DTCC and the OTC Derivatives Industry Break New Ground in 'Credit-Event' Processing
When the second-largest commercial printer in the world, Quebecor World Inc., filed for bankruptcy protection in Canada and the United States in January, firms holding over-the-counter (OTC) credit derivative contracts that referenced Quebecor needed to adjust their positions. This triggered the industry’s first usage of functionality DTCC built for its Trade Information Warehouse to facilitate the automated processing of such trades when the market determines a “credit event,” such as a default or bankruptcy, has occurred.
The International Swaps and Derivatives Association (ISDA®) publishes cash settlement protocols that have greatly simplified credit-event processing for the industry, said Frank De Maria, DTCC Deriv/SERV, chief operating officer. “The Warehouse data and functionality provide an automated operational infrastructure to support these protocols,” he said. “And enabling holders to adhere transactions to the protocols in a centralized platform significantly streamlines the calculation of net payments.”
‘Easier and more straightforward’
The verdict on the inaugural deployment of the Warehouse’s credit-event capability? “I can’t believe how much easier and straightforward the entire default process has become,” said Peter Katsanos, vice president, head of operations, Mizuho Alternative Investments LLC. “It’s comforting to know that both counterparties to a transaction can agree in advance to the number of and amounts of all affected trades.”
This is good news for the global OTC derivatives operations community in today’s volatile market environment. “By processing the Quebecor credit event electronically, we are demonstrating how the Warehouse is helping industry players efficiently manage a wide range of complex, important and time-sensitive market situations,” said De Maria.
Ready for Real Time
DTCC added support for credit-event processing to the Warehouse in 2007, after extensive testing with market participants. While the pilot provided a good sense of how the Warehouse would perform if a credit event were triggered, it wasn’t until Quebecor that the functionality was employed in a “real-life” situation.
Bringing customers live on this new functionality involved close collaboration and communications between DTCC and key industry members. Deriv/SERV relationship managers actively reached out to customers to explain the process of adhering their credit default swap (CDS) transactions through the Warehouse, assist them in their efforts and explain the benefits of automated credit-event processing.
Participants that chose to have their Quebecor transactions processed by the Warehouse needed to meet certain prerequisites, including direct adherence to the ISDA Protocol for the event or a signed bilateral side letter with their counterparty dealers and an agreement from counterparties to participate in this process.
How it worked
The Quebecor credit-event processing took place from January 22, the date the market determined it was a credit event, through March 4, the final settlement date. More than 18 dealers and 40 buyside firms, representing approximately 90% of the eligible Warehouse contracts, participated in processing the event through the Warehouse.
After adhering to ISDA’s Quebecor Protocol or to counterparty-specific side letters, firms were able to use the Warehouse to centrally process applicable trades.
The Warehouse calculated payment obligations for applicable single-name credit default swaps (CDS) and CDS indices based on the recovery rate of 41.25 cents on the dollar that was agreed upon by dealers at an auction administered by Creditex and Markit. For holders of CDS index contracts, a new coupon for the remaining components of the index was calculated and transmitted. Warehouse records were also updated with the correct factors for future coupon processing. Payment obligations for counterparties utilizing the Warehouse’s central settlement services were included in the net payments that settled through CLS.
The Warehouse also prepared nightly reports summarizing participants’ cash flows, which they could access through the platform and their digital certificate. This helped give firms a greater sense of certainty about their gross and net positions against their counterparties throughout the time they were processing the event.
Learning from experience
With this first automated credit event now concluded, DTCC is focused on expanding the functionality in preparation for future events.
“While Warehouse processing of the Quebecor credit event involved a relatively small group of market participants, it provided a good case study on the value in centralizing and automating the processing of these events,” said De Maria. “It also allowed us to assess what else we can do to bring greater efficiency and security to the process. We have several significant enhancements to the credit event process that have been approved by the Credit Event Working Group and the DTCC Operational Management Group, and work is underway to bring them into production over the coming months.”
Priorities for Deriv/SERV include increasing the number of participants that adhere their transactions through the Warehouse, automating the selection of covered transactions, expanding the number of customers settling payment obligations in this centralized platform and extending product support to include other credit derivative instruments such as index tranches. @