“There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.”
I regret - deeply - every math class I ever taught to an economics major. Or, to put it more simply, we are in deep doo-doo.
Life cycle of an OTC derivatives trade
An OTC derivatives trade goes through several processing steps from the point at which two parties agree to a trade to the point where the transaction has been confirmed (Figure 1). Typically, before a trade is executed between two parties, they will establish the parameters of their trading activities through a bilateral master agreement and other supporting documentation such as a collateral agreement (a Credit Support Annex). Internally, dealers will conduct counterparty credit reviews and establish credit lines and trading limits.
See diagram
Trade execution occurs when two counterparties agree to a transaction. In OTC derivatives trading, this traditionally takes place over the telephone directly between two parties or through a broker. More recently, electronic trading systems have become available for counterparties to trade some of the more standardised OTC derivative products (information on electronic trading platforms is available in Annex 5).
Once a trade has been executed, the parties must capture the trade details in their internal systems for post-trade processing and risk management. Trade capture can be manual, where trade tickets prepared by traders are passed to the middle office for processing, or automated, where the trader enters the information directly into a front office trading system and the trade details flow through to downstream systems with limited or no manual intervention. Data on trades completed over third-party electronic trading systems can often be transferred into internal systems through a file transfer or direct link with the electronic trading platforms.
Before the two parties to the trade begin the process of reviewing the full terms of the trade that would result in a trade being confirmed, the counterparties may choose to go through an additional step of verifying a dozen or so key economic details of the trade. 1 This process is commonly called economic affirmation but is also known as trade verification. Economic affirmations are accomplished through a variety of methods. For brokered trades, the broker check-out serves as an economic affirmation. For non-brokered trades, counterparties communicate bilaterally via telephone, fax, e-mail or messaging systems (eg Bloomberg, Markit Connex etc). Electronic trade affirmation systems (described below) also serve to carry out this process.
There are two types of operational processes that support the creation of the final record of the transaction that is agreed upon by both parties (ie confirmation, which can be in paper or electronic form). One model uses trade affirmation, whereby one party provides trade details to the other, who then verifies the information, resulting in a finally agreed trade. The second model uses trade matching, where both parties submit records of the trade to each other. When both sides agree that the trade details match, they have a finally agreed trade.
With paper-based confirmations, the trade affirmation model is used for trades between dealers and clients; the dealers issue the confirmations to clients for them to sign and return. Similarly, in the inter-dealer market for credit derivatives, the dealer selling credit protection typically drafts the confirmation and sends it to the counterparty for review and agreement. In contrast, in the inter-dealer market for interest rate swaps, the trade matching model is more commonly used, where both dealers prepare a confirmation, and the two confirmations are then matched by the counterparties for final agreement. These individually prepared confirmations are passed between counterparties by fax, e-mail and messaging systems. Most dealers have internal systems that facilitate the creation and sending of confirmations, but some manual intervention might be required, depending on the complexity of the transaction.
Third-party service providers now offer electronic platforms to generate and complete confirmations in many OTC derivative products. The electronic processing platform offered by SwapsWire is an example of the affirmation model, and Deriv/SERV is an example of the confirmation matching model (see Box 1 for a detailed discussion of the two automated models).
The underlying tenure of an OTC derivatives transaction is typically long-term and as such, these transactions have recurring events (eg periodic payments) and one-time events (eg novation) that must be managed during the life of the trade (Figure 2).
Automating the confirmation process
The automated trade affirmation model is a front-end approach in which both sides agree on a single record at trade capture. Because the full details of the trade are agreed upon and captured electronically at the beginning of the life cycle of the transaction, amendment and transaction rejection rates are typically low and final confirmation of the trade can be achieved quickly. Indeed, 99% of inter-dealer confirmations generated through the SwapsWire platform are completed on T+0. The challenge in implementing this type of model is that it requires a change to existing systems and processes designed to handle OTC trades. Traditionally, the front office hands off trades to the middle office for downstream processing after traders have agreed to a trade. In the upfront affirmation model, the front office personnel must enter the trade information into the trade affirmation system or affirm the transaction that has been captured in the system by the counterparty. Although this model eliminates the potential for errors to occur when information is passed between the front and middle offices, the process requires extra upfront work by the traders and potentially a change to a firm’s IT systems.
n contrast, the trade matching model allows for the middle or back office staff to enter trade details into the matching system, which is comparable to the traditional post-trade processing approach. There are two records of the trade (one at each party to the trade) that are processed through two different internal systems before the information is entered into the central matching system. Both the timing and accuracy of the information entered into the matching system by the two parties to the trade become elements that can contribute to delays in completing the trade confirmation.
Additional services are being built to connect systems and address deficiencies in the matching model. For example, in credit derivatives, T-Zero provides workflow services to facilitate the transmission of trade data among different systems in the post-trade process. A trade executed on the electronic trading platform Creditex can be affirmed in T-Zero and then matched and confirmed in Deriv/SERV. In this example, T-Zero provides the connection between the trading platform and the confirmation matching engine. Similarly, in 2006 DTCC launched an affirmation service called AffirmXpress in cooperation with some inter-dealer brokers, which allows front office traders to review and affirm inter-dealer brokered trades before the information is sent to Deriv/SERV for matching and confirmation. Markit Trade Processing also offers workflow solutions for a wide range of OTC derivative products, which centralise back office processing and connect customers to different post-trade processing systems. Markit’s services were initially developed for buy-side firms but are now provided to the dealer community as well.
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As described in Section 3.2, collateral is frequently used to mitigate counterparty credit risk arising from OTC derivatives transactions, and collateral management is an important function that includes calculating collateral requirements and facilitating the transfer of collateral between counterparties. Collateral management systems (usually developed internally but sometimes provided by third-party vendors) are used to manage this operationally complex process. Central counterparties (CCPs) also perform collateral management services for the transactions they clear.
Payments are periodically exchanged between counterparties under many different types of OTC derivative contracts. Payment obligations are calculated using a wide variety of methods and some firms will confirm or match upcoming payment obligations with counterparties prior to the settlement date. Cash flow matching may be accomplished by telephone, spreadsheet exchange, or through automatic advices sent by one counterparty to the other. For credit derivatives, which have standard quarterly payment dates, DTCC Deriv/SERV offers a cash flow matching service that results in an agreed net payment amount between counterparties for the quarterly payment date. The settlement of cash flows (ie the actual transfer of cash due to counterparties) is typically based on standard settlement instructions, but the methods used to effect payments for settlement vary. Some central counterparties (eg SwapClear) offer cash flow settlement-related services, but these services are restricted to payments associated with the transactions cleared by the CCP.
Portfolio reconciliation, ie verification of the existence of all outstanding trades and comparison of their principal economic terms, is considered good market practice but does not occur routinely with OTC derivatives portfolios. Problems such as disagreements over collateral obligations or missed payments may prompt a portfolio reconciliation between counterparties. Still, most market participants argue that without an automated process for reconciling the details of some or all outstanding transactions, the process is too costly relative to the perceived benefits. TriOptima has been testing a portfolio reconciliation service (triResolve) and other service providers (eg Markit and Algorithmics) are reported to be developing similar services.
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OK
ENOUGH****
Trading on Trust...it would seem....no wonder this Global structure is having problems.....
This sounds like something the Stardust (if it were still around) would have an over-under line on.