Assessing the Interdependencies

In January 2010 the publication, Review of the Differentiated Nature and Scope of Financial Regulation released by Bank for International Settlements, recognized that inadequate management of risk specifically associated with credit transfer products, in some instances, contributed to the instability of confidence in the financial markets. The United States President's Working Group on the Financial Markets also identified that reform is needed in clearing and settlement processes. Other post-crisis reviews have focused on the need to promote automation, standardization and interoperability of infrastructure as well as better management of counterparty risk.

Given the complexity of OTC derivatives instruments, linking the contractual terms and conditions with business process and specific reference data definitions is a challenge for any organization. Ultimately, one should be aiming to automate as many processes as possible, including credit risk management, clearing, settlement and regulatory reporting.

Originally, credit default swaps (CDS) were designed to hedge cash positions held by a party with the equivalent derivatives, however, as time has passed credit transfer products have matured into tools for credit risk management in their own rights, with volumes traded outstripping the volume of the reference obligation, normally bonds, outstanding in the market.

Counterparty risk management has been the real hot potato for some time, but the global recession really pushed it to the forefront. Buyers of protection had not properly assessed whether sellers could meet their obligations, and the sellers had not adequately measured the potential losses. Merely identifying the buyer and seller of protection in a deal has been shown, in a number of cases, not to be sufficient. Guarantees may be in place, between protection buyers/sellers and other third parties, which results in the ownership of obligations or collateral posted being transferred to a third party at time of distress.

Attempting to understand one's exposure to a counterparty "in default" is rarely simple, as different factors come into play, such as the timing of the delivery of the notification of default. Given the complexity inherent in counterparty risk management, there has been the recognition that to fully understand the relationships and guarantees in place between business entities, these interdependencies need to be understood and effectively modelled.

In addition, the industry would benefit from a globally acceptable unique business entity identifier, as recognized when ISO Working Group 8 originally defined the draft International Business Entity Identifier (IBEI) standard. Since its publication in late 2005 and its rejection by the ISO community, the working group has changed its focus and is now developing the Issuer and Guarantor Identifier (IGI). Whether this or an alternative will be able to fulfil the needs of counterparty risk management, we will have to wait and see.

The consultation process on OTC derivatives products has also identified the need for greater standardization of products as well as reform to clearing and settlement processes. There has been an ongoing process of reducing the number of distinct contract variants. At the last count there were 22 styles of CDS products and further standardization of agreements is expected to continue, even without a nudge from legislation.

Meanwhile, regulators have also been examining reporting requirements. From a regulating reporting perspective, identifying the buyer/sellers of protection of a specified reference obligation is not necessarily providing the whole picture. Such reporting only offers a snapshot at deal initiation, the focus thereafter has been on monitoring the risk associated with reference obligation, and regulators have used CDS spreads to achieve this.

Nevertheless, the collapse of Lehman Brothers highlighted the need to take a closer look at counterparties involved in the deal throughout its lifecycle, rather than just the reference obligation itself. There is the need to understand any guarantees in place between parties, which may not be directly involved in the deal. When a party defaults, do their obligations transfer to a third party and does the ownership of collateral posted, transfer to a third party? The regulators must be provided with the capability to monitor the capital requirements of writers of credit transfer products and positions of market participants.

Still, credit should be given to the International Swaps and Derivatives Association, which has addressed the issues raised by the various investigations. In addition to defining the settlements auction supplements and the associated protocols, it has been responsible for instigating the creation of the FpML Reporting/Regulatory Reporting Working Group, tasked with extending the current version of the FpML standard to support the requirements for reporting OTC derivatives positions between market participants and the regulators.

From a reference data perspective, organizations need to examine a number of areas. Deficiencies in counterparty risk management, collateral management and settlement, has highlighted the need for every organization to audit its processes and data models to ensure they align with their active derivatives agreements. The efforts undertaken by the Isda/FpML Reporting/Regulatory Reporting Working Group will make this a great deal easier, and a new version of FpML that addresses the issues raised is planned for release shortly.

Martin Sexton is a consultant at London Market Systems. Email at msexton@londonmarketsystems.com.