Part 2 of the OMG Commitments Spotlight Series
In the second installment of DerivSource’s OMG Commitments Spotlight Series, Christopher Natale of Sapient discusses the regulatory commitments made by the Operations Management Group as they relate to lifecycle event processing and explains the industry’s new ‘game plan’ for optimizing workflow in the future.
“The first rule of any technology used in a business is that automation applied to an efficient operation will magnify the efficiency. The second is that automation applied to an inefficient operation will magnify the inefficiency.” Bill Gates–Chairman, Microsoft
It is incredibly hard to imagine conducting any business today without PCs. Heck, it’s hard to imagine conducting life today without PCs. These astonishingly intricate tools have changed the human race forever. They’ve opened and zoomed through doors once thought to be impassable. They’ve led us to places that even just two decades ago were thought to only exist in science fiction. The personal computer has taken its place alongside the likes of the steam engine, automobile and atomic bomb as one of the most significant technological inventions in the history of mankind. More specifically, the development of “Windows” by Microsoft has been the key to optimizing the use of PCs. Prior to the arrival of Windows, computers were black-screened, fancy calculators with green fonts that printed on green and white striped perforated paper. While these machines were integral to NASA putting men on the moon, these were bicycles compared to today’s racecars in terms of accessibility, functionality and scalability. Without PCs as we know them today, our jobs, our economy and our lives would be unrecognizable.
In the OTC Derivatives world we are at a similar crossroad — further advancement through increased automation and scalability is pivotal to the ability to effectively capture all the lifecycle events of these instruments and will alter the very market itself. Throughout this decade and the last, new products, increased volumes and a shifting economic landscape sketched out a demanding roadmap. The rapid evolution and expansive growth of derivatives along with the recent unraveling of our financial markets has dumped a large measure of urgency into the mix.
In the October 31, 2008 letter to the Federal Reserve Bank of NY from the Operations Management Group (OMG), a governing body made up of senior management representatives across investment banks and buy-side firms (including hedge funds and asset managers), commitments were made to increase usage of automated platforms to process lifecycle events. Lifecycle events include novations (transfer of ownership from one entity to another), credit events, succession events, corporate actions, maturities, expirations and bulk events such as mass terminations or novations. The incorporation of the auction-based settlement mechanism, used for cash settling credit events, into standard International Swaps and Derivatives Association, Inc. (ISDA) documentation was also cited as an objective. The majority of these mandated objectives lie in the credit derivatives or CDS space as this product is further along in standardization and automation as opposed to interest rate and equity derivatives. This, along with the fact that CDS is inherently a more risk laden instrument which has been routinely characterized as the toxic poison that has led us to the edge of Pier 11, has forged its spot as priority one. Figure 1 below provides a further breakdown of the Fed Letter as it relates to lifecycle event processing across the three asset classes.
Figure 1 – Here are some of the highlights and details of the regulatory commitments made by the OMG as they relate to Lifecycle Event Processing. Some are grander in scale, impact and criticality than others and therefore warrant broader coverage.
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For CDS, the central processing unit or hub for nearly all lifecycle events will be the Depository Trust and Clearing Corporation’s (DTCC – Deriv/SERV) established Trade Information Warehouse (TIW). This is where the central record of the vast majority of all CDS trades resides. The Trade Information Warehouse for CDS went live on November 13, 2006; all major broker-dealers “backloaded” the bulk of their legacy standard or vanilla trades in 2006/2007 and all new trades done after this date are sent and stored in the TIW. Data makes its way to the TIW via FpML messaging, spreadsheet upload or direct input into the platform. Most large firms utilize a straight through process (STP) to get trades into the graphical user interface (GUI). However, all firms did not participate in this process back in 2006/2007 and a subset of “sticky” trades was not covered in this first go round. As part of the commitments in the Oct 31 Fed letter, OMG, as well as other firms, are currently in the process of backloading these residual trades. Backloading is the process by which firms bilaterally submit all of their eligible live trades into the TIW. The “golden copy” with a universal ID is the result of matched trades. Any discrepancies must be addressed and rectified to achieve this status. This process is the crucial first step toward the automation of lifecycle events. These records provide the essential foundation for lifecycle event processing. Scrubbed, golden records are currently used to process CDS settlements via CLS Bank. The process of central settlement, underway since October 2007 amongst most OMG firms, has been a very successful one and is prototypical of the efficiencies gained through automation of event processing.
The drive for full automation of the Novation Consent Protocol has passed a significant milestone whereby all firms are required to utilize electronic platforms by the end of February 2009. Firms not adhering to this commitment will not be able to novate trades and will be reported to regulators. Service providers such as Deriv/SERV, TZero and Tradeweb all offer viable electronic solutions with Bloomberg and Markit offering full interoperability through their platforms. Historically, novations have been a major pain point for the CDS world as the resulting aftermath frequently resembled the operational equivalent of cleaning up Times Square on January 1 with tissues and toothbrushes. This initiative’s aim is to fully retool the email-based process that has been utilized for CDS since 2005 which proved to be a hurried suture job that, while stemming much of the bleeding, proved ineffective in providing an airtight, automated solution. The next phase here would be for a fully consented electronic novation to feed the TIW, update and confirm the trade then feed all participants in-house systems via FpML messaging—in short, STP nirvana.
ISDA is integrating the auction settlement of contracts after a default or other credit event on a corporate name referenced in credit default swap transactions into its standard documentation. This will be implemented via the “hardwiring” of a supplement into the 2003 ISDA Credit Derivatives Definitions. The Auction Supplement will modify the ISDA CDS Definitions to incorporate the CDS settlement auction terms that are currently included in all auction protocols. It will also include a provision for the ISDA Determinations Committee, which will make binding determinations for issues such as whether a credit event has occurred, whether an auction will be held and whether a particular obligation is deliverable. This is a big step toward efficiency in the CDS world as it removes the need for individual protocols for every market event in addition to eliminating many of the uncertainties around events. In the past, and more frequently lately, there are occasions where the fallout post a credit event has been numerous conference calls, fire drills and confusion. ISDA has released a draft and is looking for a March 12, 2009 go-live with an adherence period through April 7, 2009.
The further automation of credit events remains a challenge for the industry. The already in use credit event processor offered by Deriv/SERV has thus far added great value through the netting of settlements related to these events. This instrument facilitated the successful netting of the ensuing settlements from the Lehman Brothers default in October 2007 to $5.2 billion on $72 billion worth of contracts registered in the TIW. It successfully netted down settlements on approximately $12 billion worth of CDS contracts to $429 million across the Fannie Mae, Freddie Mac and Tembec defaults. The reduction of operational risk here is almost immeasurable. The settlement process alone across all of the events that have occurred over the last 12 months, had it remained a manual, bilateral one, would have resulted in tremendous operational strain and thousands of settlement breaks which would’ve been akin to rubbing rock salt into the already raw wounds of the OTC derivatives community. The challenges remain however on effectively managing other aspects of the credit event process such as an improved universal event determination date and trigger methodology, notice delivery and in-house system maintenance.
The process of compression or “tear-ups” has provided considerable relief to the seemingly enormous systemic risk in the CDS world. Since 2005, Swedish-based service provider TriOptima has performed regular “tri-reduce” tear-up cycles for CDS index trades. Due to their standardized pricing, index trades present a less complex challenge for this algorithmic-based program as well as the industry’s operational infrastructure. TriOptima has been performing compressions in the interest rate world since 2003. TriOptima reduced $30.2 trillion in CDS notional in 2008. Since August of 2008, Creditex in partnership with Markit has reduced over $1 trillion in single name CDS notional through regular compression cycles amongst the top dealers in the industry. Both programs produce upload-able files to facilitate the exit process for terminated trades in Deriv/SERV. However, as fruitful as these processes have been in terms of reducing operational risk and increasing liquidity, the operational burden is untenable. The true strategic solution on tap for 2009 is a process initiated by these service providers, which simultaneously updates the TIW as well as simplifying firms’ in-house processes.
The extremely large primate looming in the CDS room is central clearing. With politicians and the media alike ginning up public fervor for things like increased regulations, transparency and compensation caps, a central clearing platform sits atop the wish list for regulators. This platform would essentially eliminate the systemic risk of standard CDS as all firms would face a central counterparty. Positions would be netted down, obligations guaranteed and the collateral process substantially reduced. Platforms are being offered by Intercontinental Exchange Inc. (ICE), CME Group Inc. and NYSE Euronext in the US. In Europe, at least four offerings are in the mix including one from ICE. ICE has recently gone live and a small number of trades have been cleared amongst ten member banks since March 13. CME has also received clearance from the SEC to begin clearing. The devil here is in the details of the operational process. Currently, this is largely a manual, novation-based workflow whereby firms trade bilaterally and trades are then subsequently replaced with trades facing the central counterparty. The strategic solution would have this taking place automatically utilizing the TIW as the interface between firms and the central clearer. Steps are already underway in preparation for this including price standardization (ala CDS index trades) and the streamlining of the standard CDS template. Many of these initiatives can be considered “game changers” but this one is a “season changer” as the product itself and how it is traded will be considerably altered.
The automated processing of other events such as succession, maturity, expiration, corporate actions and shortfalls for Asset Backed Securities (ABS) are all part of the master plan as well. All of these are hurdles to be cleared en route to the grand prize of maximum efficiency and transparency through automation. They all entail manual processes which vary from firm to firm and all too frequently result in settlement breaks and other assorted operational risks as the sheer volume and number of moving parts is often overwhelming. Markit is one of the major architects along with Deriv/SERV across many of these events through their established data and pricing services. The ability for gold TIW records of trades to be automatically and universally updated across these events and effectively disseminated to firms represents the ultimate workflow.
Figure 2 Basic, optimum workflow for future state of lifecycle event processing
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Much of what will be accomplished in the CDS realm in 2009 will once again set the bar for the other asset classes — interest rates and equity derivatives as well as commodities and foreign exchange. What once had the feel of a perpetual game of catch up and recovery of dropped balls for many of us in the industry now shows tangible progress and a promising road ahead. We have certainly crossed midfield and all but eliminated many of the “turnovers” that once plagued us. Much of the vision and strategy for all of the above has been in the works for a few years and the necessary step of improving processes prior to even considering automation has been a constant theme. Market participants have become more agile in planning and adapting to change as the demands of an evolving market have dictated. There is still much to accomplish but unlike in the past we are now on offense, have a clear game plan and can see the goal line.
* "Lifecycle Event Processing" is the second article 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.
Read first article of the series – "The Rise and Sprawl of CDS."
