Part 3 of the OMG Commitments Series
Sapient’s Gil Koenigsberg and Nick Fry explain why a smaller volume of equity derivative transactions are electronically confirmed compared with interest rates and credit derivatives
In September 2005, the major broker-dealers made a commitment to the FED to reduce the number of outstanding confirmations in the credit derivative market. The industry enjoyed considerable success in reducing the number of outstanding confirmations in credit derivatives and the utilisation of electronic matching platforms was seen as key in achieving these goals. Subsequently, similar commitments were made for interest rate and equity derivative products. While outstanding confirmations have reduced in all asset classes, there has been a marked difference in performance between asset classes around the percentage of electronically-confirmed trades.
The graph below shows the percentage of electronically-confirmed equity, interest and credit derivatives from December 2006 to December 2008. This data, reported by FED 16 banks, shows the progress the broker-dealers have made in increasing the electronically-confirmed trade population. The graph illustrates the difference in the percentage of transactions that were electronically-confirmed for the three asset classes; equity derivatives clearly lag behind credit and interest rate derivatives. This article seeks to explain the reasons for this lag and discuss why the equity derivative community is struggling to process more of its trade population via an electronic matching platform.
The electronic-matching process
Electronic matching of OTC derivative confirmations involves two parties entering the same trade into an electronic-matching platform. For equity derivatives, the most common platforms are DTCC Deriv/Serv (a back-end matching platform, typically managed downstream by operations) or Markitwire (a front-end affirmation platform managed upstream by front office). Banks submit eligible trades to these platforms via either FpML messaging or spreadsheet upload. Less sophisticated clients have the ability to affirm alleges via the system GUI. These electronic-matching platforms typically have around twenty confirmable fields, although the numbers of fields will vary from product to product. If the platform’s fields are accurately populated with the trade details from both counterparties, then the system will show a perfect match. If there is a discrepancy between the two entries, the trade will remain unconfirmed and each discrepancy would require investigation. Each counterparty will investigate the unconfirmed trades and once the error has been identified, the trade will be amended and subsequently matched.
An equity derivative trade can only be eligible for electronic matching platforms, if the parties have an executed Master Confirmation Agreement (MCA) in place. An MCA is a legal agreement signed between two counterparties, which sets out the terms and conditions that will apply to a particular type of derivative transaction. The MCA enables two parties to agree all the legal terms and conditions for a particular product in advance, so that only the core economics need to be confirmed. This can be done either via a paper Transaction Supplement or via electronic-matching platforms, which replicate the fields reflected on the paper version and therefore link in to the legal framework. A variety of MCA templates are published and maintained by ISDA®.
Why are fewer equity derivative trades electronically matched?
The equity derivative business is more client-driven than other derivative businesses. There are a number of reasons for this:
• Underlying equities are better understood and more accessible than debt;
• There is a strong market for hedging merger and acquisition activities of corporate clients; and
• There is a deep, retail-driven, structured equity notes market.
It is often time consuming and difficult for a large broker-dealer to negotiate the MCA, as clients typically do a smaller volume of trades and have fewer resources to deal with the negotiations. In resource-constrained legal departments, broker-dealers often do not see the need to spend time negotiating one MCA for a small-volume player. As such, MCAs with small-volume clients are often not signed and hence these trades cannot be confirmed on the electronic-matching platform.
Another barrier to trades being electronically confirmed is because equity derivative MCAs are also subject to regional legal divergences. For example, a variance swap transaction traded on a Japanese underlying will need a separate MCA to be executed for the same product traded on a European underlying. In addition, regional MCA coverage is still far from complete. Currently MCAs only cover transactions on underlyings in established markets in North America, Western Europe and specific countries in the Asia-Pacific region. Hence, vanilla OTC options on underlyings traded in countries outside of this scope cannot be confirmed electronically. The regional MCA model therefore significantly reduces each party’s ability to increase executed MCA coverage and its ability to confirm via electronic-matching platforms. This is because each executed document only accounts for a small proportion of the global trade population on that particular product.
There are two vendors for electronic confirmations for equity derivatives: Markitwire and Deriv/Serv. This choice has led to confusion as to which platform to use, with political differences further blurring the issue. The confusion has also resulted in both banks and clients being reluctant to commit to using one or the other and instead defaulting to paper. By contrast, the credit derivatives market led by Deriv/Serv and Markitwire is the dominant platform for interest rates. DTCC Deriv/Serv operates a service called MCAXpress which turns the traditional paper based MCA negotiation into an electronic template driven process, enabling lawyers to track, organise and negotiate the many MCAs required in a more streamlined way.
As the range of products traded in the equity derivatives market is generally wider and more fluid than the other asset classes, each template that is standardised within an MCA generally only covers a small percentage of the overall traded volume. The market therefore receives a diminishing return of investment on each new MCA that is agreed to, as the larger volume products (with the exception of equity swaps) have been standardised. The regional MCA model therefore hinders each party’s ability to increase executed MCA coverage, resulting in an inability to confirm via electronic matching platforms.
Addressing the issues
Employing more resources is the simplest way a legal or documentation department can accelerate the MCA negotiation process, and increase the amount of clients that have executed MCAs in place for the currently eligible products. However, increasing the number of resources is a costly, short term solution. Legal departments find it cost prohibitive to employ full-time resources to deal with clients who trade a low volume each year.
In order to improve the current process the market has agreed to try negotiating global MCAs for new products. The hope is that this model will reduce the amount of negotiation and administration currently required to execute and manage multiple regional MCAs for essentially the same product. ISDA® has recently initiated a working group for a global MCA in relation to basket options and if this proves a success, then this model should be adopted for other standardisation projects during 2009.
In the longer term, ISDA® has proposed that the market agree on a new set of market-standard definitions based on the provisions contained in the current suite of MCAs and the 2002 Definitions. This proposal, if adopted, will eliminate the need for bilateral MCAs. However, given that many banks currently add bilateral provisions to MCAs based on the type of counterparty they are facing, the requested outcome is not guaranteed.
Another proposed solution is there should be a single industry facilitator to bring disparate parties together to drive towards a common goal. The facilitator could project manage delivery across all streams (business, legal, operational and technological). Historically each of these streams has been unable to meet deadlines or successfully engage with the other streams.
In the short term, there are no easy answers to increasing electronic matching in equity derivatives. Banks need to find new cost-effective ways of on-boarding the remainder of their smaller clients onto MCAs, in order to benefit from the opportunities electronic matching affords. As more equity swap MCAs are agreed by the market, the spread of clients that will become electronically eligible will grow. However, in the current economic environment, where there are cost constraints on resources, it is a challenge. The market must improve on its historical performance with regards to standardisation of new products. The proposed measures referred to earlier, such as global MCAs and a new set of 2010 definitions, will help improve efficiency in this area. It is clear that electronic matching is the future for OTC equity derivative processing and market participants must continue to work together to become more efficient and take full advantage of the benefits offered by vendor solutions.
Gil Koenigsberg is a Managing Director based in New York, specialising in industry utilities
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* "Electronic Matching" is the third installment of the 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 Operations Management Group.
Read first article of the series – "The Rise and Sprawl of CDS," written by Christopher Natale of Sapient.
Read second article of the series – "Lifecycle Event Processing", also written by Christopher Natale.