Credit derivatives operations get 33% rise in investment, says survey

Dealers devoted greater resources to their operations procedures in 2005, a year when both the UK Financial Services Authority and the New York Federal Reserve applied regulatory pressure on credit derivatives practitioners because of the rapid rise in volumes of unconfirmed trades, according to a new survey by UK data provider Markit.

All top-tier dealers – defined as those executing more than 2,500 trades a month – now use the Depository Trust & Clearing Corporation (DTCC) for trade-matching, according to the survey, which was produced in conjunction with Reoch Consulting, a London-based credit derivatives consulting firm.

Overall, it found that 80% of first- and second-tier firms were using the DTCC, compared with 60% in 2004. Average head count in credit operations increased by 25%, while technology investment in operations rose by 33% – each dealer spent an average of $32.7 million in 2005 compared with $24.6 million in 2004.

Meanwhile, Jonathan Davies, Reoch’s chief operating officer, said confirmation mismatches in reference entity names were no longer a problem because of the widespread industry adoption of Markit’s reference entity database (Red). However, he added there was still a high number of ‘confirmable amendments’ – changes to outstanding confirmations – that contributed to the total number of outstanding confirmations. But he claimed respondents were addressing the problem through greater investment in trade capture systems and the Red preferred reference obligations list.

Davies also said that 32% of dealers amended their collateralised debt obligation models after the May 2005 market fallout caused by the downgrading of Ford and General Motors. “Up to that point, some dealers and users were incorrectly using tranche correlation rather than implied correlation for mark-to-market and risk management,” said Davies. “This resulted in incorrect deltas and therefore these dealers were incorrectly hedged for large moves in correlation. The hiccup in May was quickly dealt with and we understand no institution suffered catastrophic losses. This is a sign of maturity in the credit derivatives market as it continues to evolve and residual is resolved.”

Markit and Reoch surveyed 23 dealers for their study.