Derivatives Systems Then and Now
By Eunice Bet-Mansour, Actualize Consulting
Originally published on TABB Forum
Seismic changes have occurred in the world of derivatives since 2008, and derivatives systems best practices and integration requirements today are markedly more complex, with dual workflows for cleared and non-cleared trades and industry demands for real-time data and risk management. Vendors in the space continue to play catch up.
Seismic changes have occurred in the world of derivatives since 2008, beginning with the industry’s post-crisis response and followed by passage of Dodd-Frank in 2010 and the subsequent passage of EMIR – changes in valuations (OIS, Clearing), in collateral and margining (Standard Credit Support Annex, Standard Initial Margin Model, clearinghouse Initial Margin and Variation Margin), in stay protocols (Resolution Stay), and in workflows. Throughout, vendors in the derivatives space have played – and continue to play – catch up with industry and regulatory developments. To date, many vendors’ solutions are still evolving. It is worthwhile to take a step back and highlight some of the seismic shifts in derivatives systems’ best practice and integration requirements that have occurred with the change in the regulatory landscape and industry responses to the 2008 crisis and ensuing regulation.
In the “old” pre-2008 days, user requirements from large-scale derivatives systems were “relatively simple.” The focus was on booking, models rendering accurate pricing with Libor-based risk-neutral valuation (much-analyzed and well-understood analytics) and end-of-day risk parameter/metrics such as VaR, robust market data feeds, straight-through processing (STP) for all pricing, risk management, documentation, accounting and post trade life-cycle events management.
In the “new” post-2008 days, derivatives systems best practices and integration requirements are markedly more complex, with dual workflows for cleared and non-cleared trades and industry demands for real-time data and real-time risk. New STP best practices requirements for derivatives vendors include connectivity to trade repositories such as MarkitSERV/DTCC for regulatory reporting requirements for both cleared and non-cleared trades. Clients are also requiring derivatives vendors to provide connectivity to trade middleware such as MarkitWire for STP of cleared trades. Swap dealers and major swap participants require connectivity to Swap Execution Facilities (SEFs). Since vendors have been slow in providing these connections from their applications, most major derivatives users have developed their own solutions to connect third-party vendor applications to the various middleware, trade repositories and SEFs.
On the pricing front, OIS risk-neutral pricing is now the norm for both cleared and non-cleared trades. While vendors were initially slow and incremental in providing OIS pricing solutions in their applications, at this juncture OIS is a key new functionality of most third-party derivatives applications. OIS pricing, however, is multi-dimensional and complex, with a multitude of curve construction methodologies, and not all derivatives systems provide a comprehensive array of these methodologies.
Derivatives valuations, P/L and risk analytics are now further layered by CVA, DVA and FVA risk adjustments. While CVA was adopted by some major broker-dealers prior to 2008, CVA and DVA emerged at the forefront of industry best-practice response to the 2008 crisis and are now a regulatory requirement under Basel III for non-cleared derivatives. Derivatives users’ in-house quantitative analysts are at the forefront of OIS, CVA, DVA and FVA vendor model validations, and if validations fail, risk management and valuation best practices require connectivity of the vendor booking system to in-house models.
For cleared trades, best practices for third-party derivatives systems is to have connectivity to exchanges for retrieving end-of-day prices as well as to clearinghouses via clearing brokers to address both margining and CCP compression/netting. While variation margin (VM) is well-defined, initial margin (IM) and price accrued interest (PAI) calculations are not. Derivatives vendors have lagged behind the industry in developing these margining requirements. Most major derivatives users, therefore, have developed their own IM/PAI/VM calculators outside of their third-party derivatives vendor systems in order to meet the tight regulatory compliance timelines. Given these applications are outside the vendor system, STP requirements during implementation necessitate new connectivity between users’ vendor applications and the users’ proprietary IM/VM/PAI calculators.
For non-centrally-cleared trades, phased regulatory implementation of VM and Standard Initial Margin Model (SIMM) requirements loom on the horizon for various financial counterparties from December 2015 through 2019. Once again, as derivatives users are developing their own applications to address the regulatory requirements, derivatives vendors will likely lag behind the industry in providing these margining solutions for their clients. Here, too, STP requirements will necessitate new connectivity between the vendor applications and users’ proprietary SIMM/VM calculators for uncleared trades.
An important industry trend in OTC derivatives since 2008 is increased emphasis on risk reduction via notional compression. Major broker-dealers undertook bilateral and multilateral compression periodically prior to 2008. Post-crisis, however, portfolio compression for non-cleared trades has become an industry-wide exercise undertaken in regular monthly cycles. On the one hand, for non-cleared derivatives, while Dodd-Frank mandates the undertaking of bilateral and multilateral compression when appropriate, this initiative has been given further industry impetus due to high Basel III capital requirements. On the other hand, for cleared derivatives, this initiative is being pursued by clearinghouses as a means of risk and line item reduction.
As such, a critical addition to post-trade STP lifecycle event management is trade compression/netting for both non-cleared and cleared trades. Non-cleared derivatives trades counterparties now participate in monthly multilateral portfolio compression cycles through third-party compression infrastructure such as TriReduce of TriOptima. After every compression cycle, it is critical for these users, therefore, to ensure that their in-house derivatives systems reflect accurate trades, positions and risk. Third-party vendors have been slow to introduce connectivity between their applications and compression infrastructure providers such as TriReduce. To date, most derivatives users have been terminating/replacing trades after compression cycles either manually or via proprietary automated in-house solutions so as to ensure the accuracy of their positions, risk and P/L.
Cleared trade netting/compression is still evolving. While some clearinghouses such as CME Group have implemented end-of-day netting for a subset of products such as vanilla fixed-float interest rate swaps and vanilla credit default swaps, other clearinghouses are just beginning to develop netting infrastructure. It is critical that line item trades of counterparties to clearinghouses match the trades that are actually held by clearinghouses as well as those reported to trade repositories. Given that each clearinghouse implements a product-specific proprietary netting algorithm, third-party derivatives vendors will also have to develop the identical netting algorithms for their applications. Vendors have not yet begun to develop these algorithms, and most cleared trade derivatives users are looking to develop proprietary in-house solutions.
We have highlighted herein some new best practice and integration requirements from derivative systems. Although it has been six years since the 2008 financial crisis, new derivatives industry best practices and/or regulatory requirements are still evolving and emerging in both cleared and non-cleared spaces. As seen herein, the onus on derivatives systems now is much weightier than in the pre-crisis days.