Push for machine-readable contracts poses problems

Regulators want more automation in the over-the-counter derivatives market, but that means much of the documentation will need to be machine-readable. Attempts to establish new standard identification codes are under way, but this is just the tip of the iceberg. Clive Davidson reports

In an ideal scenario, the over-the-counter derivatives market would run like a well-oiled machine. The majority of contracts would be traded and confirmed electronically, and be automatically farmed out to a central counterparty for clearing and settlement. Key transaction data would then be filed with repositories – giving global regulators a complete and readily available set of records that could be used to spot any increase in systemic risk. That’s the world envisaged by the Dodd-Frank Act, and one that US regulators are currently trying to make a reality with a succession of rule-makings.

That scenario requires some fundamental rewiring of the system, however. Master agreements that set out specific contract terms are mostly paper-based, as are the credit support annex (CSA) agreements that accompany collateralised trades. One way to ensure the requisite level of automation, and to provide regulators with comprehensive data that can be monitored and analysed, would be to convert these terms into an electronic form that can be read by computers. A quicker and cheaper option would be to extend existing industry technology infrastructure, some argue. Either way, it’s a huge challenge, and one that will determine whether the system runs smoothly or splutters to a halt.

Regulators recognise the importance of this issue. The Dodd-Frank Act specifically asks the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to study the feasibility of requiring derivatives participants to adopt standard computer-readable algorithmic descriptions that may be used to describe complex and standardised contracts. After soliciting comments from the industry, the two agencies published a paper in April, which concludes that current technology is capable of representing derivatives using a common set of computer-readable descriptions”, and that these descriptions are “precise enough to use both for the calculation of net exposures and to serve as part or all of a binding legal contract”.

However, the regulators noted three developments would be needed before they could mandate the use of standardised computer-readable descriptions of all derivatives. The first is the development of universal legal entity identifiers, as well as unique instrument identifiers – an area where the industry is currently focusing (Risk June 2011, pages 50–52). A uniform way of representing financial terms not covered by existing definitions would also be required. In addition, the agencies called for an analysis of the costs and benefits of having all aspects of legal documents related to derivatives represented electronically.

Some market participants say that underplays the challenges ahead in moving to full automation. Certain terms within derivatives contracts – the economic details, such as trade date and notional amount – lend themselves to computerisation. However, even here, banks and trading and risk management systems suppliers have formatted this data in many different ways over the years, leading to problems in communicating and aggregating the information.

An attempt to remedy this was made in 1997 by JP Morgan and PricewaterhouseCoopers, which proposed a standard electronic representation for OTC derivatives based on the Extensible Markup Language (XML) format. Called Financial Products Markup Language (FpML), the standard was later taken over by the International Swaps and Derivatives Association, and is now widely – but not universally – used by market participants to represent deals in their systems and for electronic messaging and confirmation.

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Push for machine-readable contracts poses problems