In the spotlight

The Financial Services Authority has warned banks about the high number of unsigned confirmations in the credit derivatives market. Banks need to take action to clear the backlog, and with the FSA watching closely, they need to do it quickly. By Hann Ho

It’s not everyday that confirmation and settlement is the biggest talking point in the derivatives markets. But a letter from UK regulator, the Financial Services Authority (FSA), warning banks about the level of unsigned confirmations in the credit derivatives market, has put back-office operational issues firmly in the spotlight.

The credit derivatives market has surged over the past few years, with the International Swaps and Derivatives Association reporting that volumes had increased 123% to $8.42 trillion during 2004. However, while the front-office has powered ahead, the middle and back offices appear to be floundering in its wake. According to the FSA, the number of unsigned credit derivatives confirmations is relatively high, with some remaining unsigned for months – an issue it identifies as a serious operational problem. And while the FSA doesn’t specify the scale of the problem or name individual firms, it appears to be an industry-wide issue.

“In a growing market, parties need to clearly define and agree on what the transaction is between them,” says Gay Huey Evans, London-based head of the FSA’s capital markets sector. “To allow the problem to continue without tackling it would be unacceptable in such an important and complex market.”

The FSA hasn’t set a deadline for firms to resolve the problem. But the inference is that banks needs to sort out this issue as soon as possible. “We have not given banks a deadline, but by sending a letter to the chief executives we have indicated that we mean business,” says Huey Evans. “We hope banks will deal with the problem as soon as is practically possible.” In a worst-case scenario, offending dealers could be penalised, although Huey Evans does not specify what measures the FSA would take.

It’s certainly got derivatives practitioners – from the front, middle and back office – talking about it. In fact, unsigned credit derivatives confirmations were a major topic at Isda’s annual general meeting in Barcelona in March. “We need a ‘call to arms’,” said Jonathan Moulds, Isda chairman and Bank of America’s head of international debt and equity markets. “This is not just a middle-office issue. You also need to include the traders and marketers [to resolve the backlog]. Bank of America has pushed very hard for traders to be involved in the decision process and sit down with operations people. We have just got to do that.”

Nonetheless, no-one suggests the answer lies in cutting back the volumes of trades. Instead, most of the attention is focusing on easing the strain on the back and middle office by improving processes and systems. “This industry has shown a fantastic ability to innovate, find new products, increase volumes and attract new participants,” says Frédéric Janbon, global head of fixed income trading at BNP Paribas in London. “But it has not been particularly good at improving post-trade processes.”

One area where problems have occurred is getting banks to agree on the reference entities and reference obligations underpinning credit derivatives trades. Without agreement, the confirmation of the trade can be delayed. “A lot of the problems are between market dealers,” says one head of credit derivatives. “A lot of the issues are around what the reference entity is. It’s all about standardising the business.”

However, dealers say there have been improvements in this area. The Reference Entity Database (Red), a market data platform run by UK company Markit, has attempted to resolve some of the issues by offering a standard list of reference entities for credit derivatives. The list of reference entities, which was devised through consultation with market practitioners, effectively reduces the potential for disputes.

And Markit has also developed a ‘preferred’ reference obligation list, which was incorporated into Red in January. The list of 750 preferred reference obligations was compiled through canvassing opinion from dealers and collecting data on the most commonly used reference obligations from trades settled through the Depository Trust and Clearing Corporation (DTCC), an electronic post-trade confirmation and settlement system based in New York.

Although there is no formal agreement among dealers to use the list, the firm claims most trades are now using the preferred names. The risk of mis-matching reference obligations should therefore be reduced.

The establishment of Red – originally backed by Deutsche Bank, Goldman Sachs and JP Morgan, but sold to Markit in February 2003 to ensure neutrality – has “greatly assisted the establishment of a liquid European credit default swap (CDS) market”, says Guy America, JP Morgan’s head of credit trading in London.

Dealers also point to the growing automation of trades as a positive step in helping resolve the backlog. Isda estimates that the proportion of trades being confirmed automatically jumped from 6% to 33% in 2004. This is largely due to the adoption of the DTCC since the end of 2003. The system matches fields such as the counterparty name, notional and rate traded, using Red to match reference entities. Dealers say the DTCC typically matches trades minutes after execution, and the vast majority are matched by t+1.

In fact, many market participants report that good progress has already been made in reducing the number of unsigned confirmations. “We’ve been at it for two months, and the number of unsigned confirmations is going down despite trading volumes going up,” says the credit derivatives head. “The level of unsigned confirmations is nothing that can’t be solved in the next three months.”

The main problem, however, centres on those trades that cannot be confirmed electronically. Jeff Gooch, Morgan Stanley’s head of European fixed-income operations in London, explains that the overwhelming majority of outstanding unsigned trades are paper-based. He points to certain types of credit derivatives that have not yet migrated to DTCC’s electronic confirmation process – namely, emerging markets, indexes and assignment trades.

“Hedge funds have primarily driven the growth of assignment trades,” says Gooch. Assignment trades allow hedge fund managers to monetise any gains they have made by assigning existing trades to different counterparties. In other words, a different party – typically an investment bank – might step into a CDS trade, cancelling the hedge fund’s exposure for the remainder of the contract. Typically, the dealer will trade with the fund at an agreed rate. The dealer becomes the counterparty to the initial bank at the original rate, and pays the hedge fund the difference.

In such a case, the Isda master agreement stipulates that all three parties – the original dealer and hedge fund, plus the new dealer taking on the assigned trade – must sign the assignment confirmation.

“Getting all three signatures on the assignment confirmation is very time-consuming,” says Gooch. What’s more, post-trade communication with operations groups can be very poor.

One senior credit derivatives trader at a prominent investment bank points the finger specifically at hedge funds. “They are very focused on trading and can be very under-resourced on the operational side of the business,” he says, adding that one fund had about 100 trades still unconfirmed with his firm three days after trading. “We’re getting close to stopping doing business with it,” he says.

Other dealers, however, say the problem is broader than that. However, Gooch points out that the major dealers are committed to extending DTCC to cover assignments by the end of March, as well as the Dow Jones iTraxx Series Three roll out on March 21. Emerging markets and Asia are expected to follow suit later in the year. This should prevent the build-up of unsigned confirmations in the future, he says.

In the meantime, banks have to work on reducing the existing backlog. Huey Evans is already warning banks to expect FSA supervisors to pay closer attention to their back-office processes in the coming months. If the FSA were to carry out its ultimate sanction – to curb the credit derivatives activities of any of the major dealers – it would be a major shock to an industry that has seen unprecedented growth.Risk