OTC Cash and Derivative

Markets in 2010

Frankfurt, 2 February 2010

OTC Derivatives Regulation
Marcus Schüler

2 February 2010
 Objectives of OTC derivatives regulation
ƒ Risk
– Reduce systemic
– Operational

ƒ Increase transparency
– To the public and to regulators
– On transactions and on positions

ƒ Secure market integrity

ƒ Improve market functioning

ƒ The ideal solution should

– Encompass also products that are not suitable for central clearing or electronic trading
– Use proven infrastructure to secure delivery in a timely and cost effective fashion
– Maximize interoperability, foster competition and avoid the creation of vertical silos
– Provide useful, high quality information in the right format, not
just more data

3
 What has been achieved so far?
ƒ Risk reduction
– Electronic trade confirmation
– Novation protocol
– Credit Event settlement
– Trade compression
– Launch of CCPs for CDS

ƒ Transparency
– Creation of Trade Repositories for CDS, Interest Rate and Equity derivatives

4
 Agenda for 2010 and beyond*
ƒ Reduction of systemic risk
– Central Clearing
ƒ Greater use of CCPs
ƒ Interoperability of CCPs
ƒ End user exemption
– Further improve the efficiency of collateral management and trade compression

ƒ Transparency
– Mandatory reporting of OTC derivatives transactions to Trade Repositories
– Public dissemination of price and volume information
ƒ Establish a TRACE-like trade reporting system (US)
ƒ Extension of MiFID to non-equity markets (Europe)

ƒ Market functioning
– Increased use of exchanges and electronic trading platforms for execution
– Attract new liquidity providers and reduce bid/offer spreads

*See New York Federal Reserve Bank Staff Report “Policy Perspectives on OTC Derivatives Market Infrastructure”, January 2010 for details

5
 OTC derivatives legislation – the current status
ƒ US Legislative proposals ƒ Asia
– US Administration OTC Derivatives Bill − Japanese FSA
– August 11, 2009 − Blue Print, December 2009
– Reed Bill
– Senate Banking Committee, September 22
– House Bill
– Passed December, 2009
– Senate Banking Committee
– Dodd Bill, November 10, 2009
– Senate Agricultural Committee
– Draft bill expected in February

ƒ Europe
– European Commission communication
on OTC derivatives
– October 20, 2009
– Discussion paper “Legislation on Market
Infrastructures”
– January 2010
6
 Relevant parties and their responsibilities
ƒ Alternative Swap Execution Facilities (ASEF) and regulated exchanges
– Execution of swap trades
– Timely dissemination of trade information (post-trade transparency)
– Emergency powers of regulators and position limits

ƒ Central Counterparty (CCP)

– Assume, consolidate and manage counterparty risk from bilateral trades
– Capture data and make it available to regulators and the public

ƒ Swaps Repository (SR)

– Capture details of all OTC derivative trades
– Might perform life cycle management
– Make transaction and position information available to regulators and the public

ƒ Major swap market participants

– Report customized trades to a SR or the Commission
– Store the complete audit trail and make it available to regulators
– Aggregate positions in security-based products across formats and asset classes

7
 Critical issues to be addressed
ƒ Clearing requirement
– Which OTC derivatives have to be centrally cleared? How to deal with moral
hazard issues?
– Proposed approaches
ƒ Standardized vs customized products
ƒ Regulators to decide on clearability
ƒ CCPs to apply to the Commission
ƒ In addition grant the Commission the right to declare products as clearable
ƒ Restrict dealer ownership of CCPs (Lynch amendment)

ƒ Trading requirement
– Which products have to be traded on regulated exchanges or ASEFs?
– Proposed approached
ƒ Standardised vs customised products
ƒ No requirement to trade electronically as long as the trade is reported
ƒ All cleared products need to be traded electronically
ƒ Voice brokerage permitted if trades are processed through ASEFs
ƒ Require electronic trading also for non-cleared products

8
OTC market practices

Swaps Repositories

Report
to
Negotiated
Telephone, OTC
IM, Voice Transaction
Broker, or
Other ECN
Electronic Trade
Majority of Processing
Means
trades Facility
submitted to

Electronically
Traded OTC Submit
Transaction to
Clearing Houses
ECN or ECM
or any other
Electronic
Execution or
Negotiation
Facility

9
 Legislative proposals

Submit Trade to Repository Swaps Repositories

Negotiated
OTC
Telephone, Transaction
Data

Report
IM, Voice
Broker, or Audit Trail

to
Other ECN
Fragmentation
Means
Regulator Problem
Public /
Market
Electronically Public Trade Participants /
Traded OTC Regulators
Reporting
Transaction
Clearing Houses
Public
Alternative
Swap
Execution Submit Trade to
Facility Clearing House
"ASEF"

10
Role of Trade Processing in
the OTC Derivative Markets
Jeff Gooch

2 February 2010
 Agenda

ƒ Current environment

ƒ About MarkitSERV

ƒ Future plans

12
 Current environment
ƒ Market faces unprecedented challenges from both regulators and participants

ƒ New derivative regulations being drafted in both Europe and the US

ƒ Industry commitments to clearing:

− Interbank and client clearing
− Multiple clearers

ƒ Volumes have generally held steady despite industry challenges

13
Current credit volumes

14
Rates volumes

15
Equity volumes

16
What is MarkitSERV

DTCC’s Deriv/SERV Post-Trade Markit’s Trade

Confirmation and Matching + Processing Services
Services

Integrated multi-asset class solution for OTC derivatives market

17
 Key facts
ƒ Go-live on 1st September

ƒ 50:50 owned by DTCC and Markit

ƒ Industry governed with seven customers on its board

ƒ A management committee that consists of 14 executives, whose combined operations,

technology, management and commercial experience averages 18 years

ƒ 300+ staff

ƒ Over 8 million confirmations per year

ƒ The largest OTC processing network that has over 80 banks connected, more than 50
interdealer brokers and over 1,600 buy-side firms

18
 Combined product set
Legacy Product MarkitSERV Product

Deriv/SERV Confirmation and Matching Service MarkitSERV DSMatch

Deriv/SERV MCA-Xpress MarkitSERV MCA-Xpress

Deriv/SERV Novation Consent MarkitSERV Credit Novation Consent

Markit Trade Manager MarkitSERV Trade Manager

Markit Wire MarkitSERV MarkitWire

Markit PBWire MarkitSERV PBWire

Markit PortRec MarkitSERV PortRec

Markit Tie-Outs MarkitSERV Tie-Outs

19
Proposed architecture – dealer to client flow

Voice IDB E-Trading

New Trades
Backloading
Life Cycle Event

Broker MarkitSERV Broker

Dealer A Dealer B

Prime Affirmation SP 1
Brokers Confirmation

Clearing Allocation SP 2 Buy-side

members Novation consent
Portal

TIW Gateway

Other service
CCP
providers
DTCC TIW

Portfolio Reconciliation

Portfolio Compression PR 1 PR 2 PR 3

PC 1 PC 2 PC 3
CLS

20
 Industry benefits
ƒ Increase industry efficiency and decrease operational risk by joining the two largest
derivatives confirmation platforms, spanning the entire post-trade life cycle

ƒ Connect multiple market participants, execution venues and clearing providers

through a single, secure gateway

ƒ Reduce/eliminate the dependencies on manual-based processes

ƒ Improve accuracy and security of OTC derivative transactions globally

ƒ Lead and assist the industry in meeting the challenging regulatory demands in a
very dynamic environment

21
 Implementation approach
ƒ Phased implementation with early deliverables (e.g. development of a cross-product
client portal)

ƒ Minimise impact on existing customers

ƒ Maximise attractiveness to new users to adopt electronic solutions by improving

functionality, reducing uncertainty and linking platforms together to increase industry take
up across asset classes

ƒ Support for different workflow and business models:

– Affirmation and matching models
– Prime brokerage relationships
– Links to clearing houses
– Outsourcing to fund administrators

22
 Implementation approach (continued)
ƒ Meet user requirements for processing in a holistic front to bank environment – from
block affirmations to settlement and portfolio maintenance

ƒ Develop key middleware to support full trade lifecycles

ƒ Support DTCC Trade Information Warehouse and any other repositories or clearers
selected by the industry

23
Delivery plan
Single Sign On LIVE

Integrated Portal - Rates TBD

Common
Integrated Portal - Credit TBD
Portal Integrated Portal - Equities Phased-in, Q3/4 2010+

Client Clearing LIVE

Data Migration April 2010

Rates Novation Consent solution March 2010

Interoperability April 2010

Allocations solution TBD

Front Office affirmation model LIVE Interbank

Clearing designation on T Developed

Credit Expansion to buy-side clearing Developed

Block/allocation and give-up TBD

Novation Consent solution Q2 2010

24
Delivery plan (continued)
Increased eligibility and take-up ongoing
Meet all mandates (options, swaps) and implement ongoing
industry-agreed corporate actions processing solution
Equities
Field Harmonisation, Convergence, Single Platform Phased-in, 2010+

Equity Trade Reporting Repository July 2010

Extend Physical Power and Gas Coverage to North America Q1 2010

Buy-side firms Q1 2010

Commodities Turn on 2 way link with MTM Q1 2010

Allocations Q1 2010

Emissions, Physical Coal, Return Swaps on Commodity Indices 2010

Tri-party reconciliation for TIW Q1 2010

Collateral /
Direct links to DS Match and MarkitWire Q1 2010
Portfolio Continued integration with Valuations Manager ongoing

Reconciliation

25
Common portal – web view

26
 Trade Manager
ƒ MarkitSERVTrade Manager (MTM) reduces operational risk and manual
intervention by allowing participants to manage their risk and various processes in a
timely manner electronically on one platform
– Automates Front to Back Processing, with real-time connectivity to MarkitWire and
DSMatch platforms, as well as web-based workflows for electronically-ineligible product
types

ƒ Proven cross-asset class solution

– MTM has a broad existing user client base, covering investment managers, hedge
funds, and fund administrators
– MTM encompasses all products – Credit, Equities, Rates, Commodities, FX and all
structured products

ƒ MTM’s flexibility allows participants to implement any or all of the components

available on the platform depending on their need and business model
ƒ Suite of management reports for aging, counterparty scorecards and internal
productivity
 PortRec
ƒ MarkitSERV PortRec helps buy-side firms and fund administrators identify and
address challenges associated with position and valuation differences within their
derivative portfolios

ƒ Automatic reconciliation & reconciliation review process

– Highly flexible rules engine for optimal reconciliation rates (target by counterparty,
product, date & value ranges)

ƒ Identification of critical economic breaks & online dispute resolution

– Drill down to underlying trade details & confirmation status to uncover the root cause of
discrepancies via MarkitSERVTrade Manager, DSMatch and MarkitWire confirmation
services

ƒ Side by side valuation comparisons

– Quickly locate significant valuation differences
– Incorporate independent mark via Markit Portfolio Valuation Service

ƒ Cross-asset management reporting

– Instant production of management reports
– Targeted dashboards for top issues, trends and aging
 Improving the customer experience
ƒ New combined customer service help lines:
– UK/Europe/Asia: + 44 (0)84 4994 7378
US and Canada: + 1 877 765 8737

– support@markitserv.com

ƒ Dedicated multiproduct account management teams (including Italian, German and

French speakers)

ƒ Steamlined signup and legal documentation process for buy-side customers

ƒ New integrated case management system

29
Central Clearing and
its Impact on the
Derivative Markets
Tom Price
2 February 2010
 Agenda
ƒ What is Central Clearing?
− Bilateral Clearing (legacy) vs. Central Clearing
− Structure and obligations of participants
− Hierarchy of loss protection in default of a clearing member

ƒ Scope of Central Clearing

− OTC Derivatives market overview
− Addressing systemic risk
− Systemic risk vs. liquidity (CDS single name example)

ƒ Prerequisites for centrally clearing CDS

ƒ Current state of the CDS clearing market

− Current state
− Obstacles to a robust central clearing market in CDS

ƒ Expected ultimate impact of CCPs in OTC Derivatives

31
What is Central Clearing? Bilateral Clearing (legacy)
vs. Central Clearing

ƒ New entrant in the market

ƒ Buyer for every seller

a and a seller for
32
every buyer
What is Central Clearing? Structure and obligations
of participants
Example: CCP Membership Criteria:
ƒ Minimum capitalization
ƒ Minimum net worth
ƒ Ratings criteria
ƒ Operational compliance
ƒ Legal compliance
ƒ Monitoring as ongoing entity
Obligations of various participants to ensure
stability for CCP Structure:

ƒ Central Clearing Party

– Contribution of First Loss Capital

ƒ Clearing member
– Contribution to guaranty/reserve fund
– Initial and variation margin
– Contingent claims

ƒ Non-clearing members
33 – Initial and variation margin
What is Central Clearing? Hierarchy of loss protection in default
of a clearing member

1. Initial margin of defaulting member

2. Defaulting member’s contribution to

guaranty/reserve fund

3. Central clearing house’s first loss capital

4. Guaranty/reserve fund

5. Central clearing house has ability to raise

additional funds from surviving participants

34 Source: Duffie, Li, Lubke

Scope: Size of the OTC Derivatives market

ƒ OTC derivatives have become

systemically important
ƒ Current focus is on expanding CDS clearing
Source: BIS

35
 Addressing systemic risk
ƒ Central Clearing

ƒ Trade repositories

ƒ Public transparency

ƒ Trading on electronic platforms or alternative swap execution facilities

ƒ Operational metrics

ƒ Trade compression

ƒ T+0 settlement

36
Scope: systemic risk vs. liquidity (CDS single name example)

Source: DTCC, Markit

ƒ There are over 3,000 single name reference entities in the CDS market
ƒ The majority of these are not expected to centrally clear
ƒ Top 1,000 reference entities above, represent over 95% of the Gross Notional
ƒ 80% of the Gross Notional is covered by the top 476 entities

37
 Pre-requisites for centrally clearing CDS
ƒ Increased standardisation
− CDS Big Bang
− Determination committees
− Full coupon and IMM dates
− Standard protection period
− Hardwiring auction
− ISDA CDS Standard Model
− Developed and supported in collaboration with Markit

ƒ Improved pricing accuracy

38
 Improved quality of clearing prices in CDS market
CDS pricing services historically suffered from some or all of these issues:

ƒ Submission window
– Quotes come in throughout the day. More often in morning.
– Books are closed at different times
ƒ Submission obligation
– There is no obligation to provide Quotes
– Quotes dry up during volatility (“Call desk”) or near holidays
ƒ Submission size
– Books of Record prices are not of a standard size
– The size of a Quote is often not stated
ƒ IDs
– Quotes do not have RED IDs. Educated guessing on instrument priced
ƒ Quality incentives
– Insufficient incentives and therefore focus on pricing quality
ƒ Coverage
– Quotes often only address the 5 year point on curve.
Other points modeled
39
 Current state of the CDS clearing market
ƒ Large number of potential and active CCPs

ƒ Higher costs

ƒ Increased collateral/margin means less leverage

ƒ More reporting requirements

ƒ Buy-side on sidelines

ƒ $1 billion revenue in 2012 for OTC clearing in CCPs ($323 million in CDS) as
estimated by Morgan Stanley

ƒ Dealers have made commitments to regulators to centrally clear, increase

transparency and continue operational efficiency

40
 Obstacles to a robust Central Clearing market in CDS
ƒ Scope of products:
− No bespokes, SN sovereigns and CPP member entities

ƒ Multiple CCPs
− Cost: Less netting and higher transaction costs

ƒ Lack of cross asset margining within CCPs

ƒ Regional legal structures

− Laws are generally national rather than global [e.g. bankruptcy]

ƒ Interoperability of CCPs
− Standardisation risk and valuation metrics
− Accessibility of dealers to all CCPs

41
 Expected ultimate impact of CCPs in OTC Derivatives
ƒ Reduced systemic risk

ƒ Higher standardisation of OTC product

ƒ Improved pricing accuracy

ƒ Increased scope coverage of cleared instruments

ƒ Changed liquidity profile of market (cleared vs. non-cleared)

ƒ Greater transparency through more reporting requirements

ƒ One dominant CCP per asset class per region

ƒ Increased margin/lower leverage

ƒ Buy-side and sell-side involvement

ƒ Greater regulatory involvement

42
 Clearing The Way For
Electronic Loan Processing
Joe Widner

2 February 2010
 Current state of the loan market
ƒ Globally the largest inefficient financial market

ƒ Key areas of concern

– Faxes as primary communication method
– Secondary settlement times range from weeks to months
– Independent processes for loan transfer and cash settlement
– Decentralised data coupled with privacy requirements
– Operational costs and errors

ƒ The loan asset class will see limited growth or advancement past historical
levels without changing the environment

44
 Critical requirements
ƒ Basic building blocks are necessary to lay foundation for change
– Counterparty identification
– Loan identification
– Standardised communication protocols
– Availability and access to agency data
– Common and published practises (e.g. Know-Your-Customer process)

ƒ With these the next layer of efficiency can be built

– Reconciliation
– Trade settlement workflow
– Cash settlement integration (DVP)

45
 Markit’s objective and ability
ƒ Markit is uniquely position to provide the platform and leadership required to
execute changes for the loan industry

ƒ Leverage parallel experience in derivatives markets

ƒ Unique relationship with both the buy-side and sell-side

ƒ Approaching 400 loan specific associates worldwide (25% of Markit)

ƒ Leading global provider of loan products and services

– Valuations (Loan Pricing)
– Portfolio management (Wall Street Office - WSO)
– Loan reference data and distribution (WSOData)
– Operations outsourcing (WSOWeb)
– Trade Processing (ClearPar)

ƒ Loan Board created in 2009 consisting of 10 global sell-side banks, 3 global

buy-side firms, DTCC and Markit

46
 Accomplished to-date
ƒ Acquisition of Wall Street Office (WSO) in 2008
– 8mm faxes processed centrally
– 5004 facilities available for electronic STP processing
– 3mm faxes eliminated

ƒ Acquisition of ClearPar in 2009

– 100,000+ trades processed per year
– New European enhancements and online agent signing
– New distressed enhancements to manage inventory and PSA integration

ƒ New loan offerings

– Over 20,000 Markit Entity Identifiers (MEIs) issued
– Major agent/broker banks setup on Market Document Exchange for KYC
– Launching of new cash loan indices

47
Required components

Future: DVP STP Settlement Repos

Advanced: Trade Collateral Agent Validation STP Processing

Basic integration: KYC Automation Trade Matching Reconciliation

Electronic
Centralized Data: Counterparty Data Loan Data
Messaging

Foundation: Entity Identifiers Loan Identifiers FpML

Launched in final or interim state In design / development

Launched in interim state Under consideration

48
 Appendix

49
Focus transitions from returns to risk
For most of 2009, secondary loan prices have been posting a strong recovery. However,
memories and perhaps wounds from the financial crisis are still fresh. Before the crisis, loans
were considered to be a relatively stable asset class with low price volatility. This perception
began to change in July 2007, the start of the crisis. With the fall of Lehman Brothers in
September 2008, volatility
skyrocketed. The credit crisis has
led investors to re-examine the
way they think about investing in
the loans asset class, namely a
shift in focus from returns to risk.
Because the credit crisis
threatened the health of the
overall financial system, this new
focus on risk goes beyond just
investment risk but includes
systemic and operational risks as
well.

50
Initiatives in progress

51
Integration efforts to decrease settlement times

LEGAL & PROCESS REFORM

Trades Trade Allocations CA KYC Inventory Funding DVP

Submitted Matched Checks Check Memo

Trade Check / Consent & Check Settlement

P Capture Enrich Minimums Status Instructions
L API Data
A
T
WSO WSO WSO WSO MDE Agents WSO MDE
F
Data Data DTCC Data
O
R Check
M Affiliations / Send Wiring
Holdings Packet Details

MEIs MDE Agent DTCC

DTCC

52
 Question & Answer session

53
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