The head of operations at a large investment bank grimaces as he recalls the conversation with the global head of all the firm’s markets businesses about settlement delays in credit derivatives. “Basically he called me in to tell me: ‘This is absolutely insane’. And I had to tell him: ‘Yes it is, but this is the way this market now works.’”
What roused the ire of the division head was how traders at his and other firms had let hedge funds get away with assigning positions originally written with one dealer and passing them on to another without first obtaining the written consent of the original counterparty.
Following the letter of the law, hedge funds should have been careful to obtain such consent from what is known as the remaining party before assigning contracts. But given the volume of business done with hedge funds and the earnings derived from them, no credit derivatives dealer seemed prepared to insist on the letter of the law.
The result was a sizeable backlog in unconfirmed and uncleared transactions, leaving uncertainty as to counterparty exposures, margin limits and, in the case of disputed trades caught up in a back-office log-jam for perhaps 30 days and more, the true extent of risk exposures.
In its annual operations benchmarking survey, trade body Isda found front-office error rates in 2005 on 11% of all credit derivatives tickets at large firms. That’s better than the dismal 26% error rate in 2004 and 28% in 2003 but still worrying in a large and fast-growing market.
In February, Gay Huey Evans, capital markets sector leader at UK regulator the Financial Services Authority, fired a warning shot about “unsigned confirmations with some transactions remaining unconfirmed for months”. In September, the Federal Reserve Bank of New York really turned up the heat by summoning representatives of 14 leading dealers to discuss the issue. Early last month they undertook to the New York Fed to reduce by January 31 2006 confirmations outstanding for more than 30 days by 30% of the level occurring in September 2005.
“I’m just surprised it took this long,” says the head of European credit trading at one of the largest dealers. “We’ve been banging on about this for months but some other firms don’t seem to have given it such a priority. We’ve been calling for lock-ins [meeting where counterparties get together to resolve all unconfirmed trades] and they’ve been sending junior staff.”
Now the New York Fed has pushed the leading dealers into concerted action and provided the perfect cover for them to close ranks against the hedge funds and insist on correct market practices.
Why have hedge funds been keen to assign trades quickly and slow to confirm details with dealers? Partly, it’s because margin calls have driven high-velocity trading. If a hedge fund sells protection on $500 million of France Telecom to Bank of America, it has to post collateral. So if it seeks to offset some or all of that risk one day later, the fund might prefer to assign all or part of the original trade to Barclays Capital rather than buy protection on a new trade and post collateral on two contracts.
The hedge fund might not want to tell BarCap straightaway that it is assigning a trade rather than writing a new one and it certainly won’t want Bank of America to know that it is now hedging exposure on the original deal. The worry is that it might move the market against itself.
Now market behaviour will have to change, and this might cause some unhappiness. “As the Fed meeting drew closer the whole focus shifted to the Isda novation protocol, which is a bit of a rush job,” says one dealer. “Is it an improvement? Yes. Is it as good as it could be? Maybe not.”
The Managed Funds Association, the hedge funds’ trade body, has tried to reduce the burden imposed by Isda’s novation protocol on the transferor to obtain written consent from the remaining party by 6pm on trade date in the location of the transferee. It argues that oral consent should be adequate and is keen that the transferor should not be left party both to the original contract with the remaining party and to a new contract with the transferee.
The good news is that electronic trade confirmation systems, such as T-Zero, are now being rolled out. T-Zero allows speedy electronic confirmation of trade details between parties and transferees and assigns trades unique identifiers that all parties can use to speed up reconciliations. It’s simple stuff. But the biggest problems in the back office arise from delays in capturing precise trade terms at the very outset. T-Zero did its first trades at the start of October between one of the leading dealers, Goldman Sachs, and hedge fund KBC Alternative Investment Management on a series of single-name default swaps.
Mark Beeston, president of T-Zero, says: "If the dealers were to draw a line in the sand, inputting only 100% accurate and agreed trade data from here on in, then within 10 weeks the trade confirmation backlog would be 95% cleared."
| Error rates and weekly deal volumes |
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