OTC Automation Efforts Pick Up as Regulators Call for Better Processing
March 24, 2008
Seeking to curtail the credit crunch and prevent such events in the future, the President's Working Group on Financial Markets (PWG) has recommended improving the processing of over-the-counter derivatives. In response, trade groups and infrastructures are ramping up efforts to advance automation.
The Securities Industry & Financial Markets Association (Sifma) is working with its dealer and buy-side members to make electronic novations occur in real time and to further automate collateral management. The Depository Trust & Clearing Corp. (DTCC) plans to funnel more types of OTC derivatives into its DerivServ processing platform. And the International Swaps & Derivatives Association (ISDA) is considering fully standardizing documentation and protocols for its cash-settlement auction process used for payouts on credit default swaps (CDS) triggered by credit events.
These ongoing initiatives took on new urgency after U.S. Treasury Secretary Henry Paulson on March 13 called upon the industry to fulfill the recommendations of the PWG. The group, comprised of top officials from the Treasury Department, Federal Reserve, Securities and Exchange Commission and Commodity Futures Trading Commission, worked with Treasury's office of the comptroller of the currency and the Federal Reserve Bank of New York on the proposals.
The PWG stated that "supervisors should insist that the industry promptly set ambitious standards for the accuracy and timeliness of trade data submission and the timeliness of resolutions of trade matching errors for OTC derivatives."
Further, it urged the industry to "amend standard credit derivative trade documentation to provide for cash settlement of obligations stemming from a credit event, in accordance with the terms of the cash settlement protocol that has been developed but not yet incorporated into standard documentation."
Standardized Cash Settlement
The ISDA said it is looking at hardwiring a cash-settlement mechanism for CDS payouts into its protocol, standardizing the process in its documentation. Currently, users implement cash settlement on an ad-hoc basis, sending an "adherence letter" to the ISDA to activate the mechanism.
The protocol enables firms to exchange cash payments instead of forcing delivery of the debt of a defaulting entity referenced by a swap--the volume of CDS far outweighs the available and outstanding bonds to which they are linked. Trades referencing a defaulted obligation are settled in cash; prices are established at auctions held by interdealer derivatives broker Creditex and derivative index and market data provider Markit Group.
The lack of an integrated, standard and fully electronic way to manage the payment that is supposed to occur in a CDS that references a defaulting corporation makes it difficult to ensure that the contracts are honored in the agreed upon manner, particularly in times of market stress. The regulators are asking that the ISDA better integrate cash settlement into the process--thus making it more binding--to prevent systemic problems such as concurrent cash-outs, which could overwhelm protection sellers.
"Until the protocol is incorporated into standard industry documentation, there is a risk of significant market disruption if one or more major market participants chose not to adopt the protocol following a credit event," the PWG said. "Of particular concern is the market impact such choices could have if multiple credit events were to occur simultaneously."
The ISDA responded in a March 13 statement: "To date, it has not been apparent to the industry that the benefits of hardwiring the mechanism outweigh the benefits of flexibility that the current system provides. However, we are committed to continue exploring with the industry the most efficient way forward."
