Derivatives 2005 - Breaking the backlog
Mounting credit derivatives confirmation backlogs have drawn increasing public expressions of concern from regulators in Europe and the US over the past 12 months, spurring dealers into action. Mark Pelham reports.
The derivatives industry was already aware of the issue and had been working for some time on addressing default swap confirmation backlogs. Much of the work has been done under the aegis of the International Swaps and Derivatives Association (ISDA).
“The association has published a series of documents outlining timetables for tighter end-to-end processing and increased automation of bilaterally negotiated derivatives processing,” said Robert Pickel, executive director and chief executive officer at ISDA. Notably, ISDA published a consultative paper outlining its vision for a shift to full automation for the bulk of OTC products in December 2003. The paper included a target timeline for key elements of the post-trade process, which was augmented when ISDA produced implementation guidance for OTC derivatives processing automation in 2004.
“This year,” Pickel said, “a series of high level meetings, sponsored by ISDA, has brought together business, legal and operational staff from buy and sell-side institutions of all sizes to address these issues, focusing on the increasing range of automated solutions, many of which are based on FpML [Financial Products Mark-up Language], the industry data communications standard sponsored by ISDA.”
The result of those meetings was a commitment to prioritise the resolution of credit default swap confirmation backlogs and set even more stringent goals for the industry. For example, a target was established for 70% of plain vanilla CDS trades to be automatically generated by the end of 2005.
The target would build upon the progress evidenced by ISDA’s annual operations benchmarking survey. The 2005 survey found that the automated generation of credit derivatives confirmation had increased to an average of 40% from 24% the previous year, while the number of credit derivatives confirmation backlogs dropped from an average of 17.8 business days in the 2004 Survey to 11.6 in 2005. And 68% of respondents that have not yet automated credit derivatives confirmation stated that they plan to do so in the next year.
Despite such progress, regulators remain concerned by the issue and, as a result, the US Federal Reserve called a meeting in September to discuss the strains placed on the credit derivatives market by the explosive growth of the instruments. Attended by representatives from regulators around the world and 14 derivatives dealers, one key focus of the meeting was the un-notified assignment or novation of trades.
The practice, which is believed by many to be the cause of a significant proportion of unconfirmed deals, is a particular issue with hedge funds, according to dealers. Jeanmarie Davis, a Federal Reserve staffer, said at the meeting that consent should be agreed before assignment of a default swap to a separate counterparty, that third-party deals should not be placed on bank risk management books unless the original counterparty had been notified, and that guidelines for assignment should be agreed and applied.
To this end, the dealers present observed that they had all signed up to the novation protocol published by ISDA earlier that week. “Under the terms of the ISDA Master Agreement, the prior written consent of the remaining party is required when its counterparty in a trade wishes to ‘novate’ or ‘assign’ (i.e. transfer) its position in a trade to a third party. The protocol enables the parties to specify a clear process to facilitate a streamlined exchange of electronic communications among the parties involved,” Pickel said.
The hedge fund industry appeared reluctant to comply with the dealers’ plans, however. On the day of the novation protocol launch, the Managed Funds Association (MFA) sent a letter to ISDA detailing hedge fund concerns with the proposed new market practice code.
MFA president John Gaine said that the liquidity and transparency of interest rate and credit derivatives would suffer due to the ISDA Novation Protocol because the market's ability to price and transfer risk would be impaired. He complained that the protocol increased the likelihood that a hedge fund transferor could end up with two trades rather than one, thereby using up more capital than necessary.
In spite of this issue, dealers at the Fed meeting outlined steps that they hope will ease the administrative pain for hedge funds in weaning themselves from their current practice of assigning trades to separate dealers at will. All the major dealers committed to establishing assignment desks as part of their credit derivatives operations, with email facilities to allow funds to notify banks of their assignment intentions.
A first step to bringing hedge funds into line is expected to be an insistence by dealers that funds process all eligible credit derivatives trades electronically through the DTCC system (see box). Renewed efforts to take the credit derivatives market electronic are also key to an attempt by dealers to convince regulators that they can tackle the problem of their own late confirmation of trades.
Two weeks after the Fed meeting the 14 dealers wrote to the Federal Reserve confirming their proposal for an overhaul of credit derivatives market practice.
The letter detailed the metrics that the dealers will report to regulators on the number of credit derivatives trades they transact, the number of assignments of trades they handle, the split between inter-dealer and client trades and the number of unconfirmed trades on their books, along with the time these trades have remained unconfirmed. After the new monitoring regime is in place, leading dealers are expected to report trading metrics to their primary regulators on a monthly basis.
At the same time, the dealers committed to the eradication of all confirmation backlogs by mid-year 2006. If the target is to be met it will require all market participants to play ball.
To this end, Pickel said: “ISDA’s role will be to help the entire credit derivatives industry to focus on the deadlines being discussed with the Fed.”