Mark Beeston of TZero weighs in on the importance of improving processing of novations
The challenges posed by the mass processing of novations once again came to the fore this week with the publication of the latest set of OMG industry commitments to the Federal Reserve Bank of New York. These latest set of commitments provide the basis for a real transformation of Novation processing in 2008.
In 2005 ISDA published the first version of the so called Novation Protocol. The protocol set in place the minimum set of standards expected of market participants for the communication of novations via fax or email. This protocol was deemed essential because contrary to what the language within the standard ISDA contract call for, market practice had evolved to the point where it was considered acceptable for novating counterparties to not communicate that trades had been novated to their bank counterparts. Whilst this may seem at first glance a bizarre stance, the relatively high velocity trading by some counterparts meant that they were reticent to show their counterparts that they were exiting trades frequently and trades only entered into hours before. The introduction of the quarterly rolls had the effect of making contracts substantially fungible and facilitating easier novation. Clients began to execute purely on price and left the operational cleaning up to the dealers.
The result of this cycle of high velocity trading and poor communication was a major contribution to the original documentation backlogs that brought the regulators into the frame in August 2005. The introduction of the novation protocol was one of a number of actions introduced in order to bring more orderly standards into the CDS marketplace and to thus facilitate more efficient settlement. However the novation protocol was only able to improve matters so far. By providing for defined methods of communication and minimum standards of data within those communications the protocol raised the bar, but also created a cottage industry of novation processing teams around the community. Whilst the data was now arriving in a more timely basis there was a significant processing burden developing to support it.
The latest letter calls for the adoption of electronic means to communicate novations over the course of 2008 and the subsequent automation of remaining party consent. The intention here is to also leverage the golden trade records at the DTCC warehouse wherever possible. So how should this be achieved?
The good news is the technology already exists today. A number of vendors claim to offer electronic novation tools, including of course T-Zero. The key to unlocking the scale that such systems promise is of course mass adoption by the counterparties and subsequent integration and automation by the volume players. Whilst electronifying the ISDA novation protocol is a simple task, the protocol itself can be considered a building block for more complex novations structures. Examples of these might include mass novation of multiple allocated trade legs, or novation of trades previously given up to prime brokers. The number of electronic platforms that are ready to accommodate such complexities is a very small subset of vendors indeed, but to gain mass adoption by the market these are exactly the complexities that need to be handled for the tools to be truly useful…
Whilst the new letter makes the commitment to affect a transfer to electronic communication element of these technologies within 2008, it sets no firm date for full integration of all events nor does it provide any guidance as to what to look for in a system. The largest impediment to buyside adoption, as any vendor knows, is creating a large enough pool of trade liquidity to be operationally relevant to the client. Very few vendors in this space have meaningfully achieved that over any asset class.
If the industry is to achieve its goals in the nine remaining months of 2008 then the banks will be picking the winners in the novation space right now and signalling it to the market, if they have not done so already. For any market participant involved in the novation space it promises to be an interesting year.
*Mark Beeston is the president of T-Zero, a provider of trade affirmation and connectivity solution.