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New Derivatives Regs Threaten Operational Labyrinth

Over-the-counter derivatives, once known for their obscurity, are center stage in the Securities and Exchange Commission's lawsuit against Goldman Sachs and President Obama's financial reforms. When values went south in 2007 and 2008, an inability to properly judge and react to the risks contributed to the bankruptcy of Lehman Brothers and the near-failure of AIG.

Operations executives heading to the Securities Industry and Financial Markets Association's 2010 conference in Palm Desert, Calif., this week agree regulation is imminent.

And that spells plenty of operational headaches. According to Jon Williams, managing director and head of U.S. markets for online marketplace operator TradeWeb, the most likely changes include mandates for more transparency on pricing of derivative contracts before trades are made, the creation of a central counterparty for clearing standard contracts and regulators' interest in monitoring trading activity through the data repositories.

The overarching goal, of course, is to monitor and reduce systemic risk to avoid the collapse of financial firms of such size that a domino effect could blow up economies around the world.

Yet operations specialists say they face plenty of risk in deciding how to prepare for the most likely outcome: a required central clearinghouse for many OTC contracts.

In the past, buy- and sell-side firms' middle and back offices have only dealt with exchange-traded instruments or transactions negotiated "bilaterally" by two parties, generally over the phone. The changes will affect how post-trade functions, such as reconciliation, collateral management, margin calls and valuations are handled.

The challenges for small- to mid-tier mutual fund managers and broker/dealers will be far more difficult than for large ones with deeper pockets-and add another level of brokerage services.

"Fund managers may decide to rely on brokers for clearing rather than face the expensive and time-consuming task of building connectivity to individual clearinghouses," said Jeff Gooch, chief executive of MarkitServ, a joint venture between Depository Trust & Clearing Corp. and Markit Group, a global financial data, valuations and trade processing firm.

Bottom line: for each product, fund managers will need to pick a clearing broker and decide which clearinghouse to use for their over-the-counter derivatives.

That's no easy task because they will have to interpret just which contracts out of $450 trillion worth of derivatives can be considered "standardized" over-the-counter contracts, Gooch said.

Morgan Stanley has estimated that up to 60% of OTC derivatives will move through a central clearinghouse over the next two years-leaving 40% remaining at the bilateral, paper-based level.

Last December, Intercontinental Exchange's ICE Trust and the Chicago Mercantile Exchange's CME Clearing beganofferinginstitutions access to clearing services for credit default swaps. Clearnet did so for interest-rate swaps. Nasdaq has also entered the fray offering a clearinghouse for interest rate swap futures contracts called International Derivatives Clearinghouse.

The clearinghouses offer proprietary interfaces to their processing systems, but data suppliers and market operators such as Bloomberg, Tradeweb and Markitprovide links as well. Bloomberg's VCON service allows buy-side firms to execute orders on the phone and affirm them electronically before sending them to multiple clearing firms and clearinghouses, said Bloomberg Director of Credit Trading George Harrington.

Markit's MarkitServ goes further than Bloomberg in permitting OTC derivative trades to be electronically confirmed with a legally binding agreement between counterparties for onward delivery either to a clearing B/D or clearinghouse. Among the other front-end functions are allocations and innovations.

TradeWeb claims it also provides a "complete electronic workflow" for institutional fund managers and allows fund managers to engage in price-discovery with multiple broker/dealers. In so doing, it offers a "competitive auction" of sorts, which Bloomberg does not, for credit-default swaps.

The decision on which provider to use when linking to a single or multiple clearinghouses is just the tip of the iceberg in the technology spend institutional investors must make.

The Great Reconciliation

Next up is how to reconcile their positions and records with their clearing broker and the clearinghouse. In short, this adds yet another player to the post-trade processing equation; a fund manager and B/D can't simply settle any differences between each other.

"In the world of bilateral clearing outside a centralized clearinghouse, the counterparties would match up their positions; then decide on the daily valuations of the OTC derivatives for efficient collateral management and margin calls," explained John Burchenal, director of market growth for Omgeo, which provides post-trade communication services. "But once the central clearinghouse is put in the middle, there needs to be further reconciliation of positions and margin requirements between the fund manager and the B/D, and the B/D and the clearinghouse, and vice-versa back down the food chain." Omgeo offers a reconciliation and collateral management platform for fund managers and broker/dealers.