More MCAs needed to meet equity derivatives targets

Participants in the equity derivatives market say a significant amount of work remains to be done on standardising documentation before it can meet regulators' electronic processing targets for over-the-counter trades.

Dealers have committed to ensure 60% of trades will be eligible for electronic processing by the end of 2009, a significant step up from levels of 40% last October. This is part of a broader initiative to reduce operational risk, involving the Operations Management Group (OMG) - a collective of 16 dealers and several industry bodies, including the International Swaps and Derivatives Association - and the Federal Reserve Bank of New York. The two bodies set the latest array of targets on October 31.

But one dealer said the industry has not made much headway since then.

"After Lehman Brothers' failure in September, many high-volume counterparties decided to put more of their vanilla equity derivatives flow on exchange to reduce counterparty risk. While large-volume clients reduced their OTC trades, smaller firms that typically executed several times a month continued to trade at the same rate," said Eric Litvack, chief operating officer for options trading at Société Générale in Paris.

"This meant a higher proportion of OTC equity derivatives trade was composed of smaller buy-side firms, many of which are still using paper confirmations. These lower-volume clients also trade a higher proportion of non-electronically eligible trades. This has made the 60% target by the end of the year more challenging to achieve."

To be able to process equity derivatives on an electronic platform, Isda first has to work with dealers and buy-side firms to create a standard contract with terms that the majority agree on, which is called a master confirmation agreement (MCA). Once an MCA has been created it cuts down on paperwork and manual processing, and contracts can be traded through electronic platforms much more quickly.

MCAs have already been created for the highest-volume trades, for example options on equities in developed countries. But to meet the target by the end of the year, the industry still needs to create documentation for some high-volume products, such as equity swaps. Despite there being a relatively large amount of ground to cover to meet the target, one dealer is confident it can be achieved:

"As of today, the high level of electronic matching rates with counterparties [from the OMG] and its top clients makes us very confident it will meet such target by the end of 2009," said Marie-Clémence Séguret, a member of BNP Paribas Equity Derivatives' legal and transactions team.

By last October, 94% of electronically eligible transactions between the major dealers and 80% with the top 20 buy-side counterparties were being confirmed electronically.

Standardising equity derivative trades is more difficult: "Compared to other derivatives asset classes, equity derivatives have more variation in types of products available, differences according to regional variations in underlyings, and a greater range of firms that trade them. This means this asset class needs more work to standardise contracts to be able to process the majority of them electronically," said Julian Day, head of trading infrastructure at Isda in London.

He also remarked that Isda has to continue to create and publish new MCAs to keep pace with the rapid product innovation. These standard documents can often take around four or five months to complete. And the OMG has also promised that, starting in July, it will publish an MCA if a product comprises an average of 2% or more of dealers' non-electronically eligible volume over a six-month period.

Day says equity swaps are the biggest issue the association is currently working on, and creating MCAs for these transaction types would get the industry a long way towards meeting its targets. Dealers agree this is the priority for them right now; these products are estimated to make up 20% of total trading volumes.

"I think the equity space realises 2009 is another pivotal year, and challenges (such as further technology builds and signing more MCAs) exist as each firm handles the targets individually, and as a group as a whole. We have identified swaps as the number one product we must onboard this year, but dealer, client and vendor co-operation and co-ordination is absolutely needed for this target to succeed, more so this year than any year before," said Philip Franz, vice-president at Bank of America and chair of the Operations Equity Working Group, an organisation set up in conjunction with Isda to work on MCAs and the automation of trade processing.

The euro index/share variance MCA which Isda published recently will help the industry meet its target, dealers believe. And by the end of June it should be joined by others: MCAs are now being drawn up on emerging market options (covering Europe, the Middle East and Africa and Asia excluding Japan), and basket options for both indexes and shares.

BNP Paribas' Marie-Clémence Séguret said the industry is already working on these standard contracts: "Two issues have to be addressed here. One relates to the scope of such an initiative - which countries and products should be covered. Currently, variance swaps and vanilla options are envisaged. And the other relates to reaching a market consensus on elections applicable to all such countries and products. We anticipate both aspects will take some time, but hope participants will remain focused in order to meet such targets in time," she commented.

Another challenge is ensuring enough buy-side firms sign up to electronic processing platforms to execute the trades, dealers say. Although they report progress has been made in this area, many of these companies are either small or only execute a few trades a month, and so can sometimes be resistant to investing resources to improve trading infrastructure.

"The current commitments reflect the agreed requirements for reducing the backlog and for increasing the rate of electronic capture. A greater challenge will be to cast the net to a wider range of counterparties, many of which may not be bound by the same commitments that the leading dealers and buy-side associations have given to the regulators," explains Société Générale's Litvack.

See also: November target for CDS central counterparty
Regulators push for operations changes
Confirmations in the spotlight