New technology is needed to keep pace with the speed and volume of credit derivatives trades. The first step must be for all the players in the market to buy into the need for change, says Dan Barnes.
The huge growth in credit derivatives trading has outstripped the systems used to confirm the deals. In September, the Federal Reserve Bank of New York met with a number of banking groups and regulatory bodies to discuss the backlog of unconfirmed trades. Banks have pledged to take action. The movement must come from both sides of the fence: the funds involved in these instruments have to make changes where necessary, and most of the change is going to revolve around technology.
“The market has been growing in terms of volume, innovation and the methods it uses to trade complex products at about 2000mph where the technology to deal with this has been following along at 20mph,” says Mas Nakachi, senior business analyst at technology provider Calypso.
That is not to say that the technology does not exist, just that it has not been utilised. With the downturn early this decade and the speed of growth in the market, infrastructure has been left behind.
Inadequate solutions
Mark Beeston, president of trade processing platform T-Zero, says that the existing trade capture solutions that are often used to help the process are not enough. “If you implement any risk system, it will come with a nice trade capture module. If you have high volumes on with a broker and you ask them to deliver an electronic trade feed, so you don’t have to capture them in the middle office, they will work with you to do that. The problem is that those methods of connectivity don’t enhance the accuracy of the actual trade data or help to enforce timeliness.
“They’re all designed to make it easier to use that vendor’s product. That’s no bad thing on an individual basis but in terms of saying ‘I want to use service A and service B’, having connectivity to service A doesn’t facilitate you using service B,” he says.
A connection has to be made. The lack of it had resulted in a backlog of credit derivatives totalling $12,340bn as of June 2005, according to the International Swaps and Derivatives Association (ISDA). To reduce the backlog and to prevent a future build-up will require implementation of entirely new systems. Re-engineering the current methods will not work, according to Mr Nakachi. “In one environment we’ve seen 20 different systems in use to capture credit default swaps and bonds. It doesn’t take a genius to realise that’s untenable.
“Everyone’s leaning toward rip and replace. Previously, the problems have been bandaged. Now everyone from the front to the back office is saying ‘forget the bandages, we need a whole new solution’. A trader said to me recently: ‘I’m looking for a fire-and-forget solution. I can input a trade and know it is going to take care of itself’,” says Mr Nakachi.
The right fit
With complex over-the-counter products, it is not simple to find a solution that will fit all product shapes and sizes. Many data variables must be communicated both internally and externally. Even confirming the product internally can be problematic, warns Bill Stenning, chief operating officer for trading at SunGard Adaptiv.
“Although less prevalent now, it used to be the case that a credit derivative confirmation had to go past everyone before it got approval. Such a legal document could be many pages long or it could be one page,” he says.
The complexity – or in some cases, over-simplicity – of systems carries a risk of damaging the market when tied to complex products. Mr Nakachi says that the impact of mortgage derivatives on the US market in the 1990s showed the potential long-term harm that can be caused.
According to Wisam Mahmood, SunGard Front Arena’s product strategist for credit derivatives, about 80% of the major banks involved in credit derivatives already have a good level of automation. Conversely, only 10%-20% of smaller players are trading lower volumes with adequate technology, he says. Banks are concerned that even if they could get their own houses in order, they would still be exposed to their counterparty’s arrangements. That is why many are pleased at the Fed’s intervention to prevent bad habits from becoming recurrent in what is still a young market.
The technologies needed must give the front and back office a single view of a trade. This will involve streamlining the contracts process and ensuring that data is captured at the front office and directly passed on to the back office.
Thomson TradeWeb has launched the Beta version of an online market for credit derivatives, which Lee Olesky, president of Thomson Tradeweb, believes has the potential to provide this process. “We’ve been listening to our customers as to which product will be next up for automation in pre-trade, trade and post-trade. We’ve automated most of the different processes that dealers and their customers have to effectively trade electronically,” says Mr Olesky.
Many big buy-side firms trade block style and then allocate the trade to sub-accounts – Thomson TradeWeb has built a tool intended to process this electronically. Where this may have been an over-the-phone process or a fax-based process, allocation can be conducted via Tradeweb and then communicated electronically to the dealer.
Electronic trade facilitation
Fixed information held in TradeWeb’s AccountNet database (a standard settlement instructions database) facilitates the process, says Mr Olesky. “In the derivatives space, AccountNet is the depository for the master agreement between the customer and the dealer. So all of the static provisions, from the name of the legal entity to whatever unique things may be in the master agreement between the customer and the dealer, are in this database,” he says.
The service then extends to post-trade, he says. “After a trade is done electronically, we’re able to populate a ‘confirm’ instantly with all of the static relevant data that is the terms and conditions of the deal. That may include credit issues and termination issues and also the legal entity with all of the variable data that’s tied to the actual trade itself – so the product that was traded, the size, the settlement and the unique characteristics if it is a swap. Between the electronic execution and the static database we can deliver this electronic confirmation.”
Online platforms could reduce the level of internal change needed compared with some other technology-based solutions. However, before any steps are taken, all of the players in the market must buy into the need for change, and this will require careful handling in what is a potentially combustible situation, as Mr Nakachi acknowledges.
“It’s a tough line to draw because over the past years the dealers have become increasingly dependent upon hedge fund business for revenue. They know from experience that all you need is one big blow-up and you hurt everyone. There’s a fine line between not shutting them out and making sure they’re under control so there are no explosions in the market,” he says.
