The archaic methods still being used to process credit derivative trades have been well-documented - perhaps most famously by former Fed chairman Alan Greenspan, who described the use of scraps of paper in this technically advanced age as "appalling".
The Fed had already publicised the issue by summoning major derivatives dealers to a meeting where they committed to a series of targets to resolve the problem last October. Within six months, the industry had succeeded in cutting the number of trades unconfirmed after 30 days by 70%, and the total number of unconfirmed trades by 50%.
Now there's little excuse for failing to process standard credit derivatives trades on time (the agreed target is within five days of execution). Since the Fed's not-so-gentle tap on the back, a whole host of initiatives have flooded the market to help banks and their clients automate the post-trade process.
These STP platforms, so-called because they 'straight-through process' trades from point of trade through to legal confirmation, enable users to affirm trades, resolve 'exceptions' (where parties disagree over any trade terms) and perform legally binding confirmations.
Central to all initiatives is the Depository Trust & Clearing Corporation's Deriv/Serv platform. "Vendors are building technology around DTCC Deriv/Serv as the de facto electronic matching engine for credit default swaps," says Brad Bailey, senior analyst at technology consultancy Aite Group in Boston.
Using a standardised messaging protocol known as Financial Products Markup Language (FpML), Deriv/Serv electronically communicates trading information between counterparties. It matches and confirms trades by verifying that counterparties enter corresponding trade details, and those that match perfectly are confirmed as legally binding contracts. Where discrepancies arise, the counterparties amend details until a match occurs.
The DTCC is now in the process of creating a central warehouse for credit derivatives trade information to provide a database containing a 'golden copy' of each trade, a record of the status of each contract, as well as cashflow and netting calculations. But the latest developments in straight-through processing credit derivatives are largely centred on one key area: affirmation.
In order to minimise the level of exceptions in the back office, a process called affirmation has arisen. This allows both trade counterparties to affirm details before the trade is sent on to be confirmed. "Credit derivatives seem to be migrating to a process of affirmation at the point of trade," says Bailey. "This virtually guarantees accurate trade details as the trade moves downstream. This model is gaining traction."
AffirmXpress is an affirmation service launched by the DTCC in partnership with three major credit derivatives interdealer brokers, GFI Group, Icap and Tullett Prebon. The service will initially be focused on affirming interdealer trades, although it could eventually be expanded. "I think eventually AffirmXpress will be offered for dealer-to-client business as well," says Michael Fuhrman, head of e-trading for GFI in New York.
Once a trade has been affirmed via AffirmXpress, both counterparties may choose to move it on to Deriv/Serv, which turns the affirmed trade into a legally binding contract. AffirmXpress was set to go live before the start of October.
When live, it will affirm global single-name, index and index tranche derivatives trades. Its appeal is clear-cut, says Fuhrman: "All trades ultimately settle at DTCC, so why not begin the process there and try to verify any errors before they get into the back office."
But the interdealer market isn't the main concern: more than 90% of interdealer brokered credit trades are now confirmed through the DTCC.
"The big banks or dealers are not the problem," says Simon Morris, head of European credit trading at Goldman Sachs in London. "They have invested in automating a lot of their processes so they're able to deal with electronic affirmations and confirmations. The problem is the customers who have not yet invested sufficiently in back-end systems to match their front-office volumes."
For these customers too, progress is now being made.
In the dealer-to-client world, a couple of STP hubs now offer electronic affirmation of trade details. T-Zero was the first to market in July 2005. Although T-Zero was born out of interdealer broker Creditex, the company was spun out as a separate entity with its own management to ensure independence from the brokerage arm. T-Zero says it is open and agnostic about connecting to any vendor. "We do one thing: helping clients get their trades correct at the start of the lifecycle. How they choose to process them is their choice - we're not at all prescriptive in that respect," says Mark Beeston, president of T-Zero in London.
T-Zero's numerous partnerships include tie-ups with fund administrators and prime brokerage firms, bringing it in front of more hedge fund clients. The advantage to them is the cost. "If you're a client and you don't have a big IT spend, this is a prepackaged, instantly connected solution that you don't pay for," says one head of credit trading at a major investment bank in London. One hundred buy-side firms now use the platform, and a recent deal with omnipresent Bloomberg should further expand the number of users.
"The Bloomberg tie-up is a killer piece of functionality and the response has been overwhelming," says Beeston. "We have a roadshow coming up covering 18 locations across Europe and the US; more than 300 accounts have requested a demo."
John Burchenal, managing director of asset class expansion for Omgeo in London, notes that Creditex was one of the first brokers to spin off the STP element of its business, recognising it as a profit centre in its own right. "An independent STP platform allows customers to trade anywhere and achieve best execution while harvesting the efficiencies of a single post-trade process. That highlights one of the reasons why Omgeo has been successful: because we're independent of the trading side," he says.
Omgeo is an industry utility jointly owned by Thomson Financial and the DTCC. As well as providing its own matching services, Omgeo enables customers to process credit derivative trades through the DTCC using its ASP hub. The service supports both file-driven and message-based approaches to move trades into the Deriv/Serv processing environment.
One of Omgeo's sibling companies, Thomson TradeWeb, recently launched another affirmation service to rival T-Zero. CreditXpress, a wholly owned subsidiary of Thomson TradeWeb, was launched in July 2006. "When we started to trade derivatives, we got positive feedback from clients that wanted to use these STP tools irrespective of how they executed, completely independently of the trading platform," says John La Vecchia, director of credit markets, Thomson TradeWeb.
Survival of the fittest
With the recent launch of AffirmXpress and CreditXpress vindicating Creditex's decision to spin out T-Zero a year earlier, some might ask whether there is room in the market for many competing services.
"The theory is that there's more benefit in having one solution," says Mas Nakachi, senior business analyst at trading platform provider Calypso in London. "But in practice, when you're coordinating the interests of many parties, it's hard for that to play out. Other markets have tended to stabilise around two or three providers," says Nakachi.
Pontus Eriksson, credit and interest rate derivatives product manager for SunGard's Front Arena, another front-office trading platform, agrees: "For the market, and us as a vendor, it's always easier to link into one service than many; we like to see standardisation."
SunGard's Front Arena is currently developing a link to T-Zero, largely on the back of customer demand. "The majority of our customers are medium-sized banks and hedge funds. A lot of them are asking for integration to T-Zero," says Eriksson.
The development process should be relatively painless, but once a link is in place, further development work will be required to keep the integration updated. "We'll kick off by doing the easy part first, which means feeding trades from T-Zero to Front Arena," says Eriksson.
Calypso already has a partnership in place to provide connectivity to T-Zero, but Nakachi doesn't rule out the success of other initiatives. "There may end up being two or three competing solutions, and that's fine. We're agnostic to each of these initiatives," he says.
TradeWeb's La Vecchia agrees that it would be beneficial to have a single solution, but thinks there will be room for more than one supplier if the market is big enough. "What we believe is an important selling point from a client perspective is that we can ease the processing of all credit market trades, not just derivatives," says La Vecchia. Yet T-Zero's head-start may ultimately prove unassailable.
In addition to electronic affirmation hubs, vendors also provide back-office processing platforms that support point-to-point connections between counterparties. These platforms enable users to create and manage the documentation used to process derivatives, and thus to confirm trades that are not accepted by the DTCC's Deriv/Serv.
One of the major providers here is Markit Trade Processing, formerly known as Communicator before being bought by Markit last May. "Many of the trades we process aren't STP trades, which means they can't be confirmed via DTCC's Deriv/Serv," says Leo Schlinkert, who founded Communicator in 1999. "However, our process eliminates the paper trail for these securities by creating electronic documents and providing a full audit trail."
Schlinkert casts doubt on some of the affirmation models that have close links with the brokers that founded them. He says it's important to understand the principles of a buy-side manager's fiduciary responsibility in maintaining his firm's position management and trade capture systems. "You can't hand over the responsibility of affirming a trade to your counterparty. By far the best solution is programmatic affirmation, which avoids human error," says Schlinkert.
Markit's technologies provide processing for all over-the-counter derivative contracts and integrate with clients' position management systems - a key selling point for investors. "One of the reasons why Communicator has been so popularw on the buy side is because it covers all types of OTC derivatives, as well as the entire process, including legal confirmation and reconciliation. Portfolio reconciliations are a vital feature for buy-side clients."
In August Markit processed about 16,000 credit trades. "Our buy-side clients can feed to the DTCC via our platform, and we feed the information back to our clients' trade capture systems, something not all service providers do," says Schlinkert.
Thunderhead is another provider in this area. Glen Manchester, founder and chief executive, says about 15% of trades going through Thunderhead go through the DTCC, "but that number is increasing. There are still a lot of complex derivative trades that aren't easy to STP."
For the complex transactions Thunderhead offers derivative trade confirmations that minimise manual intervention. The platform aims to be as accessible as possible to business users to help eliminate their dependency on IT in building electronic documents. "At the same time we're able to help our clients migrate towards STP trades confirmed on Deriv/Serv by keeping updated on any changes to the DTCC's FpML schema and rules. This saves our clients the effort of doing this individually," adds Manchester.
Still lagging the front office
Much progress has been made in automating the credit derivatives trade process. As STP reduces processing backlogs, firms have mitigated risks associated with failed trades. Greater levels of automation are also helping to reduce trading costs. Aite's Bailey projects the average cost of processing a CDS trade will fall from $420 in 2006 to just $190 in 2008.
But as new financial products are created, the market inevitably takes time to incorporate standardised processing practices for them. "Every product goes through an initial phase, with the market iterating a bit to come out with a standard," says Calypso's Nakachi. "There's still room for customisation in contracts, but once things become vanilla, the focus turns to process innovation rather than product innovation."
And the pace of product innovation at investment banks will always lead the ability of vendors to incorporate processing standards. Recent developments in credit default swaps of asset-backed securities and loan CDS are a case in point. "As the doctors at investment banks create new instruments and the financial wizards come up with new and improved OTC derivatives, there will always be a lag between the creation of new products and the ability to process them electronically," says Omgeo's Burchenal.
Who's who in STP - and what do they offer?
Ownership: AffirmXpress is the affirmation platform of the Depository Trust & Clearing Corporation, which is owned by a consortium of financial institutions.
History: AffirmExpress was launched in June 2006. The DTCC's Deriv/Serv automated matching and confirmation service was launched in late 2003. Starting with credit derivatives, the service was expanded to support equity derivatives in December 2004 and interest rate derivatives in September 2005.
What does it do? The process starts with interdealer brokers GFI, Icap and Prebon Tullett using AffirmXpress to affirm credit derivative trades. The DTCC plans to open this up for dealers and buy-side firms in the future. Once affirmed, trades are passed on to Deriv/Serv for confirmation. If trade data is matched, trades are returned to parties as confirmed. If not, counterparties may adjust information until the trade is confirmed.
Regional coverage: DTCC Deriv/Serv customers are located in 25 different countries.
Who uses it? Clients include the leading global derivatives dealers, traditional asset managers and hedge funds. To date, more than 615 customers use Deriv/Serv.
Cost: The service is free to the buy side and charged at an undisclosed cost to the sell side.
Partnerships: A number of third-party service providers have created links to Deriv/Serv. Apart from AffirmXpress, these include CreditXpress, Markit Trade Processing, Omgeo, T-Zero and Thunderhead.
Ownership: T-Zero is a sister company of Creditex Brokerage Services; both are fully owned subsidiaries of Creditex Group but run and staffed as stand-alone entities.
History: Launched in July 2005.
What does it do? T-Zero captures trade information at the point of trade so that counterparties can manually or automatically affirm trade details. Partnerships with a range of third parties mean that trades transacted on Bloomberg and Calypso trading platforms may be passed on to T-Zero automatically for affirmation; sent on GlobeOp to reconcile trade data, and then on to Thunderhead or the DTCC for confirmation.
Regional coverage: 50% Europe, 50% US. A launch across Asia is planned for the end of 2006.
Who uses it? Three interdealer brokers (Creditex, CreditTrade and BGC), eight dealers, more than 90 buy-side firms, three prime brokers, fund administrators and document management providers. T-Zero can also be accessed via Bloomberg terminals, which are used by more than 250,000 traders.
Cost: The service is free to the buy side; the sell side pays according to an undisclosed pricing model.
Ownership: Thomson TradeWeb
History: Launched in July 2006.
What does it do? CreditXpress connects dealers to hedge fund and institutional asset management clients to automate post-trade processing. The service affirms corporate bond and credit derivative trades, and allocates them to specified client accounts. Affirmed trades may be sent automatically to the DTCC's Deriv/Serv and Omgeo TradeMatch platforms. Users may also track positions in real-time and send notifications of trade novations to counterparties via CreditXpress.
Regional coverage: Current focus is on the US and Europe; Thomson TradeWeb is also building the platform in Asia.
Who uses it? About 50 (unnamed) clients.
Cost: Free to buy-side users that have a legal agreement in place with TradeWeb. The unspecified per-ticket cost to dealers is "competitive", claims TradeWeb.
Markit Trade Processing
Ownership: Markit Trade Processing was formerly known as Communicator. Markit Group bought Communicator in May 2006 and renamed the business Market Trade Processing.
History: The trade processing platform was launched in 2004 with the help of fund managers Pimco and BlueMountain.
What does it do? Fund managers and banks use MTP to affirm and confirm their OTC derivatives trades. Users may send notifications of novated or disputed trades via a secure instant messaging platform. Clients also use the platform to reconcile portfolios. MTP handles both STP and non-STP trades. It can pass STP trades on to the DTCC and SwapsWire automatically. Processes 40,000 trades per month.
Regional coverage: 60% US, 40% UK
Who uses it? More than 100 client firms use the platform, split along a ratio of 60% sell side, 40% buy side.
Cost: Undisclosed charge for all users
Ownership: Privately owned by Glen Manchester, founder and CEO.
History: The Thunderhead Document Generation Platform launched in November 2003; the company was founded in 2001.
What does it do? Users generate documents on the platform to process OTC derivative trades. Thunderhead delivers documents via choice of channels - email, web, print and XML - to confirm trades between counterparties. Can also confirm trades electronically via a link to DTCC's Deriv/Serv.
Regional coverage: 60% Europe, 40% US.
Who uses it? Sample clients include banks such as Lehman Brothers, Morgan Stanley and Nomura. The company will not disclose client numbers.
Cost: Licensed on a per-user basis; the company will not disclose costs.
The week in Risk.net, February 10-16 2017Receive this by email