Fine Print As Yet Unwritten, But the Gist is Clear for OTC Derivatives

By Christopher Faille

TABB has put out a report on the development of clearing technology for over-the-counter derivatives, called “OTC Derivative Clearing Technology: Bringing the Backoffice to the Forefront,” which projects that sell-side institutions and other market participants will in 2011 alone spend more than $12 billion on technologies related to clearing. This sum includes expenditures on trade matching, valuation, novation, trade accounting, reporting, and processing. The part of that pie related to OTC derivatives is the largest slice.

As to continued spending in the middle and long terms, TABB cautions that “the fine print of the final regulations is still uncertain,” but it says the market participants are prepared to err on the side of caution. It quotes a professional at a major clearinghouse who said his industry is not worried that it will implement a clearing technological infrastructure that will prove “surplus to requirements.” The worry, rather, is “sitting on the fence doing nothing and then having to play catch up to the market.”

The Starting Pistol

Most discussions of “speed” in markets these days involve the speed of the trades themselves. But one theme of this report is that the speed with which trades are cleared and processed after the “buy” button is pressed is bound to change dramatically. “[P]roposed new rules in both Europe and the US make it abundantly clear that OTC derivative technology will finally move into the 21st century,” which means away from overnight or even sometimes multi-day clearing toward real-time clearing.

As this new race for speed develops, quite aside from what the regulators want, the race will become an important part of the competition for investor dollars.  Although “providing your clients with a snazzy front end to trade swaps electronically is one thing” supporting that with “a fast and efficient downstream process that helps the client optimize their collateral usage” and reap other valuable rewards is still another, and can bring competition satisfaction to a higher level.

The central counterparty clearinghouses (CCPs) will in the process find themselves at the center of a much more complicated web of contractual relationships than anything they’ve had to accommodate to date. The required real-time connections will include swap execution facilities (SEFs) and swap data repositories (SDRs) as well as clearing members, valuations providers and market-data firms.

The “medium term” in the development TABB is describing takes us to 2014. In that year, after a swap trade has been executed between a dealer and a client by way of an SEF: what will happen? If either the regulators or the client himself wants central clearing for the trade, the SEF will transmit the particulars of the trade to the CCP, both counterparties, regulators, and one or more market data provider. This (in particular the transmission to the CCP) may occur using any of a number of protocols: the CCP’s own API, or XML, FIX, or FpML.

The CCP will then get to the heart of the matter and “replace the original trades with two new trades, one for each side of the deal.”

The increase in complexity will require innovation in databases and storage management which, fortunately, TABB tells us is coming on-line.

When all the pieces of the puzzle are in place, a settlement message will be generated and sent to each counterparty by the Society for Worldwide Interbank Financial Telecommunication (SWIFT) or an analogous network.

Bottom Line

Clearing within ten days after the transaction (T+10) was once the norm, though it now seems archaic. Clearing overnight or in a once-a-day cycle will in the years ahead become equally unsatisfactory. It may soon “become standard practice for risk managers and eventually traders to demand proof that their trades have been cleared mere seconds after execution.”

Getting to that point will be expensive for those institutions that will have to provide the proof. But, in the words of the opening sentence of the report, “One man’s nightmare is another man’s opportunity.” Those who are selling solutions will benefit.

Even at the big global dealers, and more obviously so in the case of the smaller market players, the creation of the necessary infrastructure will not be possible without third party involvement, building new systems and revamping the legacy systems.

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  1. Hamlin Lovell
    October 8, 2011 at 5:00 am

    When some credit instruments such as bank loans, bank debt, and other bonds can sometimes take a month or more to settle, it will seem strange for the associated CDS on the same name to settle instantly. Arbitrageurs may seek to speed up settlement in the cash credit markets.

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