Move to speed up derivatives trading

[FaGal]

Move to speed up derivatives trading
news.ft.com - By Charles Batchelor in London - March 3, 2005


Some banks have cut back their trading of credit derivatives to clear their backlogs of unconfirmed trades, derivatives specialists said.

The Financial Services Authority, the UK regulator, last week warned banks and other financial services firms to tighten up their back office systems.

The rapid growth of the credit derivatives market has meant banks have fallen behind in confirming the often complex terms involved in transactions, the FSA said.

Unlike more established and standardised interest rate and equity derivatives, credit derivative trades have to be backed up with lengthy documentation outlining the terms of the deal. The rapid growth of the credit derivative market has caught banks on the hop.

Trading of credit default swaps, the most commonly traded credit derivative, has increased 28-fold since 1997 to an estimated $5,000bn in 2004, according to the British Bankers Association. CDSs allow investors to insure the credit risk of their bond and loan holdings or take exposure to risk that they think attractive.

But measuring the extent of any downturn – or slowing down of the rate of growth – in short term is difficult since this is an over-the-counter market and aggregate data of dealing volumes is not available.

“Some banks are attacking it by setting up task forces to deal with the problem,” said one consultant. “Some are near to limiting or stopping trading while these problems are sorted out. Others are still making prices but not trading.”

“Some banks are going slowly [on trading] to get the infrastructure in place while they get comfortable with the risk,” said Ian Linnell of Fitch RatingsMove.

“Banks have underestimated the amount of back office capacity needed to keep up. I am not surprised there is a backlog in a market as complex as this.”

But the International Swaps and Derivatives Association said it was not aware of members cutting back while one broker said the banks were unlikely to tell their traders “to stop marking money”. But trading volumes were lower, he said.

Delays in confirming trades is not a new issue for the banks and securities firms but it has been given additional urgency by the proposed introduction of the Basel II rules on bank capital adequacy in December 2006.

Basel II adds a capital charge to banks that are regarded as having unsatisfactory operating systems. The level of undocumented transactions is one criterion by which banks will be judged.

Even before the FSA warning, the leading investment banks involved in derivatives trading had been engaged in efforts to improve their processes.

More than 20 banks last year began benchmarking their performance on operational issues, including a detailed statistical analysis of their deal confirmations. Banks taking part in the “Scorecard” process have to answer more than 1,000 questions.

Apart from legal challenges and the damage to their reputations if deals go wrong, the banks are seeking to avoid the high cost of deals cannot be confirmed because the documentation from the two parties does not match.

A failed deal that is picked up on the day of trade might cost $30 to put right, said Jonathan Davies, chief operating officer for Reoch Consulting, which manages the scorecard process for Markit, a data provider for the derivatives markets. But wait a day and the cost rises to $60 and after 30 days the cost could be $900.

Most transactions in the derivatives markets are handled by either The Depositary Trust&Clearing Corporation or SwapsWire, both owned by groups of banks and financial services firms.

But some of the smaller banks and institutions investing in derivatives do not always have the in-house systems to process deals quickly or are not signed up to the main confirming houses.

“Banks find they cannot scale up their systems or produce documents efficiently,” said Glen Manchester, chief executive of Thunderhead, a software company. “We have designed a process that allows people to design confirmations without involving their IT department.”