Reducing the backlog of confirmations of derivatives contracts remains a big problem for our industry.
Christoper Natale of Sapient explains how far we have come in reducing the confirmation backlog and suggests what the industry needs to do to tackle this problem in the current market climate and to meet the commitments made by the Operations Management Group.
The torches have been lit, the pitchforks drawn. The angry mob has been thoroughly agitated by a steady diet of bad news, tales of mounting losses, malevolent greed and immoral schemes. While these words conjure images of grainy, old horror movies, this is Wall St. circa 2009. Words like “toxic assets”, “bailout” and “trillions” are the lead-ins for what seems like all of our economic news. At the center of this maelstrom, of course, are derivatives. How did these mysterious investment products seemingly topple the world economy like a poorly constructed house of cards? How did they light the fuse that has led to widespread foreclosures, mass layoffs and 401k meltdowns?
Differing alibis and “facts” are everywhere and will undoubtedly be written about many times over in years to come. Derivatives always seem to be at the center of all things that have gone awry in the economy over the last 10 years; notwithstanding the fact that they have played a large role in the unprecedented growth and expansion of the economy over the same period. Weapons of financial mass destruction? Extraordinarily useful risk transfer vehicles? Either way, the dramatic growth from 72 billion in outstanding notional in 1998 to 684 trillion in 2008 across all OTC derivatives is certainly eye popping. It became increasingly apparent almost four years ago that one of the major byproducts of this exponential growth, outstanding or “unexecuted” derivative contracts, had to be reined in… fast. The above numbers are intimidating in and of themselves but this element of hidden or unknown risk needed to be confronted.
Back in the fall of 2005, a shot was fired across the bow of the derivatives market. The credit derivatives (CDS) market was running wild. Its volume was growing at an average of 50 percent year on year. The backlog of outstanding contracts was at 12+ billion in notional value. Traders were trading at 200 mph and operational support and technology were lagging way behind at 20 mph… maybe 30. Even with electronic platforms, such as DTCC, in use at all major broker-dealers the confirmation process was still clunky and antiquated. The increased fungibility brought about by short-form confirmations or transaction supplements and automation led to explosive volumes. As buy-side firms (hedge funds and asset managers) jumped in and began trading CDS like equities – buy at 200 bps, sell at 215 bps often in the same day – things really got chaotic from an operational risk perspective. Big firms were doing hundreds of these trades per day with almost 40% being novations (a transference of ownership, largely from buy-side to sell-side in this case), which required tri-party execution. At this time most novations were still being confirmed on paper and required three signatures.
In an attempt to stave off increased regulation and penalization from the Federal Reserve Bank in the US and the Financial Services Authority (FSA) in the UK, the “Fed 14” broker-dealers, as they were then known, agreed to self-regulate and hit backlog elimination targets. The targets focused on backlog confirmations greater than 30 days old. This initiative, coupled with a mandatory protocol for tri-party novations issued by the International Swaps and Derivatives Association, Inc. (ISDA), whereby same-day notification and consent were required via email in order to validate the transaction, provided the beat to which the operational infrastructure of the CDS market now marched. By June 2006, the targets were met by the Fed 14 through tremendous focus and a concerted effort.
“Lock-in” schedules were mandated for the Fed 14. A lock-in is when firms lock themselves in a room and agree to amend and execute as many aged outstanding documents as possible. However, this nine-month sprint needed to somehow become part of the everyday process across all asset classes in the industry. The quest for further standardization, automation and risk mitigation became the derivative market’s Holy Grail. The quest is still in full swing today as the latest letter drafted by the Operations Management Group (OMG), today’s version of the Fed 14, to the NY Federal Reserve Bank on October 31, 2008 expanded on established “steady state” targets as well as added others across credit, interest rate and equity derivatives. Operational efficiency through automation and risk mitigation remain the headliners and running themes throughout. The full text of the Oct 31 letter is available at http://www.ny.frb.org/newsevents/news/markets/2008/an081031.html
It’s Getting Better All the Time
Having gone through the aforementioned regulatory targets push, CDS is viewed as the “bar-setter” for other asset classes. Make no mistake, great progress has been made over the last 3+ years in the CDS space. Markit’s latest quarterly metrics report (Figure 1), shows how outstanding CDS confirmations aged 30 days or more has held steady at just under 500 amid rising volumes amongst the 16 OMG firms over the last two years. The only spike occurred in the summer of 2007, the beginning of the current “credit crisis”, when volumes doubled and sometimes tripled on a daily basis. The key contributor to maintaining and improving outstanding volumes has been the increased usage of electronic platforms to confirm trades.
Figure 1 – Outstanding Credit Derivative Contracts
In figure 2, also from Markit’s latest quarterly metrics, the sharp rise of electronic volume from 82% in December 2006 to 96% in December 2008 is clearly depicted. The concept of straight-through processing (STP), whereby trades move from inception to confirmation without manual intervention, has been a key driver as it is naturally more efficient while allowing for timelier resolution of mismatched or breaking trades.
Figure 2 – Credit Derivative Electronic Volume
Buy-side firms’ increased usage of DTCC’s Deriv/SERV platform, as well as improved interoperability between firms’ internal systems and the platform, have served as major contributors to the increased activity. In November of 2006, DTCC’s Trade Information Warehouse (TIW) was launched. Conceptually, this was to provide a mutually agreed “golden copy” of all electronic trades with universal IDs thus further enhancing operational efficiencies through transparency. Markit’s Reference Entity Database (RED) provides scrubbed records of all names being traded and assigns six and nine digit codes to them; greatly reducing both legal risk and text mismatches. The reduction of the number of live trades through “tear ups” or trade compression via platforms such as Trioptima and Markit have also became part of business as usual amongst key market participants.
In the Interest Rate Derivatives (IRD) world, platforms like Markit Wire (formerly SwapsWire) provide an electronic platform for trade confirmations. While the average number of >30 day outstanding confirms has decreased by 50% and the increase in electronic confirmations has risen from 27% to 68% over the last two years amongst the OMG 16, the urgency has not been quite the same as in the CDS space due to the inherent and systemic risks not being as grave. Being a more mature product, IRD by its very nature is more transparent as interest rate risk is a more tangible and measurable animal. Nevertheless IRD confirmation backlog still carries many of the same operational risks as CDS and its reduction is a mandate from regulators.
Equity derivatives (EQD) has also shown a marked improvement over the same two-year span with the average number of >30 day outstanding confirmations dropping from approximately 2,500 amongst the OMG 16 to just under 500. However, the uptake of electronic processing has not seen nearly the same gains as CDS or IRD (Figure 3). This is largely due to the lack of standardization of templates and execution of Master Confirm Agreements (MCAs). Much of the contracts associated with equity derivatives are customized at the client’s behest and are subjected to conflicting legal terms across regions. This element, along with the fact that the products do not easily lend themselves to standardization, has been the major stumbling blocks toward automation. However, methodical progress is being made and, like interest rate derivatives, equity derivatives are not the current prom queen – that title still belongs to CDS.
Figure 3 – Equity Derivative Electronic Volume
Rise of the Machines
While the derivatives industry has certainly come very far in terms of risk mitigation through confirmation backlog reduction, the challenge to attain trade date plus zero days or “T+0” confirmation for the vast majority of standard contracts remains the ultimate goal. This can only be achieved through optimum use of automated electronic solutions. Many of the targets set forth in the October 31 Fed letter revolve around further automation. As previously mentioned, one of the major catalysts of the explosion in CDS volume was novations. The email-based protocol around consent begun in 2005 was exposed as strategically flawed when volumes spiked in mid-2007 and served as a spark for the industry to fast track a fully automated solution. Platforms already in use for the novation consent process from DTCC, T-Zero and Bloomberg are the engines for the CDS industry’s commitment to 100% electronic consent by early 2009. The much publicized commitment to move the CDS market to a central clearing platform is in its final stages with various offerings in the mix. This looming objective is shaping much of the work being done in the industry and will radically change not only the way the product will be confirmed, but traded going forward. However one slices it, all roads lead to efficiency, transparency and risk reduction.
The current Fed letter has set forth clear backlog and steady state milestones across all three products. For CDS, the goal remains to have all electronically submitted trades confirmed by T+5. But major dealers have also committed to reporting their volume of T+0 confirmed trades in an effort to track progress. Targets have been ratcheted up for electronic submission timeliness across all three products. Electronification is atop the list for IRD where, as of September 2008, only 54% of total volume was confirmed electronically despite 87% of volume being eligible. Commitments have also been made around risk mitigation through affirmations. Affirmation of key economic details can be done verbally, via email or through reconciliation of brokered trades to Broker recaps. The affirmation process serves as an upstream control or placeholder in lieu of an executed confirmation.
Figure 4 (below) is a snapshot of the commitments made around backlog reductions. Note that back in 2005 the unconfirmed aged confirmations stood at approximately 17 business days worth of volume for CDS.
Figure 4
Where Do We Go Now?
The world is certainly different today than it was 18 or even six months ago. The financial services and banking industry, which was soaring through hyperspace just two years ago is now slumped over and gasping for air. The daunting challenges we’ve committed ourselves to will require strategic precision in their execution but partners, such as Sapient, can utilize their industry knowledge, expertise and experience to help companies navigate their way through this new regulatory landscape. Reducing and maintaining confirmation backlogs is no longer a “let’s throw people and money at it” exercise, which more often than not was futile unless the right people and the right money were being thrown. Motivated people and adept technology remain essential for success but the room for error and unfocused strategy has become much narrower. Automation is certainly the route to efficiency but the right people and process will always be integral in determining the outcome.
Managers need to ensure their teams, are best positioned to succeed through clear and achievable goal setting, accurate management information systems (MIS) and tight processes. Keeping the confirmation process under control is an everyday mission – not just a regulatory-induced fire drill. Bucketing backlogged confirmations by age groups (>30, >60, etc.) and agreeing prioritization with counterparties is a solid foundation for any backlog reduction process. However, an eye must be kept on newer trades as well so as to avoid continuous seepage from one bucket to the next. Keeping staff in tune with all industry developments and new technology often will naturally foster an environment of achievement.
While far from foolproof, these lessons work more often than not if executed properly. At the very least, they better position your staff and your firm to weather almost any storm and keep you ahead of the regulatory curve.
* "The Rise and Sprawl of CDS" is the first of a series on the OMG Commitments. In each article Sapient consultants provides its expert insight and practical advice on how financial institutions should change internal processes to improve efficiency and comply with commitments outlined by the OMG.
Stay tuned for the next installment on "Lifecycle Event Processing."
