2009-07 Derivatives Compass - Are You On Course - JPM

WORLDWIDE SECURITIES SERVICES
Derivatives Compass
JULY 2009
Are You On Course?
The market events of last year have thrust the previously
TABLE OF CONTENTS
little-known world of over-the-counter (OTC) derivatives Summary & Executive Considerations ... 2
processing into the spotlight. For several years, the industry
No Buy-Side Immunity ........................... 2
has been working to streamline and automate processing,
How Does This Affect Me? ...................... 2
and to increase the use of industry utilities. The recent focus 1. Central Settlement ....................................3
on systemic risk by governments and regulators has included 2. Confirmation Platform Consolidation..... 4
a reappraisal of how the OTC derivatives market operates, 3. Central Counterparty Clearing ................ 4
and will result in increased requirements for operational 4. 'Hardwiring' and CDS Standardisation ....5
change in an aggressive timescale. The Outsourcing Solution....................... 5
Conclusion..............................................6
2009 may prove to be a watershed year for the OTC
References & Notes ..................................... 6
derivatives industry, as the pace and extent of change in
post-trade processing are greater than ever before. Few
ABOUT THE AUTHOR
functions are excluded from its scope, and all of the key
Rob Wood is the EMEA product head for
asset-classes are under scrutiny. J.P.Morgan’s Global Derivatives Services
(GDS) group. Rob has 20 years of experience
This paper highlights the likely impact of four areas of OTC
in the financial services industry, 15 of which
derivatives industry change on asset managers and investors, have been working with OTC derivatives.
and provides checklists of key questions for operations
managers to assess the readiness of their own operations or
those of their suppliers.
J.P. Morgan Global Derivatives Services (GDS)
provides comprehensive OTC derivatives
processing services across all major asset classes.
More information on GDS is available at
jpmorgan.com/visit/gds.
©2009 JPMorgan Chase & Co. All Rights Reserved. JPMorgan Chase Bank, N.A. 1
Issued and approved for distribution in the United Kingdom and the European Economic Area by J.P. Morgan Europe Limited. In the United Kingdom,
JPMorgan Chase Bank, N.A., London branch and J.P. Morgan Europe Limited are authorised and regulated by the Financial Services Authority.
DERIVATIVES COMPASS — ARE YOU ON COURSE?
EXHIBIT 1: 2 JUNE 2009 ‘FED LETTER’ BUY-SIDE COMMITMENTS
Summary & Executive Includes ongoing commitments set out in the 31 October 2008 letter;
Considerations excludes collateral-related commitments
Month Commitments
The OTC derivatives industry is undergoing
an unprecedented set of changes, as June 2009 • 30 Jun 2009: Industry proposals published for buy-side access
participants seek to deliver on a committed to CDS Clearing (credit)
set of structural enhancements designed to
• Reporting of clients trading 20+ nonelectronic confirmation trades
reduce systematic risk to the financial
per month (rates)
system. The buy-side community is within
the scope of many of these changes, and August 2009 • 31 Aug 2009: 90% of settlements on DTCC-eligible trades to be
impact on operational processes could be centrally settled via TIW / CLS (credit)
significant. OTC operations managers need September 2009 • 30 Sep 2009: All eligible new trades & novations must be
to assess their readiness to respond to these confirmed on DTCC or other electronic platform (credit)
changes. For example:
• Strategic road map for cash flow reconciliations, netting
• The move from bilateral calculation and
and central settlement (rates)
instruction of credit derivative cash flows
to central settlement through the DTCC November 2009 • 30 Nov 2009: All eligible CDS backloaded onto DTCC TIW and 96%
and CLS Bank infrastructure of settlements on DTCC to be centrally settled via TIW / CLS (credit)
• The proposed integration of the industry’s December 2009 • 15 Dec 2009: Latest date for buy-side access
two primary OTC confirmation platforms to CDS Clearing (credit)

through the MarkitSERV strategic • 31 Dec 2009: 90% T+0 submissions, and 94% T+2 matching for
partnership electronically eligible transactions (credit)
• The roll-out of central counterparty ments and industry best practices are also
clearing to buy-side participants likely to become legislation in the months How Does This Affect Me?
• The ongoing program to standardise ahead, as governments globally seek to
Despite the recent market turmoil, many
credit derivative contracts mitigate the risks of another financial crisis.
asset managers and pension funds intend to
With so much complex change to execute, Critically, these changes are no longer just increase their use of OTC derivatives over
and the need to quickly respond to these the preserve of the major OTC dealers, and the next 12 months.4 This increase will stem
industry changes, firms are increasingly the buy-side community is now under the primarily from their rollout of incremental
considering the outsourcing option for their spotlight. Many of the commitments fund strategies incorporating OTC
OTC operations. incorporated into the most recent Industry derivatives, such as liability-driven
Letter to the Federal Reserve Bank of New investment utilising interest rate and
York (Fed Letter)3 from the Operations inflation swaps, and long/short using equity
No Buy-Side Immunity Management Group (OMG, see Exhibit 1) portfolio swaps.
The publication on 13 May 2009 of the US impact all market participants, including
However, any firms failing to engage in the
administration's proposals for OTC those buy-side firms that are not direct OMG
current program of change will attract close
regulatory change1 provided us with a participants. The cumulative Fed Letter
scrutiny from the regulators with 'naming
glimpse of what's in store. Transparency commitments add up to a material
and shaming' at best, and being 'struck off'
through centralised record keeping, program of change for the OTC derivatives
the list of clients with whom the leading
extension of central counterparty (CCP) industry. Regulators will be tracking
brokers are willing or able to trade OTC
clearing, broader authority for the progress across the program closely, and the
derivatives at worst. This will very quickly
regulators and investor protection through major dealers will be actively encouraging
thwart front-office plans at those firms to
tighter controls on OTC trading eligibility are their clients to comply.
extend the use of OTC derivatives in new and
all likely to feature in the months ahead.
With so much change underway, OTC evolving fund strategies. The net result could
Many of these themes were also echoed in
derivatives operations managers at asset be one set of buy-side firms that have access
the European Commission’s 3 July
management firms are realising that they to OTC derivatives strategies and another set
Communication on ‘Ensuring efficient, safe
can no longer watch and wait. Any that do not. At a time of broader commercial
and sound derivatives markets’2, which
perceived lack of progress by the buy-side challenges for the asset management
outlined a set of focus areas for public
firms is likely to attract the attention industry, it would be unwise to be on the
consultation, including contract
of the regulators. wrong side of that particular divide.
standardisation and central data
repositories. Today’s regulatory commit-
Let's consider four specific areas of CHECKLIST — CENTRAL SETTLEMENT

industry change, what they mean for the
Topic Checklist
buy-side and what preparations firms
should be making. APPLICABILITY • Are you trading or planning to trade credit derivatives?
• Has your broker dealer or DTCC contacted you to enquire about

1. Central Settlement your central settlement plans?
The on-boarding of buy-side firms to
‘NO MATCH, DON’T PAY’ • What are your confirmation matching statistics?
central settlement of credit derivatives via
Are your trades confirmed by T+2?
DTCC's Trade Information Warehouse (TIW)
• Can you identify and quickly investigate unmatched trades
and CLS Bank (CLS)5 is proving more
due for imminent settlement?
challenging than the dealers and regulators
had originally hoped. The target date of 31 SETTLEMENT ROUTING • Have you defined the business logic for
May 2009 for OMG buy-side firms to go live central settlement eligibility?
onto central settlement has come and gone
• Have you backloaded all your eligible CDS trades
with only partial take-up. In-scope firms
into the DTCC’s Trade Information Warehouse?
have expressed various concerns, including
• Can you automatically withhold settlement instructions
dependencies on confirmation matching
timeliness, novation consent upgrades and for central settlement-eligible cash flows?
custodian readiness, as well as limitations on POSITION AND CASH FLOW • Are you reconciling your CDS positions and cash flows
access to CLS settlement members. These RECONCILIATION to the DTCC TIW?
dependencies were less relevant to the
• How quickly can you investigate and resolve pre-settlement breaks?
onboarding of the major dealers in
Does this change at peak quarterly settlement dates?
2007 and 2008, resulting in a simpler
rollout to this initial group. ACCESS TO CLS • Is your custodian ready to support central settlement
and have they arranged access to CLS?
With central settlement now live for the
inter-dealer market, the focus has shifted to • Have your custody agreements been updated and signed?
the buy-side. The October 2008 commitment IMPLEMENTATION PLAN • Have you booked a testing slot?
of 96% of settlements on DTCC-eligible
• What is your target go live date?
trades to be centrally settled by 30
November 2009 remains in place, and is • Have you notified DTCC of your plans?
being tracked. Furthermore an interim
checkpoint of 90% by 31 August 2009 has accordingly (the instruction will instead flow same-day confirmation, and a two day
been set by the industry. In practice, to meet from DTCC to the custodian via CLS Bank). confirmation window if central settlement of
this target, any firm with more than a fees is to occur three days after trade date.
The ‘No Match, Don’t Pay’ rule means that if
handful of credit default swap (CDS)
the position held in the TIW is not certain Even once a firm is ready to migrate,
positions will need to be live in 2009, posing
(that is, there are outstanding unconfirmed it remains dependent on third parties
a significant challenge for these firms, their
events), then the cash flow on that trade will such as custodians, fund administrators
dealers, custodians, administrators, and the
not be settled on the value date. Timely and CLS settlement members to go live.
DTCC itself.
trade matching prior to settlement is Only a handful of custodians met the
Implementation can represent a significant therefore a prerequisite for successful 31 May milestone, leveraging their own
project, even for firms trading a low volume implementation of central settlement. With CLS settlement memberships to gain access
of credit derivatives. Moving from a bilateral the advent of standardised single name CDS to central settlement on behalf of their
settlement model where individual contracts, the window for confirmation clients. User testing with DTCC is a key
settlement instructions are sent to matching has narrowed in order to settle up- prerequisite and this requires careful
custodians, to a central settlement model front fees for a much broader set of trades. planning and coordination. Firms also need
where net settlements are determined by The lack of readiness of medium and large to complete the appropriate DTCC
the TIW and messaged to CLS for settlement asset managers on this point is significant. documentation in advance. Testing and
requires change in a number of areas. The Alpha Financial Markets Consulting subsequent implementation are constrained
OTC processing systems will need to Investment Operations Benchmarking study to specific calendar windows to avoid the
determine eligibility of cash flows for central 2008-2009 revealed that the average heightened settlement activity around the
settlement by reference to the cash flow confirmation time for single-name CDS quarterly rolls on 20th March, June,
type, currency and trade status in TIW, and amongst participant managers was nine September and December.
to withhold settlement instruction days, compared with an industry target of
2. Confirmation Platform utilities for interest rate derivatives are • Do you leverage an electronic platform
already on the agenda for 2010.
Consolidation to communicate fund allocations to
As these changes take shape, the buy-side your counterparties?
The historical development of electronic
workflow and confirmation utilities in the firms and their service providers may need
OTC derivatives market evolved on an asset to adapt their own OTC derivatives process 3. Central Counterparty
class-specific basis. As a result, SwapsWire flows to take advantage of the enhanced Clearing
(rebranded MarkitWire following its offering. Over time and depending on the If the longer-term ramifications of
acquisition by Markit in May 2008) became underlying asset class, the industry-standard MarkitSERV on the buy-side processing
the dominant electronic platform for interest interface into the combined MarkitSERV model are uncertain, those of CCP clearing
rate derivatives, and DTCC's Deriv/SERV platform may change. Ultimately, the dual are even more so. With multiple CCPs
trade matching platform became the interfaces to DTCC and MarkitWire are competing for business, differences of
industry standard for credit derivatives. For likely to be replaced by a single link. Trade opinion between regulators and the industry
equity derivatives, there was no standard allocation and novation processing will and even debate between sell-side and buy-
offering. This split has long been a source of become more streamlined and may side institutions on the way forward, it is
frustration for buy-side users seeking the require changes in front office processes likely to be some time before the CCP
efficiency of using a single platform across at asset managers. road map is clear.
asset classes and dealers. A longer-term opportunity lies in Despite the uncertainty, CCP is already a
Finally in 2009, with the advent of the Markit rationalising the interfaces between asset reality in the credit and interest rate
and DTCC strategic partnership announced in management firms and their third-party derivatives arena, and further commitments
2008, the vision of a common platform will service providers (e.g., fund accountants, have been made to the regulators. For
become a reality. Pending final regulatory administrators and outsourcing providers). nearly 10 years now, the LCH-Clearnet
approval, MarkitSERV will be formally Today these interfaces are largely bilateral SwapClear service has been clearing interest
launched at the end of July with the goal of links using a broad range of formats and rate swaps for the major dealers. LCH are
becoming the single, interoperable OTC delivery mechanisms — some straight- now working to extend the benefits of the
workflow utility for use across the industry. through processing (STP) and some manual. service to the buy side, and although not an
Interoperable, in this context, refers to the In future, the data held within MarkitSERV explicit commitment in the June Fed Letter,
ability to electronically match both sides of a could offer a potential single consolidated client access to a CCP for rates is a
trade on a consolidated platform, source of transaction events. Should regulatory priority for 2009.
irrespective of the specific utility to which MarkitSERV elect to offer this, service
For credit derivatives, a handful of dealers
each party submitted its trade. There is a providers would be able to build a single
went live in March 2009, clearing a subset of
great deal riding on its success: MarkitSERV standardised interface from the MarkitSERV
US index underlier credit default swaps
is already being put forward by the industry infrastructure, leveragable across multiple
(CDS) through ICE US Trust — by June over
as one solution to a number of its key clients, to capture confirmed OTC transaction
$1 trillion of notional had been processed.
processing challenges, such as single-step events at the allocated level. This would
Furthermore, the banks have committed to
novation (consent plus confirmation), reduce the need to build, test and maintain
European clearing by 31 July 2009.
automated allocation processing and client-specific interfaces, reducing cost and
interoperable electronic confirmation. effort for all parties. The industry has articulated to the
regulators a goal to achieve buy-side access
Over time, as the MarkitSERV platform
to CDS Clearing by 15 December 2009, but a
becomes a reality, existing buy-side users of Checklist – MarkitSERV number of legal and regulatory issues
platforms such as MarkitWire, Deriv/SERV,
• Which OTC asset classes do you confirm via remain open, such as the optimal approach
DTCC Novation Consent and other leading
electronic platforms today? to margin segregation and treatment of
workflow utilities will find their services
• Do you interface to DTCC Deriv/SERV and/or credit events. In general buy-side firms are
evolve, and the end state for OTC utilities
MarkitWire, or access their Web portals today? not expected to face the CCPs directly, but
and vendors is likely to look very different
gain access through either (a) a prime
from today's marketplace. Focus areas for • Are you planning to develop or extend your
brokerage model, where trades are ‘given-
2009 are likely to include the development OTC electronic confirmation interface(s)?
up’ to a single clearing member; or (b) an
of a common portal into the suite of • Where does the responsibility for novation executing broker model, where each broker
services, regulatory reporting for interest management sit in your organisation? submits both trade perspectives to the CCP.
rate derivatives and client access to central
• Does responsibility differ for consent and The standardised nature of credit derivatives
counterparty clearing across credit and
confirmation of novations? may prompt more brokers to offer their
interest rate derivatives. Novation process
clients the prime brokerage model for
reengineering and interoperability of the
these transactions than for interest
rate derivatives.
Derivative operations managers at buy-side One of the key aspects of the hardwiring process as appropriate. This analysis is
firms are beginning to ask what all of this is changes, the establishment of the ISDA relatively straightforward for single name
going to mean for their counterparty Credit Derivatives Determinations CDS, but for index CDS it requires up-to-date
exposure and OTC process flows. Until the Committees (DCs) requires firms to change information on the index constituents and
CCPs are established, the open issues the way in which they track and manage thus can be more time-consuming.
resolved, and the operating model locked- credit events (bankruptcies, filings for Given the pace of change in the CDS market
down, the full answers will not be available. bankruptcy protection, failure to meet so far in 2009, we can expect more
However, the changes required are likely to payment obligations, etc) which impact challenges ahead. Already market
be material — CCP eligibility will need to be their CDS portfolios. Historically, there has participants are being strongly encouraged
determined, trades will need to be novated been an element of subjectivity in to report all of their CDS trades into a
once accepted into a CCP and daily margin determining the triggering of a credit ‘Centralised Repository’ by the third quarter
will need to be posted. The industry utilities event on a relevant underlying entity. The of 2009 to increase the level of transparency
such as MarkitSERV may take care of some regional DCs will opine on potential credit to regulators. The first phase covers weekly
of the required logic to implement CCP, but and succession events and become the reporting by the dealer community, but buy-
the project overhead is still likely to be definitive source of resolutions on these side reporting and increased reporting
material for each participant firm. events, which are binding on all trades frequency may follow. Similar reporting for
incorporating the relevant hardwiring terms. the rates and equity asset classes will follow
Central Counterparty Clearing With the recent increase in volumes of as we move into 2010.
Look out for: corporate bankruptcies, the advent of these
changes has been very timely.
• Interim analysis on buy-side access to
In order to take advantage of the DCs, firms
The Outsourcing Solution
Credit CCP
may wish to implement procedures to track With so much complex change to execute,
• Industry proposals for margin segregation many derivatives operations managers and
the DC resolutions published on the ISDA
and contract portability executives are considering the outsourcing
website, analyse the extent of the impact of
• Announcements on implementation of specific events on their existing portfolios of solution, even those who for many years
European Credit CCP by the major dealers CDS trades and then trigger the credit event have preferred to keep processes in-house.
Based on a sample of buy-side firms recently
• LCH proposals to extend SwapClear to the
buy side in 2009
CHECKLIST — CREDIT DERIVATIVES STANDARDISATION
• Detailed scope for the 15 December 2009
milestone of buy-side CDS clearing Topic Checklist
• More information from your counterparties CDS STANDARDISATION • Are you trading credit derivatives?
• Can you differentiate between non-standard and standard CDS

4. 'Hardwiring' and CDS contracts (‘SNACs’ or ‘SECs’) in your systems and messaging
Standardisation to third parties?
Most OTC operations managers at ‘HARDWIRING’ • Have you adhered to the ISDA ‘Big Bang’ Protocol
buy-side firms will have already been effective April 2009?
through their assessment of whether to
• Do your incoming paper CDS confirmations reference the ISDA
adhere to the 2009 ISDA ‘Big Bang’
2009 Credit Derivatives supplement?
Protocol in order to ‘hardwire’6 auction
settlement terms into their CDS contracts • Do any of your CDS trades list restructuring as an
(over 2,000 market participants agreed to applicable trigger event?
adhere). Furthermore, the process may need • Have you adhered to the ISDA ‘Small Bang’ Protocol
to be repeated for the July 2009 ‘Small- on restructuring events effective July 2009?
Bang’ initiative to extend the auction
CREDIT & SUCCESSOR • Are you tracking information on credit and successor events as
mechanics to include restructuring events.
EVENT MANAGEMENT published by the ISDA Determinations Committees?
These changes and related initiatives to
standardise the CDS market have moved • Have you implemented the tools to identify the scope of your
from concept to implementation very trades impacted by a specific event?
quickly, making it difficult for firms trading
REGULATORY REPORTING • Have you traded any CDS that were not confirmed in DTCC?
CDS to plan and organise their OTC
derivatives investment efforts. • Are you working with your CDS counterparties to ‘backload’
additional deals into DTCC?
surveyed4, 64% believe that there will be References & Notes

more demand for OTC process outsourcing 1. Regulatory Reform of Over-the-Counter
as a result of the market turmoil and the (OTC) Derivatives, U.S. Department of the
likely enactment of regulatory change. Treasury, May 2009,
Commonly cited benefits of outsourcing http://www.ustreas.gov/press/
include access to scarce high-calibre staff, releases/tg129.htm
enhanced capabilities, product complexity
2. Communication COM(2009) 332 final;
and avoidance of high investment expen-
Ensuring efficient, safe and sound
diture on an in-house infrastructure. The
derivatives markets, European
ability to respond to industry changes on a
Commission, July 2009,
timely basis should now be added to that list.
http://ec.europa.eu/internal_market/fina
To date, valuation and collateral ncial-markets/derivatives/index_en.htm
management functions have more
3. Letter to the Federal Reserve Bank of
commonly been subject to outsourcing. In
New York, Operations Management
the future, the industry changes outlined
Group, June 2009,
above may result in outsourcing of
http://www.newyorkfed.org/newsevents
confirmation and settlement management to
/news/markets/2009/ma090602.html
providers who can build and maintain a
flexible infrastructure to support the 4. Derivatives Outsourcing Competitive
evolving industry landscape. Given the likely Landscape Investigation, Alpha Financial
continued evolution of the post-trade Markets Consulting, April 2009
processing space over the next few years, a 5. The DTCC’s Trade Information
strong partnership between client and Warehouse (TIW) contains an up-to-date
outsource provider will be critical to success. record of the majority of credit
derivative trades and enables reporting
and lifecycle management including cash
Conclusion flow calculation on those trades. DTCC
Looking ahead, the remainder of 2009 and
has built an interface to CLS Bank to
2010 will be dynamic and challenging for all
facilitate the settlement of those cash
involved in OTC derivatives operations.
flows calculated in TIW.
Whether addressing these challenges in-
house, or via an outsourcing solution, buy- 6. Hardwiring has the effect of
side OTC managers need to act now to incorporating auction mechanics and
ensure that their operation remains up-to- cash settlement terms into a CDS
date and compliant with industry best contract upfront, as opposed to relying
practice. Furthermore, we can expect the on agreement of terms only on the
landscape to continue to evolve — further occurrence of a credit event.
standardisation, more aggressive processing
targets and evolving industry utilities across
a broad set of OTC derivatives asset classes.
In the years to come we will look back at
2009 as the year in which the paradigm for
OTC post-trade processing changed
fundamentally. The changes have arrived,
and they’re not optional.
This document has been prepared for J.P. Morgan's clients for
informational purposes only and is subject to change. It is not
intended to provide, and should not be relied on for,
accounting, investment, tax or legal advice. J.P. Morgan
clients should consult their own accountants, lawyers or other
experts for specific advice.

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WORLDWIDE SECURITIES SERVICES

change in an aggressive timescale. The Outsourcing Solution....................... 5

EXHIBIT 1: 2 JUNE 2009 ‘FED LETTER’ BUY-SIDE COMMITMENTS

Considerations excludes collateral-related commitments

two primary OTC confirmation platforms to CDS Clearing (credit)

Let's consider four specific areas of CHECKLIST — CENTRAL SETTLEMENT

• Has your broker dealer or DTCC contacted you to enquire about

• Can you differentiate between non-standard and standard CDS

surveyed4, 64% believe that there will be References & Notes

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