November 13, 2009

Vinod Jain, Headstrong
Vinod Jain, Headstrong
Equity swaps offers depth to the market, enabling institutional and retail players to get synthetic exposure to physical equities without owning them. Due to their customized nature, OTC equity derivatives products are more complex than credit default swaps and interest rates swaps. In response to the credit crisis, industry players came together to increase electronic confirmation across asset class and transparency in reporting by building a central repository of OTC trades. The major industry commitment for OTC equity derivatives are:

  • To achieve 80% of interdealer and 50% of dealer-to-client equity total return swap trades electronic confirmation by Dec. 31, 2009.
  • A centralized trade repository for OTC equity derivative by July 31, 2010.

With the Fed targets coming up for equity derivatives and focused on equity swaps, the industry is scrambling to streamline the current trade processing practices and reduce the cost of compliance, and in the process faces several industry, operations and technology challenges.

Industry Issues

Define the product -- One of the prerequisites to confirm a trade on the electronic confirmation platforms is to know the product category. The firm’s definition should match the definition used by the electronic platforms. Electronic platforms can accept equity swaps with underlying securities which are listed on the exchanges. Further, not all equity swaps' underlying securities are listed on the exchanges and thus they may not be eligible for electronic confirmation.

Single or Multiple Underlying -- It is critical to know whether the equity swap will have single or multiple underlying securities. This information determines whether the trade can be electronically confirmed because electronic confirmation platforms support trades only with single underlying. Trades with multiple underlying securities are manually confirmed and necessitate more time to identify the correct lifecycle event for processing.

Private MCA to ISDA MCA -- For manual confirmation firms have signed private master confirmation agreements (MCAs) for equity swaps. ISDA is aggressively rolling out more ISDA MCAs to facilitate electronic confirmation of trades. The conversion from private MCA to ISDA MCA is a lengthy process as the terms of the ISDA MCA will have to be agreed on by the counterparties. The details of the underlying security drive the ISDA MCA and private MCA documentation region.

Operational Issues

Managing the lifecycle -- Most of the equity swap systems struggle to identify and process the correct trade lifecycle event. The swap systems were built as part of ongoing development with patch-up work to meet the business requirements. Defining the lifecycle event for an equity swap would involve tracking the position of the underlying trade. Amendments, closing out the positions, booking the stock dividends for a swap, managing the work flow for each event, managing the collateral, resets and payments on resets impact the life cycle of the trade.

Prime-Brokered Trades -- The complexity of the swap increases if the trade is prime-brokered, more so when the prime broker and the dealer are different entities. Managing the collateral margin call process and trade allocation process consumes more resources. The work flow involved in electronically confirming a prime-brokered trade is different from regular flow. Using a multi-prime brokerage facility increases the effort of consolidating reporting, accounting and performance evaluation.

Resets and Corporate Action -- Similar to interest rate swaps, schedule and reset dates are difficult to track in a system as they are constantly changing on resets. A five-year swap paying monthly will involve more than 100 schedule records. Identifying a change in such a schedule is challenging as the changes could be due to regular trade amendment or any holiday date amendment in the system. Schedules generation requires key trade parameters and an accurate holiday calendar to be set up in the system.

Corporate action processing is fragmented and involves heavy manual processing. There are not many systems which can efficiently process a corporate action event for an equity swap trade. Most of the process is manual fix and involves multiple verification processes to correctly capture the corporate action event in the system. The challenge is how to reflect the impact of corporate actions in the swap trade.

Middle-Office and Back-Office Processing -- Middle-office and back-office processing complexity in OTC equity derivatives is further highlighted in the ISDA operations benchmarking survey for 2009. The confirmation process for equity showed the lowest degree of eligibility, at 40 percent with only 23 percent electronically confirmed. Sixty percent of the equity derivative trades are not eligible for electronic confirmation because of the customized nature of the trade or nonavailability of ISDA MCAs. Equity derivatives also showed the highest level of nostro breaks.