The backlog in clearing and settlement of credit derivative trades and the increased risk of confirmation failure is leading to pressure on firms to tighten up procedures. Banks that do not pay due attention to operational risk management issues could wind up in difficulty, says Nick Kochan.

Mismanagement of back office systems handling the confirmation and settlement of credit derivative trades risks is bringing instability to the entire economic system. Such is the concern of the US Treasury about the risks posed by credit derivatives that it is putting great pressure on firms to tighten procedures and improve transparency.

That pressure appears to be paying off, at least in terms of some basic settlement and clearing procedures. For example, industry body the International Swap and Derivatives Association (ISDA) claims that the number of days that large firms take to confirm transactions has been cut by a third. ISDA oversees the over-the-counter derivatives sector and maintains industry-standard ISDA documentation.

Broadly speaking, credit derivatives act as insurance against default on corporate debt. They can be used to hedge bond or loan portfolios, or to speculate on credit trends. Products providing that sort of cover have boomed and about $12,340bn worth of credit derivatives were outstanding in the middle of last year.

Smaller confirmation backlog

ISDA now finds that the backlog in credit default swap confirmations has decreased from 23.5 days to 16.2 days worth of business for large firms. Across all firms, the time taken for credit derivatives confirmations has fallen from 13.2 days to 12.6 days. Firms are reducing the time it takes to generate and send credit derivatives confirmations to their counter-party upon completing trades.

About 53% of respondents send out a confirmation by T+1 (that is, within one day after the trade date), up from 33% a year ago. Similarly, 67% of respondents send a confirmation by T+2, compared with 50% a year ago. All but 9% are sent out by T+5. Among large firms, 50% send out confirmations by T+1, 63% by T+2 and 100% by T+5.

A derivative transaction must be confirmed in terms of the accuracy of the transaction. The average period for confirming an interest rate derivative with a counter-party should be about five working days, according to ISDA. But the confirmation process can take up to 27 days.

Confirming transactions is a critical control to all counter-parties to the trade, both to eliminate fraud and to maintain accuracy. The process is particularly important for complex trades, for which there can be debate about the exact terminology. Counter-parties need certainty about the size and legal security of transactions, says ISDA.

“Some counter-parties have grown their business beyond their capacity to manage it,” says Aashish Kamat, managing director and global investment banking controller at JPMorgan Chase. “Hedge funds sometimes do more business than they are capable of. They didn’t have the right technology and people and, as a result, we see that they are struggling. Both sides need to sign the confirmation but if you have your side in order and your counter-parties are not capable of validating the transaction when you chase them, you are in trouble.”

Risky ramifications

The ramifications of a confirmation failure can spread beyond operational risk, says Mr Kamat. “This is an area where operational risk can change to credit risk. The credit risk is where you have a trade-off with counter-parties and the counter-parties don’t exist or deny that the trade ever took place. Then you are stuck with a trade that you have to unwind in the market and you will be a price away. Counter-parties have to find a solution to clearing, netting and settlement issues that they can live with in the long term.”

Tighter confirmation procedures would have led to a quicker scrutiny of multi-million dollar frauds at Barings and at the US branch of Allied Irish Bank, for example.

Operational risk’s insistence on a tightening of confirmation issues has had some very positive effects, say the JPMorgan managers. For example, the US Federal Reserve Board (Fed) has acted to improve performance, by holding a meeting of key counter-parties and requiring banks to reduce the levels of outstanding confirmations held at end-September 2005 by 30% by January 30 this year. The Fed has set further targets for reducing these levels by 50% by the end of April and by 75% by the end of June.

Hedge fund resistance

Hedge funds initially sought to resist some of these measures, foreseeing the need for increases in investment. However, the Managed Funds Association (MFA), a hedge fund industry group, now appears to be prepared to go with the industry tide. John Gaine, president of the MFA, says: “We applaud the major dealers for reaching out to our members for their support in achieving the 2006 targeted objectives.”

The dealers said they would increase the level of automation in the industry, improve transparency and upgrade training and other staff procedures. They said that all standard trades with active customers would be processed electronically and fully confirmed within five days by October this year. They also said they would propose mechanisms for confirming non-standard trades more quickly than at present.

The MFA also endorsed an idea mooted by the Depository Trust & Clearing Corporation (DTCC), which envisaged the creation of a central database of credit derivative transactions. The structure would serve as a further means of making the market more transparent and efficient. The number of trades still outstanding after more than a month would be reduced, and more information shared with customers and regulators.

Struggling banks

Hedge funds are not the only market players to fall under the regulatory spotlight. In the past three years, banks have also struggled with the confirmation issue. The booming sector has proved hugely profitable and no bank has wanted the back office issues posed by counter-parties to stymie their ability to play in the sector. So while the operational risk experts have counselled caution, the managers have said they should play for all they are worth.

This was the case at one bank, where the operational risk department had told its business operations management that confirmation failure presented real risk to the bank’s stability. The bank’s management sought to play the risk down, telling the operational managers that this was an industry-wide problem and they were no better and no worse than their peers. The risk professionals took the matter higher up the bank and, after much lobbying and debate, senior management decided to invest in expert staff. According to one manager in the bank: “We improved connectivity between the front office and the back office to ensure there were no hold-ups in our internal process. We invested in human capital, hiring more experienced confirmation staff. This is a relatively new market and individuals were taking time to get up to speed.

“Although we recognised that we could only go so far because it was an industry issue, there were things that we could do to improve the process internally. We also recognised that we should take a more proactive stance in the industry. We are in a relatively strong position on confirmation controls in the credit derivatives market. So that was a specific issue that was escalated. With the benefit of hindsight, it was the correct decision.”

The growth in credit derivatives has far outpaced the introduction and application of controls and back office procedures. This part of the business is only now catching up. But until a fully developed and much more efficient confirmation system is up and running to industry standards, the risk of loss and even abuse remains.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter