Operational Efficiency in the OTC Derivative

Markets

Bank Depository User Group October 17, 2006

Michael Vellecca

2DTCC Confidential

OTC Derivatives --- 2005 A Banner Year with No Signs of SlowingOTC Derivatives --- 2005 A Banner Year with No Signs of Slowing

• Total market reached $236.0 trillion across all asset classes

• Double digit year on year growth in:

• Credit Default Swaps up 105%; 2nd year > 100%

• Interest Rates up 16%

• Equity Derivatives up 34%

• Gross credit exposure estimated to be $9.4 trillion

• Growth precipitated regulatory attention on operating challenges throughout the year

• Total market reached $236.0 trillion across all asset classes

• Double digit year on year growth in:

• Credit Default Swaps up 105%; 2nd year > 100%

• Interest Rates up 16%

• Equity Derivatives up 34%

• Gross credit exposure estimated to be $9.4 trillion

• Growth precipitated regulatory attention on operating challenges throughout the year

3DTCC Confidential

02,0004,0006,0008,000

10,00012,00014,00016,00018,000

Am

ount

s

1H02 2H02 1H03 2H03 1H04 2H04 1H05 2H05

Years

CDS & Equity DerivativesNotional Amounts Outstanding

(in Billions of US $)CDS

EQ

OTC Derivatives --- CDS Now 3x EquitiesOTC Derivatives --- CDS Now 3x Equities

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050

100150200250300350400450

Num

ber

of T

rade

s

2003 2004 2005 2006

Years

Average Reported Weekly Deal Volume (Vanilla - All Respondents)

CDS

IRS

EQ

2005: CDS Surpassed IRS in Trading Volume2005: CDS Surpassed IRS in Trading Volume

5DTCC Confidential

0200400600800

1,0001,2001,4001,600

Num

ber

of T

rade

s

2003 2004 2005 2006

Years

Large FirmsCDS IRS EQ

0

50

100

150

200

250

Num

ber

of T

rade

s

2003 2004 2005 2006

Years

Medium FirmsCDS IRS EQ

2005: Use of CDS Doubled for Medium Firms2005: Use of CDS Doubled for Medium Firms

6DTCC Confidential

Market Growth Reflects Benefits of OTC MarketMarket Growth Reflects Benefits of OTC Market

•Flexible and cost effective for solving complex financial needs

•Easily customized to meet specific customer requirements

•OTC allows ready changes to contract specifications

•Adaptable to bilateral definitions of risk and exposure

•Flexible and cost effective for solving complex financial needs

•Easily customized to meet specific customer requirements

•OTC allows ready changes to contract specifications

•Adaptable to bilateral definitions of risk and exposure

7DTCC Confidential

Continued High Rate of Product InnovationContinued High Rate of Product Innovation

•Over 22 CDS templates since 2003

•Asset-backed CDS

•CDS on Loans

•??????

•Over 22 CDS templates since 2003

•Asset-backed CDS

•CDS on Loans

•??????

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Deriv/SERV Product Coverage -- CDSDeriv/SERV Product Coverage -- CDS

• Transaction Management Working Group prioritizing next templates --- CDS on ABS and CDS on Loans most likely

9DTCC Confidential

Broader Market Participation --- Across ProductsBroader Market Participation --- Across Products

• 2000+ signers of ISDA Novation Protocol

• 600+ Buy Side users of Deriv/SERV• Hedge Funds

• Asset Managers

• Pension Funds

• Expansion of prime brokers

• New Advisory role of Asset Managers Division & MFA in definition of industry solutions

• Plethora of new solutions providers targeting stages of the value chain

• 2000+ signers of ISDA Novation Protocol

• 600+ Buy Side users of Deriv/SERV• Hedge Funds

• Asset Managers

• Pension Funds

• Expansion of prime brokers

• New Advisory role of Asset Managers Division & MFA in definition of industry solutions

• Plethora of new solutions providers targeting stages of the value chain

10DTCC Confidential

Keys to Managing Growth Keys to Managing Growth

Industry Standards

•ISDA documentation•Novation Protocols•Master Confirms•ISDA Matrix•Mark-it RED•FpML

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Keys to Managing Growth -- STP Keys to Managing Growth -- STP

Industry Standards

•ISDA documentation•Novation Protocols•Master Confirms•ISDA Matrix•Mark-it RED•FpML

E-Trading &

Matching

• TradeWeb• MarketAxess• Creditex • T-Zero• SWIFT Accord• Swapswire• Deriv/SERV• BClear

12DTCC Confidential

Keys to Managing Growth -- STP Keys to Managing Growth -- STP

Industry Standards

•ISDA documentation•Novation Protocols•Master Confirms•ISDA Matrix•Mark-it RED•FpML

E-Trading &

Matching

•TradeWeb•MarketAccess•Creditex •T-Zero•SWIFT Accord• Swapswire• Deriv/SERV• BClear

Post Trade

Services

• Swapclear• DTCC Payment Rec• TriOptima/eClerx• DTCC Warehouse

13DTCC Confidential

Industry Agenda 2006Industry Agenda 2006

•Reductions in backlogs – October regulatory targets for CDS

•Increased automation – e-trading, trade matching/confirmation (IRS, CDS, Equities)

•Broad adoption of standardized business processes --- e.g. ISDA Matrix

•Consideration of cash settlement for CDS

•Full life cycle servicing with the Trade Warehouse

•Reductions in backlogs – October regulatory targets for CDS

•Increased automation – e-trading, trade matching/confirmation (IRS, CDS, Equities)

•Broad adoption of standardized business processes --- e.g. ISDA Matrix

•Consideration of cash settlement for CDS

•Full life cycle servicing with the Trade Warehouse

14DTCC Confidential

Status: Trade Confirm and Related ServicesStatus: Trade Confirm and Related Services

•Credit (all standardized products)

•Used by all major dealers and over 600 investment and fund managers

•Market standard (over 20 templates & all life cycle events)

•Related payment reconciliation service also market standard - over 1.8 million payments per quarterly run, 98% match rate

•Credit (all standardized products)

•Used by all major dealers and over 600 investment and fund managers

•Market standard (over 20 templates & all life cycle events)

•Related payment reconciliation service also market standard - over 1.8 million payments per quarterly run, 98% match rate

15DTCC Confidential

Status: Trade Confirm and Related ServicesStatus: Trade Confirm and Related Services

• Interest Rates (swaps and swaptions)

•Large Investment Managers want one solution for their OTC needs

•Major dealers are implementing to accommodate customer demand. Dealers will need to support different services depending on the client needs

•Users looking for assistance with best practices (e.g., straddles – 1 deal or 2)

• Interest Rates (swaps and swaptions)

•Large Investment Managers want one solution for their OTC needs

•Major dealers are implementing to accommodate customer demand. Dealers will need to support different services depending on the client needs

•Users looking for assistance with best practices (e.g., straddles – 1 deal or 2)

16DTCC Confidential

Status: Trade Confirm and Related ServicesStatus: Trade Confirm and Related Services

• Equities (options, variance swaps and equity Swaps)

• Increased equity derivative volumes (vanilla up 50%, non-vanilla over 100%, year-over-year)

• ISDA 2006 Benchmarking Survey results (outstanding confirmations for vanilla over 12 days, non-vanilla 21 days, large firms >1500 deals/week, 30+ days outstanding)

• Lead to an increased focus on automation, similar to what was achieved for credit

• But challenges exist:

• Largest issue is the MCA execution and complicity

• Multiple templates, geographic regions

• Equities (options, variance swaps and equity Swaps)

• Increased equity derivative volumes (vanilla up 50%, non-vanilla over 100%, year-over-year)

• ISDA 2006 Benchmarking Survey results (outstanding confirmations for vanilla over 12 days, non-vanilla 21 days, large firms >1500 deals/week, 30+ days outstanding)

• Lead to an increased focus on automation, similar to what was achieved for credit

• But challenges exist:

• Largest issue is the MCA execution and complicity

• Multiple templates, geographic regions

17DTCC Confidential

Why a Warehouse for Credit Derivatives?Why a Warehouse for Credit Derivatives?

• Rapid, multi-dimensional growth on a global scale

Trading volumes; new products; new market participants; secondary market development

• Rapid spread of automated trade confirmation

Bulk of all trading is now confirmed on an automated basis – both inter-dealer and dealer-to-customer

• Rapid, multi-dimensional growth on a global scale

Trading volumes; new products; new market participants; secondary market development

• Rapid spread of automated trade confirmation

Bulk of all trading is now confirmed on an automated basis – both inter-dealer and dealer-to-customer

Trends create both concern around trade administration and opportunity to mitigate the concern

Trends create both concern around trade administration and opportunity to mitigate the concern

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Current Bilateral Administration EnvironmentCurrent Bilateral Administration Environment

Parties must constantly “sync up” during contract life

• Payments, events, margining, etc.

• Many manual and duplicative reconciliation/resolution processes (internal and between firms)

Each party is hostage to its counterparties’ processing

• You’re only as good as your counterparty – your records may be right, but if your counterparty disagrees or doesn’t know, you have a problem

• Operating models vary across firms: different processes for different counterparties

Parties must constantly “sync up” during contract life

• Payments, events, margining, etc.

• Many manual and duplicative reconciliation/resolution processes (internal and between firms)

Each party is hostage to its counterparties’ processing

• You’re only as good as your counterparty – your records may be right, but if your counterparty disagrees or doesn’t know, you have a problem

• Operating models vary across firms: different processes for different counterparties

19DTCC Confidential

Central Trade Information Warehouse Solution Central Trade Information Warehouse Solution

Two primary components:

• A comprehensive, centralized trade database with the most up-to-date record of each contract

• A central processing capability to standardize and automate “downstream” processing of payments and other post-confirm processes

Processing flows automatically from the electronic confirmation environment

Two primary components:

• A comprehensive, centralized trade database with the most up-to-date record of each contract

• A central processing capability to standardize and automate “downstream” processing of payments and other post-confirm processes

Processing flows automatically from the electronic confirmation environment

20DTCC Confidential

Basic Trade Information Warehouse FunctionsBasic Trade Information Warehouse Functions

• Contract Maintenance• Maintain the “official legal record” of all

contracts eligible for automated legal confirmation

Must be DTCC eligible, but can come in through other providers

• Maintain basic economic information for other contracts

• Event Processing/Messaging• Involuntary position adjustments

e.g., index notional adjustments due to credit events, etc.

• Event triggeringe.g., credit events, assignment consents,

option exercises, etc.

• Contract Maintenance• Maintain the “official legal record” of all

contracts eligible for automated legal confirmation

Must be DTCC eligible, but can come in through other providers

• Maintain basic economic information for other contracts

• Event Processing/Messaging• Involuntary position adjustments

e.g., index notional adjustments due to credit events, etc.

• Event triggeringe.g., credit events, assignment consents,

option exercises, etc.

21DTCC Confidential

Basic Trade Information Warehouse FunctionsBasic Trade Information Warehouse Functions

•Central Payment Calculation

• For all “offical legal records” maintianed in the warehouse (payment matching for contracts with economic records only)

• Automated feeds to central multi-currency settlement service

•Central Payment Calculation

• For all “offical legal records” maintianed in the warehouse (payment matching for contracts with economic records only)

• Automated feeds to central multi-currency settlement service

22DTCC Confidential

Core PrincipalsCore Principals

•Open and attractive to all market participants

•Global Infrastructure

•Design should be extendable to other OTC derivative products

•Open architecture

•Open and attractive to all market participants

•Global Infrastructure

•Design should be extendable to other OTC derivative products

•Open architecture