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SIFMA Operations 2010

Standardizing OTC Derivatives: Central Clearing Arrives, With Pain |  Over-voting or Over-reporting: 'Tempest in a Teapot'?

Standardizing OTC Derivatives: Central Clearing Arrives, With Pain

May 17, 2010
By Chris Kentouris

Lacking final details on which over-the-counter derivative contracts will be considered standardized and eligible for centralized clearing, institutional investors may be reluctant to jump on board the clearing bandwagon.

But financial reform legislation is coming to the much-maligned market, valued at $605 trillion in notional value at the end of June 2009 by the Bank for International Settlements. And central clearing, in all of its incarnations, will likely be a key component. For sellers and buyers alike that means that, for an estimated 60 percent of all OTC derivative contracts, the days of negotiation and processing over the phone or sending faxes between two counterparties will be gone.

In anticipation of the new regulations, clearinghouses are lining up to serve investors with the players including subsidiaries of the Chicago Mercantile Exchange, InterContinental Exchange and LCH.Clearnet. Those clearinghouses will stand in the middle of transactions between two counterparties in the event that one goes bust and decide which contracts will be standardized, hence cleared. Broadly speaking, they will likely be those which are liquid enough to be priced on a daily basis.

"Derivative indexes and single-name credit default swaps will win out over more complex structures such as a credit default swap on a synthetic corporate collateralized debt obligation," said Jeff Gooch, chief executive of MarkitServ, a joint venture between the U.S. umbrella organization for clearing and settlement Depository Trust & Clearing Corp. (DTCC) and Markit Group, a global financial data, valuations and trade processing firm.

Indexes and single-name CDS contracts have a ready market of buyers and sellers, as evidenced by bids and offers that change throughout a trading day. By contrast, more-complex products such as a CDS on a synthetic CDO are pretty hard to price because they are far less liquid. There is a lot more data to analyze and far fewer trades conducted. While indexes and single-name CDS contracts trade on a daily basis, a CDS on a synthetic CDO might not trade for days or weeks.

Gooch's biggest concern? It isn't whether a contract is considered standardized or not; it's whether a fund manager has invested in the systems needed to manage the risk associated with its book of business in OTC derivatives. That risk includes a potential valuation error, which can lead to all sorts of problems-errors in calculating the initial collateralization needed, the size of margin calls or the precise amounts of payments on the instruments, to name a few.

"Pricing is a big challenge. Portfolio managers and risk managers need to think about consistency when developing hierarchies to reconcile pricing data they receive from central clearinghouses, independent valuation firms and their own trading desks," Gooch warned. "Relying on Excel and paper-based communications with counterparties will be insufficient."

The basics of straight-through processing also apply when it comes to centralized clearing. A clearinghouse or its clearing member will need to get the correct details of the trade from some type of automated system. That means signing up to use an electronic affirmation and confirmation system, which will capture and acknowledge the details of the transaction between counterparties.

Affirmation usually refers to an initial acceptance of the trade details, while confirmation is an actual legally binding contract that precedes central clearing and collateralization.