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Clash looming over credit derivatives backlog - Financial Times

Clash looming over credit derivatives backlog - Financial Times - [Google News: Credit Risk]

Richard Beales writes on September 29, 2005 in the Financial Times that a clash is looming in the efforts by major investment and commercial banks to resolve the backlog of unconfirmed credit derivatives trades. The New York Federal Reserve Bank took an unusual step earlier this month and summoned 14 leading credit derivative dealers, together with international regulators, to a meeting at the Fed to discuss the credit derivative back-office problems. The investment banks are set to respond in a formal letter byt he end of the month that they will pledge to eliminate “virtually all” their backlogs by June and adopt market practices aimed at standardising and automating future trades.

The back-office settlement issue has become pressing in recent months following the rapid expansion of the market for credit derivatives products that allow investors to hedge their credit exposures. According to the International Swaps and Derivatives Association ("ISDA"), the total notional value outstanding of credit derivatives rose to $12,430bn in June, up 48 per cent from January 2005. However, many of these trades -- especially those that are "assigned" to a third party -- have not been confirmed because of the need to check the creditworthiness of the firm to which the trade is assigned and the resulting backlog in resolving assignment confirmations.

The ISDA proposals could set the stage for a clash between the banks and their most lucrative customers: hedge-funds who in many cases like to actively trade their credit exposures. In the "old" days of derivatives, it was not common for two parties to unwind their contractual obligation by assigning one part of it to a third party. Rather the customer typically returned to Bank A to "pair-off" the transaction, and suffered the consequences of whatever price Bank A was willing to agree to unwind the derivative. With the advent of hedge funds as large and lucrutive market participants, price transparency has become even more important and the hedge fund is likely to unwind its contractual obligation with Bank A by "assigning" the transaction to Bank B should it receive more favorable terms. The problem for Bank A, though, is that it entered into the transaction with the hedge fund based on that firm's financial position and ability to post collateral. Bank A has little knowledge of the credit worthiness of the third-party. In many cases, the third-party is another Qualified Institutional Buyer with whom Bank A probably has a Master ISDA Agreement in place with already. But what happens if there is no Master ISDA or Bank A's credit exposure to Bank B is above or near internally set limits? Should the hedge fund be allowed to assign its credit derivative to such a thrid-party customer without the consent to Bank A?

The Fed is expected to hold more meetings with the banks. However, while regulators are pressing banks to improve back-office processes, they have no direct sway over lightly regulated hedge funds, in spite of their increasingly critical role in the credit derivatives world. Regulators, meanwhile, remain concerned. “The big uncertainty is not getting the banks to play along but how to deal with the unregulated players,” said a senior regulator.

Although big credit derivatives banks have signed up to adopt the ISDA protocol by October 24, only a handful of hedge funds have done so. The Managed Funds Association, a hedge fund industry group, has called parts of the protocol unworkable. “As it stands, the protocol could kill the [assignment] market,” said a person close to the hedge fund community. Both sides in the debate are working to avert conflict. The MFA is expected to propose an alternative protocol soon, and the ISDA said the organisation was still “working to coalesce market practice”. But some in the hedge fund community say that investment banks are blaming them for the backlog problems, when the dealers themselves are sometimes slow to confirm trades and assignments.