NY Fed Welcomes Industry Effort on OTC Derivatives Infrastructure

The Federal Reserve Bank of New York has praised the initiative of hedge fund industry groups and major market participants to further strengthen the operational infrastructure for OTC derivatives. In a letter to NY Fed President Timothy Geithner, the Managed Funds Association, ISDA and global financial institutions outlined concrete plans for building a stronger integrated operational infrastructure capable of supporting the rapidly growing OTC derivatives market. The industry’s goals are consistent with the objectives of the March 2008 Policy Statement of the President’s Working Group on Financial Market.

Although efforts by the Federal Reserve and other U.S. and European regulators over the past three years have led market participants to significantly improve many operational elements of the OTC derivatives infrastructure, financial market events have demonstrated that broader action is warranted to address additional market design elements. The New York Fed pledged to work with domestic and international regulators to monitor progress and encourage further effort to improve OTC derivatives operational infrastructure.

In the letter, the industry said that it wants to create global central counterparty processing and clearing in order to significantly reduce counterparty credit risk and outstanding net notional positions. Another goal is to achieve electronic processing of eligible trades to enhance T+0 confirmation issuance and execution. The group also aims to eliminate material confirmation backlogs.

For its part, the Fed, along with the SEC and CFTC, urge the industry to accelerate efforts to bring a credit default swap central counter party to market. U.S. regulators are jointly reviewing the risk management designs of existing proposals with the objective of granting regulatory approvals as soon as they are determined to meet risk management standards. The FED and SEC are hopeful that one or more central counter parties can begin operation in November or December 2008, enabling market participants to rapidly move trades onto it.

The Fed believes that a well-managed central counterparty for credit default swaps will reduce the systemic risk associated with counterparty credit exposures. In addition, it can help facilitate greater transparency of market prices and volumes and support an open trading environment that includes exchange-traded credit default swap contracts.

Regulators are also seeking to increase the information about credit default swaps that is available to the public. In that regard, the members of the President’s Working Group welcomed the decision of the Depository Trust & Clearing Corporation (DTCC) to publish aggregate market data from the central repository on credit derivatives maintained by the DTCC.
Starting November 4th and continuing weekly, the DTCC has begun to release a set of aggregate stock and weekly trade data, including the levels of both gross and net notional credit default swaps traded on the 1,000 largest credit default swaps reference entities. Regulators will continue to work with market participants and service providers to further expand the public release of market data.

Regulators continue to demand that market participants improve the back office processes that support OTC derivatives trading. The industry letter details how those efforts are expanding to encompass all major OTC derivatives asset classes and to improve collateral management practices in these markets. Key long-term objectives and milestones in the letter include increasing the portion of equity derivatives eligible for electronic matching from 40 per cent to 60 per cent and raising the matching target to 85 per cent for all counterparties. Another objective is to develop plans for central trade repositories for equity and interest rate derivatives.