Confirmation of a typical CDS contract
A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association.
The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection extends is defined by the contract effective date and scheduled termination date.
The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations (for example necessary if the original reference obligation was a loan that is repaid before the expiry of the contract), and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent.
It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.
CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer.
Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not.
The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured).
This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco's restructuring in 2000 led to the credit event's removal from North American high yield trades.
Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency before becoming due.
The legs of CDS confirmations
- Source: Convenience store Markit Magazine, Spring, 2010
Since 1973, the Financial Accounting Standards Board (FASB) has established standards of financial accounting and reporting. The FASB refers to these standards as essential for the efficient functioning of the economy.
On September 15 2006, the FASB issued FAS 157 statement, which provides enhanced guidance for using fair value to measure assets and liabilities. This standard, which became effective in November 2007, forces institutions to ensure that their valuation models consider what a third party would be willing to value the asset for, hence its “fair value”.
While the standard provided transparency and greater standardisation on values, some firms argued this came at the detriment of their bottom line.
The use of valuation vendors has increased significantly over the past five years. This results from shareholders and investors demanding an independent verification of portfolio or fund value, and regulators and auditors demanding additional transparency.
Fund administrators, consultants and auditors increasingly rely on vendors such as Markit to calculate the value of transactions for net asset value, collateral, performance and risk management purposes.
Confirmations and reconciliations:
The International Swaps and Derivatives Association (ISDA) represents the privately negotiated derivatives industry and has initiated many efforts to identify and reduce the sources of risk in the derivatives and risk management business.
Since 2008, the ISDA collateral committee has published guidelines and considerations to ensure common agreed standards allowing institutions to maintain the efficiency of, and to develop further, the portfolio reconciliation process.
Portfolio reconciliation was created for financial institutions to use a process that allows them to compare and agree the content of two counterparties’ over-the-counter (OTC) portfolios, in addition to ensuring valuations are aligned. Today, participants look to automate position reconciliation and valuation comparison to meet industry and the US Federal Reserve (Fed) requirements.
Most portfolio reconciliations take place through a vendor application or in-house solution. MarkitSERV PortRec today services more than 50 buy-side clients and five fund administrators.
In 2009, ISDA focused on publishing best practices for reconciliations and dispute resolution procedures for collateral management. They also continued to emphasise the need to reduce outstanding confirmations and increase electronic submission. The credit derivatives industry has continued to work to reduce outstanding confirmations, ensuring that all electronic confirmations are being confirmed within 30 days.
Likewise, the equity and interest rate derivatives industry has continued to tackle the requirement to confirm trades and reduce paper confirmations electronically.
On September 30 2009, ISDA published the ‘Collateral Dispute Resolution Procedure’ document. This was a proposal to provide an agreed standard industry approach for dealing with disputed OTC derivative collateral calls.
In January 2010, they published ‘Collateralised Portfolio Reconciliation Best Operational Practices’, which focuses on some core best practices including: understanding your counterparty processes and reconciliation frequency and technology.
The Fed also plays an active role in expecting financial institutions to uphold best practices in line with regulatory requirements. Since June 2009, the Fed’s focus has shifted to a number of initiatives including: improving market transparency, increasing the range of cleared products and market participants, and providing buy-side access to CDS clearing.
To increase market transparency credit (DTCC) trades should have been recorded within the central repository by July 17 2009, rates (TriOptima) universal trades by December 31 2009 and equity (Markit/DTCC) universal trades by July 31 2010.
Confirmations, reconciliations and valuations
With the industry pushing to ensure confirmations, reconciliations and valuations are aligned, it is only natural that institutions started to tackle these processes as one seamless workflow rather than as individual silos − thus allowing for better lifecycle management and cost benefits, as well as more efficient operational processes. Institutions are now looking for a solution where they can confirm a trade electronically T+0 and ensure that this position is accounted for, reconciled and subsequently valued accurately. The industry is also looking to ensure that market participants have greater transparency and interoperability between these three services which will allow for better issue identification and dispute resolution.
CDS confirmation warehouse promotes transparency
- Source: CDS market is far less opaque than presumed Credit Risk Chronicles, December 28, 2009
Letter to the Financial Times posted by Stewart Macbeth, Managing Director and General Manager, Trade Information Warehouse, DTCC:
Sir, Your article on sovereign credit default swaps, “CDS market needs reform if more drama is to be avoided” (December 18) erred when it said “nobody really knows exactly how low volumes are (or not) since this is an over-the-counter market, conducted away from any exchange”.
In fact, The Depository Trust & Clearing Corporation (DTCC) has brought an unparalleled level of transparency to the OTC derivatives market through its trade repository, the Trade Information Warehouse, which holds the underlying position data on virtually all credit default swap contracts traded globally. These data include figures on sovereign CDS contracts such as the Hellenic Republic that was referenced in your article.
Trades are currently fed into the Warehouse on a real-time basis by MarkitSERV, a joint servicing offering of DTCC and Markit Group Limited, which is used to confirm electronically more than 95 per cent of credit defaults traded globally, thus permitting the Warehouse to maintain real time position and turnover information for the entire market. Currently this information is published weekly on www.dtcc.com. In addition, Warehouse information is provided separately to regulators worldwide, including the Financial Services Authority, the European Central Bank and the Federal Reserve. Our goal is to release publicly even more data and initiate daily reporting in 2010.
The value of the Warehouse was highlighted, following the Lehman bankruptcy in 2008, when rumours of $400bn in CDS exposure amplified stress in the financial markets. From our unique vantage point we were able to disclose that the market's exposure to Lehman would be closer to $6bn on a net basis. Ultimately, the trades were closed out at $5.2bn. We regret that the FT did not contact us or refer to our data tables prior to publishing their story, since we could have provided data addressing questions about the level of trading activity in sovereign CDS. The CDS market is far less opaque than the FT presumes, because there is a global trade repository supporting this asset class. If CDS trades were moved on to exchanges or CCPs and they did not report their data to a trade repository, the transparency that exists today would be lost.
As policymakers on both sides of the Atlantic take steps to increase regulatory oversight of the over-the-counter derivatives market, we urge them to consider the proven value of a single, central trade repository for each asset class, where both cleared and uncleared trades across the globe are registered.
JP Morgan launches new OTC derivatives platform
- Source: JP Morgan reveals OTC derivatives platform Hedge Funds Review, April 1, 2010
JP Morgan has announced the launch of its centralised over-the-counter (OTC) derivatives platform, giving clients including hedge funds online access to a range of products across multiple asset classes.
The platform, known as DerivClear, has already attracted some hedge fund clients. It provides services including trade capture and lifecycle management, confirmation control, settlements and reporting.
A JP Morgan spokesperson said the platform would enable hedge funds to outsource the middle- and back-office functions for OTC derivative trades, although it would not give hedge funds the full end-to-end processing that the bank's hedge fund services division offers.
The platform will also enable hedge fund managers with Ucits-compliant funds to link into the fund accounting requirements needed for Ucits, according to the bank.
JP Morgan global fund services executive Susan Ebenston said: "With the OTC industry undergoing significant change, clients are required to review their infrastructure to address new connectivity, reporting and timing challenges. Clients need to reduce costs associated with OTC processing and require the scale and control of an industrialised infrastructure and support operation to manage their portfolios."