By James Conmy

DTCC's Fixed Income Clearing Corporation (FICC) is developing a new capability to help prime and executing brokers reduce cost and risk by increasing automation in the clearance and settlement of the U.S. Treasury securities trades they oversee and/or execute for hedge funds.

The new capability, scheduled for rollout in the third quarter, will enable prime brokers to submit trades for "matching-only" or "matching and netting" by FICC's Government Securities Division (GSD), even when the prime brokers are acting simply as an agent for their hedge fund clients.

"This innovation will lower settlement costs while reducing counterparty and settlement risk because GSD will become the counterparty and guarantee settlement on a large number of trades that currently settle outside FICC on a bilateral basis," said Murray Pozmanter, DTCC managing director, Clearance and Settlement Group.

Problem: trade-for-trade costs
Hedge funds generally trade U.S. Treasury securities through multiple "executing brokers," and then count on their prime broker to oversee the clearance and settlement of the trades. But because prime brokers often function only as the agent for fixed income hedge fund trades, they typically don't transmit those trades to FICC for matching and netting since the prime brokers are not a legal party to the trade.

Instead, the transactions settle on a trade-for-trade basis on the Fedwire, which can be costly. In addition, because trades are not typically matched prior to settlement, any problems have to be dealt with at, or immediately after, settlement, creating settlement risk and potentially additional costs.

Solution: matching and netting
To deal with these issues, FICC is developing an enhancement to its Real-Time Trade Matching [RTTM] system that will enable prime brokers to submit their trades for matching and netting to GSD in much the same way that correspondent clearing firms submit their trades.

Using an assigned symbol to indicate a hedge fund client, prime brokers will have the flexibility to indicate how each client's buy/sell and repo transactions should be processed. For example, a prime broker may choose to set up a client's buy/sell trades to match and net, while its repo trades will be handled as match-only, and then settle trade-for-trade.

"Prime brokers will be able to submit their trades to GSD through our RTTM system, which will give them automated matching of trade details, and then, based on their own risk tolerance, they can choose to match-only or match and net by trade type," said Lisa Meiselman, DTCC director, Clearance and Settlement Group.

GSD will net the trades that are eligible for netting, which reduces risk and will have a big impact on costs and operations for the brokers. "A firm may go from managing hundreds of separate trades with credit risk on each one to the point where it can net those trades down to one position per security with FICC," said Meiselman. "For trades that are match-only, the benefit is reduced settlement risk."

Listening to customers
FICC launched a research initiative to understand and quantify hedge fund volume in U.S. Treasuries after a customer commented on how fast this business was growing. FICC met with several prime broker business units, which tend to have their own operations area within firms, and identified the need to provide a real-time matching and netting service for this book of business. FICC then formed an industry working group to explore specific proposals for solving the problems.

A key issue the working group tackled was varying interpretations of the FICC rules regarding matching. To clarify any confusion about prime brokers having to take financial responsibility with FICC for trades submitted for matching-only, FICC filed a rule interpretation with the Securities and Exchange Commission, which the commission approved effective immediately. The interpretation says that, under FICC rules, participants submitting trades for matching-only are not subject to settlement-related obligations with FICC and that FICC rules do not alter the relationship between a participant and its customers.

"This project is an example of how DTCC works with customers to bring new solutions to growth areas of their businesses," said Pozmanter. "We are leveraging existing technology to build a new capability that will reduce cost and risk for our prime and executing broker clients, which in turn strengthens their ability to compete in this booming hedge fund market segment." @

[For more information, contact Lisa Meiselman at 212.855.1207 or lmeiselman@dtcc.com.]