London.
Another key focus for the OMG is to reduce front-office error rates and the proportion of trades that need to be re-booked - a major contributor to back-office snarl ups, and often resulting from mistakes made when manually inputting trade data. "There are two main areas market participants need to improve to meet the targets: structural issues in their back-office systems, such as using electronic platforms; and the quality of their front-office data capture," explains the New York Fed's Lubke.
According to the Isda 2007 Operations Benchmarking Survey (the latest figures available as Risk went to press), 16% of paper and electronic credit derivatives trades contained errors, while 13% of trades needed to be rebooked. The latest letter to the New York Fed pledges to reduce this by July, so that no more than 10% of trades contain errors.
One initiative that may help improve accuracy is greater use of the Markit Red identifiers. Red is used to confirm the legal relationship between reference entities that trade in the CDS market and their associated reference obligations, minimising the operational risk of a mismatch. The database currently contains more than 3,700 nine-digit Red code identifiers.
"Red has become the market standard for identifying reference entities and reference obligations in CDS contracts, thereby reducing legal and operational risk," notes Jeff Gooch, head of trade processing and valuations at Markit in London. Markit Red CDS is fully integrated with the DTCC and SwapsWire, a London-based electronic trade confirmation service acquired by Markit at the end of last year, and subscribers can access the service through the Markit website, via downloads or through integration into in-house trading systems.
But while the major dealers and large buy-side firms use this service, take-up by smaller firms has been much lower, concedes Gooch: "Some small, low-volume, buy-side firms do not yet use Red data because the licence fee has been a deterrent given the low volumes of CDS trades they execute."
In response, the firm announced on May 19 that it has removed fees for smaller firms with "light credit defaults swap trading volumes". The service will be free to those asset managers that trade up to 240 CDS contracts a year; above that, fees work on a sliding scale. This step is in direct response to the commitments made by the OMG, the company said.
Another major focus is the automation of novations via electronic platforms. "Presently, the novation process is managed via email, which is not sufficiently scalable to support high trading volumes," notes Goldman Sachs' Godfrey. Isda developed a novation protocol in 2005, intended to speed up the transfer of existing trades to third parties. Until then, the written consent of all parties was required before a trade could be assigned. The novation protocol simplified the process to allow approval by email. However, this still requires someone to manually check each email - and given the rise in the number of unwinds and restructurings over the past six months, some back offices have been swamped with novation requests.
Again, market participants remain confident that a solution is achievable ahead of the year-end deadline, noting that several platforms already exist. T-Zero, for instance, launched its Novations+ service at the end of March. This links in with the DTCC's Trade Information Warehouse, which contains the primary records of CDS contracts, and provides point-and-click functionality for trade assignments. Markit is also updating its service to enable the automation of novations.
"Automating novations shouldn't be a difficult issue to tackle by the end of the year. It will require some technological developments to provide this service. There are already tools out there that could be adapted to add this extra functionality," says Markit's Gooch.
Perhaps the most challenging target is the incorporation of the auction mechanism into standard Isda documentation to allow for cash settlement of credit derivatives trades. Since the first auction took place in June 2005, on the back of the bankruptcy of Michigan-based auto parts manufacturer Collins & Aikman, Isda has organised nine auctions, most recently for Quebecor World, a Canadian printing company, in February. However, these auctions are organised as and when defaults occur, and are not embedded into standard documentation.
"The credit event auction process is being incorporated into Isda standard documentation to increase certainty of how a credit event will play out and avoid the possibility of one or more major counterparties not participating in an auction," explains the New York Fed's Lubke.
Dealers have already begun to thrash out some of the key issues - but finding agreement among all firms will inevitably be a long and drawn-out process. The OMG says participants will need to "agree in advance to a mechanism to address these and other issues that may arise".
Despite the work required, dealers remain confident the targets can be met, and, with regulators scrutinising the industry's response, there's a real sense of urgency that the problems need to be resolved. After years of steady progress, dealers need to make this round of improvements count - otherwise the regulators could come calling.
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