The Partial (80 Percent) CDS Solution
By Chris Kentouris
October 16, 2006 - Firms in the over-the-counter derivatives sector have been fighting an uphill battle, to say the least, in trying to bring automated efficiencies to the burgeoning market in credit default swaps (CDS). These instruments have been doubling every year in notional value outstanding, to $26 trillion as of the most recent, midyear survey by the International Swaps & Derivatives Association (ISDA).
There has been progress, to be sure. The Federal Reserve Bank of New York, which since September 2005 has been leading a global effort by regulators to get the top CDS dealers to clear away a mountain of risk-laden back-office paperwork, said last month that confirmations outstanding had been reduced by 70 percent, and those outstanding more than 30 days were down 85 percent. The industry also doubled, over a year's time, the proportion of trade volume confirmed on an electronic platform, to 80 percent, and it agreed upon a protocol for settlement of market-rattling credit events. A lineup of vendors and utilities that includes ISDA, Depository Trust & Clearing Corp. (DTCC), Swift, Omgeo, T-Zero, Interwoven, Markit Group and Calypso Technologies, as well as multi-firm and interdealer trading platforms such as those of MarketAxess, GFI Group and Creditex are all playing roles in the streamlining process.
But will the investments in automation and straight-through processing to date be sufficient to stem the risks that arise in the future from backlogs of unconfirmed transactions? The good news thus far applies only to standardized contracts; there are still around 20,000 trades remaining unconfirmed 30 days after the trade date, and 5,000 of those are 90 days beyond trade date.
At a panel discussion last week during the Swift Sibos conference in Sydney, Goldman Sachs managing director E. Gerald Corrigan, whose Counterparty Risk Management Policy Group spurred the New York Fed into action on the CDS backlog, said the industry's performance over the past year was "nothing short of sensational." Corrigan said that similar attention will now be paid to the smaller but similarly troublesome class of equity derivative products. Other speakers, including Liz Nolan, SVP of alternative investments at JP Morgan Chase & Co., and DTCC managing director Peter Axilrod, said that perfect, total coverage will never be achieved because of the pace of product innovation and the uniqueness and complexity of individual deals.
Thomas Huertas, head of the U.K. Financial Services Authority's wholesale firms division, speaking at the ISDA conference in London last month, said that the industry "has turned an accident waiting to happen into a near miss." The underlying problem was that the front office was allowed to "run so far ahead of the back office." The answer should have been--and is--to get the process right from the start, from front end to back. The front-end order management systems (OMS) that have so effectively automated institutional equity and fixed-income trading "weren't designed with credit derivatives in mind," notes Scott Sykowski, a founding partner of Boston-based Athena Investment Systems, a technology consultancy that customizes OMS and portfolio management systems to add credit derivative functionality. "Given the complexity of so many bespoke deals, automated trade capture doesn't ensure an automated match on the terms and conditions even though it facilitates internal accounting, risk management, documentation and deal tracking," added Sykowski.
To push solutions at the infrastructure level, regulators have at least tacitly endorsed DTCC's Deriv-Serv trade-matching platform, which has more than 500 customers in 25 countries. Going beyond that, for the post-trade process, DTCC is nearing the launch of its trade information warehouse.
Deriv-Serv doesn't solve everything because there are connectivity costs, not often discussed in a big-firm context, that might hinder smaller buy-side firms or those with minimal credit derivative volumes. Further, although "some firms use automated trading platforms or have an electronic trade capture platform, others rely on spreadsheets and yet others on a combination of the two," says Rolf Theisen, VP of San Francisco-based software house Iris Financial Systems.
As is the case with many electronic systems, Deriv-Serv thrives on standardization in confirmations and accompanying messaging protocols. That's true of single-name and index CDS, but not the customized "bespoke" products sought especially by hedge funds, which according to research firm Greenwich Associates account for 58 percent of CDS trading. "When such contracts are part of customized baskets of indices or collateralized debt obligations, dealers must notify their clients of any change in an underlying contract," says Guillaume Weeger, VP of Calypso Technology in San Francisco. "Too often that doesn't occur, or the client doesn't keep track of such information correctly so the transaction is erroneously booked."
Even with the use of Deriv-Serv, a firm may not have an automated method to track the entire life cycle, according to Gary Brackenridge, president and CEO of New York-based Integrated Trade Processing. "If there are multiple legs to a derivatives trade, more than one trading desk may be involved, which increases the potential for error," he says.
There is also a human element. The people dealing with trade inputs, confirmations and documentation work in silos that prevent effective communication, must wrestle with legacy systems and are "overworked, underpaid and undertrained," says Kevin Sauls, president of KGS Financial, a New York consulting firm that advises firms on operational support and training for derivative transactions. "Those that are qualified are in high demand and turnover can be as high as 40 percent," says Brad Bailey, senior analyst with Boston research firm Aite Group. And many firms, adds Sauls, "would rather spend money on widgets, machines and technology than staff overhead and training to deal with new products."
Even after the recent--granted, "sensational"--improvements affecting the vast majority of CDS volume, there is still a need to find the right mix of technology and personnel to make sure that all the bases, some still manual, are covered. Otherwise, there will be no end to the Sisyphean struggles that dealers and asset managers have become all too familiar with.
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