Standardisation in the Derivatives Market

STANDARDISATION IN THE DERIVATIVES MARKET

CREDIT DERIVATIVES

In March 2010, we committed to global regulators todrive a high level of product, processing and legal standardisation in each asset class with a goal of securing operational efficiency, mitigating operational risk and increasing the netting and clearing potential for appropriate products (recognizing that standardisation is only one of a number of criteria for clearing eligibility). The narrative below together with the attached matrix, analyzes existing, and where appropriate, potential opportunities for further standardisation in the credit derivatives market.

1. CURRENT LEVEL OF STANDARDISATION IN THE CDS MARKET

The vast majority of credit derivatives products have been highly standardized since the late 1990’s. The standards have developed over time and, since 2007, additional standardisation has occurred with a specific focus on electronic confirmation of trades, lifecycle processing of trade events and ease of trade compression and clearing.

Definitions
Almost all CDS trades are executed under standard legal terms. Typically, they are contained in the ISDA Master Agreement between the parties, although in a limited number of cases they are contained in the national equivalent such as Rahmenvertrag in Germany (or in another master agreement between the parties). At the trade level, the standard trade incorporates the ISDA definitions, supplements, protocols and other documentation as set forth for that particular product in the attached CDS Documentation Annex which have been developed over the past decade. This development has included incremental modification and standardisation over time in order to make trades on the same reference credit, to the same maturity date fungible in order to facilitate compression and clearing, where appropriate. For trades confirmed electronically, these standard provisions are typically incorporated via the rules and procedures governing use of the platform, such as DTCC’s Operating Procedures or a central counterparty’s rules and procedures (if confirmed at such CCP instead of DTCC). For trades confirmed on paper, these standard provisions are usually incorporated via a Master Confirmation Agreement.

Contracts

Across the CDS market, the vast majority of all contracts are confirmed electronically via the MarkitServ confirmation matching platform.In 2005, less than 50% of all CDS contracts were confirmed electronically. This reliance on a highly manual documentation process led to the creation of a significant backlog of unexecuted confirmations.By April 2010, more than 99% of all CDS trades eligible to be confirmed electronically were actually confirmed electronically, representing more than 98% of all CDS transactions confirmed during that month.Currently, there is no material backlog of unexecuted CDS confirmations.Over the past few years, we have also seen an increase in the number of vendors supporting access and enhancements to the MarkitServ platform for market participants, and at least one central counterparty has emerged which offers its own separate electronic confirmation process.The small subset of transactions which are not confirmed electronically are confirmed via paper. Paper confirmations are signed by both parties. These trades represent two types of trades: 1) standardized products for which electronic confirmation is not yet available and which are confirmed via short form templates and 2) bespoke trades which use standardized long form industry templates, with variances as per the terms of the trade.

The MarkitServ confirmation matching process is accomplished by the bilateral electronic submission or affirmation of confirmable transaction details by each party to the trade.When all details are matched, the legal record of the transaction is stored in the Warehouse Trust’s Trade Information Warehouse (TIW).Any unmatched trades (or unmatched fields of linked trades) are investigated and resolved by the parties to the trade.The MarkitServ platform provides both detail and summary analysis of the current status of all transaction within the platform for efficient risk management of the confirmation process. Market participants have well established processes for escalation and resolution of trade breaks. In May 2010, more than 97% of all electronically confirmed transactions were confirmed and registered in the TIW within two days of Trade Date.

Going forward, all new industry sponsored standard products, Index and Single Name Derivative Contracts, will be launched with standard electronic confirmation support.

Market Practices

Standardized Terms:

Within the CDS, there are standards for legal terms and operational protocols to improve efficiency. In addition, the vast majority of transactions utilize certain market practice and trading standards such as:

• Standardized Coupons (with market premium or discount paid upfront).
• Full first coupon payments on all trades.
• Standardized payment dates.
• Standardized maturity/roll dates.
• Standardized model for calculation of upfront payments (the ISDA CDS standard model: see
• Quoting Conventions:
• Investment Grade: Quoted in current market par spread in basis points running, upfront payment is calculated using the ISDA Standard Upfront Calculator model.
• High Yield/Distressed: Quoted in current market clean upfront payment, accrued to date premium is added to allow a full first coupon payment.

Lifecycle Events

Confirmable Events:

• New Trades
• Partial Unwinds
• Novations/Partial Novations
• Backloading into clearing

As outlined above, confirmable activeity on standard trades is typically confirmed via electronic affirmation/confirmation mechanisms. With respect to Novations, following the adoption of the 2005 Novation Protocol, novation consent has moved to electronic processing platforms for almost all Credit Derivative transactions. In September of 2010, the industry will launch a new Novation “Consent = Confirmation” process whereby the multilateral consent process will result in a legally confirmed trade in a single step for the vast majority of CDS transactions.

Non-Confirmable Events:

• Credit Events: Determinations as to the occurrence of a credit event are made by the regional ISDA Determination Committee relevant to the particular Reference Entity. The determination process provides for the use of a robust dispute resolution process if needed. If a Credit Event is determined to have occurred, such event will typically be settled using the ISDA Credit Event Settlement Auction process to determine the recovery rate upon which cash settlement will be based for all auction covered transactions, which make up the vast majority of trades in the market.
• Succession Events: Determinations are made by the regional ISDA Determination Committees.
• Coupon Payments: Centrally processed in the TIW for the vast majority of CDS contracts (all those registered as “Gold Calc” in the TIW)
• Maturity.

Other Standardisation Features

STP: The Credit derivatives market has developed a very high level of Straight Through Processing. From the use of electronic trade booking by Inter-Dealer Brokers (IDBs) to central processing of bulk novations and trade terminations resulting from portfolio compression, the industry continues to leverage the universal infrastructure to drive efficiency in trade processing and a reduction in operational risk. The TIW centrally processes most lifecycle events for credit derivative contracts including periodic payment calculation, succession event processing, credit event settlement and reference entity “rename” events. The launch of “Consent = Confirmation” will further increase the level of STP for a significant portion of buy-side activity.

CCPs: Central Clearing between major dealers has been in place for 15 months in North America and 1 year in Europe. We estimate that over 90% of the historical stock of eligible trades is now cleared. Additionally G-14 dealers have committed to a submit new eligible activity for clearing at the rate of at least 85%. Client clearing was launched in North America in December, 2009, though volumes have remained low. In both the US and Europe multiple CCPs are working to expand the available set of products eligible for clearing as well as to expand capabilities for and client access to client clearing.

Collateral: For non-cleared transactions there is widespread use of bilateral collateral arrangements (via the ISDA Credit Support Annex (CSA))and over 90% of credit derivatives trades are subject to such arrangements according to the ISDA Margin Survey 2010.

2. EXECUTION

The attached matrix provides indicative data on the trading mechanisms used for execution in the market. The level of electronic execution of credit derivative varies by region, contract and whether the trade is dealer to dealer or dealer to client. For example, the interdealer market in European corporate indices has a high percentage of trades executed electronically, with client volumes lower but expected to grow. Electronic execution began later in the US, but client driven activity has found a steady user base, though many clients still prefer voice execution. Execution is split across multiple market venues including TradeWeb, Bloomberg, dealers' client platforms, and a variety of interdealer brokers.

In contrast to other asset classes, credit derivative trades are purely OTC with no instances of exchange trading. Typically the traditional futures or stock exchanges work best where there is depth of liquidity around standard products that persist in their original form for the life of the contract. This allows for simple trading protocols, anonymous trading and limit order driven markets. This is evidenced by futures exchanges which play an important part in the Rates and Equities markets. Prior to the “Big Bang” and “Small Bang” protocols,credit derivative instruments lacked standardisation and a central mechanism for determinations around credit events. Thus, they were completely unsuitable for either clearing or exchange trading. Since these protocols were enacted, the instruments were structurally rendered clearable (liquidity is still an additional fundamental requirement for clearability). Currently credit derivative contracts are quoted in four quarterly dates in standard coupons (potentially different per region) and with standardized restructuring conventions. Contracts are quoted with full first coupons thus rendering contracts with matching reference entity and maturity dates fungible. Post a credit event, accrued interest is no longer used and the quotations take the form of “1-Recovery”.

Exchange trading however still remains inappropriate for the general CDS market, in particular due to the dispersed nature of credit. Liquidity is distributed across all the tenors of a given credit derivative curve. At the request of the ISDA Credit Steering Committee, DTCC released statistics around the trading frequency of the 1000 most traded credits over a 9 month period. Based on that data set, we observe that for the average credit 20-50% of the trading activity occurs around the “on the run” 5 year point but trading frequency drops significantly as a contract goes “off the run”. The key to note is that exchanges work well where the market, unlike in CDS, concentrates liquidity around a small number of widely traded contracts.

Organized trading venues can take multiple forms and there is some scope for more of the market to move onto other types of electronic trading platforms, particularly those that are quote driven and provide the certainty of execution that clients are generally looking for. TradeWeb and Bloomberg are examples of multi-dealer platforms where clients can request prices from a number of dealers, thus putting them in competition in an efficient way. In addition, many dealers are starting to offer electronic execution on their own proprietary platforms. These electronic platforms supplement the voice market which, as in Bond markets and Foreign Exchange markets, provides for an ability to work larger orders without adversely impacting the market price for a client, or for off-the run trades for specific risk management needs.

The OTC Credit Derivative markets work well today. They operate for professional users only, are competitive, with a high degree of price transparency, offer a broad set of reference credits for clients, and on average have more liquidity and tighter pricing than the corresponding bond market. There is a strong consensus across both dealer and end-user that the markets in their current form provide for price transparency with good liquidity.

3. CONFIRMATION

As highlighted in section 1 above, the confirmation of CDS transactions has become a highly automated process, largely supported by industry-sponsored infrastructure and leveraging the TIW. In contrast to a few years ago, there is currently no material backlog of outstanding CDS confirmations. More than 97% of all electronically eligible CDS transactions, including new trades, unwinds/termination, and novations, are confirmed within two days of Trade Date. The nearly universal use of ISDA documentation forms and ISDA definitions has also led to a dramatically improved process for those trades that remain confirmed on paper. Market participants and supervisors continue to work with the confirmation platform providers to expand the population of transactions covered by electronic confirmation. Continued industry efforts, in conjunction with continued rollout of additional electronic confirmation templates, will move more types of products onto electronic affirmation/confirmation platforms and will further mitigate risks and increase automation in this process.

4. SETTLEMENT

Settlement breaks in the CDS market have been dramatically reduced over the past five years largely with the advent of three major process standardisations; the industry wide use of the ISDA Standard Upfront Calculator with fixed yield curves, the adoption of “Gold Calc” functionality with in TIW and the use of CLS settlement by major market participants.

The ISDA Calculator is a publicly available CDS calculator used to convert quoted spreads for CDS products into a present value number using agreed standard input values (interest rate curve, assumed recovery rate, curve shape, etc). Because the present value being exchanged between buyer and seller is a required field for confirmation and small differences (due to counterparties using slightly different calculator models) historically led to backlogs in both documentation and settlement, the adoption of the standard calculator has played a critical role in building scalability in the CDS market.

One of the major advantages of the single industry repository for CDS contracts has been the development and adoption of TIW Gold Calc functionality. In cases where the TIW is the single holder of the legally confirmed transaction confirmation, it uses this data to perform the calculation of all cash flows required for the life of the contract. These calculations are supplied to all parties to the trade for settlement and the use of a single calculating party has removed the risk of differences in calculation methodology by each party. This process is used for periodic payments as well as life cycle event such as credit events.

Over the past two to three years, CLS (Continuous Linked Settlement) has partnered with TIW to combine the CDS settlement requirements for its member firms with its very successful process for netting payment obligations in the Foreign Exchange market. The service identifies all cash movement requirements, by currency, among its various members and reduces the required cash movement to the minimum net movement possible. Through the use of this service, the CDS industry has reduced the gross amount of currency being exchanged through the CDS market on any given settlement date by up to 50%. This is a service that is utilized by many of the largest participants in the market and is open to any party with a CLS clearing members relationship.

5. CLEARING – CCPs

There are several existing central counterparties (CCPs) which currently clear credit derivatives. These CCPs currently engage in varying states of clearing activity across regions and products and all are expanding their capabilities to clearing a wide range of Credit Derivative products. Moreover, CCPs operational for other product types continue to also develop platforms to clear credit derivative products. There is an activeprogram of work to extend the eligible product set, including the addition of tranches, sovereign and the expansion of cleared dealer to client volumes over the remainder of 2010. In addition, new CCPs are beginning to come online, although this will take time to extend the superset of eligible products.

CCP platforms are being extended to enable end-user access. For larger financial institutions who may present a systemic risk this will be a significant step forward and, in time, will increase the proportion of volume in the market to be cleared.

The attached CDS Cleared Product Annex shows the superset of Credit Derivatives products currently being cleared globally. To date clearing efforts have focused on the interdealer transactions. Backloading by dealers continues to increase the stock percentage of eligible cleared in line with the regulatory targets in place for G14 v G14 dealers.

It is important to note that certain CDS products are not suitable for clearing due to a lack of depth of liquidity or clear availability of pricing. The data recently released by DerivServ relating to trading volumes in credit derivatives should help the industry, CCPs and regulators determine which products are capable of being cleared. CCPs should be well regulated though to ensure standardisation (or at least, minimum standards), particularly around risk management and margin.