Novation revolution ... or the death of email for CDS processing

Mark Beeston explains the evolution of novation processing from an email-based system to fully automated consent through T-Zero, which combines front-office connectivity, workflow for all novation operations and a real-time link to the DTCC Trade Warehouse

Addressing the operational challenges posed by the high volume of novations in the credit derivatives market continues to be at the forefront of industry efforts to improve efficiency and scalability. The most recent industry commitments to the Federal Reserve Bank of New York highlighted novations as a key area of operational focus and established clear targets for 2008 that apply to all market participants. These new targets are acting as a catalyst for a real transformation of novation processing from email to electronic messaging using T-Zero.

T-Zero is the most widely adopted affirmation and novation consent platform for credit derivatives. The platform was launched in 2005 to help improve operational processing in the credit default swap market with a primary focus on front-office trade date affirmation. Electronic novation consent has been an integral part of the T-Zero offering since inception, but over the past year the platform has introduced a number of developments to improve dramatically the industry's ability to scale novations processing.

The Isda Novation Protocol to which the CDS market adheres requires firms to obtain consent from their counterparties before they can assign or novate a CDS contract to a third party. Since the introduction of the protocol in 2005, market participants have used email as the primary means to obtain novation consent. The party wishing to novate (known as the 'transferor') sends an email to its original counterparty (known as the 'remaining party') requesting novation consent. The email should include the original trade details and the name of the party to whom the contract is being assigned (known as the 'transferee'). The remaining party then replies to the email either providing or withholding its consent.

An email process sounds straightforward, yet it is not scalable since it does not allow market participants to automate the novations consent process. Novation consent is ripe for a straight-through processing solution, but the email process is standing in the way. The text content of an email is unstructured and thus not easily system-readable. Consequently information received in these emails must be manually re-keyed into trade capture systems by middle-office staff.

Additionally, the information included in the email is not validated against the trade record at the DTCC Trade Warehouse - the 'golden copy' of the legally executed trade - so there is no guarantee that the trade details described in the email match the details of the 'golden copy'. Finally, the emails require manually intensive tracking and don't provide the transparency, accountability or auditability that an electronic solution can provide, all of which are key to speedy and efficient error resolution.

Replacing novation emails and fully automating novations processing requires three key components:

- Front-office connectivity and distribution allowing buy-side systems to talk to sell-side systems in real time.

- Robust electronic workflow that models the real-life complexity of the interaction that occurs among traders, salespeople and middle-office staff.

- Real-time connectivity to the DTCC Trade Warehouse, ensuring trade data communicated in the novation request is completely accurate.

Block buster

Since novation consent must be given on trade date, front-office connectivity and distribution is essential on both the buy side and sell side. T-Zero is already distributed in the front office at more than 200 buy-side institutions, the majority of which are already using the platform for novation consent. A large number of high-volume buy-side clients have already fully automated their novations process using T-Zero such that they action their novations directly from their own trade capture systems. T-Zero is also distributed into the front office at all credit derivative dealers, many of whom have also used T-Zero to automate fully their consent process including the subsequent updating of their books and records.

The messaging solution

Front-office connectivity must be coupled with robust novation workflow to allow effective interaction between traders, middle-office staff and their respective trade capture systems. Most novation consent platforms provide support only for simple novation operations, but the real-life interaction for most novations is usually more complex.

T-Zero is the only platform that provides industry standard novation workflow for all complex novation interactions including 'block novation' of trades originally allocated across multiple funds, 'SuperBlock(TM)' novation of an entire trading position composed of multiple trades, 'partial novation' where only a percentage of the original notional is transferred and Prime Broker 3-party 'stay-in' and 4-party 'step-out' novations. To gain mass adoption by the CDS market a novation consent platform must support all of these complexities.

The final critical component to the novation consent process is real-time connectivity to the DTCC Trade Warehouse. By leveraging the trade record at the Warehouse, buy-side institutions can ensure that the original trade details delivered with the novation consent are 100% accurate. Real-time connectivity to the Warehouse also ensures that a novation is not sent on a trade that has already been novated.

T-Zero's 'GoldSync+(TM)' connectivity is the culmination of nearly two years of development by a seasoned engineering team with extensive experience with and knowledge of the Trade Warehouse. The connectivity, which was introduced late last year, is unique in providing buy-side institutions with real-time access to all eventing at the Warehouse. This real-time connectivity allows T-Zero to support, among other things, 'in-flight novations' where, in the case of high-velocity trading, novations may occur even before the original trade has been fully confirmed.

T-Zero is the industry's pioneering and most widely adopted platform for electronic novation consent because it is the only solution that combines front-office connectivity, workflow for all novation operations and real-time connectivity to the DTCC Trade Warehouse.

Wide adoption of the T-Zero platform is a critical milestone that has been achieved by the CDS market, solving the classic chicken-and-egg problem faced by participants on any electronic platform. Buy-side firms can immediately adopt T-Zero because all of their dealer counterparties are ready and able to respond to electronic novation consent requests and sell-side firms can confidently make further investments in their T-Zero connectivity and novation automation knowing that most of their high-volume buy-side counterparties are successfully using the platform.

The deadline set by the industry to eliminate novation emails is fast approaching (31 Dec 2008), but the CDS market is well-positioned to achieve the target. Most major counterparties have already moved to electronic novation consent using T-Zero and many more are in the process of doing so. With continued focus and investment, novation emails will soon be a thing of the past and all CDS market participants will benefit from the operational efficiency and scalability that electronic novation consent can offer.

- Mark Beeston is President at T-Zero

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