Mention of the latest developments in credit default swaps, whether on CDOs or ABS, usually calls to mind an ever-swelling notional market value and customized deal structures. But the call for a standardized trading framework has prompted several leading industry professionals to refine plans to create standardized frameworks for documenting and tracking credit default swaps trades to make sure they are in keeping with the spirit of their original contracts.
The Depository Trust & Clearing Corp. (DTCC), a leading clearing and settlement firm, says it is close to finalizing a central trade information warehouse on CDS, which would allow swap buyers and counterparties to access updated information on each contract. Expected to be global in its reach, the warehouse would provide confirmation on downstream CDS trades. It could also compute payments that are coming due and track funds as they are moved around.
Several firms, including Bear Stearns, Goldman Sachs and PIMCO are also hard at work refining their CDS tracking infrastructures.
That is good news for the ABS market and its mighty offshoot, CDOs, because the nature of the deals are determined by the contracts, said James Croke, a partner in Cadwalader, Wickersham & Taft's capital markets department. Potential problems creep in, however, when dealers improvise with forms that are not specifically designed to accommodate certain types of trades, or when dealers fall far behind on confirming subsequent trades.
In trades involving synthetic deals, there is usually a master agreement, supplemented by a trade confirmation and a schedule that can turn certain elements of the master agreement on or off, Croke said. The current backlog at many institutions is raising concerns among regulators, who see potential operational risk if subsequent trades are not recorded.
"Often times you'd just execute a certain schedule," he said. "Every time you do a trade there needs to be a confirmation, and it should be documented as promptly as possible."
The next test for many investors and dealers will be to create a standardized product and an infrastructure that can bring transparency to highly sophisticated and esoteric products, and for that to happen naturally, said James Keller, a managing director at PIMCO, at the recent Bond Market Association (BMA) annual meeting.
"The ABS marketplace is growing quickly," Keller said. "We are getting down to high credit-intensive products. Our concern is not to over manage that process."
About 70% to 80% of CDS trades are confirmed electronically, but even this system hits a few snags, especially when it comes to administering those original contracts over the lifetime of the deal, said Peter Axilrod, a managing director at the DTCC, during the BMA annual meeting. Under the prevailing bi-lateral system between a swap buyer and the provider, the two agree to such terms as payment dates. The problem is that electronic tracking also involves a certain amount of manual reconciliation. As such, said Axilrod, there is no guarantee that a swap buyer and the provider have similar operational models and can confidently work within the confines of their respective models.
"Operational models vary, and that is not really where you want to be, especially when the market volume keeps on expanding," Axilrod said. The CDS market has about 20 to 30 different products, and the growth of the market makes administrating them difficult, especially post-confirmation. That is why the clearing company is aiming to get away from bi-lateral procedures and move to a centralized process for contract administration, he said.
The DTCC is currently working with more than a dozen dealers and investment managers, to update their legacy books and identify and resolve any breaks in the system. The company is aiming to complete the first phase of the central trade information warehouse this fall, when it will basically maintain information on CDS contracts. After that, all new trades will be put into the central trade information warehouse and the warehouse data will be squared with the Central Payment Transfer Facility.
"We're moving forward, but there is just a ton of work to do," Axilrod said.
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