OTC Clearing

Analyzing Operational Readiness for Buy-Side Firms

September, 2011

TABLE OF CONTENTS

2 3 3 4 9 9 12 15 15 17 26 26 29 31 32 33 33 33

EXECUTIVE SUMMARY OTC REGULATIONS OVERVIEW OTC CLEARING CURRENT STATE OTC PROCESSING AN OVERVIEW BILATERAL OTC PROCESS CLEARED OTC PROCESS OPERATIONAL READINESS ANALYSIS FRAMEWORK SUMMARY FRAMEWORK DETAILS EVALUATING OTC PROCESSING SYSTEMS SYSTEM FEATURES INTEGRATION CHALLENGES CONCLUSION APPENDIX A CURRENT STATE OF OTC REGULATION BY COUNTRY APPENDIX B LIST OF CLEARING HOUSES (CCP) APPENDIX C LIST OF AFFIRMATION PLATFORMS (AF) APPENDIX D REFERENCE

COPYRIGHT
Copyright 2011, Eagle Investment Systems LLC. All Rights Reserved. Every effort has been made to ensure the accuracy of this document. Information in this document is subject to change without notice and does not represent a commitment on the part of Eagle Investment Systems. Eagle Investment Systems makes no warranties with respect to this document. This document is proprietary information of Eagle Investment Systems LLC. The recipient agrees not to distribute, modify, adapt, translate, or otherwise alter the document without the express written consent of Eagle Investment Systems LLC.

EXECUTIVE SUMMARY
The financial crisis of 2008 was in part due to the lack of transparency in the trading and processing of OTC derivatives. It highlighted the need for data standards and management of counterparty risk for OTC instruments. The global impact of this crisis required collective action by governments around the world and hence the issue was taken up by the G-20 leaders at the 2009 summit. The G-20 group has committed to work towards implementing regulations that address issues in this area by the end of 2012. At present the progress of implementing the regulations of OTC derivatives is in various stages in different countries. The US and the European Union currently are leading the pack and are on-track to meet the G-20 deadline. The key part of the regulations require swaps that are standardized to be traded through electronic platforms, cleared through clearing houses and reported timely to the trade repositories. There are many nuances to the proposed regulations. For example, certain swaps such as those used by corporations for hedging are exempt and OTC derivatives that are bilaterally traded will need higher capital requirements going forward. Currently, firms using OTC derivatives are not required to clear swaps through clearing houses until timeframes are finalized by regulators. However, proactive buy-side firms are closely following the regulations and are reviewing which cleared swaps will be supported by various clearing houses, in order to develop a roadmap and be ready by the time the implementation dates are finalized. This review includes details not just from a trading perspective but also from a processing perspective, i.e. the operational/systems controls necessary to effectively process these swaps. While regulators plan to reduce counterparty risk through the use of clearing, this should not result in additional operational risk for firms that process these instruments. Firms should first review the clearing swaps process with the goal to create an effective operations/systems implementation plan. A thorough analysis should be performed in key areas in the clearing process including connecting to trading and affirmation platforms, evaluating systems to perform daily margin/mark-to-market calculations and also to review the reconciliation process to reconcile positions/margins with clearing members. An added complexity involves the need to understand the various cleared swap products currently offered by the clearing houses and the details of how they are processed at each clearing house. This paper provides a framework which will help firms (within both middle and back-office) planning to process OTC cleared swaps to analyze their readiness. It does this by not only providing a set of high-level guidelines, but also by describing a series of detailed steps we believe are necessary for successful adoption. In addition the paper describes some of the challenges that need to be addressed while the regulations are being finalized and attempts to detail some idiosyncrasies of processing the currently supported instruments by some of the existing clearing houses. Last but not least, the paper provides some key system characteristics that firms need to look for when evaluating a system that supports processing of OTC clearing products.

OTC REGULATIONS
OVERVIEW
The G-20 communiqu of September 2009 requires all member countries to clear standardized OTC derivative contracts through Central Counterparties (CCP) by the end of 2012. The regulators from the US and the European Union are currently on track to meet this date. In the US the Dodd-Frank Act legislation was passed in July 2010 while the European Union has proposed a legislation that is expected to be passed by end of 2011. In the Asia Pac region, various countries are in different stages of the regulatory process. Here are some of the key points pertaining to OTC regulations from the legislation of the US Dodd-Frank Act: Commodity Futures Trading Commission (CFTC) will be responsible for finalizing proposals for swaps i.e. commodity, FX and interest rate derivatives Securities and Exchange Commission (SEC) will provide proposals for all security-based swaps, i.e. equity derivatives All standardized swaps need to be traded on exchanges or SEF (Swap Execution facilities) and cleared through CCPs. OTC derivative contracts should be reported to Trade Repositories (TR) Non-cleared OTC derivatives are subject to higher capital requirements. In Canada, decisions regarding use of local/global infrastructure for clearing and transaction reporting are expected to be taken up by end of 2011. In the European Union the proposals are part of European Market Infrastructure Regulation (Emir) and are similar to that of the US. However, the US is ahead in terms of finalizing some of the proposals. Here are some of the key developments from the Asia Pac region: Singapore SGX exchange is already clearing interest rate swaps Hong Kong Plans to start clearing OTC interest rate swaps in 2012 Japan Legislation is in place for clearing OTC derivatives in Japan South Korea Finalized plans for mandatory clearing of OTC derivatives India Finalized plans to have Clearing Corporation of India (CCI) to be the CCP and trade repository for OTC instruments. The progress on OTC regulations of all G-20 member countries is summarized in Appendix A. In its most recent report, the Financial Stability Board (FSB) has warned that countries are taking too long to implement the necessary rules2. Challenges aside, the global regulators are continuing to work closely to achieve harmonized and timely implementation of these regulations. In addition, the focus of these efforts is to prevent potential regulatory arbitrage opportunities that may only benefit institutions in certain member countries.

Improving over-the-counter derivatives markets: All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. Source - http:/ /www.pittsburghsummit.gov/mediacenter/129639.htm 2 Please see http:/ /www.financialstabilityboard.org/publications/r_110415b.pdf.
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OTC CLEARING CURRENT STATE

Even though the regulations are not completely finalized for OTC clearing, a number of firms are working together and have made progress towards offering cleared swap products. Much of the progress on this front has been driven mostly by sell-side firms and the firms responsible for connecting the various clearing stakeholders (Clearing counterparties (CCP), Derivatives clearing merchant (DCM), Dealers, etc.) such as MarkIt, Bloomberg, etc. In addition, a small number of large OTC buy-side clients such as PIMCO3 have successfully cleared swaps through existing clearing houses. From a product stand point, only two main OTC product categories are live using the existing clearing model: Interest Rate Swap (IRS) and Credit Derivatives (CD) products. Specific products under these categories include Fixed/Float IR Swap (under IRS category) and Credit Default Swap (CDS)/Credit Index (CDI) Swaps (under CD category). Key Stakeholders in OTC Clearing Process The following are key stakeholders in the OTC Clearing process: a. Central Counterparty (CCP) b. Affirmation Platform (AP) c. Trade Repository (TR) d. Derivatives Clearing merchant (DCM) e. Swap Execution Facility (SEF) a. Central Counter Party (CCP) In the clearing model, CCPs act as the counterparty for all cleared swap trades. All trades are negotiated privately between buyer and dealer and given to CCP for clearing. After this point there is no direct relationship between the two negotiating parties for further processing of the trade. Note: CCPs are also referred to as Clearing Houses or Derivatives Clearing Organizations (DCO).

See article on Bloomberg VCON at http:/ /www.securitiestechnologymonitor.com/news/bloomberg-vcon-interest-rateswaps-26272-1.html.

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The following table provides a summary of key CCPs in the OTC Clearing space:

Clearing House

Market

Details
CME is the leader in the futures and option market in the

Chicago 1 Mercantile Exchange (CME) US

US. CME has started offering products for both CD and IRS product categories. It started CDS clearing in December 2009 and IRS clearing in October 2010. This was formerly called ICE Trust, the US-based clearing house for credit default swaps. It was the first operational clearing house that started clearing of CDS in December 2009. It is also the worlds largest clearinghouse for credit default swaps. ICE Trust became ICE Clear Credit on July 16, 2011. With this transition, ICE Clear Credit is now a CFTC-regulated Derivatives Clearing Organization (DCO) and SEC-regulated Securities Clearing Agency (SCA) as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act. ICE Clear Europe is the London-based subsidiary of

ICE Clear Credit

US

ICE Clear Europe

Europe

Intercontinental Exchange (ICE) that offers CDS clearing in Europe. LCH.Clearnet is based in London and is the largest

LCH.Clearnet

Europe

clearinghouse in Europe. Through its SwapClear platform, LCH.Clearnet provides OTC clearing of Interest Rate Swaps. It started this service in March 2011. SGX, the Singapore exchange, launched clearing of

SGX

Asiapac

Singapore-dollar OTC Interest Rate Swaps in late 2010 through its clearinghouse AsiaClear. It is the first to offer OTC clearing products in the Asia-Pac region.

IDCG

US

The US-based IDCG launched its clearinghouse for OTC Interest Rate Swaps in December 2008.

b. Affirmation Platform (AP) An Affirmation platform in the OTC clearing model provides post-trade execution functionality such as trade matching, affirmation, confirmation and trade reconciliation functionality. In addition, these platforms provide functionality to send trades to other stakeholders such as DCMs and CCP and also to Trade Repositories as necessary. The following table provides details of some of the key affirmation platforms in operation today:

Affirmation Platform

Details This platform is the leader in the OTC area. Its affirmation platform allows buy-side clients to connect to almost all the current CCPs

MarkItSERV

and DCMs. They are working closely with other market participants to integrate potential SEFs/TRs and have a first mover advantage in this space. Owned by ICE Trust and provides clearing connectivity to the CME, ICE Trust, ICE Clear Europe CDS clearing houses for CDS products.

ICE Link

Bloomberg VCON

Owned by Bloomberg,the platform allows clients to clear both IRS and CDS products through multiple CCPs.

See Appendix C for a complete list of affirmation platforms.

c. Trade Repository (TR) A Trade Repository provides for centralized warehousing of various OTC transactions that is primarily intended for regulators to be used for monitoring and managing systemic risk. The following table provides a summary of key TRs in the OTC space:

Trade Repository

Product Category

Details TriOptima4 is a Stockholm company and is a subsidiary of inter-

TriOptima

Interest rate derivatives

dealer broker ICAP. It was the first interest rate swap repository awarded by ISDA in 2009. It started public reporting of interest rate swap data in March 2010. This new London-based entity is owned by DTCC and was awarded to be the interest rate swap repository by ISDA in May

DTCC Interest Rate Swap repository

Interest rate derivatives

2011. This is not operational yet. This being the second interest rate repository approved by ISDA, the future of TriOptima as a rates repository was not known at the time of writing this paper. The industry now has two approved rates repositories

DTCC Trade 3 Information Warehouse (TIW) Credit derivatives

TIW5 is ISDAs preferred repository for all credit derivative products. TIW is the markets first and only centralized global repository for trade reporting and post-trade processing of OTC credit derivatives contracts. In mid-June 2011, it was announced that EFETnet and DTCC Deriv/SERV LLC (DTCC) will be working closely with market participants in the commodities industry to establish a global Commodity derivatives Commodity Derivatives Trade Repository. The proposed new repository will be domiciled in Europe and will be jointly owned by DTCC and EFETnet. EFETnet B.V. is an independent company 100% owned by the European Federation of Energy Traders (EFET).

EFETnet and DTCC6 4 - Commodity Derivatives Repository

Please For more on TriOptima please see http:/ /www.trioptima.com. For more on TIW please see http:/ /www.dtcc.com/products/derivserv/suite/ps_index.php. 6 See press release - http:/ /www.businesswire.com/news/home/20110616006135/en/EFETnet-DTCC-Selected-IndustryDevelop-Commodity-Derivatives.
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d. Derivatives Clearing Merchant (DCM) CCPs have strict membership rules including set initial capital requirements to be part of a clearing house. As not all clients can be members of a CCP, DCMs act as a liaison between buyers and the CCP for all post-trade functions, including daily margin management. DCMs are also referred to as FCM (Futures Clearing Merchant). Most of the major swap dealers in the market today are clearing members of all major swap clearing houses mentioned above. e. Swap Execution Facility (SEF) Per regulations, all standardized swaps need to be traded electronically and SEFs provide the required platforms for buyers and dealers to trade the OTC cleared swaps electronically. At present there are no approved SEFs in the OTC space, however the regulators in the U.S. are reviewing various vendor proposals with the goal to finalize the standards and names of SEFs to be used in the OTC Clearing model.

OTC PROCESSING AN OVERVIEW

BILATERAL OTC PROCESS
Overview In the Bilateral OTC model the client and dealer interact with each other for all activities during the complete lifecycle of the OTC instrument. First, a summary of the process is described using an interaction diagram. The process flow of the OTC life-cycle is detailed next which is then followed up by the key challenges faced by participants in this model. Interaction Diagram

Dealer

Dealer

Dealer

Key Process Points

radeisnegotiatedprivatelybetweenDealerandtheClient. T lllife-cycleeventprocessingistheresponsibilityofthe A parties themselves. econciliationofTrade/Position/Cashisperformed R between parties at agreed upon frequency. ollateralismanagedthroughuseofmutuallyagreed C upon ISDA Credit Support Annex (CSA).

Investment Manager

Investment Manager

Investment Manager

Figure 1: Interaction among stakeholders in Bilateral OTC Model

Process Flow

Investment Manager

1. Negotiate and Execute trade

Dealer

2. Send Trade to Middle-office for processing

Match Utility Pricing Sources

3. Match Trade 4b. Capture Price

Middle Office/ Back Office

4a. Trade Capture, Position Management, Cash Processing, Pricing, reporting, Collateral Management, Reconciliation and accounting Management

5. Payments, Reconciliation, and other lifecycle events

Figure 2: Process flow details in the Bilateral OTC Model

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Description 1. Trade is executed after private negotiation between the client and the dealer and captured either in the Order Management System (OMS) or is input manually. 2. Trade is routed to middle office (MO) and back office (BO) for further processing. 3. Trade is then sent to matching utilities7 (if applicable), and matching status is recorded. 4. The following is performed by MO and BO teams: a. Calculation of position and cost b. Calculation of daily accruals and payments c. Send/receive payment instructions d. Reset of positions as applicable (e.g. for Total Return Swaps, CFDs) e. Perform other life-cycle events such as credit event processing for CD products f. Capture and validate prices from various price sources (MarkIt/Super Derivatives, etc.) g. Perform Market Value and Realized/Unrealized Gain/Loss calculations h. Provide necessary details to collateral system to calculate applicable collateral per agreed upon ISDAs credit support annex i. Perform NAV calculation and calculate ledger balances j. Deliver required activity reports, client reports and other regulatory reports to interested parties k. Reconcile trade/position/cash activity with counterparty and custodian (as appropriate) at agreed upon frequency with counterparty

OTC CDS and CDX trades in the US currently need to be sent for matching to DSMatch (a service offering of MarkItSERV)

utility. Also, matching utilities do not exist for some products that belong to equity/commodity product family.

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Challenges 1. The manual trade data capture in the bilateral OTC model can result in incorrect payment amounts that are usually caught late during payment reconciliation process. 2. The data discrepancies between trade ticket and the term sheet8 can also result in impact to daily numbers calculated by cash/accounting systems. 3. Additional work is created for operations personnel to correct data caused by not performing frequent trade/ position/cash reconciliations9. 4. The inability to have reports that allow clients to view daily trade activity, positions and counterparty exposure across all OTC products can affect other areas including counterparty risk management. 5. The use of different systems for processing OTC data across front, middle and back-offices can at times result in loss of data as the data moves from front to the back-office. This is mostly caused by the system or operational limitations that occur during processing of these OTC instruments. For example, a trade ticket for a bespoke OTC instrument may be represented accurately with twenty different data elements. However, the front office may have a system limitation causing it to allow entry of just ten elements necessary for its processing. The middle/ back office may need some or all of the remaining elements for proper processing. A number of above challenges stem from the fact that the details of these deals are known only to the two parties and a lack of standards for data structures for trades/payments messages. The derivatives industry group created Financial Product Markup language (FpML ) standards in 1999 and in 2001. ISDA got involved in promoting use of these standards. The increase in trade data discrepancies and also payment discrepancies due to increased volumes in the middle of the last decade has highlighted the need for using data standards and increased transparency to manage both counterparty and operational risks. The move towards a cleared OTC model that is described in the next section is a direction that the industry is taking to address these challenges.

8 9

Term sheet availability for certain bespoke OTC products can vary from two days up to two weeks. Daily reconciliation is preferred by most active OTC clients.

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CLEARED OTC PROCESS

Overview In the Cleared OTC model, the clearing house will act as the intermediary between the client and the dealer for every trade. Similar to the futures model, in the OTC clearing model all the counterparty risk is assumed by the clearing house. This risk is in turn managed by the clearing house through the exchange of initial and daily variation margins among participants during the life of the instrument. The interaction diagram below describes key process points in this model. The process flow section then provides details of data flow through the instruments lifecycle. Lastly, a summary of key challenges faced by participants in this model is detailed. Interaction Diagram
Dealer Dealer Dealer

Key Process Points

nlystandardizedswapsareeligibleforclearing O radeisnegotiatedprivatelybetweenDealerandthe T Client and given to clearing house (CCP) for clearing ifecycleeventsarecollectivelymanagedamongCCP,DCM L and the client econciliationofTrade/Positon/Cashisperformed R

DCM

DCM

DCM

Clearing House

DCM

DCM

DCM

daily by Buyer and Dealer through their DCMs ollateralismanagedthroughuseofdailymarginsettlement C by all parties

Investment Manager

Investment Manager

Investment Manager

Figure 3: Interaction among stakeholders in Cleared OTC Model

*DCM Derivatives Clearing Merchant

Process Flow

Investment Manager
6. Trade sent to Middle/Back office for processing

1. Negotiate and Execute

Dealer
2b. Trade Data for Matching and Clearing

2a. Trade Sata for Matching and Clearing

(MarkiltSERV, ICE Link, TradeWeb, Bloomberg VCON)

3. Matched Trade Submit 5. Trade Submit

Affirmation Platform

Middle Office/ Back Office

7 Trade capture, Position Management, Cash Processing, Pricing, Reporting, Collateral Management, Reconciliation and Accounting Management
Reporting Daily Margin

Reconciliation Price Data 4. Trade Allege

Clearing House

DCM

Price Data

Figure 4 Process flow details in the Cleared OTC Model

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Description In the cleared OTC model, the counterparty for all trades is the clearing house. All counterparty risk therefore is the responsibility of the clearing house. This risk is managed through the use of segregated customer margin accounts to handle both the initial margin and the daily variation margin amounts. The initial margin is calculated by the clearing house on trade date to be paid by the clearing members (DCMs) on successful clearing of the trade on T+1. Subsequently, T+2 or T+3 and beyond the variation margin11 is calculated and exchanged daily by the clearing house and its members. In turn the DCMs do the same (i.e., initial/variation margin) with their clients on a daily basis. This daily margin settlement process, similar to that used for the futures, eliminates the need for additional collateral management process (such as CSAs in bilateral OTC) and thus mitigates the counterparty risk for all parties to the trade. Here are the key steps in this process: 1. The trade is executed after private negotiation between client and the dealer using OMS12. 2. The trade is sent to affirmation platform13 for matching and clearing. 3. The trade is then sent to MO/BO office for further processing. 4. All steps performed by MO/BO personnel in the Bilateral OTC process are also applicable for a cleared OTC process. In addition the following steps will be necessary: a. Calculate initial margin14 and variation margin by asset, currency and DCM. b. Send/receive initial/variation margin instructions. c. Reconcile margin amounts with DCMs. Challenges 1. There is a need to electronically capture all trade details and the ability to route the same to affirmation platforms. anualtradecapturemaynotbeefficientasthereisaneedfordailymarginsettlement. M tisimportanttonotethatclearinghousesneednotusethesameVMcalculationsfortheproductsthey I support. Although the concept, at a high level can be the same, there can be minor differences in the formula that need to be understood and used for processing. 3. The need for robust reconciliation and reporting capabilities in this model is even more important. Dailyreconciliationoftradeactivity,positionsandmarginsettlementwillbeanecessity. nterfacetoswapdatarepositories(SDRorTR)(ifnecessary)andtheotherpotentialregulatoryreporting I requirements are now mandatory. hereisademandfrominvestorsforincreasedtransparencytodatarelatedtoOTCproducts. T The challenges in the cleared model are mostly driven by the fact that it is a new approach to process OTC instruments in an environment where regulations are still evolving. Increased standardization of the products in the cleared model will necessitate participants to perform straight through processing (STP) by systems processing these instruments including connecting to new intermediaries such as AF, TR and SEF as necessary. This need for STP will in turn provide the much needed transparency the regulators hope to achieve as they finalize their proposals in this area.
The daily price is calculated by the clearing house and provided to its members and clients so they can calculate the variation margin themselves. The initial margin model is also made transparent so interested parties can calculate and reconcile the same with other parties. 12 In the US, per the Dodd-Frank Act proposal all Standardized Swaps should be traded electronically on organized trade facilities (OTFs) and swap execution facility (SEFs). Therefore the clients OMS will need to interface with approved OTFs/SEFs for trade execution. 13 The following are some of the available affirmation platforms MarkItSERV, TradeWeb, Bloomberg VCON and ICE Link. Please see Appendix C for a current listing of affirmation platforms. 14 The initial margin calculation requires use of various quant models defined by clearing houses and clients may not have the right expertise to do this daily. As this is a one-time event per position a number of clients may decide to not calculate and instead just use the number provided by their DCMs for processing.
11

2. Existence of multiple clearing houses requires firms to understand the potentially different variation margin calculations.

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OPERATIONAL READINESS ANALYSIS

While the ongoing clearing regulation proposals are getting finalized, and the date is getting closer for some action, the clients who are new to the OTC space or OTC clearing space will have some obvious questions: Where do I start? How should I go about it? What are the potential challenges? All are good questions to ask. However, no clear answers exist as the regulations are still being finalized. By heeding the saying, action is better than inaction, users cannot just march towards taking actions that they are not comfortable with, especially in an environment where they cannot be certain on how regulations may pan out. Not taking any action or waiting until all regulations are finalized is definitely not an option that proactive users should take. This is primarily because the opportunity costs are just too high for most. Therefore, it is imperative upon users to take concrete actions in areas that are clearer and keep the plan flexible in areas where actions are uncertain. For example, it is known that users need to connect with multiple CCPs A review of currently available affirmation platforms and start work on connectivity with them is a prudent action. Connectivity to SEFs may not be an area for taking concrete action yet. However, the fact that there a number of CCPs already offering cleared OTC swaps should help users with a starting point of their journey in this effort. The framework proposed in this section is intended for users to not only help assess their readiness for processing OTC cleared swaps but also to serve as a guide for creating an action plan for implementation of OTC cleared swaps.

FRAMEWORK SUMMARY
Assumptions The framework review is strictly from a swaps processing by MO/BO point of view and not from a front-office standpoint. Description After identifying that there is clearly a business need for trading cleared swaps, the senior management team from the front-office, operations and IT should start looking at a high-level business view of the clearing landscape. Creating this team of leaders from various groups ensures that all high-level business decisions on choosing platform/system/ CCPs/DCMs are the collective ownership of the senior management team. This buy-in is important for the successful execution of implementation efforts that affects all areas of operations. In addition, a senior team consisting of middle-office and back-office users, IT and project management will need to focus on detailed process and implementation. The composition of the senior team is also cross-functional so that all stakeholders can collectively understand and manage issues as the effort progresses. Figure 5 below describes high-level steps of the proposed Cleared Swaps Operational Readiness framework. The details of each step are described in the next section. The proposed framework consists of two main sections Business and Implementation. The steps within the Business section will be owned by the business users and the Implementation section will be the responsibility of the IT/Project Management group.

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Business Product and Platform selection Senior management team members from front/middle/back-office and also IT will work together to execute steps in this section. Understanding the priority of the products that need to be cleared as set by FO users will be the first task in this section (B1). Selecting the counterparties (DCMs) for trading selected cleared swaps and identifying the clearing houses (CCPs) will need to be done next (B2.1). Parallel to this effort is the step that involves understanding the key life-cycle events of each of the prioritized products (B2.2). Lastly, the team needs to review and finalize the affirmation platform(s)(B3). Implementation Process Analysis and Execution Key members representing front/middle and back office along with IT and project management members will work together in this section. Understanding the current operational and system workflows to perform a gap analysis is the first step in this section (I1). Identifying system/operational changes necessary to be used to create an implementation roadmap should be done next (I2). Finally on an ongoing basis monitoring and managing the implementation to accommodate the changing business is the goal of last step (I3).

B1 Prioritize Products
Front Office Users, MO/BO Operational Managers and IT Management

B2.1 Select CCP and DCM B2.2 Understand Product Life Cycle

B3 Select Affirmation Platform(s)

Business

Implementation
I1 Perform Process Assessment I2 Create Implementation Roadmap I3 Monitor/Manage Implementation

MO/BO Operations User Representatives, IT Analysts, IT Development/QA team and Project Management

Figure 5: The Cleared Swaps Operational Readiness framework

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FRAMEWORK DETAILS
B1 - Prioritize Products
Overview Only the products under IR and CD category are currently considered standardized swaps that will be eligible for clearing. In this step the front-office users will define the list of cleared products that they plan to trade along with potential timelines.

B1 Prioritize Products
Front Office Users, MO/BO Operational Managers and IT Management

B2.1 Select CCP and DCM B2.2 Understand Product Life Cycle

B3 Select Affirmation Platform(s)

Business

Implementation
I1 Perform Process Assessment I2 Create Implementation Roadmap I3 Monitor/Manage Implementation

MO/BO Operations User Representatives, IT Analysts, IT Development/QA team and Project Management
Participants Front-office users, MO/BO operations managers and IT management Owner Front office Key Tasks 1. Review planned list of cleared swap products, i.e. IRS, CD, CDX, etc. 2. Review trading timelines for each of cleared swaps, i.e. when is front office planning to start trading each product? Deliverable(s) 1. Finalized list of cleared swap products. 2. Timeline for planned trading start timelines for each product. Below is a sample deliverable: # 1 2 3 Product CDX CDS Vanilla-IRS Planned Trading Start Time Q3-2011 Q1-2012 Q2-2012

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B2.1 - Select CCP and DCM

Overview Investment managers need to review potential CCPs and DCMs to clear the swaps in the new model. In this step, the team needs to evaluate the various criteria that the firm wants to use to make the right selection for potential CCPs and DCMs.

B1 Prioritize Products
Front Office Users, MO/BO Operational Managers and IT Management

B2.1 Select CCP and DCM B2.2 Understand Product Life Cycle

B3 Select Affirmation Platform(s)

Business

Implementation
I1 Perform Process Assessment I2 Create Implementation Roadmap I3 Monitor/Manage Implementation

MO/BO Operations User Representatives, IT Analysts, IT Development/QA team and Project Management

Participants Front-office users, MO/BO operations managers and IT management Owner Front office Key Tasks 1. Perform review of potential CCPs who can currently support/have plans to support required cleared swap products identified in B1. AlistofcurrentCCPsandproductstheysupportisinAppendixB. eamshouldrevieweachCCPsmargin/riskmodelandtheiroperationalworkflowaspartofthiseffort.This T can be done in collaboration with potential DCMs. 2. Finalize list of CCPs that can support required cleared swap products. 3. Perform review of potential DCMs who can currently support/have plans to support above selected CCPs. ListofDCMssupportingeachofthecurrentCCPscanbeobtainedfromCCPswebsite.SeeAppendixB. eamshouldreviewthefees/marginspreadchargedbyeachDCMforeachproductandexplorepotential T benefits (if any) of using the same DCM to support both cleared and non-cleared OTC swaps. 4. Finalize list of DCMs that can support clearing at selected CCPs.

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Deliverable(s) 1. Finalized list of planned CCPs and DCMs to process OTC swaps, e.g.: # 1 2 3 Product CDX Vanilla-IRS CDS Selected CCPs ICE, CME, ICE Europe CME, LCH.Clearnet ICE, CME, ICE Europe Selected DCMs organStanley&Co.Incorporated M .P.MorganClearingCorp. J Goldman,Sachs&Co. eutscheBankSecuritiesInc. D NPParibasSecuritiesCorp. B

B2.2 - Understand Product life-cycle

Overview The processing of standardized swaps that are eligible for clearing should be clearly understood to accommodate the differences in the way they are processed at various CCPs/DCMs. A review of key process details at a high-level for trade, position, cash flows and life-cycle events associated with these instruments is one of the key objectives in this step.

B1 Prioritize Products
Front Office Users, MO/BO Operational Managers and IT Management

B2.1 Select CCP and DCM B2.2 Understand Product Life Cycle

B3 Select Affirmation Platform(s)

Business

Implementation
I1 Perform Process Assessment I2 Create Implementation Roadmap I3 Monitor/Manage Implementation

MO/BO Operations User Representatives, IT Analysts, IT Development/QA team and Project Management

Participants Front-office users, MO/BO operations managers and IT management Owner MO/BO operations team Key Tasks Perform review of key business process workflow steps and understand day-in-life events for each cleared swap product. Below is a sample task list by business process.

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Business Process

Key Review Tasks 1. Understand various data elements that need to be captured as

Reference Data Management

reference data for each product. 2. Check to see if DCMs can provide reference data feed once the CCPs announce new tickers for supported products. 1. Review format of trade data received from DCMs in order to capture,

2.

Trade Data Management

validate and process trades. 2. Check to ensure all data required by the selected affirmation platform is provided in the trade data.

Cash Management

1. Understand initial margin and variation margin calculations for each CCP/product. 1. Understand the delivery (automated feed/ftp/e-mail) of pricing data by DCM for each supported CCP. 2. Understand support and timing of both indicative/final settled prices. 3. Understand the format of prices received: a. Clean vs. Dirty b. Par-Zero vs. Par-100 1. Understand various processing and control reports provided by DCMs. 2. Daily initial/variation margin report details by CCP/Asset/Account/ Currency. 3. Position recon report. 4. Trade activity report. 5. Cash settlement report.

Pricing Management

Reporting Management

Market Event Data Management

1. Understand credit event handling for applicable products by CCPs (Note This is applicable only to credit products)

Deliverable(s) Firms should document additional/modified control steps necessary for operations to process cleared swaps effectively. For example there may be need to enhance existing operational control reports such as daily trade activity report, daily margin details report, daily pricing report, etc. An ideal deliverable in this step is to create a document that details the current operational workflow with highlights pointing to the changes necessary for operations to support processing of cleared swaps.

20

B3 Select Affirmation Platform

Overview Affirmation and matching of cleared swaps is a requirement in the new OTC Clearing Model. Ease of integration with selected CCPs and DCMs, fees and the ability to scale as the volumes grow are some of the key factors that should be taken into account during selection of an AF platform.

B1 Prioritize Products
Front Office Users, MO/BO Operational Managers and IT Management

B2.1 Select CCP and DCM B2.2 Understand Product Life Cycle

B3 Select Affirmation Platform(s)

Business

Implementation
I1 Perform Process Assessment I2 Create Implementation Roadmap I3 Monitor/Manage Implementation

MO/BO Operations User Representatives, IT Analysts, IT Development/QA team and Project Management

Participants Front-office users, MO/BO operations managers and IT management Owner MO/BO operations managers Key Tasks 1. Review list of current/planned affirmation platforms that support required CCPs/DCMs a. Appendix C provides a list of some of the current affirmation platforms that support existing OTC Cleared Swaps. b. Consideration should be given to ease of integration with middle/back-office systems to send swap trades for clearing and the ability to receive and process the status of trade affirmation from multiple CCPs. 2. Select affirmation platform Deliverable(s) Details of selected affirmation platform

21

I1 - Perform Process Assessment

Overview Understanding current operational and system workflows and identifying potential gaps in processing cleared swaps is the key objective in this step. The gaps thus identified needs to be addressed either by modifying system functionality and/or by modifying operations workflow as a deliverable in this step.

B1 Prioritize Products
Front Office Users, MO/BO Operational Managers and IT Management

B2.1 Select CCP and DCM B2.2 Understand Product Life Cycle

B3 Select Affirmation Platform(s)

Business

Implementation
I1 Perform Process Assessment I2 Create Implementation Roadmap I3 Monitor/Manage Implementation

MO/BO Operations User Representatives, IT Analysts, IT Development/QA team and Project Management

Participants MO/BO operations users, IT analysts and IT development Owner IT analysts team Key Tasks 1. Perform gap analysis for processing clearing swaps. a. Identify current/new functionality necessary to meet the needs identified in Step B2.2 Deliverable(s) Reviewed gap analysis document.

22

See sample gap analysis document below.

Business Process

New Functionality 1. Ability to capture reference data (manual/automated) from DCM for required swap products. 2. Functionality to default values to select data elements by product e.g., day count/ business convention, etc. 1. Ability to capture trade data (manual/automated) from DCM

Enhancements to existing functionality

Reference Data Management

1. Ability to receive and map data from CSV file received from DCM for new cleared swap products.

Trade Data Management

for required swap products. 2. Need for validation of necessary trade elements. Need functionality to support correct

Position Management

cost calculations for both long/short positions including the scenario when netting is enabled. Enhance variation margin functionality

Cash Management

to include daily accrual component in margin approval process. Develop functionality to capture

Pricing Management

clean/dirty prices from data received from DCM for accounting. Develop new margin detail report for cleared swap product. Enhance existing position/trade activity reports to include new cleared swap products. Enhance existing credit event functionality for CDS/CDX to support cleared CD products.

Reporting Management

Market Event Data Management

23

I2 - Create Implementation Roadmap

Overview Planning for the changes identified in the gap analysis document in prior step and creating an implementation roadmap is the goal of this step.

B1 Prioritize Products
Front Office Users, MO/BO Operational Managers and IT Management

B2.1 Select CCP and DCM B2.2 Understand Product Life Cycle

B3 Select Affirmation Platform(s)

Business

Implementation
I1 Perform Process Assessment I2 Create Implementation Roadmap I3 Monitor/Manage Implementation

MO/BO Operations User Representatives, IT Analysts, IT Development/QA team and Project Management

Participants MO/BO operations leads, IT analyst lead/IT development/QA lead and implementation project manager Owner Implementation project manager Key Tasks 1. Review gap analysis document and create a implementation roadmap. a. The roadmap should align the delivery timeline with the front office planned go live timeline provided in B1. b. Detailed project plan with incremental milestones will aid in better management/monitoring of the effort. 2. Review and finalize implementation roadmap. 3. Communicate implementation roadmap to all stakeholders, i.e.: a. Front-office management. b. MO/BO operations management/leads. c. IT analyst team. d. IT development/QA team. Deliverable(s) Implementation roadmap

24

I3 - Monitor/Manage Implementation
Overview It is assumed that the user requirements will change in the cleared swaps area mostly due to evolving regulations. This step emphasizes managing and monitoring of the implementation plan for the changing needs.

B1 Prioritize Products
Front Office Users, MO/BO Operational Managers and IT Management

B2.1 Select CCP and DCM B2.2 Understand Product Life Cycle

B3 Select Affirmation Platform(s)

Business

Implementation
I1 Perform Process Assessment I2 Create Implementation Roadmap I3 Monitor/Manage Implementation

MO/BO Operations User Representatives, IT Analysts, IT Development/QA team and Project Management

Participants IT analyst team, IT development, QA team and Implementation project manager. Owner Implementation project manager Key Tasks 1. Review project milestones at regular intervals and make changes as necessary. 2. Communicate changes to Implementation roadmap (if any) to all relevant stakeholders. Deliverable(s) Modified Project Plan (as necessary).

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EVALUATING OTC PROCESSING SYSTEMS

SYSTEM FEATURES
The necessary features below are broken down by various business processes across the life-cycle of the cleared swap instruments.

Trade Management
Description This process is responsible for capturing and validating trade data after the trade is successfully executed. Features # Feature Description 1. System should provide an interface to capture trades electronically. 1 Ability to electronically capture cleared trades Systems with only manual trade capture capability can be a potential limitation in future for STP when volumes increase. 2. Systems should be flexible to allow for additional electronic interfaces to integrate with potential SEFs. 2 Integration with existing affirmation platforms Need ability to extract all required data from system to be able to send data to existing affirmation platform(s). Functionality to rollback and replay of trades automatically would be necessary when trading volume is expected to be high. System should be able to pull in reference data related to assets traded in various clearing houses daily so trades can be validated automatically for correct static details such as payment frequency, day count, etc.

Ability to cancel and rebook trades

Functionality to View Trade Activity 4 and Add/Modify trade details manually

Position Management
Description This process calculates accurate notional (based on long/short trade indicator) and cost by traded lots. Features # 1 Feature Description

Ability to calculate accurate Position/ System should handle long/short Cost for each asset Functionality to calculate and to view as of positions positions correctly. System should allow for users to get data on positions/activity going back at any point in time.

26

Cash Management
Description This process is responsible for all cash related activities during the lifecycle of the derivatives. Specifically the calculation of traded interest, daily accruals and the variation margin (as necessary). In addition, this module also handles functionality related to cash settlement (for both up-front fees and coupon payments). Features # Feature Description

Ability to perform variation margin calculations for multiple CCPs

Rules-driven approach to calculate variation margin to accommodate minor differences in calculations of variation across multiple CCPs.

Pricing Management
Description This business process performs functions related to capturing, validating and applying the prices to positions in order to perform accurate portfolio valuation. Features # Feature Description

Capture prices from CCPs

Integration with multiple CCPs to capture daily pricing details.

Capture price details

Ability to handle both clean/dirty price as input for calculating variation margin.

27

Accounting Management
Description This business process is responsible for generating and maintaining the ledger of the portfolios in the accounting system. This involves ensuring that the ledger is balanced as a result of trade/cash activity, daily valuation and all other lifecycle events of the instruments in the portfolio. Features # 1 Feature Handle ledger entries for variation margin Description Functionality to configure required ledger accounts to be mapped to calculated daily variation margin amounts.

Reporting Management
Description The functionality in this process includes configuring, generating and delivering various operational/system reports, client reports and regulatory reports. Features # 1 2 3 Feature Margin Report Control Reports Reconciliation Reports Description Reporting of daily variation margin by asset, currency, CCP and DCM. Daily trade activity, daily position and daily cash movement. Reconciliation exception reports for trade, position and cash.

Reconciliation Management
Description Reconciliation of trade, position, price and cash activities at set frequencies and able to manage the exceptions is the key responsibility of this business process. Features # Feature Daily variation margin reconciliation capability with DCMs. Daily trade activity, positions and cash reconciliation capability with multiple DCMs. Description Ability to take in data in multiple formats (assuming DCMs will have different formats) as input with rules-driven engine to perform mapping of this data prior to recon. Same as above.

28

INTEGRATION CHALLENGES
Order Management System (OMS) Integration
OTC derivative trades have a larger number of key elements that need to be captured compared to trade data from other asset classes. Lack of OTC data standards implies most OMS will have proprietary OTC data structures that need to be translated and used by other systems. Key in integrating OM systems is to ensure that all data elements are captured to pass to downstream systems. In the clearing space this will need to include information on clearing house and DCM. Key Task(s) Identifyandcaptureofallrequiredtradedetailsaftertradeexecution. Challenges SupportdataformatsrequiredbyvariousSEFs. Needtoperformvalidationonreceivedtradedataforcontent/format.

Affirmation Platform (AF) Integration

The AF platform integration is new to players in the traditional OTC space. Understanding and reviewing the requirements to connect, send data and interpret statuses received will be one of the keys to success during implementation. Also, implementing right operational controls to monitor the statuses will be important to effectively manage STP of cleared swaps. Key Task(s) Sendingoftradedataforclearing. Receiptofaffirmationandmatchingstatus. Challenges ReviewoftradedataformattoensurealldatarequiredbyCCPsispassedtotheplatform. Understandvariousdatadeliverymechanismrequiredbytheplatform. Reviewtheplatformssupportstructureandunderstandtheplatformssupportprocess.

Clearing House Integration

As an investment manager, the clearing house integration may be necessary only to receive daily prices of cleared swaps to perform valuation. A number of buy-side clients may prefer to get the prices from DCM. However, some of the managers may want to get the prices directly from clearing houses as in order to ensure daily valuations are completed in a timely manner. For DCMs there are additional clearing house integration needs such as the need to settle margin and reconcile/report on daily trade, position and cash activities.

29

Key Task(s) Receivedailyindicative/settlementpricesforclearedswaps. Receiveandsenddailytrade/position/cashactivitydataforreporting/reconciliation(DCMonly). Challenges Needforunderstandingdatacontentandformat,i.e.cleanvs.dirtyprices,CSVvs.XML,etc. DataDeliveryMechanismIsitftporMQorWebService? Reviewtimingofwhenthisdataisavailabledailyandensureinternaloperational/systemprocessesaretunedaccordingly.

DCM Integration
As the counterparty for all cleared swaps for an investment manager is a DCM, the integration exercise involves margin settlement and reconciliation/reporting of daily activity (of trade, position and cash). Also, this being a new effort for both DCMs and investment managers for cleared swaps, it is key to understand the timing and data formats for various data sources provided by different DCMs. It is fair to assume that the data format and delivery mechanism will be different across DCMs and thus integration testing with all the potential DCMs will be crucial for success. Key Task(s) ReconciliationofDailyVariationMargin,TradeActivityandPositionData. DailyTrade,PositionandCashReports. Challenges Data Format Need to support CSV and XML as data input. Data Delivery Mechanism ftp, MQ, Web Service. Also, review delivery frequency. Handling of exceptions and alert management process to manage exceptions.

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CONCLUSION
OTC processing is undergoing a major change primarily as a result of evolving global regulatory changes. According to a recent survey from Citigroup15, Dodd-Frank will push 60% of OTC volumes to central clearing. Processing of increased OTC data to meet the evolving regulation and reporting requirements requires investment managers to have robust operational and system workflows that can scale to the growing needs of the future. Improper planning will expose investment managers to operational risks that can adversely impact their credibility and reputation. Implementing changes should not be taken lightly as this involves major changes to the way current systems are used to process OTC data16. Regulatory reporting and the STP requirements mandate a complete review of existing OTC processes. Although the Dodd-Frank regulation in the US and the European Market Infrastructure Regulation in Europe are top priorities for many buy side firms, many reports observed that the majority are not prepared17. This paper calls for buy-side clients to take action now and position their firms for success in the new OTC clearing model. The framework provided in this paper is a starting point for managers to take concrete steps in understanding the cleared swaps model and to analyze operational readiness for processing cleared swaps. The step-by-step approach provided can be used as a guideline to prepare a robust implementation plan that can then be monitored and managed as regulatory changes are finalized.

Dodd-Frank will push 60% of OTC volumes to central clearing - http:/ /www.finextra.com/news/fullstory.aspx?newsitemid=22765 SIFMA TECH 2011: Dodd-Frank Will Drive Systems Changes -http:/ /www.securitiestechnologymonitor.com/news/sifma-ryansnook-dodd-frank-computing-system-changes-28174-1.html?zkPrintable=true 17 Buy-side firms unprepared for OTC derivatives reform: BNYMellon/InteDelta - http:/ /www.thetradenews.com/asset-classes/ derivatives/5680
15 16

31

APPENDIX A CURRENT STATE OF OTC REGULATION BY COUNTRY *

# 1 Region North America Country United States of America Canada OTC Volume High Current State of Regulation Legislation enacted; implementation of regulation is progressing on target Key decision regarding use of local infrastructure/ global infrastructure for clearing and transaction reporting to be undertaken in 2011 Regulatory initiatives involving implementation to be undertaken in 2011 CME ICE IDCG Mexican Derivatives Exchange (MexDer) ICE Clear Europe Eurex Credit Clear LCH.Clearnet CCPs

North America

Medium

North America

Mexico

Medium

4 5 6 7 8 9 10 11 12 13 14

Europe(EU) Europe(EU) Europe(EU) Europe(EU) Europe Europe Europe South America South America Asia-Pac Asia-Pac

France Germany Italy United Kingdom Russia Turkey Switzerland Argentina Brazil Australia Singapore Medium Low Medium Medium Medium Medium High Legislation for central clearing adopted in Feb 2011. In consideration - Price Transparency of OTC Derivatives Early stage Regulatory initiatives involving implementation to be undertaken in 2011 Nearly 75% are already centrally cleared on the exchange Nearly 90% of all derivatives are standardized, exchange traded and centrally cleared Regulatory initiatives involving implementation to be undertaken in 2011 Preliminary Industry consultation on the regulatory regime and market structure is underway Central bank has required use of standardized documentation and reporting to authorities of OTC derivatives transactions, and has promoted the establishment of a CCP to clear OTC Derivatives Legal framework for a regulatory regime to govern an as-yet-to-be established CCP and TR is to be proposed during 2011 Regulatory initiatives involving implementation to be undertaken in 2011.Plan is to have Clearing Corporation of India Limited(CCIL) to act as both CCP and Trade Repository Early stage Legislation enacted; implementation of regulation is progressing on target Regulatory initiatives involving implementation to be undertaken in 20 High Legislation proposed - Expected to be adopted by end of 2011

Argentina Exchange BM&FBOVESPA Singapore Exchange(SGX) -

15

Asia-Pac

China

Medium

16

Asia-Pac

Hong Kong

Medium

17

Asia-Pac

India

Medium

18 19 20

Asia-Pac Asia-Pac Asia-Pac

Indonesia Japan Saudi Arabia

Low High Low

Tokyo Stock Exchange(TSE)

-

32

#
21 22

Region
Asia-Pac Africa

Country
Republic of Korea South Africa

OTC Volume
Medium Medium

Current State of Regulation

Finalized plans for requiring mandatory clearing, and a CCP is to be established by mid-2012 Regulatory initiatives involving implementation to be undertaken in 2011

CCPs
-

*As of April 2011

APPENDIX B LIST OF CLEARING HOUSES (CCP) **

#
1 2 3 4 5 6 7 8

OTC Clearing House(CCP)

CME Group ICE Trust IDCG ICE Clear Europe Eurex Credit Clear LCH.Clearnet Singapore Exchange (SGX) Tokyo Stock Exchange(TSE)

URL
http://www.cmegroup.com/clearing/index.html https://www.theice.com/clear_overview.jhtml http://www.idcg.com https://www.theice.com/clear_europe.jhtml http://www.eurexclearing.com/markets/creditclear/ overview_en.html http://www.lchclearnet.com/derivatives http://www.sgx.com/wps/portal/marketplace/mpen/products/asiaclear http://www.tse.or.jp/english

Location
United States of America United States of America United States of America Europe Europe Europe Singapore Japan

Supported Products
IRS, CDS and CDX CDS and CDX IRS CDS and CDX CDS and CDX IRS and CDX IRS IRS

**As of September 2011

APPENDIX C LIST OF AFFIRMATION PLATFORMS (AF)

#
1 2 3 4

OTC Clearing House(CCP)

MarkItSERV ICE Link TradeWeb Bloomberg VCOM

URL
http://www.markitserv.com https://www.theice.com/ http://www.tradeweb.com https://www.bloomberg.com

APPENDIX D REFERENCE
1. FSB - OTC Derivatives Market reforms Progress report on Implementation, April 15, 2011 - http:/ /www.financialstabilityboard.org/publications/ r_110415b.pdf 2. BIS - Principles for financial market infrastructures - consultative report, March, 2011 - http:/ /www.bis.org/publ/cpss94.pdf 3. IOSCO - Report on Trading of OTC Derivatives, February, 2011 - http:/ /www.iosco.org/library/pubdocs/pdf/IOSCOPD345.pdf 4. FSB - Implementing OTC Derivatives Market reforms, October 25, 2010 - http:/ /www.financialstabilityboard.org/publications/r_101025.pdf 5. IMF - Global Financial Stability Report - Making OTC Derivatives Safer: The Role of Central Counterparties, April, 2010 - http:/ /www.imf.org/ external/pubs/ft/gfsr/2010/01/pdf/chap3.pdf 6. All about OTC derivatives Latest News, Events and Articles - http:/ /www.otctrack.com

EAGLE INVESTMENT SYSTEMS

Eagle Investment Systems LLC enables financial Institutions to grow their assets by creating operational efficiencies and delivering award-winning solutions for data management, investment accounting, and performance measurement and attribution, supported by an unparalleled level of service. Eagle deploys its solutions via a secure private cloud, Eagle ACCESSSM, which hosts and provides on-going support of the applications and systems infrastructure, reducing complexity and risk. Eagle Investment Systems LLC is a subsidiary of BNY Mellon. Additional information is available at www.eagleinvsys.com.

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Vega Investment Technologies, LLC is a provider of post-trade processing solutions with focus on OTC derivatives. It has deep expertise in the middle and back office processing of global securities in the custody and accounting space. Vegas target clients represent asset servicing firms, asset management firms including hedge funds, and software vendors in the custody/accounting space. Vega Investment Technologies is based in Braintree, Massachusetts. Additional information is available at www.vegainvtech.com For more information please contact: Kishore Saokar, Partner +1 781 664 7175 kishore.saokar@vegainvtech.com

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