SIFMA OPS 2010
SIFMA OPS 2010: Solving Headaches When Processing Derivatives
SIFMA OPS 2010: Solving Headaches When Processing Derivatives
April 19, 2010
Over-the-counter derivatives-once known for their obscurity-have now taken center stage as lawmakers on both sides of the Atlantic try to reform how financial markets work-or don't.
An inability to properly judge and react to the risks, when values went south, contributed to the bankruptcy of Lehman Brothers and the near-failure of U.S. insurance conglomerate AIG.
Reform is intended to prevent a repeat. No measure has been passed and there are some differences between the House and Senate bills in the U.S. as well as between European and U.S. counterparts. But as the Securities Industry and Financial Markets Association's 2010 Operations conference begins on May 4, there is consensus that some sort of regulation is imminent.
And that spells plenty of operational headaches. According to Jon Williams, managing director and head of U.S. markets for online marketplace operator TradeWeb, the most likely changes include mandates for more transparency on pricing of derivative contracts before trades are made, the creation of a central counterparty for clearing standard contracts and creating the ability for regulators to monitor trading activity through the data repositories.
The overarching goal: to monitor and reduce systemic risk. This translates to avoiding the collapse of financial firms of such size that a domino effect could blow up economies around the world.
Yet operations specialists say they face plenty of risk in deciding how to prepare for the most likely outcome-required central clearing of many OTC contracts. That means using a central clearinghouse to guarantee the trade in the event that one of the counterparties-like a Lehman Brothers-goes bust. Such a scenario requires buy- and sell-side firms to adapt their middle- and back-office systems.
In the past, these systems often have dealt with only exchange-traded instruments or transactions negotiated "bilaterally," by two parties, generally over the phone. The changes will affect how post-trade functions as reconciliation, collateral management, margin calls, and valuations are handled.
The challenges for small- to mid-tier fund managers and broker-dealers will be far more difficult than for large ones with deeper pockets.
"Fund managers may decide to rely on brokers for clearing rather than face the expensive and time-consuming task of building connectivity to individual clearinghouses," says Jeff Gooch, chief executive of MarkitServ, a joint venture between Depository Trust & Clearing Corp and the Markit Group.
DTCC is the umbrella organization for clearing and settlement of U.S. securities while Markit is a global financial data, valuations and trade processing firm.
Bottom line: aside from making changes to their operating systems to accommodate the new financial instruments, the fund manager will need to pick a clearing broker and decide which clearinghouse to use for each product. Firms will then have to decide which of their over-the-counter derivative transactions to centrally clear.
That's no easy task because they will have to interpret just which contracts out of $450 trillion worth of derivatives can be considered "standardized' over-the-counter contracts, says Gooch. Morgan Stanley has estimated that up to 60 percent of OTC derivatives will be cleared through a central clearinghouse over the next two years. That leaves 40 percent to be cleared bilaterally, directly between two parties.
Last December, the Intercontinental Exchange's ICE Trust and the Chicago Mercantile Exchange's CME Clearing offered institutions access to clearing services for credit default swaps. LCH.Clearnet did so for interest-rate swaps. The NASD has also entered the fray offering a clearinghouse for interest rate swap futures contracts called International Derivatives Clearinghouse.
