Regulators’ crackdown creates business opportunity
Natasha de Terán
Financial News, 22 Jan 2007
CDL technology will cut out external providers, opening doors for over-the-counter markets
When financial regulators realised what a mess banks’ credit derivatives operations were in, they created an almighty stink.
But their demands that support systems be cleaned up has paid off, with dramatic improvements in processing times and reductions in trade backlogs.
But one notable consequence of the regulators’ focus on operations has been the business opportunity it created. Systems, communications and software providers have not missed a trick.
Scores have offered over-the-counter services and scarcely a day goes by without a new entrant boasting of its market-leading capabilities, or an existing player expanding its remit deeper into the operationally testing waters of the OTC markets.
Faced with tough regulatory demands, banks and their clients have been willing to pay for these services; the proliferation of providers and the expansive agendas of the longer standing players has been testament to this.
But mumblings of discontent can be heard. This is because the largest users of OTC products have become concerned about how, in the rush to automate, they have become highly dependent on external providers.
Their concerns have been particularly acute in the credit derivative markets, where the US Depository Trust & Clearing Corporation’s Deriv/SERV platform has emerged as a monopoly provider for post-trade services.
The 14 banks that were taken to task about their operations by the US Federal Reserve in 2005 were responsible for this. In a letter to the Fed, they promised to clean up their operations and simultaneously committed to using the Deriv/SERV platform to do so.
Regulators have since expanded their operational scrutiny outside the credit markets. The DTCC has added equity and interest rate derivative products to its post-trade armoury, moved into affirmations, and shifted sideways into OTC trade warehousing.
It spotted a huge opportunity in servicing the £360 trillion (€536 trillion) OTC markets and sought to exploit it.
Perhaps aware of how listed derivatives businesses realised too late they had been handing blank cheques to exchanges, OTC operators have been keen to impose order on this land-grab.
Their efforts depend on a new web-based technology – Web Services Choreography Description Language. This is a technical standard from the World Wide Web Consortium, which is believed to be the emerging standard for representing web services’ interaction.
CDL is relevant for the OTC markets because it enables participants to develop a standard way of describing the economics of OTC products and the processes involved in trading them. In other words, industry IT specialists will be able design CDL-based templates or blueprints for every stage of an OTC trade, irrespective of the product type.
When these are approved by the industry, they will be established as standards and published on an open-source basis. Each player will be able to download, upload and use them to automate their processes.
They will no longer need to rely on external service providers that have proprietary methods of codifying and messaging and will be able to cut them out if they choose.
This is important because it will change the competitive landscape, keeping providers’ pricing in check and systems up to scratch. Second, it should make it easier for OTC users to automate new and emerging products.
Third – though perhaps more subjectively – descriptions will be formalised, containing correct specifications of business processes and product economics and improving on existing proprietary systems.
Karel Engelen, policy director of the International Swaps and Derivatives Association, said having a single industry standard to describe a trade confirmation would make communication between service providers easier as well as between firms.
Though rarefied, the industry’s plans for CDL are well under way. The association recently published recommendations, which include CDL-based language that allow for peer-to-peer communication between asset managers and custodians.
JP Morgan, one of the largest OTC participants, is understood to have been a pioneer behind the development of CDL for OTC trading. The US bank has developed further CDL descriptions, which are being reviewed by peers and are expected to be adopted as Isda standards.
Full descriptions will eventually be available as will the means for firms to conduct their OTC business electronically.
Those with large OTC businesses will be able to manage these uploads and integrations themselves and small players will be catered for.
Stephen Ross-Talbot, former co-chairman of the W3C choreography working group and instrumental in delivering the WS-CDL standard, has joined forces with Michael Paull, formerly of UBS, Bank of America and Citibank, and Alex Wilkinson, former Dresdner Kleinwort Wasserstein futures head.
They formed Hattrick Software and have developed ClearGate out-of-the box software that will function as a CDL messaging gateway between firms and their trading partners.
The full roll-out of CDL technology is some time off but, if it is half as good as it is cracked up to be, it should be a exciting development. The financial implications are enormous – and not just for the providers whose dominance it could threaten.
The latest Isda benchmarking survey estimated that 21% of credit derivatives need to be rebooked, and the Derivatives Consulting Group estimates the average error on a credit derivatives trade costs $35 to remedy if it is fixed on the date of trade.
If the error lasts three months, it can cost $800 to fix. Error rates in equity derivatives are the same and the costs similar. If CDL can automate trades, ensuring affirmations and confirmations are matched on a low or no-cost basis on day one, the savings could be immense.
