Counterparty Risk Central to Dodd-Frank Compliance

Terry Flanagan

Ahead of next month’s Dodd-Frank compliance deadline, the derivatives industry is ratcheting up its use of counterparty risk management tools and technology, and is building out platforms for trading and clearing OTC swaps products, a cornerstone of the G20 reforms.

The Bank for International Settlements, an inter-governmental organization of central banks, estimates that at the end of 2011, $1.8 trillion of collateral was posted against counterparty credit exposures.

Asset managers are facing systems challenges as banks switch over from Libor to overnight indexed swaps (OIS) for discounting their derivatives portfolios.

The International Swaps and Derivatives Association (ISDA), a trade body, earlier this year introduced a standardized credit support annex (CSA), based on OIS discounting, in order to accelerate the trend toward a more accurate method for pricing OTC interest-rate swaps.

“OIS/CSA discounting for pricing interest rate instruments has become the industry standard,” said Dmitry Pugachevsky, director of research at Quantifi, a provider of analytics, trading and risk management solutions to the global OTC markets.

Quantifi has unveiled a new version of its pricing and risk analysis software, Quantifi Version 10.3, which includes support for OIS/CSA discounting and enhanced counterparty risk management.

Quantifi “was first-to-market with consistent pricing and curve calibration with OIS discounting, and this is our third release with OIS discounting, which significantly increases the speed of calculation, especially for market quote sensitivities”, Pugachevsky said.

An OIS is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate which is also called overnight rate) over every day of the payment period.

The index is typically an interest rate considered less risky than the corresponding Libor interbank rate.

Markit, a global financial information services company, has enhanced its OIS discounting methodologies to allow for more accurate valuations of collateralized and uncollateralized trades.

The enhancements enable Markit clients to select the discounting method that matches their credit support annexes (CSAs), namely OIS, Libor or specific dual-currency funding curves, and to match the funding curve to the tenor basis of the trade, the company said.

Markit first introduced OIS discounting to its valuations services in 2011, and the practice has since become the industry standard for calculating the margin requirements specified in CSAs, the agreements that govern collateral posted for non-cleared OTC derivatives transactions.

The CFTC’s external business conduct rules, which have an October 15 compliance date, impose new obligations on swap dealers in a range of areas, focusing on enhanced customer protection.

Swap dealers must sign amendments to their ISDA documentation with impacted swap counterparties to become compliant with these Dodd-Frank rules.

State Street Global Markets, the investment research and trading arm of custodian bank and investment manager State Street Corp, has announced that it has joined U.S. exchange operator CME Group for clearing of OTC interest rate swaps.

State Street’s membership in CME Group expands the clearing options available to clients amid the changing regulatory environment.

“As derivative markets evolve, State Street’s membership provides buy-side clients with a new, neutral model for trading, clearing and processing of their swap positions,” said Cliff Lewis, executive vice-president and head of State Street’s eExchange business, in a statement.

CME Group membership is the latest move by State Street to prepare for the new regulatory regime for OTC derivatives. In 2011, State Street announced its intention to expand its futures commission merchant services to cover swap clearing capabilities and announced DerivOneSM, its end-to-end derivatives servicing offering.

And this year, State Street launched SwapEx, an execution platform for the trading of derivatives products. Together, these services are designed to reduce operational risk through the automation of the many stages of derivatives processing, including execution, clearing, collateral management, cash and securities flow between the middle and back offices, transaction cost and risk reporting, valuations and the reconciliation of positions.

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