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Hedge Fund Industry Urges SEC and CFTC to Find a Market Solution to Uniform Description Standards for Financial Derivatives

By Jim Hamilton

Given the dynamic nature of derivatives markets, noted the Managed Funds Association, the ultimate manner in which uniform computer readable description standards are developed for financial derivatives should be left to the market. In a letter to the SEC and CFTC, the MFA said that the Commissions should act as facilitators in a principles-based and collaborative approach to develop the appropriate method to implement standards for computer readable descriptions in derivatives markets. The Commissions should engage market participants in an ongoing dialogue about how best to move the markets in the proper direction.

Dodd-Frank Section 719(b) requires the SEC and CFTC to conduct a joint study and file a report with Congress on the feasibility study of requiring standardized computer-readable algorithmic descriptions of derivatives products. The short comment period on the study ended on December 31, 2010. The notice for public comment, Release No. 34-63423, was published in the Federal Register on December 9, 2010, 75 FR 76706. In the notice, the Commissions posed a number of questions related to the study. Generally, the Commissions asked how firms calculate net exposures to complex derivatives and whether firms rely on a discrete set of computer-readable descriptions to define and describe derivative transactions and positions.

Generally, said the MFA, firms value and analyze derivatives by using internal valuation models and external market information. Algorithms and standardized computer readable descriptions play some limited role in this process. Standard contracts such as vanilla interest rate swaps can be easily valued using a relatively simple algorithmic model by referencing external inputs such as market interest rate curves.

In contrast, continued the MFA, market participants often use more sophisticated proprietary algorithmic valuation models to value complex derivatives that have multiple factors driving their value. In general, the more complex a derivative might be the more difficult it is to arrive at a market standard algorithmic valuation model that can be used by counterparties to reach a common valuation. Complex derivatives and customized derivatives do not currently lend themselves to the use of algorithms or standardized computer readable descriptions.

The industry has taken affirmative steps to move towards a higher degree of standardization, where appropriate, within individual derivatives markets to make trade execution, confirmation and processing more efficient. One tool that enables the improvement of market practices is the use of standardized computer readable descriptions. In certain markets, participants have collaborated to standardize the legal terms of widely-traded derivatives to the degree that, using standardized computer readable descriptions, such contracts are now able to be matched and confirmed on electronic platforms and reported to trade repositories. For example, DTCC?s Trade Information Warehouse is a fully operational trade repository for credit derivatives. The warehouse utilizes standardized computer readable descriptions of derivatives to manage life cycle events for a substantial portion of the OTC credit derivatives market.

However, the MFA cautioned that the successful use of standardized computer readable descriptions of derivatives in certain markets and for certain instruments should not lead the SEC and CFTC to conclude that mandating similar practices across all derivatives markets is advisable or even possible. The individual markets and products that do not utilize standardized computer readable descriptions of derivatives do not do so for a reason, explained the MFA.

Many instruments that have multiple factors determining their value are too complex or customized. They require manual confirmations and active management of life cycle events. Thus, even sophisticated users of derivatives do not operate exclusively through fully-automated, electronic systems.

For most OTC derivatives transactions that are executed bilaterally and not over an electronic execution platform, very little, if any, communication is done using standardized computer readable descriptions. Typically, for a bilateral OTC derivative transaction, traders exchange material terms by electronic message or over the telephone. There is no specific electronic format for such communications. The swap dealer will then produce a paper confirmation for execution and, prior to confirmation, the legal terms of the swap are discussed and negotiated.

After execution, the terms of the transaction are reported to a trade repository, if available.
Life cycle events for most bilaterally executed derivatives are also managed over electronic message or the telephone. Exposure and accompanying collateral requirements are determined on a counterparty-to-counterparty basis based upon a portfolio of derivatives transactions. Any discussion as to valuation or exposure discrepancies is generally conducted over the telephone or by electronic messaging. Computer readable descriptions of the transactions (or the valuations) generally are not used.

The MFA suggested that the Commissions, when studying the possible use of computer readable descriptions and algorithms in derivatives markets, do so with a view towards facilitating market evolution. The Commissions should not impose mandatory requirements to use such computer-based tools. MFA recommends that the Commissions study the feasibility of using standardized algorithms and methodology to identify and more efficiently resolve collateral or valuation disputes. Standardized computer readable descriptions and algorithms should be tools, but generally should not serve as the actual and only means of communication or confirmation to form a legally binding trade.

Full post as published by Jim Hamilton's World of Securities Regulation on January 06, 2011 (boomark / email).