CDS processing: The challenges

Complete automation of trading has long been viewed as a holy grail by participants in the credit derivatives market, and recent events have underscored the need for such a development. Credit talks to Udayan Goyal of Deutsche Bank about the next stages in the evolution of CDS processing

Whilst the financial markets have already made significant moves towards a more efficient credit derivatives processing structure, there is still much to do. New pressures that have been brought to bear on the market have increased the urgency for change. Udayan Goyal, managing director within Deutsche Bank's global financial technology advisory practice, talks to Sarfraz Thind about the progress that has already been made and the hurdles that are yet to be cleared.

Credit: Could you explain a little about the challenges of processing credit derivative trades. Why has there been so much of an issue with credit default swap backlogs?

Udayan Goyal: The biggest challenge of processing CDS trades is not a technical one. Bilateral trades which are executed off Isda documentation are generally straightforward. The problem is that there is a lot of volume in the system and it takes time to get the volumes processed. The huge size of the CDS industry and the exponential growth in the markets over the last few years has led to the backlog developing.

What kinds of initiatives has the industry come up with so far? How much progress has been made towards establishing full straight-through processing for the CDS market?

The market has been moving in the right direction and there have been some very strong initiatives taking place in the past few years. You have seen the likes of Creditex, which was sold to IntercontinentalExchange (ICE) earlier in the year, starting its T-Zero automated trade processing service in partnership with Bloomberg.

This initiative proved a significant play in helping the market move towards trade automation. But T-Zero is more on the trade documentation side. It is an automation system used to clear and match trades but as such it is one step behind a full STP solution. Essentially it is one half of the puzzle. The other half is a central clearing counterparty (CCP).

And so lately you have seen a move towards a central clearing counterparty with the efforts of LCH Clearnet and the Clearing Corporation in the US, both of whom have begun developing platforms to get automated CDS trade processing and then move to a full central clearing counterparty. At present the Clearing Corporation is the most advanced of the market initiatives. The Clearing Corporation was the CCP for the Chicago Board of Trade (CBOT). Since it is backed by 11 investment banks and the CDS valuation company, Markit, it carries a lot of clout. We expect them to roll out something quite soon. They also have the Depository Trust & Clearing Corporation (DTCC) involved who will act as the repository for storing the trade documentation. In other words we don't have STP yet but it is close.

But dealers have had a long time to get their act together. Why the delay in setting up a central clearing service?

It is fairly complicated to get things up and running. First of all you need to create a legal entity. Every time two counterparties trade together you have a central body guaranteeing trades. And for this you need to create a robust margining framework. The minute you get people to use central processing platforms you need them to post margins and collateral. You have to capitalise the central clearing counterparty and post margins on every trade. To get people to clear through a new system is a costly and time-consuming process.

On top of this the documentation requirements and the lack of standardisation are huge issues. It gets very complex. While banks have invested a lot into these initiatives you can't do anything overnight. The market has moved faster than the infrastructure.

Lack of standardisation has been cited as one major issue in the CDS processing world. Could you explain a little more about the problem? Why is standardisation necessary - after all aren't participants are able to work on disparate processing platforms for other asset classes?

The esoteric nature of the over-the-counter CDS market means that most contracts are highly customised to the needs of the hedging counterparty. Trading desks are generally sophisticated enough to price these contracts.

Fundamentally, a clearing house acts as a back-to-back intermediary between two counterparties. In order to mitigate risks, the clearing house must calculate the mark-to-market position of the contract and then take margin (or release margin) to each of the counterparties in the trade. This is so that if one counterparty goes bankrupt, it can minimise the loss to the clearing house when it closes out the contract.

If contracts are highly customised, the ability of a clearing house to technically calculate margins on so many different contracts is limited and ultimately it becomes a capacity/complexity/computing power issue. Standardisation clearly mitigates this problem.

What are the major issues that the buy side faces in terms of CDS processing? Some dealers accused hedge funds of being one of the contributors to the build-up in CDS backlogs in 2005 due to their slow trade reporting procedures. Is this still the case?

The buy side are part of the Isda Operational Management Group (OMG) and are therefore committed to the timelines specified in the various letters to the Fed in NY. Clearly, the buy side was also a contributor to the backlog as a major market participant. However, it is now working in tandem with the sell side to resolve this issue.

Do you think it makes more sense to have a number of competing platforms out there? Would the costs be reduced by having more competition in the market?

No, far from it. There are definitely more disadvantages to having different platforms. Having competing and disparate platforms makes it more difficult to share collateral, on top of which people need to be registered across different entities which costs more money. It would be best to have one entity, and I believe that this should be the Clearing Corporation.

How committed do you think the industry is towards achieving a single processing platform?

The letter that the dealers sent to the US Federal Reserve earlier this year commits to a specific strategic roadmap to achieve electronic matching by October 31. It also commits to having a DTCC-style settlement structure by December 31. As per a recent press release by T-Zero, the industry has not only met the targets set in the letter but has actually exceeded most of them (92% submission by T+1, 90% match rate without amends, 95% T+5 match rate).

Hence it looks like the industry is really making an effort to get there. Credit default swap processing is clearly something that is of utmost importance in this current market and I believe that the industry is doing what it can to tackle the issue quickly and efficiently. There will be more expenditure in such a system than doing it bilaterally but these initiatives will reduce risk since your counterparty risk is eliminated.

How important is increased transparency for the market given the current turmoil?

The current turmoil will lead to increased pressure on the industry for transparency. The whole concept of bilaterally traded contracts will be given extreme scrutiny. But it is still too early to tell what will happen with Lehman Brothers and those who have CDS exposure to the bank and other companies.