Trade Lie Cycle in OTC Derivative Markets
The continued growth in OTC derivatives volumes combined with inflexible and manual processing has led to confirmation backlogs, regulatory attention and constraints on the front office’s ability to allocate assets or capital to these instruments.
OTC derivative trade life cycle events.
This life cycle is defined worldwide by the existing operational practices of most institutions, and the processes are more or less similar. The emphasis is on getting the orders transacted at the best possible price and on getting trades settled with the least possible risk and at manageable costs. Designated employees in the member’s office ensure that each trade that takes place through them or in their house account gets settled properly. Unsettled trades lead to liability, risk, and unnecessary costs.
Trading Events - Pre-trade ( Part – 1 )
Introduction
Every trade has its own life cycle. The entire Life Cycle of a trade can be broken down into pre-trade and post-trade events. Before going into the details of the trading events, let me explain how a trading deal is being struck between two entities.
We know that one of the primary usages of derivative contract is to hedge the risk. Let us consider that a company has got a floating rate liability in LIBOR (London Inter Bank Offered Rate) and it wants to convert its liability into a fixed rate. The feasible option would be to enter into an Interest Rate Swap. The company would strike a deal with a bank and enter into a swap where it would pay fixed rate to the bank and receive floating rate. The company and the bank would enter into a trade and the trade passes through various stages. The various trade events can be categorized into Front Office, Middle Office and Back Office activities which are explained below:
Front Office:
The FO forms the stage where the trade gets initiated. Here, the order gets placed and the entity will price the instrument and give the quote to the counterparty. If the counterparty agrees to the details of the trade and is willing to enter into the deal, the trade gets executed. The trade is then captured in the trading desk usually using a deal capture system. The deal capture system validates all the necessary trade economics before assigning a trade reference number. Subsequent trade events like amendment, cancellation would refer to the trade with the help of the identifier. An acknowledgment is being sent to the counterparty with the trade details who confirms it back.
Middle Office:
The important function that MO performs is to do the Limits and Risk Management. The Limits are being calculated at a business hierarchy level. The usual hierarchy would be at a Portfolio level and subsequently aggregating to a Trader Level, a Desk Level, an Entity Level, and finally to a Group Level. Validations are being done on the trade captured, and in case of any discrepancy, an exception is being raised.
The MO plays a vital role in the exception management. The trade gets enriched by static data like the standard settlement instructions of the counterparty, Custodian details, City holidays, etc.
Such static data details are important for the completion and settlement of the trade. The allocation of the trade is done in the MO and finally the trade is being pushed to the BO and the trade goes live.
Back Office:
The BO is the back bone of the entire life cycle of the trade. The BO mostly deals with the operational activities like record keeping, confirmation, settlement and regulatory reporting. In most cases, BO activities are being outsourced to cheaper sources to cut down on costs for the company.
The Life Cycle of such a trade can be categorized into pre-trade events and post-trade events which are discussed below: -
Pre-Trade Events
Setting up a Master Agreement:
It is a standardized contract between the counterparties and should be there in place before the two parties enter into a deal. For derivative contracts, the Master Agreement is drafted according to ISDA protocols
Define Product Characteristics: Every Deal has to be defined by some primary characteristics called the primary economics of the trade. In case of a Plain Vanilla Interest Rate Swap, the economics of trade would be as follows: -
Pre-Trade Negotiation:
In this stage the client tries to reach a preliminary agreement with the bank. This stage may include documentation, indication of the interest rate and defines the criteria for executing a trade which may include the credit support and the bank policies which the counterparty has to abide by.
Request for Quote:
The client will ask for a quote to the bank, say the fixed rate against LIBOR.
Provide Quote:
The bank will provide the quote which may be through their traditional channels like phone, fax and email, or through standardized channel as provided by Swaps wire.
Request Trade Pricing Inputs:
The Client will ask inputs which will help to price the product. It may relate to volatility of the underlying in some cases. The trade is priced after matching every detail of the trade. For an IRS, both the parties will agree to the rates when the Net Present Value of the swap is zero.
Setting up master agreement/master confirmation.
Know Your Client (KYC)
Define product characteristics.
Pretrade negotiation - Present term sheets to clients/ preliminary agreement.
Request/provide documentation / governing law.
Indication of interest.
Provide indicative price/rate/value.
Request/define criteria for executing trade (conditionality,credit support, bank policies.
RFQ - Product Details - Request Quote.
Provide Quote - Price/Rate/Value - Request Quote Response.
Chek Credit - Client Product Details.
Request Trade Pricing inputs - Price Input Values(Vol,etc.) - PRWG under Development.
Thursday, November 18, 2010
The Structure and Trade Life Cycle of OTC Derivatives
The Structure of OTC Derivatives
INTRODUCTION
Derivatives are financial contracts whose value is linked to the price of an underlying commodity, asset, rate, index or the occurrence or magnitude of an event. The term derivative comes from how the price of these contracts is derived from the price of some underlying commodity, security or index or the magnitude of some event. The term derivative is used to refer to the set financial instruments that include futures, forwards, options and swaps. The combination of a derivative with a security or loan is called a hybrid instrument or alternatively a structured security and structured financing. Derivatives are traded in two kinds of markets: exchanges and OTC markets. Exchanges have traditionally been defined by “pit” trading through open outcry, but exchanges have recently adopted electronic trading platforms that automatically match the bids and offers from market participants to execute trades in a multilateral environment. The trading of derivatives (traditionally futures and options) on exchanges is conducted through brokers and not dealers.
TRADITIONAL DEALER MARKET – “BILATERAL NEGOTIATION”
The OTC markets have traditionally been organized around one or more dealers who “make a market” by maintaining bid and offer quotes to market participants. The quotes and the negotiation of execution prices are generally conducted over the telephone, although the process may be enhanced through the use of electronic bulletin boards by the dealers for posting their quotes. The trading process of negotiating by phone, whether end-user-to-dealer or dealer-to-dealer, is known as bilateral trading because only the two market participants directly observe the quotes or execution. This bilateral trading arrangement, from a regulatory point of view, is not considered a trading facility because it is not multilateral. However, it should be pointed out the bilateral negation process under this market arrangement is often highly automated. Dealers have direct phone lines between themselves and other dealers and their major customers, and this enables instantaneous communication so that a market participant can call up a dealer ask for quotes and then hang up and call another so as to survey several dealers in just a few seconds. A quick series of such calls can give an investor a view of the market that is not entirely different from a view obtained by observing a multilateral negotiating process.
“ELECTRONICALLY BROKERED MARKETS”
OTC markets have also adapted new electronic and networking technologies to their trading needs. One use of the technology is the formation of an electronically brokered OTC market through the use of an electronic brokering platform (sometimes referred to as a electronic brokering system). These electronic brokering platforms are essentially the same as the electronic trading platforms used by exchanges, and they create a multilateral trading environment. If this electronic brokering platform automatically matches bids and offers so as to execute a trade, the Commodity Exchange Act defines this trading as a trading facility because it is open to multilateral participation (i.e. the quoting of bid and offer prices and the execution of trades) by many parties. If it functions merely as an electronic bulletin board for the posting of bids and offers, then it is excluded from the definition.
“PROPRIETARY ELECTRONIC DEALER OR TRADING PLATFORM”
Yet another type of trading arrangement found in OTC derivatives markets is a composite of the traditional dealer and the electronic brokering platform in which an OTC derivatives dealer sets up their own proprietary electronic trading platform. Note the use of the term electronic trading, not brokering, platform because it is a dealing platform and does not function as a neutral broker. In this arrangement, the bids and offers are posted exclusively by the dealer; other market participants observe these quotes, and possibly also execution prices, in what is best described as a one-way multilateral environment. It is one-way, because no one but the dealer’s quotes are observable and those of the other market participants might at best be inferred from changes in the execution price. In this electronic trading, or dealing, platform, the dealer is the counterpart to every trade so that the dealer holds the credit risk in the market.
INTRODUCTION
Derivatives are financial contracts whose value is linked to the price of an underlying commodity, asset, rate, index or the occurrence or magnitude of an event. The term derivative comes from how the price of these contracts is derived from the price of some underlying commodity, security or index or the magnitude of some event. The term derivative is used to refer to the set financial instruments that include futures, forwards, options and swaps. The combination of a derivative with a security or loan is called a hybrid instrument or alternatively a structured security and structured financing. Derivatives are traded in two kinds of markets: exchanges and OTC markets. Exchanges have traditionally been defined by “pit” trading through open outcry, but exchanges have recently adopted electronic trading platforms that automatically match the bids and offers from market participants to execute trades in a multilateral environment. The trading of derivatives (traditionally futures and options) on exchanges is conducted through brokers and not dealers.
TRADITIONAL DEALER MARKET – “BILATERAL NEGOTIATION”
The OTC markets have traditionally been organized around one or more dealers who “make a market” by maintaining bid and offer quotes to market participants. The quotes and the negotiation of execution prices are generally conducted over the telephone, although the process may be enhanced through the use of electronic bulletin boards by the dealers for posting their quotes. The trading process of negotiating by phone, whether end-user-to-dealer or dealer-to-dealer, is known as bilateral trading because only the two market participants directly observe the quotes or execution. This bilateral trading arrangement, from a regulatory point of view, is not considered a trading facility because it is not multilateral. However, it should be pointed out the bilateral negation process under this market arrangement is often highly automated. Dealers have direct phone lines between themselves and other dealers and their major customers, and this enables instantaneous communication so that a market participant can call up a dealer ask for quotes and then hang up and call another so as to survey several dealers in just a few seconds. A quick series of such calls can give an investor a view of the market that is not entirely different from a view obtained by observing a multilateral negotiating process.
“ELECTRONICALLY BROKERED MARKETS”
OTC markets have also adapted new electronic and networking technologies to their trading needs. One use of the technology is the formation of an electronically brokered OTC market through the use of an electronic brokering platform (sometimes referred to as a electronic brokering system). These electronic brokering platforms are essentially the same as the electronic trading platforms used by exchanges, and they create a multilateral trading environment. If this electronic brokering platform automatically matches bids and offers so as to execute a trade, the Commodity Exchange Act defines this trading as a trading facility because it is open to multilateral participation (i.e. the quoting of bid and offer prices and the execution of trades) by many parties. If it functions merely as an electronic bulletin board for the posting of bids and offers, then it is excluded from the definition.
“PROPRIETARY ELECTRONIC DEALER OR TRADING PLATFORM”
Yet another type of trading arrangement found in OTC derivatives markets is a composite of the traditional dealer and the electronic brokering platform in which an OTC derivatives dealer sets up their own proprietary electronic trading platform. Note the use of the term electronic trading, not brokering, platform because it is a dealing platform and does not function as a neutral broker. In this arrangement, the bids and offers are posted exclusively by the dealer; other market participants observe these quotes, and possibly also execution prices, in what is best described as a one-way multilateral environment. It is one-way, because no one but the dealer’s quotes are observable and those of the other market participants might at best be inferred from changes in the execution price. In this electronic trading, or dealing, platform, the dealer is the counterpart to every trade so that the dealer holds the credit risk in the market.
Wednesday, October 27, 2010
Globalization and the Challenges
Globalization and the Challenges
The dominant feature of the world economy in the next decade will be increasing pace of change and expanding reach of global markets into national economies. People and businesses will need to be increasingly flexible to respond to these changes.
1. Establishing Stability in an Open Economy – further trends in increasing cross-border trade and investment, more integrated capital markets and greater global competition pose challenges to every country. These changes reinforce the need for a stable macroeconomic environment to address the potentially increased uncertainties. The India needs to capitalize on the new opportunities that increasing investment flows and trade can offer, while balancing this with flexibility to adapt to greater uncertainty
2. Promoting an Outward Looking Economy – macroeconomic stability and long-term sustainability are important in attracting foreign investment and retaining and encouraging domestic investment in increasingly integrated global financial markets, in which the sources and destinations of investment are becoming ever more diverse. As the balance of global economy shifts, firms need to establish string links with emerging economies and other trading partners to access the opportunities of the changing global economy. Investment is a crucial driver of an economy’s productivity and hence of the level of prosperity prevailing in the economy. In a world of more closely integrated global financial markets and mobile capital flows, mobile investment will increasingly locate in those economic environments where it can achieve the greatest, risk-adjusted, returns. A range of factors contributes to an economy’s investment environment, and hence to the expected returns on investment. A key challenge for the is to provide an economic environment that is able to attract high quality domestic foreign investment, not by attempting to compete with emerging economies on the basis of labor costs, but through high levels of productivity built on a foundation of macroeconomic stability and driven by skills, competition, enterprise and innovation
Challenges to business
External dialogue focuses on the explicit development of the collective learning cycles of evolving projects and programs, in which stakeholders and company representatives learn to jointly craft and implement new policies for progressive steps towards corporate social and ecological responsibility (CR) policies for sustainable development. Plotting of new business directions requires interactive shifting of company limitations expressed in the expectations and demands of stakeholders The complex business challenge is the ability to understand present and potential stakeholder demands, and the willingness to overcome such obstacles in creative and open change processes of joint learning. When companies aim for long-term success and continuity, they must improve the level of knowledge and ability in their organization, enabling staff to understand the company's limitations and to build strategies to shift these. Responding to and understanding stakeholder demands requires the highest degree of professionalism in the organization on a great variety of issues in order to create the business conditions for continuity.
Enterprises need to be open and willing to learn in interactive stakeholder approaches at the levels of the direct physical and social surroundings of the firm, of the supply and technology chains, and of the total production and consumption systems, including the private and public firms providing and developing infrastructure services. Firms can develop an approach to stakeholders with a focus on jointly developing and maintaining a collective learning cycle where progressive steps can be made toward CR policies for economic continuity and social and ecological value creation and a sustainable development. Connecting internal processes to this collective learning cycle is vital .The transition to sustainable business requires the plotting of a new direction by engaging the stakeholders of the company to understand needs and to develop common goals. It is equally important to achieve appropriate social, ecological and economic conditions and technical infrastructures for future production. Therefore, the central concern of the company is to understand its stakeholders, and to continue satisfying stakeholder objectives, thus creating the right conditions for sustainability.
Business strategies for sustainable development aim to achieve the essential conditions for long-term continuity of the company, and a stakeholder approach is crucial to determine the related requirements. The complex business challenge here is nothing less than the ability to understand present and potential stakeholder demands, and the willingness to address issues in a creative and open change processes. When companies aim for long-term success and continuity they also need to strive to improve the level of knowledge and ability in their organization, enabling staff to understand the company's limitations and to build strategies to shift these. As a business operates many challenges hound it and may cause the business process to be stopped. The different business challenge may come from its internal and external environment. With proper strategies the business may survive such challenges
The dominant feature of the world economy in the next decade will be increasing pace of change and expanding reach of global markets into national economies. People and businesses will need to be increasingly flexible to respond to these changes.
1. Establishing Stability in an Open Economy – further trends in increasing cross-border trade and investment, more integrated capital markets and greater global competition pose challenges to every country. These changes reinforce the need for a stable macroeconomic environment to address the potentially increased uncertainties. The India needs to capitalize on the new opportunities that increasing investment flows and trade can offer, while balancing this with flexibility to adapt to greater uncertainty
2. Promoting an Outward Looking Economy – macroeconomic stability and long-term sustainability are important in attracting foreign investment and retaining and encouraging domestic investment in increasingly integrated global financial markets, in which the sources and destinations of investment are becoming ever more diverse. As the balance of global economy shifts, firms need to establish string links with emerging economies and other trading partners to access the opportunities of the changing global economy. Investment is a crucial driver of an economy’s productivity and hence of the level of prosperity prevailing in the economy. In a world of more closely integrated global financial markets and mobile capital flows, mobile investment will increasingly locate in those economic environments where it can achieve the greatest, risk-adjusted, returns. A range of factors contributes to an economy’s investment environment, and hence to the expected returns on investment. A key challenge for the is to provide an economic environment that is able to attract high quality domestic foreign investment, not by attempting to compete with emerging economies on the basis of labor costs, but through high levels of productivity built on a foundation of macroeconomic stability and driven by skills, competition, enterprise and innovation
Challenges to business
External dialogue focuses on the explicit development of the collective learning cycles of evolving projects and programs, in which stakeholders and company representatives learn to jointly craft and implement new policies for progressive steps towards corporate social and ecological responsibility (CR) policies for sustainable development. Plotting of new business directions requires interactive shifting of company limitations expressed in the expectations and demands of stakeholders The complex business challenge is the ability to understand present and potential stakeholder demands, and the willingness to overcome such obstacles in creative and open change processes of joint learning. When companies aim for long-term success and continuity, they must improve the level of knowledge and ability in their organization, enabling staff to understand the company's limitations and to build strategies to shift these. Responding to and understanding stakeholder demands requires the highest degree of professionalism in the organization on a great variety of issues in order to create the business conditions for continuity.
Enterprises need to be open and willing to learn in interactive stakeholder approaches at the levels of the direct physical and social surroundings of the firm, of the supply and technology chains, and of the total production and consumption systems, including the private and public firms providing and developing infrastructure services. Firms can develop an approach to stakeholders with a focus on jointly developing and maintaining a collective learning cycle where progressive steps can be made toward CR policies for economic continuity and social and ecological value creation and a sustainable development. Connecting internal processes to this collective learning cycle is vital .The transition to sustainable business requires the plotting of a new direction by engaging the stakeholders of the company to understand needs and to develop common goals. It is equally important to achieve appropriate social, ecological and economic conditions and technical infrastructures for future production. Therefore, the central concern of the company is to understand its stakeholders, and to continue satisfying stakeholder objectives, thus creating the right conditions for sustainability.
Business strategies for sustainable development aim to achieve the essential conditions for long-term continuity of the company, and a stakeholder approach is crucial to determine the related requirements. The complex business challenge here is nothing less than the ability to understand present and potential stakeholder demands, and the willingness to address issues in a creative and open change processes. When companies aim for long-term success and continuity they also need to strive to improve the level of knowledge and ability in their organization, enabling staff to understand the company's limitations and to build strategies to shift these. As a business operates many challenges hound it and may cause the business process to be stopped. The different business challenge may come from its internal and external environment. With proper strategies the business may survive such challenges
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