The unprecedented change taking place in the Over the Counter (OTC) derivatives processing market due to changing regulations and evolution of industry utilities has created a gap in the readiness of most asset managers’ operations, according to a recent article by J.P. Morgan.
This article follows an indepth whitepaper published by J.P. Morgan’s Worldwide Securities Services assessing the impact of these changes, the actions required to meet industry deadlines and the use of service providers as an alternative.
The market events of last year have thrust the previously little-known world of over-the-counter (OTC) derivatives processing into the spotlight. For several years, the industry has been working to streamline and automate processing, and to increase the use of industry utilities. The recent focus on systemic risk by governments and regulators has included a reappraisal of how the OTC derivatives market operates, resulting in increased requirements for operational change in an aggressive timescale for market participants. Focus areas include central data repositories, extension of central counterparty clearing, contract standardisation, broader authority for the regulators and investor protection through tighter controls on OTC trading eligibility.
Critically, these changes are no longer just the preserve of the major OTC dealers, and the buy-side community is now under the spotlight. Many of the commitments incorporated into the most recent Industry Letter to the Federal Reserve Bank of New York (Fed Letter)1 from the Operations Management Group (OMG) impact all market participants, including those buy-side firms that are not direct OMG participants. OTC derivatives operations managers at asset management firms are realising that they can no longer watch and wait, and any perceived lack of progress by the buy-side firms is likely to attract the attention of the regulators, as well as pressure from their dealer counterparts.
1. Central Settlement
The on-boarding of buy-side firms to central settlement of credit derivatives via DTCC’s Trade Information Warehouse (TIW) and CLS Bank (CLS)3 is proving challenging. With central settlement now live for the inter-dealer market, the focus has shifted to the buy-side. The October 2008 commitment of 96% of settlements on DTCC-eligible trades to be centrally settled by 30 November 2009 poses a significant challenge for buy-side firms, their dealers, custodians, administrators, and the DTCC itself.
Implementation can represent a significant project, even for firms trading low volumes of credit derivatives. Moving from a bilateral settlement model where individual settlement instructions are sent to custodians, to a central settlement model where net settlements are determined by the TIW and messaged to CLS for settlement, requires change in a number of areas. These include new logic for the eligibility of cash flows for central settlement, withholding settlement instructions, and prompt confirmation matching to ensure trades settle on value date. Even though a firm may itself be ready, it remains dependent on third parties such as custodians, fund administrators and CLS settlement members to go live.
2. Confirmation Platform Consolidation
The initial development of confirmation and workflow utilities in the OTC derivatives market saw different platforms dominate for different derivatives instruments. Following the announcement of the Markit and DTCC strategic partnership in 2008, a common platform is finally on the horizon. Pending final regulatory approval, MarkitSERV will launch an interoperable OTC workflow utility for use across the industry. There is a great deal riding on its success: MarkitSERV is already being put forward by the industry as a potential solution to single-step novation, automated allocation processing and interoperable electronic confirmation.
Over time, as the MarkitSERV platform becomes a reality, the services of existing industry utilities will evolve. Focus areas for 2009 are likely to include the development of a common portal, regulatory reporting for interest rate derivatives, and client access to central counterparty clearing across credit and interest rate derivatives. Novation process reengineering and interoperability of the utilities for interest rate derivatives are on the agenda for 2010.
3. Central Counterparty Clearing
Central counterparty clearing (CCP) is a major initiative to reduce counterparty risk, but with multiple CCPs competing for business, differences of opinion between regulators and the industry and debate between sell-side and buy-side institutions on the way forward, it is likely to be some time before the road map is crystallised.
Despite the uncertainty, CCP is already a reality in the credit and interest rate derivatives arena, and further commitments have been made to the regulators. The LCH-Clearnet SwapClear service has been clearing interest rate swaps for the major dealers for nearly 10 years. LCH is now working to extend the benefits of the service to the buy side. IntercontinentalExchange (ICE) started clearing US credit default swaps for dealers last year, and both ICE and Eurex launched European CDS solutions in July.
The industry has articulated to regulators a goal to achieve buy-side access to CDS clearing by 15 December 2009, but a number of issues remain open, such as the optimal approach to margin segregation, treatment of credit events, and the scope of eligible OTC instruments. Buy-side firms are not necessarily expected to face the CCPs directly, but could gain access through either a prime brokerage model, where trades are ‘given-up’ to a single clearing member; or an executing broker model, where each broker submits both trade perspectives to the CCP.
The operating model for buy-side firms may not yet be fully understood, but it is likely to include the need to determine CCP eligibility, novate trades and post daily margin. Firms should therefore be asking what this is going to mean for their counterparty exposure and OTC process flows.
4. ‘Hardwiring’ and CDS Standardisation
Most OTC operations managers at buy-side firms will have already decided whether to adhere to the 2009 ISDA ‘Big Bang’ Protocol to ‘hardwire’4 auction settlement terms into their CDS contracts and ‘Small-Bang’ initiative to extend the auction mechanics to include restructuring events.
One of the key aspects of the hardwiring changes, the establishment of the ISDA Credit Derivatives Determinations Committees (DCs), requires firms to change the way in which they track and manage credit events which impact their CDS portfolios. Historically, there has been an element of subjectivity in determining a credit event trigger on a relevant underlying entity. The regional DCs will opine on potential credit and succession events and become the authoritative source for trades incorporating hardwiring terms.
Going forward, market participants are being strongly encouraged to report all their CDS trades into a ‘Centralised Repository’ by the third quarter of 2009 to increase transparency to regulators. The first phase covers weekly reporting by dealers, but buy-side reporting and increased reporting frequency may follow. Similar reporting for the rates and equity asset classes will follow in 2010.
The Outsourcing Solution
With so much complex change to execute, many derivatives operations managers and executives are considering the outsourcing solution, even those who for many years have preferred to keep processes in-house. Based on a sample of buy-side firms recently surveyed2, 64% believe that there will be more demand for OTC process outsourcing as a result of the market turmoil and the likely enactment of regulatory change. Commonly cited benefits of outsourcing include access to scarce high-calibre staff, enhanced capabilities, product complexity and avoidance of high investment expenditure on an in-house infrastructure. The ability to respond to industry changes on a timely basis should now be added to that list.
To date, valuation and collateral management functions have more commonly been subject to outsourcing. In the future, the industry changes outlined above may result in outsourcing of confirmation and settlement management to providers who can build and maintain a flexible infrastructure to support the evolving industry landscape. Given the likely continued evolution of the post-trade processing space over the next few years, a strong partnership between client and outsource provider will be critical to success.
Conclusion
The derivatives processing landscape will change dramatically in the next 18 months, including further standardisation, more aggressive processing targets and changes to industry utilities.
Whether addressing these challenges in-house, or via an outsourcing solution, buy-side OTC managers need to act now to ensure that their operation remains up-to-date and compliant with industry best practice. The changes have already begun, and they’re not optional.
To access the full white paper and to review the key checklists to ensure you are prepared, please click here. Or to contact JP Morgan Worldwide Securities Services for more information, please email the firm here
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