Major dealers issue joint letter to Fed on credit derivatives

The New York Federal Reserve meeting with 14 major dealers on September 15 appears to have succeeded in coercing the industry into taking more concerted action to tackle the mounting problems in credit derivatives confirmation backlogs. Following the meeting, the 14 issued a joint letter, dated October 4, detailing how they intend to deal with the problems.

In the letter, addressed to the New York Fed president Timothy Geithner, the dealers committed to a five-point action plan that includes forcing clients to use automated settlement processes, and to implement the New York-based International Swaps and Dealers Association 2005 ‘novation protocol’. The protocol aims to make novation trades, where one party in an existing trade assigns its position to a third party, easier to settle.

Hedge funds are some of the most active credit derivatives counterparties and their use of these synthetic credit instruments is viewed as a significant factor behind the build up of a backlog of trade confirmations. A number of market observers say this has reached such a critical level that some dealers have threatened to temporarily stop trading with hedge fund clients.

The dealers are currently finalising a guide that will support the protocol, which seeks to “ensure all novations have written evidence of consent received by close of business on the novation trade date”, they said in the letter. “The major dealers will not accept any novation unless they receive prior written consent from the remaining party before firm pricing is given,” the letter said. They have issued a deadline of October 24, 6.00pm Eastern Standard Time, to implement the guidelines.

The dealers also proposed to commit to “fully using” the Depository Trust and Clearing Corporation’s (DTCC) automated post-trade trading confirmation facility by October 31. Significantly, they will “require all active clients to subscribe to industry-accepted electronic platforms, including at least DTCC, and be fully using its existing functionality by January 15, 2006”, the letter said. Active clients are defined as those that have executed five DTCC-eligible trades per week or more on average over the past three months with an individual dealer. By March 31, 2006, the definition will expand to increase those clients that average one or more trades over the previous three months with one dealer.

In addition, the dealers committed to reducing the number of confirmations outstanding by more than 30 days by 30% by January 31, 2006, compared with the level on September 30, 2005 – although they did not specify this level amount. A further target will be set in mid-December for March 31, 2006, “when we expect to have substantial knowledge of the impacts of automation advances, lock-ins, and the novation protocol”, the letter said. And for vanilla confirmations, the dealers said they wanted to move the industry to a “t+5” standard, that is, confirmation within five business days after trade.

There was also a commitment to the development of metrics to measure industry progress, where provided data will include trade volumes, confirmations, settlements and fails, which will be available 10 business days after the end of each month.

The dealers also sought to improve the credit default swap (CDS) cash settlement process, currently working with Isda to complete the 2005 Delta & Northwest CDS Index Protocol following the airlines’ bankruptcy filings on September 14.

Meanwhile, the dealers will continue to promote multilateral CDS tear-ups using Stockholm-based Trioptima’s swap tear-up service, TriReduce. The next round of industry CDS terminations is scheduled for October 7.

The 14 major dealers are: Bank of America, Barclays Capital, Bear Stearns, Citigroup, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS and Wachovia.