While progress has been made in improving clearing and settlement in OTC derivatives markets "additional progress is clearly needed in some areas", says the Bank for International Settlements (BIS). In the report, ‘New Developments in clearing and settlement arrangements for OTC derivatives', BIS's Committee on payment and settlement systems (CPSS) outlined the progress made since 1998.
The total size of the OTC derivatives markets (measured by notional amounts outstanding) had increased by an annual average rate of 20% to the end of 2005. A period of very rapid growth from end 2005 to June 2006 pushed the total size of the market to almost $37trn (€27.2trn). Of this total, interest rate swaps and other interest rate contracts accounted for more than 70%.
The report cited four areas for attention: the reduction of confirmation backlogs, mitigation against contract replacement following closeout, post-trade services, and standards.
The issue of backlogs came to a head in September 2005 when regulators at the Federal Reserve Bank in New York called in representatives from 14 leading credit derivatives dealers to express their concerns about risks created by the backlogs of outstanding confirmations and what were considered at the time to be risk novation practices. Within a year, says the CPSS, the firms had reduced the total number of confirmations outstanding by 70%, mainly through the automation of trade confirmation. The firms have also worked with central securities depository, Depository Trust & Clearing Corporation to develop and implement a trade information warehouse (launched last November) that provides a trade database for credit derivatives and a central support infrastructure to facilitate automation and centralised processing of post-trade events over the life of a credit derivatives contract.
The report states: "There is evidence that some progress was also made in 2006 with respect to backlogs for most other types of OTC derivatives. Nonetheless, the same focus and energy that were brought to bear on credit derivatives confirmation backlogs need to be extended to other OTC derivative products, so that all OTC derivatives trades are accurately captured and confirmed promptly."
On the subject of closeout netting (used to mitigate counterparty credit risk), the report said market participants should identify steps to mitigate the potential market impact of replacing contracts following the closeout of one or more major participants.
The working group found that market participants should ensure that they have timely, accurate and comprehensive information on their counterparty credit exposures to major participants, so that they can make informed decisions at the time of any default. Undertaking regular portfolio reconciliation could best do this. Market participants should also more routinely identify trades that could be voluntarily terminated, to reduce the positions that would need to be replaced following a default.
As the overall OTC derivatives market infrastructure moves towards the centralised processing of trades and post-trade events, providers of post-trade services should allow more open access to their services and enable greater connectivity with other systems, says CPSS. Central banks and supervisors should also consider whether the existing standards for securities settlement systems, central counterparties and systemically important payments systems should also be applied to providers of clearing and settlement services for OTC derivatives that are not already subject to such standards.
The increasing use of OTC derivatives has been reflected in custodians' offerings. In January, Northern Trust launched a range of automated collateral management services to enable investors to manage OTC derivatives credit risk.
Stephen Andress, global head of derivatives operations at the custodian said: "We have seen a rise in the use of OTC derivatives among our client base and increasing interest from pension funds in particular in outsourcing their collateral management activities. This trend continues to gather momentum in Europe, and the US and Asia are set to follow."
The Northern Trust service includes independent OTC valuations, collateral management, collateral calls and responses to collateral demands, valuations and collateral activity reports for clients, trade reconciliations with counterparties, collateral safekeeping and clearing and also cash management through Northern Trust Global Investments.
The CPSS report acknowledges that the expanded use of collateral has significantly mitigated counterparty credit risks in the OTC derivatives market, saying: "The legal and operational risks associated with reliance on collateral have been reduced by changes in national legislation and enhancements to dealers' collateral management systems."
Revel Wood, product manager for derivatives processing at Northern Trust, said despite having an understanding of the benefit of specialist collateral management processes, investors did not want to commit resources and capital, thus driving the interest in outsourcing as an option.
The CPSS's report encourages the industry to make greater efforts to use automated systems to confirm trades for all eligible OTC derivative products. It also notes that the market infrastructure for the OTC derivatives markets will continue to evolve. "Through a trade information warehouse or otherwise, market participants may seek to achieve the operational benefits of CCP clearing while preserving decentralised counterparty credit risk management."