A spike in credit default swap volumes in July has exposed weaknesses in dealers’ ability to process trades in a timely fashion. Once again regulators, led by the Federal Reserve Bank of New York, are expressing concern over what looks like a resurgence of the backlog mess that first caught their attention in 2005.
Recent CDS market metrics published by the New York Fed show a massive burst of volumes in July, followed by an uptick in unconfirmed trades (see graph). Despite all the resources thrown at this problem by the banks that signed up to the so-called Corrigan letter in 2005 describing how they intended to resolve the unconfirmed trades, data show the backlog has been creeping up slowly since December 2006.
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Credit derivatives |
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Outstanding confirmations |
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Source: MarkIt |
Unconfirmed trades had come down from near the 12,000 mark in 2005 to about 2,000 in 2006. Banks were able to get these numbers down by automating their CDS trading systems, manually clearing up trades in a series of industry lock-ins and increasing the back-office operations staff charged with sorting out mismatched trades. Even with banks’ efforts, as CDS volumes grow the number of unconfirmed trades follow. After the summer volume spike, outstanding trades have popped up to the 10,000 mark.
The New York Fed is not taking this boom in unconfirmed trades lightly. Those who have met with Fed officials over the past few weeks report that the US regulator is seriously concerned about the CDS market’s inability to handle trades when volumes unexpectedly increase. These same officials have broached the subject of backlogs with banks during regularly scheduled supervisory visits. A spokesman at the New York Fed did not provide a comment on CDS backlogs.
This backlog predicament is not a complete surprise. Over a year ago, consultants and technology vendors warned that the systems banks had implemented to process trades cleanly and quickly would not bear up in the long term given the pace of growth in CDS volumes.
Nowadays, CDS trading is 88% automated, according to statistics from MarkIt. All the big credit derivative dealers and any counterparties executing more than four CDS trades a week are signed up to the Depository Trust & Clearing Corporation’s (DTCC) Deriv/Serv platform, a move that had until recently allowed the market to keep the unconfirmed trade problem at manageable levels. In addition, a host of technology companies are marketing solutions to address prompt and accurate trade confirmation. All this combined with the in-house systems banks built had been enough to keep backlogs in check.
Hardest part
"The summer spike revealed to people that their trade processes aren’t really fully automated or scaleable," says Henry Hunter, chief marketing officer at SwapsWire. "They’ve automated part of the process – the vast chunk of it – but a big part of the work was always around the mismatches, which are still resolved manually. If 85% of trades match first time, that piece is fully automated, but they are left with the hardest 15%."
Industry consultants estimate that at present between 10% and 20% of CDS trades remain unconfirmed because of mismatching. When trade volumes skyrocket, as they did in July, the operations staff dealing with these trades are swamped and trades stay unconfirmed longer. Banks can’t quickly double the number of people they have looking at mismatches unless they bring in temporary help, which is in limited supply.
Collectively, top-tier banks have spent tens of millions of dollars on technology to automate CDS trading and processing. However, these gateways, which link banks to Deriv/Serv, SwapsWire and T-Zero and the like, are unable to identify non-compliant events, such as duplicate transactions, lost trades, failed deliveries and out-of-sequence messages. This means mistakes are being downstreamed into banks’ other systems, such as risk management, profit and loss and payments, to be reconciled manually.
"Only now is it emerging how complex it is to automate credit default swap clearance," says Michael Paull, CEO of Hattrick, a UK software company specializing in trade processing.
Hattrick’s Cleargate solution might be able to solve most if not all of the CDS trading and processing problems. The Cleargate package works with banks’ existing gateways to catch errors before they go into the banks’ systems. It generates a log of incoming and outgoing messages from a bank’s gateway and then flags up non-compliant events to be resolved before trades are confirmed. It also features translation modules to permit a bank’s gateway to communicate accurately with outside systems.
Cleargate was scheduled to hit the market at the end of October. It will be available with a fully automated cash management and reconciliation function. However, given how much banks have spent already grappling with the confirmation backlog, they might resist further expenditure.