U.S. patent application number 11/179942 was filed with the patent office on 2006-10-05 for trading and settling enhancements to the standard electronic futures exchange market model that allow bespoke notional sizes and better global service of end users and make available a new class of negotiable security including equivalents to products normally issued by special purpose vehicles.
This patent application is currently assigned to De Novo Markets Limited. Invention is credited to Pavel Pinkava.
Application Number | 20060224494 11/179942 |
Document ID | / |
Family ID | 40125816 |
Filed Date | 2006-10-05 |
United States Patent
Application |
20060224494 |
Kind Code |
A1 |
Pinkava; Pavel |
October 5, 2006 |
Trading and settling enhancements to the standard electronic
futures exchange market model that allow bespoke notional sizes and
better global service of end users and make available a new class
of negotiable security including equivalents to products normally
issued by special purpose vehicles
Abstract
A pair of clearing house enhancements comprising a method that
allows bespoke notional sizes to be handled rigorously plus a
method that allows a plurality of daily settlement times to be
introduced over the product set within an adapted electronic
futures exchange type market model, rules and legal environment. In
addition a method allows traditional fully funded negotiable
securities such as bonds and equities to be listed on the adapted
exchange. Another embodiment allows both funded and leveraged
structured products equivalent to those normally issued by special
purpose vehicles such as synthetic CDOs to be listed.
Inventors: |
Pinkava; Pavel; (Clapham,
GB) |
Correspondence
Address: |
LEYDIG VOIT & MAYER, LTD
TWO PRUDENTIAL PLAZA, SUITE 4900
180 NORTH STETSON AVENUE
CHICAGO
IL
60601-6780
US
|
Assignee: |
De Novo Markets Limited
Woking
GB
|
Family ID: |
40125816 |
Appl. No.: |
11/179942 |
Filed: |
July 12, 2005 |
Related U.S. Patent Documents
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Application
Number |
Filing Date |
Patent Number |
|
|
60667878 |
Apr 1, 2005 |
|
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Current U.S.
Class: |
705/37 |
Current CPC
Class: |
G06Q 40/04 20130101;
G06Q 40/06 20130101; G06Q 40/02 20130101; G06Q 40/00 20130101 |
Class at
Publication: |
705/037 |
International
Class: |
G06Q 40/00 20060101
G06Q040/00 |
Claims
1. A method of daily marking to market of derivative exposures
within an adapted electronic futures exchange type market model,
rules and legal environment comprising: providing listed for
trading derivative products in an electronic futures exchange type
environment; executing a trade relative to the listed for trading
derivative product pursuant to a user command; creating at least
one post trade contract for clearing based on the executed trade
whose prices are related to the executed trade quotation either
directly or indirectly via a mapping formula; discarding the
constraints of notional trading unit size and price tick sizes such
that: a) the volumes within the electronic clearing house system
represented the face value in units of the relevant currency but
can be registered with high granularity in the post trade contract
for clearing; and b) the prices within the electronic clearing
house system represented the fractions of face value and can also
be registered with high granularity in the post trade contract for
clearing; calculating the economic value of each post trade
contract for clearing position simply as price times volume to high
accuracy; and aggregating value at the appropriate level then
rounding in the clearing house's favor for margin call and final
cash settlement purposes, such that all net payments into the
clearing house are rounded up to the nearest minimum whole unit of
the appropriate currency, whilst all net payments out are rounded
down.
2. The method according to claim 1, wherein the aggregation of
value occurs at the individual contract expiry level.
3. The method according to claim 1, wherein the aggregation of
value occurs at the contract expiry series level.
4. The method according to claim 1, wherein for swap products the
aggregation of value occurs at the paired individual contract
expiry level.
5. The method according to claim 1, wherein for swap products the
aggregation of value occurs at the relted contract expiry series
level.
6. A method of convenient global daily settlement of positions
within an adapted electronic futures exchange type market model,
rules and legal environment comprising: providing more than the
traditional single daily settlement time within the same clearing
house for each near 24-hour a day market; providing a choice of
variation margin collection cycles, via a clearing membership
qualification by regional close; designating each customer clearing
account reference to a time zone with the proviso that a clearing
member cannot supply clearing accounts for time zones in which it
is not qualified; monitoring variation margin mismatches over the
trading day caused by the splitting of settlement times and open
positions across time zones; and establishing sufficient own
capital resources or credit lines for the clearing house so that
these will not be exhausted by variation margin mismatches over the
trading day caused by the splitting of settlement times in order to
provide convenient global daily settlement of positions.
7. The method according to claim 6, wherein the account reference
time zone designation is further used to establish which
international regulatory institution or institutions have
regulatory oversight over the activities in the account.
8. The method according to claim 6, wherein for a subset of
products the default pool underlying the clearing house performance
is segregated into subsets thereby creating domestic markets within
the greater global market.
9. The method according to claim 8, wherein matched trades must
have both sides referencing the same default pool, such that both
traders will need clearing account of the relevant type for trading
to take place.
10. A method of providing highly integrated and operationally
robust primary and secondary markets in Clearing House Securities
that are fully paid or leveraged; collateralized; asset backed,
debt, equity and hybrid securities, based on an adapted electronic
futures exchange type market model, rules and legal environment
comprising: providing a restricted access primary issuance market
in which a cross transaction at zero price is performed creating
short positions in one or more obligations and corresponding long
positions in those obligations known as float; providing a broad
access secondary market for trading the float based around an
adapted give up process involving both a payment versus delivery
system and normal competitive auction process; at least once daily
marking to market of the float based on its price in the secondary
market in collaboration with the issuing member; at least once
daily marking to market of the obligation based on its underlying
theoretical value, liquidation value where available; transferring
funds from the short obligation holder to the float holders at time
periods and in amounts set out in the security specification
document; such transfers being made efficiently via the clearing
houses payment systems.
11. The method according to claim 10, wherein float and obligation
positions held in the same account are not fully offset and
cancelled by the clearing house.
12. The method according to claim 11, wherein any profit shown
between the float and obligation positions held in the same account
of the primary issuer are not disbursed by the clearing house.
13. The method according to claim 10, wherein the secondary market
adapted give up process lists float the float for front office
trading in indirect quotations which is linked to the actually
transferred float contracts for clearing via a set of algorithmic
mapping formula.
14. The method according to claim 10, wherein float contracts
created together can be traded separately or stripped.
15. The method according to claim 10, wherein cash transfers are
made via direct cash currency payments at expiry from the short
obligation holder to the long float holder in a contract or
stripped leg of a contract.
16. The method according to claim 10, wherein cash transfers are
made via Cashflow Clearing House Securities which comprising new
float and obligation pairs created at zero which are delivered
respectively to the existing float and obligation holders and then
marked to the required value in order to effect the cash currency
payments via the clearing house's variation margining system.
17. The method according to claim 10, wherein initial margin is
calculated on each portfolio in the normal way such as to create a
guide to regulators, risk managers and individual traders of the
value at risk in their portfolio.
18. The method according to claim 17, wherein the initial margin
calculation is performed across all asset classes including
derivatives held at the exchange.
19. The method according to claim 10, wherein at the time of
primary issuance assets are lodged in trust with the clearing house
in order to guarantee the performance of the obligations, thereby
allowing the clearing house and the trustees specially appointed by
it to take on the role normally performed by special purpose
vehicles.
20. The method according to claim 19, wherein at the time of
primary issuance assets are managed by a fund manager thereby
creating the equivalent of exchange traded finds within the adapted
electronic futures exchange type market model, rules and legal
environment.
Description
CROSS-REFERENCE TO RELATED APPLICATION
[0001] This patent application is related to and claims benefit of
U.S. Provisional Patent Application No. 60/667,878 filed Apr. 1,
2005, entitled "Trading and Settling System" which is incorporated
herein in its entirety by reference for all that it teaches without
any exclusion.
FIELD OF THE INVENTIONS
[0002] This invention relates to a set of linked methods, system
upgrades, computer program products and financial product designs
for enabling trading and settling of new product types on what
where hitherto only futures exchanges and their clearing
houses.
[0003] More particularly, the present invention relates to a
method, a system, and a computer program product for trading and
settling: exchange traded credit derivatives, exchange traded
interest rate swaps, exchange traded money market derivatives plus
other exchange traded structured derivative contracts and also
equivalents of more traditional non-derivative debt products e.g.
deposits etc
BACKGROUND TO THE INVENTION
Broad Context of the Invention
The Evolving Landscape for Financial Risk
[0004] This section comments on the advantages of financial futures
exchanges put inside the context of the evolving landscape for
financial risk. The financial risk content relies heavily on
extracts from a speech by Malcolm Knight, the General Manager of
the Bank for International Settlements (BIS). The BIS is an
international organisation which fosters international monetary and
financial cooperation and serves as a bank for central banks:
[0005] The financial system has undergone a profound transformation
over the past three decades, driven by the combined impact of
liberalisation and technological innovation. This in turn has
driven a significant transformation in the nature of financial
risk. The industry has gained enormously in richness, depth and
variety. The large number of new derivative financial instruments
that have developed, partly in the wake of breakthroughs in pricing
theory and advances in computing technologies, attest to this
transformation.
[0006] The size of the financial sphere of developed economies has
increased tremendously along different dimensions but above all in
terms of turnover. It is well known that monthly global turnover in
the main asset classes far exceeds yearly global GDP. Within
financial services, traded instruments have greatly outgrown
traditional non-traded ones, such as loans or deposits. On the one
hand, we have witnessed a broadening of the range of players
engaged in the same type of financial activity. And on the other
hand, the surge in cross-border activity has heightened the role of
non-residents in domestic markets in many countries.
[0007] In line with growth in turnover, the management of financial
risk has become a more important aspect of economic activity. This
also means that problems in the financial system, if and when they
emerge, can have larger consequences for the real economy than they
did in the past. The message has been hammered home by the costs of
the financial crises that have occurred in both industrial and
emerging market countries over the past two decades. Not
surprisingly, addressing financial instability has become a major
policy concern, both nationally and internationally.
[0008] By contrast over the same period the appearance of financial
futures and options exchanges have been welcomed by policy makers
and regulators. These trading venues have the virtue of
transparency and relative simplicity. They have also shown extreme
robustness to stress for example during the Barings bank collapse.
Unfortunately the growth of new derivative financial instruments
both in terms of variety and turnover has mostly happened away from
exchanges in the so called Over The Counter (OTC) market.
[0009] Unfortunately in this modern environment, financial risk has
become more complex. In the OTC market derivative instruments that
originally targeted market risk resulted, as a by-product, in a
pyramiding of counterparty risk that required separate management.
This opaque layering of direct and indirect links through the
markets also profoundly complicates the assessment of the true
underlying risks. By contrast counterparty risk issues do not arise
on financial futures and options exchanges.
[0010] The old analysis of risk that was structured around
traditional business lines has become increasingly irrelevant. In
other words, the similarities in underlying risks are becoming more
apparent, regardless of the type of financial firm incurring them.
The ongoing consolidation in the financial sector is partly driven
by the realisation that these similarities can lead to cost saving
synergies. In the resulting large financial firms, a common capital
base underpins on-balance sheet intermediation, capital market
services and market-making functions. Globally, the smaller number
of very large internationally active financial institutions has
created potential concentration risks for the financial system.
This is because losses in one activity can put pressure on the
entire firm, affecting its activities in other areas. More
fundamentally, what is sometimes referred to as the "endogenous"
component of risk could be triggered by a large bank failure. This
is the component that reflects the impact of the collective actions
of market participants on the ultimate drivers of risk themselves
i.e. the herd effect. The layering and pyramiding of counterparty
risk in the OTC derivative market adds to these concerns.
Value Add of the Invention and Basle II
[0011] Financial futures and options exchanges contain a small but
significant fraction of the liquidity of modern financial markets.
These derivatives are superbly designed to manage their users'
market risks efficiently and indeed to largely eliminate systematic
operational and counterparty credit risks. However the exchanges'
product ranges have historically been highly constrained to only
futures and options. They have therefore remained at the periphery
of the profound transformation of the financial system described in
the previous section.
[0012] The purpose of the invention is to facilitate the overthrow
of the traditional model and move derivatives exchanges firmly into
the mainstream. Such a move away from the conventional OTC market,
would rapidly achieve the goals of policy makers such as Malcolm
Knight. This in turn should be good for economic growth and
prosperity as generally speaking more efficient financial markets
lead to a more efficient real economy. The invention should be
particularly applicable to emerging market economies where both
counterparty credit risk and operational issues have held back the
development of efficient financial markets.
[0013] Several objectives that at present appear remote dreams of
policy makers can come closer to reality by harnessing the
infrastructure of a futures and options exchange for broader
purposes. For example: [0014] The general principle that similar
risks should be measured and managed in a similar way across a
firm, irrespective of their location, would largely and
automatically be met. This is because an increasing number of
positions would be held at the same exchange venue and therefore
risk margined consistently; and also [0015] The long-term ideal of
a fully integrated treatment of risk, based on a common metric,
would inevitably be met for the same reasons; and also [0016] The
condition of a financial firm with regard to its risk profile,
would become easier to identify. This is because with all positions
held and risk margined at the same exchange venue the leveraged
value at risk (i.e. initial margin) would become objectively
measurable for each firm; and indeed [0017] The treatment of the
endogenous component of risk could be revolutionalised, with
improvements in both systematic risk measurement and systematic
risk management made possible for policy makers.
[0018] On the last point it is conceivable that if a dominant
central advanced derivatives exchange emerged in each developed
economy, then policy makers could gain control of some drivers of
the endogenous component of risk. With sufficient academic research
some equivalents of reserve requirements and reserve policy could
be created but applied to the initial margin held at the exchange's
central counterparty rather than to bank lending. These
hypothetical reserve requirements (or "hair cut" rates) would be
the equivalent of creating an intelligent dynamic element in the
capital adequacy framework. Policy makers could for the first time
manipulate the markets' risk appetites directly by raising or
lowering the official hair cut rate(s) counter-cyclically. Such an
advanced policy would empower the natural incentive of market
participants to instil self discipline indirectly and efficiently,
especially when dealer performance is evaluated and rewarded using
risk-adjusted returns.
[0019] Whilst the invention has potential to go a very long way
towards meeting the needs of policy makers and regulators in the
longer term, they have until now adopted their own approach.
[0020] On 26th Jun. 2004 central bank governors and the heads of
bank supervisory authorities in the Group of Ten (G10) countries
met and endorsed the publication of the "International Convergence
of Capital Measurement and Capital Standards: a Revised Framework",
the new capital adequacy framework commonly known as Basel II. The
meeting took place at the Bank for International Settlements in
Basel, Switzerland, one day after the Basel Committee on Banking
Supervision, the author of the text, approved its submission to the
governors and supervisors for review.
[0021] Nearly all jurisdictions with active banking markets require
banking organisations to maintain at least a minimum level of
capital. Capital serves as a foundation for a bank's future growth
and as a cushion against its unexpected losses. Excessively low
levels of capital increase the risk of bank failures which, in
turn, may put depositors' funds at risk. If on the other hand
capital levels are too high, banks may not be able to make the most
efficient use of their resources, which may constrain their ability
to make credit available and hence hurt the economy.
[0022] The Basel II Framework builds on the first Basel Accord
which in 1988 created the basic structure for setting capital
requirements. It is more reflective of the underlying risks in
banking hence improving the capital framework's sensitivity to the
risks that banks actually face and providing stronger incentives
for improved risk management. These improvements will be achieved
in part by aligning capital requirements more closely to the risk
of credit loss and by introducing a new capital charge for
exposures to the risk of loss caused by operational failures.
[0023] The credit risk is the larger part of the Basle II capital
charge, and requires a lot of work to sort out. Getting credit risk
wrong can be costly for banks, but over the longer term, getting
operational risk wrong can be costlier. In either case there will
be stronger incentives for trading on organised markets with
central clearing than ever before. This can only be good for the
uptake of the invention.
A Brief on Financial Markets Before Derivatives
[0024] Before financial derivatives existed `the financial markets`
could be defined as the general term covering the separate markets
in the debt, foreign exchange and equity traded asset classes.
Since the advent of financial derivatives trading this picture has
been both split into new asset classes (e.g. implied volatility,
credit etc) and blurred by the growth of cross asset products (e.g.
forex swaps, convertible bonds etc). In order to understand
derivatives fully one most first have a good working knowledge of
their underlying (so called `cash` markets) and this is the purpose
of this background section.
The Basic Concept of Interest
[0025] The current invention is mostly concerned with derivatives
of the debt markets only. Raising debt (i.e. getting new money) is
important. Having money is an advantage as it can be used to buy
goods and services. Alternatively consumption can be deferred and
the money invested in a business either by buying shares or more
directly. In either case investing in a business always carries
some considerable risk but with the hope of receiving a risk
proportionate positive return on the investment. Taken as an
average over the whole economy but depending on prevailing
conditions such equity investments will tend to grow.
[0026] Forgoing both consumption and investment in a business is
thus a significant opportunity cost. Lenders of money to others
should therefore be compensated. Traditionally this is done by
payment of interest on such loans as well as the eventual repayment
of principle. The interest charged will differ depending on the
currency (hence economy) of issuance and also on the term of the
loan.
[0027] Borrowing and lending is clearly at the very heart of the
financial system. The level of interest is clearly important to the
fair treatment of creditors but making interest payments and the
return of principal is fundamental. The risk of default being
triggered will vary with the borrower's circumstances. The
consequences of default depend on the seniority, the legal
structure and collateralisation or otherwise of the debt. The debt
markets can be broken down according to these and other criteria.
Nonetheless the simple rule is that a borrower perceived to have a
higher risk will have to pay lenders higher interest to attract
their funds.
Negotiable Securities
[0028] There are many ways to raise money differing in interest
type charged, source of funds, principal repayment schedule etc.
Another significant difference is that between loan agreements
(usual bilateral contracts) and negotiable securities. In the
former case the lending party or parties will probably not change
during the life of the loan. Negotiable securities can also be
referred to as "financial paper" as they are documents (or merely
registry entries) indicating creditor-ship in the case of debt
securities or ownership in the case of equities.
[0029] By contrast to loans debt securities are specifically
designed to encourage the easy transfer of title. The existence of
a secondary market make both the borrower to creditor relationship
and the risks to lenders different for securities. In addition the
accounting and tax treatment may not be the same for loan
agreements and debt securities. The appropriate interest rate
required in each market may therefore differ significantly.
Credit Ratings
[0030] A credit rating agency is a firm that provides its opinion
on the creditworthiness of an entity and the debt securities issued
by an entity. Several well established agencies exist to assign
credit ratings and often fund managers will be barred from
purchasing securities from issuers below a certain rating. Issuers
will pay the agencies to rate their company or specific issues. The
rating scales are different for short term and longer term debt and
different ratings may apply depending on who the legal borrower is
e.g. parent or subsidiary.
[0031] When an issuer's credit rating deteriorates the price of its
debt securities can fall substantially in the secondary market. A
worsening perception among investors and the risk of downgrades
form part of the credit risk of a security. An investor can thus
still be exposed to credit risk even if the security he holds does
not default.
[0032] Different fund managers will be subject to different rules
thereby segmenting the investor community. Important sectors are
investment grade and sub-investment grade (junk) bonds in each
major currency. For example, a credit rating agency may assign a
"triple A" credit rating as its top "investment grade" rating for
corporate bonds and a "double B" credit rating or below for
"non-investment grade" or "high-yield" corporate bonds. A foreign
company's credit rating will typically not exceed that of it's
government.
[0033] Interest rates are to a large extent determined by supply
and demand factors and these may differ from one investor community
to another. Thus in times of crisis emerging market bond price
drops can be correlated across the world despite no obvious link
between the particular national economies concerned. In emerging
markets effective default can occur if the local currency is
devalued thereby making any bonds denominated in that currency
worth much less to outside investors. This kind of credit risk is
called country risk.
[0034] One final point worth noting is that during total bankruptcy
shares and bond prices will obviously become correlated by both
tending to zero (ignoring recovery valuations of debt etc). By
extension lower rated credits will have bonds correlating with
their issuers' stock prices even if there is only a probability of
bankruptcy. As a result bear (bull) stock market moves tend to be
associated with widening (narrowing) credit spreads.
Money Markets and Capital Markets
[0035] Another important way to categorise interest rate products
is according to their final repayment date, known as their
maturity: [0036] Debt instruments with less than one year (or
occasionally two years) to go before maturity are part of the so
called "short term" or "money markets"; but [0037] Debt instruments
with more than one year to go before maturity are part of the so
called capital markets.
[0038] The distinction is partly due to the different purposes for
which loans are typically required. The money markets are a major
source (and sink) of funds for cashflow management i.e. corporate
treasury operations. By contrast the primary capital markets are
usually used for raising money required for investment in a
company's business plans and include equities as well as debt. A
debt security issued into the money markets is generally known as a
"bill" whilst a debt security issued into the capital markets is
often referred to as a "note" or "bond".
[0039] An additional distinction between money markets and capital
markets is the role of the central banks. Central banks actively
manage and seek to dominate supply and demand in the short term
rate environment of their respective currencies. They do so in an
attempt to control economic activity. The bond markets on the other
hand are freer to find their own level occasionally frustrating
central bank short rate moves by shifting in the opposite
direction.
Annualised Interest and Day Count Conventions
[0040] For ease of comparison between instruments of different
maturity the percentage by which an investor's money will grow in a
single year is often quoted. This is known as the interest rate.
Where an instrument has less than one year to go before maturity
the percentage growth until maturity is "annualised" upward. For
example if an investor is quoted 4% per annum when placing funds on
deposit in the interbank market for 3 months that gives a total
return of approximately 1% as there are actually 12 months in a
year.
[0041] An alternative to quoting annualised interest rates which
measure total return of initial money lent is quoting the discount
rates on total money due to be paid at maturity. The latter are
conventionally used for certain money market securities. Thus a 3
month T-bill trading at 99.00% of face value at maturity is
discounted by 1% of face and hence has a discount rate of
approximately 4% per annum as there are actually 12 months in a
year.
[0042] The exact annualised rate depends on the day counting
conventions used in the relevant market. The US interbank deposit
market for example uses an "Actual/360" day count convention which
means that a 4.00% interest rate for a 3 months period that turned
out to actually be 92 days when counted, gives a total return of
4%*92/360=.about.1.022%. In the financial markets transactions tend
to be so large that a little bit of confusion can cause
disagreements to arise over substantial amounts of money hence the
importance of day count conventions. In the above example an
investor depositing $100 million would earn twenty two thousand
dollars more than would be expected by just counting three months
as 1/4 of a year. Getting it right is clearly worth worrying about.
Of course there are various different day count conventions in the
many different markets. They are important but are no harder to
understand than the example above.
Money Market Debt Instruments and the Money Market Convention
[0043] Amongst securities "T-bills" are of the best credit quality
possible and are issued by the treasury department. Other
significant money market securities include the "commercial paper"
issued by large companies especially banks. "Certificates of
deposit" which give the holder a right to money already deposited
at a bank at whatever interest rate was negotiated at the time of
issue also exist. "Bills of exchange" and "bank accepted bills of
exchange (bankers acceptances)" are used for the financing of
commerce in commodities or manufactures products and are also
transferable especially the acceptances as they are guaranteed by a
bank.
[0044] In the loan markets, interbank deposits ("depos") and
repurchase agreements ("repos") are standardised and very liquid.
As well there being no doubts surrounding day count convention
interbank liquidity resides at certain predetermined points on the
maturity curve. Overnight (O/N) lending supplies funds for today to
be repaid on the next business day (T+1), thus overnight will earn
at least three days of interests every Friday and more if Monday is
not a business day. "Tomorrow-next" or "tom-next" (T/N) is simply
the next business day's overnight but traded today. Historically
money took time to transfer so all lending terms are calculated
relative not to the trade date but to the so-called spot date which
is simply trade date plus two business days (T+2).
[0045] Typically the interbank market will only quote active two
way markets at maturities of a whole number of weeks, months or
years i.e. spot plus 1 week, spot plus 2 weeks, spot plus 3 weeks,
spot plus 1 months, spot plus 2 months, spot plus 3 months, spot
plus 4 months, spot plus 5 months, spot plus 6 months, spot plus 7
months, spot plus 8 months, spot plus 9 months, spot plus 10
months, spot plus 11 months, spot plus 1 year etc. There is an
accepted and rigidly defined market standard called the money
market convention for these so called on-the-run points, which
depend on the currency traded (because of national holidays):
[0046] Business days--A working day in the principal financial
centre of the currency (i.e. New York for US Dollars). In the case
of Euro-Currencies it must also be a working day in London (e.g. a
Euro-Dollar business day must be a business day both in New York
and in London). Business days for are any days when the TARGET
system is running. [0047] Spot date--Two business days after trade
date. [0048] N-week date--Is N*7 days after the spot date but if
this is not a business day the next business day after that. [0049]
N-month/years date--Is the same calendar day in the month or the
nearest to it as the spot date but N months or years afterwards
(e.g. If spot is 31 st March then 1 -month later is 30th April). If
this is not a business day the next business day after that applies
unless this takes us into the wrong (i.e. next) month in which case
it's the previous business day that applies
[0050] As we shall see the money market convention is also used for
certain derivatives.
Longer Term Debt Instruments and Yield
[0051] There are many medium and long term debt securities
including government notes and bonds, promissory notes, corporate
bonds, floating rate bonds etc. Because T-notes and T-bonds carry
no credit risk they are by far the most liquid longer term debt
instruments.
[0052] Where an instrument has more than one year to go before
maturity the relevant annualised interest rate is not easy to
compute. Clearly day count conventions will still come into play
but there are other complications. Most longer dated debt will pay
fixed interest at regular intervals either annually, semi-annually
or even monthly not just at maturity. An intermediate payment for a
bond or note is called a coupon payment.
[0053] If they were all traded separately the coupons and the
principal repayments could each have a uniquely defined discount
rate or interest rate associated with them just as money market
securities do. Such zero coupon bonds do indeed exist and are
traded in the market. The relevant formula for calculating the
annual rate of return will be slightly more complex than for bills
to take account of compounding i.e. a notional annual
reinvestment.
[0054] Clearly as the secondary market price of the whole bond
varies the return on investment will vary too even though it may be
hard to compute. Crucially the rate at which the coupons may be
reinvested in the future is unknown beforehand. Consider the case
of investors expecting a rising reinvestment rate in the near
future as an example. In such circumstances a higher coupon bond
will become preferable as the sooner the funds are available the
sooner they may be reinvested.
[0055] A conventional solution uses the same rate to calculate
reinvestment as the return on investment that is itself being
calculated. The relevant calculation is non trivial but can be
applied to a bond's market price without reference to any other
data, such as reinvestment rates implied by other instruments in
the market. The single assumed return and reinvestment rate when
correctly annualised becomes known as the yield to maturity. The
conventional yield in a particular market will depend on the day
counts used etc.
Convexity in the Price Versus Yield Relationship
[0056] The advantage of yield is that it gives a quick idea of
value for money. Bond prices will differ simply because of factors
like maturity and coupon rate. Yet in general the higher the yield
of one bond relative to another the better the relative value
offered by that bond, when all else is equal. Of course yields can
be legitimately higher on a bond due to it's higher risks e.g.
lower credit rating etc. The coupon effect alluded to previously
should not however be neglected in that if two bonds have the same
yield and maturity the higher coupon one may be preferred in a
rising rate environment. Conversely the lower coupon one can have a
slightly higher yield and still not offer best value.
[0057] Although yield is non-trivial to calculate it is nonetheless
a straightforward indicator of value for money. Better value in the
context of the secondary market will of course mean cheaper so it
is hardly surprising that a price against yield graph for a single
bond will show its price dropping as yield goes up. However since
holding the bond represents rights to positive cashflows on future
coupon payment dates and at maturity, the bond's price can never go
negative however high its yield goes. This means that the bond
price will drop off more and more slowly as yield goes up and this
effect is referred to as "positive convexity".
[0058] Yield is such a useful concept that traders will often
appear more interested in it than price especially when switching
from one bond into another i.e. selling a previous holding to buy a
new one. However traders will never lose sight of price because
that is what their profits and losses are measured in.
Clean Price and Accrued Interest
[0059] As stated previously most notes and bonds will pay interest
at regular intervals typically annually or semi-annually. In either
case from time to time coupon payments will actually be made.
Clearly the value of a bond will drop the moment it becomes traded
in the secondary market without the coupon attached (known as going
"ex-div"). This means that even at a constant yield the price of a
bond will show cyclical variations in price with a kind of
`saw-tooth` pattern.
[0060] These oscillations over time in the price of the bond tend
to cloud the simple relationship between the yield and the quoted
price at any one time. The situation is made more manageable by a
market convention that has been created to make them less
prominent. Dealers in the market place do not quote the full price
when trading in price terms but instead quote a so-called "clean
price". In this framework the full price is known as the "dirty
price" and the clean price is the dirty price less "accrued
interest" which is defined below.
[0061] Each day the front coupon should earn the bond holder
interest so when the bond is traded in the secondary market the
buyer must compensate the previous holder for the fraction of the
next coupon payment that is rightfully theirs. This fraction is
known as the accrued interest and is proportional to the number of
days that have passed since the previous coupon payment date.
Accrued interest must be calculated using the relevant day count
convention. Since accrued interest is taken into account the graph
of clean price at a constant yield does not show the `saw-tooth`
pattern of dirty price. Where the bond goes ex-div several days
before the notional coupon payment or is newly issued with a long
first coupon period it may trade with negative accrued
interest.
The Yield Curve and Credit Spreads
[0062] One of the most fundamental concepts of interest rate
products is the yield curve. This is sometimes grandly referred to
as the term structure of interest rates but in reality it is a
simple graph of yield against maturity for many different issues of
equal credit class. To be meaningful the yields must all be quoted
under the same convention and at the same time (since the curve
moves). Coupon effect, tax and liquidity differences
notwithstanding the points will form an obvious curve.
[0063] There are higher curves for lower quality credits
corresponding to the higher yields that investors demand. The
spreads between the different credit curves are closely traded
entities in their own right. The risk associated with a particular
borrower is conventionally expressed in terms of credit spreads
over benchmark (i.e. government bond yields or interbank swap
rates) in both the primary and secondary markets. Another way to
express risk is typically in terms of credit ratings and these will
therefore have prevailing credit spreads associated with them for
each type (sector) of issuer. Issuer type is important as credit
ratings give the risk of default but not the expected recovery
rates which are part of the overall risk and hence credit
spread.
[0064] However it is spread trading along each credit that
maintains the curve structure. Consider for example supply and
demand imbalances making a particular T-note's yield higher than
it's neighbours. If the T-note becomes cheaper in this way traders
will most probably sell the neighbouring T-notes to buy this
cheaper one. They will therefore drive the prices of the
neighbouring notes lower and that of the cheapened note itself
higher. In this way the original anomaly in the yield curve is
quickly smoothed out. Because the curve maintains its integrity as
it moves interest rate products can be highly correlated across
maturities, not just across credit quality and currencies as
discussed previously.
[0065] The yield curve is important to traders because money can be
made from predicting the shape changes it undergoes and indeed by
borrowing and lending at different maturities. It is important to
note that rates may move but with no change in shape of the yield
curve. This parallel shift up or down in the curve is a neutral
assumption that is often applied by traders when setting up their
curve related strategies.
Structured Products and Special Purpose Vehicles
[0066] Collateralised Debt Obligations (CDOs) are investments
collateralised by or referenced to a diverse portfolio of debt
rather than other assets (e.g. rents etc).
[0067] Asset backed securities including CDOs are generally issued
by Special Purpose Vehicles (SPVs) or entities set up to allow for
the transfer of risk from the originator to an entity that is
generally thinly capitalised, bankruptcy-remote and isolated from
any credit risk associated with the originator. To limit the
universe of an SPV's potential creditors, it is usually a newly
established entity, with no operating history that could give rise
to prior liabilities. The SPV's business purpose and activities are
limited to only those necessary to effect the particular
transaction for which the SPV has been established (for example,
issuing its securities and purchasing and holding its assets),
thereby reducing the likelihood of the SPV incurring post-closing
liabilities that are in addition or unrelated to those anticipated
by rating agencies and investors.
[0068] The costs of the infrastructure and services associated with
the establishment and management of SPVs are part of the context of
this invention.
[0069] CDOs are designed so that investors can directly benefit
from the diversification inherent in the underlying portfolio. This
underlying collateral pool is repackaged so that they have the
choice of buying junior, mezzanine, senior and super senior
segments etc. The exact tiering depends on the deal but typically
tranches are defined by two percentage face value numbers--The
lower number known as the attachment point defines the minimum
losses to which the investor is exposed while the higher number
known as the detachment point defines the maximum losses. An
alternative method of tranching is achieved by defining tranches in
terms of the defaulting entity i.e. the first to default, second to
default tranches etc.
[0070] CDO tranches are invariably rated in order to make them
saleable to funds whose rules demand only credit rated assets of
certain quality are purchased i.e. the majority of traditional
funds. As tranches are exposed to portfolio losses above and below
certain thresholds, each tranche must carry an attractive coupon
relative to its credit ratings or investors will not buy it.
Issuers therefore work closely with credit rating agencies to
"ramp-up" the value of each tranche relative to the risk it carries
i.e. to package the diversification benefits as attractively as
possible.
[0071] In summary buying into a CDO can give investors exposure to
a well-diversified range of credits, industries, geographical
regions or structures that they may have been unable to access
independently. An additional attraction of the market for
collateralised instruments is that they generally provide investors
with exposure to an asset with low correlation to other securities
such as vanilla bonds and equities. Indeed it has been argued that
the equity tranches of certain CDOs should warrant consideration as
an alternative asset class (alongside investments such as hedge
funds and private equity) for pension funds to consider. However
the principal attraction for investors has been and will continue
to be the greater yield CDOs offer compared to corporate issues
with similar credit ratings.
More Detailed Context of the Invention
Definition of Derivatives
[0072] A derivatives contract can be defined as an agreement
between two counterparties in which rights and obligations are set
up whose economic value, either by direct reference to a benchmark
price quote or by operation of the contract in its delivery phase,
can be derived from one or more underlying (often called `cash`)
products. Typically the exposure obtained by entering into a
derivatives contract creates the equivalent of a highly leveraged
position in the cash underlying so that traders can gain or lose
large amounts of money without putting up large amounts of actual
capital i.e. without being fully funded.
[0073] Derivatives on other derivatives can also exist in which
case the underlying is often still called the cash in the
appropriate context. Despite the high leverage typical of
derivatives there exist certain low risk trading strategies which
involve taking derivative positions and their underlying cash
positions together. The strategies can and are employed to lock in
even relatively small pricing anomalies between these related
markets whenever they arise. Such trading strategies are known as
arbitrages and are often quite mathematically complex in nature.
This is particularly true for the financial derivatives markets
with which the present invention is mostly concerned.
[0074] Financial derivatives therefore have a well deserved
reputation for complexity as far as arbitrage fair pricing and
hence position risk management theory is concerned. In practice
however the theoretical complexity is relatively easy to manage
using affordable desktop software applications which take the
strain. This allows dealers who rely on such pricing models and so
called trading tools to operate with the same degree of confidence
as others dealers do in less theoretically demanding markets.
[0075] In any case not all aspects of financial derivatives can be
labelled as complex since for example their legal structure, the
protocols of transacting business and the product designs
themselves are often easy to understand, relatively straight
forward and indeed highly standardised even where they are slightly
intricate. The present invention is largely concerned with this
simpler infrastructural side of the business.
Liquidity and the Purpose of Derivatives
[0076] Although they are hard to understand fully nonetheless the
activities of arbitrageurs play a very significant part in overall
market activity. This is because their strategies ensure there is a
close link between the value of derivatives and the market price of
their underlying cash. Trading a derivative thus becomes a viable
alternative to using the related cash market at least for exposure
management purposes as opposed to inventory management purposes.
Furthermore the capital efficiency of derivatives resulting from
leverage means that real money cashflow concerns can be set aside
from exposure requirements in these markets. This in turn means
that base liquidity is less constrained and as a result is often
higher in derivative markets than in the underlying cash.
[0077] In a competitive open market increased liquidity will
typically appear as tighter average bid to offer price spreads. The
lower bid/ask spread represents a reduced cost of doing business to
exposure managers as they enter and exit their trading positions.
Thus increased liquidity in derivatives markets make them
attractive to traders on cost grounds alone regardless of what real
money constraints (if any) they may have.
[0078] Consider for example a trader who wishes to temporarily exit
a long cash position (i.e. they have previously bought the
underlying). The trader may fear a drop in the market price of this
cash asset but knows he will eventually need to re-establish the
long position for inventory purposes. Such a trader can chose to
bear the full cash market exit and re-entry costs if they so wish.
Alternatively they can go to the more liquid associated derivatives
market and take a new short position whose profit during the
expected drop in the market price will fully offset any losses on
the cash because its value is so closely related to it. The trader
may then when the time is right return to the derivatives market
buying back the short and as a result will have churned his
position more cheaply yet with the same results. Such activity is
known as hedging and a key raison d'etre of most derivatives
markets.
[0079] As well as those hedgers who wish to lay off risk the
derivatives markets also attract so called scalpers or market
makers who seek to benefit from the bid/ask spread in the knowledge
that liquidity is usually so good they can exit quickly if the
market moves against them. Liquidity thus breeds liquidity in a
virtuous circle as risk is transferred around many market
participants.
The History and Trading Microstructure of Futures Exchanges
[0080] The earliest derivatives were listed on commodity exchanges
as so called futures contracts. These were used by farmers to
secure their selling price far in advance of harvest (thus ensuring
their annual profitability) but were also used by the food
production processing, manufacturing, marketing and retailing
industries to secure their buying price for their future inventory
needs. In addition to arbitrageurs the leverage available also
attracted specialist scalpers and speculators called local traders
with no actual inventory to shift but whose presence at the
exchanges further added to liquidity.
[0081] To access the liquidity pool in such exchange traded futures
products required either for dealers to be exchange members
themselves or for them to be customers of members acting as so
called futures brokers. As well as restricting who could execute
business, exchanges also set the trading rules and policed them to
create high profile reputable markets. During the predefined
trading hours for each market an orderly centralised continuous and
competitive public auction known as open outcry was maintained
under these trading rules. Open outcry as the name implies involves
verbal bids and offers being made face to face in the trading rings
or pits. To facilitate customer order flow phone booths lined the
arena around the pits. In open outcry verbal bids, offers and
trades were supplemented by hand signals in the pits themselves and
the same signals were used for communication between booth brokers
and pit brokers. Open outcry was made even more efficient by
participants wearing jackets colour coded to their job role or
brokerage firm. Pit dealers would also sport large badges etched
with their individual trader mnemonic (a three or four letter code)
and exchange member ID. In most commodity types there was never
more than one contract expiry available to trade per calendar
month, thus each month could be allocated a unique single letter
code.
[0082] In open outcry after a trade was agreed and checked each
counterparty in the pit would fill in an order ticket with their
own half of the trade details i.e. bought or sold, price, number of
lots, futures expiry month code and counterparty trader mnemonic.
These so called filled orders would be handed from the pit to so
called runners who would process the paperwork in order that
matched trades could be efficiently registered with the
exchange.
[0083] Much later in their history certain US based commodity
exchanges began listing financial derivatives that were designed in
analogy to commodity futures. These products quickly became
extremely successful and effectively transformed their hosts into
financial futures and options exchanges. To try and emulate these
successes in foreign financial centres around the world entirely
new financial futures and options exchanges have been set up since
the early 1980s. Some of these newer exchanges were however
established using electronic order matching rather than open
outcry. It was argued at the time that the lack of locals was
detrimental to liquidity. Though it was not immediately obvious it
has since become clear that independent scalpers can trade just as
effectively from offices in an electronic market however. History
has since shown that it is the electronic financial futures and
options exchanges that deliver the greater liquidity and so have a
competitive advantage over the more traditional open outcry
model.
[0084] In recent years open outcry has been largely or completely
supplanted by electronic order matching even at the oldest
exchanges. Despite this prior to the present invention the superior
power of computer based matching over human infrastructure to
deliver new types of products has remained unrecognised and
unharnessed. Indeed modern electronic derivative exchanges without
exception have limited themselves to listing financial futures and
options that could just as well be (and in many cases historically
once were) traded via open outcry.
The International Swaps and Derivatives Association (ISDA)
Formation of ISDA
[0085] Bilaterally negotiated derivative contracts between banks
and their larger customers or indeed other banks also began to
appear in the early 1980s. This was partly as a result of the
futures exchanges' lack of ability to innovate in order to fully
meet the exact needs of hedgers and speculators because they were
at the time still constrained by their traditional human
infrastructure.
[0086] Initially each bilateral deal took a lot of organisation to
set up and complete with every bank having its own slightly
different legal documentation. Yet by the mid 1980s genuine bid ask
inter dealer markets had emerged in some key financial products.
These became commonly referred to as the Over The Counter or OTC
markets to distinguish them from exchange traded financial futures
and options. Paradoxically perhaps a significant part of the early
growth of OTC derivatives can be attributed to the ability of banks
to hedge their private financial derivative exposures on futures
and options exchanges.
[0087] In 1985 as a result of the increased frequency of
bilaterally negotiated derivative trading a group of banks set up
the International Swaps and Derivatives Association (ISDA) as a
global trade organisation. Since its inception ISDA has tried to
streamline and efficiently reorganise the microstructure of the OTC
market by for example reducing dealer legal overheads and by
attempting to address their back office (i.e. trade confirmation
and post trade management) overheads too.
Legal Structure
[0088] A schematic representation of the legal structure of a
single ISDA based derivatives trading relationship is shown in FIG.
1. Since OTC derivatives are leveraged any legal or other
operational failings can result in substantial losses. Therefore
among ISDA's most notable accomplishments was the development of
its Master Agreement (see item 106 of FIG. 1) and the publishing of
a wide range of related documentation materials and instruments
covering a variety of transaction types (see item 108 of FIG. 1).
Note however the clumsy way that each new trade has to be confirmed
by appending a trade confirmation contract to the ISDA master
agreement (see items 110, 112 and 114 of FIG. 1). Note also that
there must be at least one master agreement between any pair of
counterparties (see items 100 and 102 of FIG. 1). ISDA therefore
failed to address in a meaningful way the scalability of trade
confirmation and new counterparty workload even as it addressed the
legal robustness of each instance of the contracts concerned.
[0089] To address the markets present failings on legal scalability
ISDA has long argued in favour of electronic straight through
processing (STP). It is also fair to say that ISDA has pioneered
efforts to identify and reduce all the sources of risk in the
derivatives and risk management businesses of its members. After
ISDA's formation and the legal streamlining of the OTC derivatives
markets the interest rate swaps markets grew exponentially for a
decade and came to dominate exchange traded financial futures and
options in terms of notional turnover.
Counterparty Credit Risk and its Reduction
[0090] Although individual OTC counterparties would revalue their
positions on a daily basis yet still all of the gains or losses
associated with a position were originally exchanged only at some
future predefined payment dates. This introduced a very significant
level of `counterparty credit` risk as market moves caused
unrealised gains or losses to build up ahead of the date of
ultimate payment. Hence even before trading potential
counterparties each had to consider if the other would be capable
of paying what might become very substantial sums by the deferred
date. The high degree of potential credit risk requires prudent
firms to expend resources investigating each other's financial
conditions in order that they set credit lines and limits for each
potential counterparty.
[0091] Enormous investments in credit screening were thus required
by the early 1990s. Regulators and central banks were at this time
often voicing concerns over the impenetrable jungle of bilateral
counterparty credit exposures within the financial system as a
result of OTC derivatives growth. Given the growth in the
importance of its markets, ISDA responded by taking a lead in
promoting the understanding and treatment of derivatives and risk
management from both public policy and regulatory capital
perspectives. ISDA also further developed its documentation and by
the mid 1990s ISDA had introduced optional but legally enforceable
netting and collateral arrangements into its documentation
structure (see item 104 of FIG. 1). There has been a substantial
uptake of these optional arrangements ever since.
Operational Risk
[0092] The promotion of the risk-reducing effects of netting and
collateral has remained at the heart of ISDA's activities since
they were first introduced. By contrast straight-through processing
for both interest-rate derivatives and particularly credit
derivatives remains even today a vision rather than an achievement.
Indeed new post trade utilities, such as the DTCC Matching Service,
Swapswire and SwapsClear, and other services are also trying to
promote efficiency in the OTC derivatives market to some extent
independently of ISDA.
[0093] In 2002 ISDA responded to these trends by focussing again on
STP. It did this by absorbing the hitherto independent trade
organisation responsible for the development of FpML (Financial
products Markup Language) into ISDA's organisational structure.
Ultimately FpML which is now used by all the new post trade
utilities just mentioned should allow for the total electronic
integration and operational streamlining of the entire industry. As
by design the FpML format is flexible enough to accommodate all
possible ISDA based derivative trade descriptions, direct
communication across the full range of OTC trade services from
electronic trading and confirmations to portfolio specification for
risk analysis (yet regardless of the specific software or hardware
infrastructure supporting these transaction related activities)
will finally become possible.
[0094] One weakness of FpML in practice is that it is more flexible
than is needed for most transaction purposes. The flexibility to
accommodate all possible ISDA based derivative trade descriptions
whilst useful in principle is of practical benefit only when all of
a bank's systems have been upgraded to this standard. Indeed only
when all other banks have also fully installed FpML can the dream
of a seamless operational infrastructure across the industry become
a reality. It is of course expensive to implement FpML across even
a single bank's entire range of trading systems and such a spend is
hard to justify when the existing systems are already adequate for
their tasks and there is no guarantee that all other banks have
made equally strong investments in FpML.
[0095] In December 2003 the ISDA strategy paper entitled `Going
Forward: A Strategic Plan` announced that a unified approach to
directing investment by industry participants and service providers
in developing new services was needed. This paper was followed by
another one in March 2004 entitled `The Implementation Plan` which
highlighted specific considerations for implementing the goals set
out in the Strategic Plan. The ISDA Operations Committee has thus
created a blueprint for the operational evolution of the OTC
derivatives industry and launched an aggressive schedule for
achieving improvements in processing.
[0096] The ISDA Operations Committee has conceded that over 80% of
ISDA based transactions are highly standardised so the schedule for
processing improvements is starting with these most `plain vanilla`
products. It remains to be seen if this latest ISDA initiative will
yield benefits to all market participants as quickly as it
hopes.
ISDA Today
[0097] Today ISDA is at its zenith covering all asset classes from
`traditional` derivatives on interest rates, currencies, equities
and even commodities through to relatively new derivatives on
energy and credit. The OTC markets have grown very substantially
from their beginnings in the 1980s mostly as a result of the
increasing participation in and acceptance of ISDA based
derivatives by all sectors of the trading community. Another key
factor has of course been the more general availability of computer
based derivative valuation tools but nonetheless it is fair to say
the financial markets have been transformed as a result of ISDA.
Indeed more often than not today's cash markets are being driven by
supply and demand changes in derivatives rather than the other way
around.
The Modern Futures Exchange Explained
Legal Structure
[0098] FIG. 2 shows a schematic representation of the legal
structure of exchange based derivatives trading. It is clearly more
intricate than FIG. 1 but crucially is far more scalable especially
for smaller clients.
[0099] Brokerage agreements (see items 208 and 210 of FIG. 2) give
customers (see items 202 and 204 of FIG. 2) access to exchange (see
item 200 of FIG. 2) via members (see items 220 and 222 of FIG. 2)
acting as their main futures broker and executing trades on their
behalf (see item 218 of FIG. 2). Such `clearing` members must
therefore be members of both the futures exchange and its clearing
house (see item 230 of FIG. 2). This is achieved via exchange
membership agreements (see items 214 and 216 of FIG. 2) and
clearing membership agreements (see items 224 and 226 of FIG. 2)
respectively. Members acting as brokers are required to collect
margins calls from customers and to enforce the rules of the
clearing house as regards maintenance of sufficient margins in
customer accounts. Clients funds are protected because funds held
in fulfilment of margin rules and requirements must be kept
separate from, or segregated from, the member firms' own funds.
[0100] Not shown on the diagram are so called non clearing exchange
members because to access the market such members need a
relationship with a clearing member in any case. They thus appear
similar to clients. Shown separately in FIG. 3 is the process
permitted by exchange rules and systems that allows a customer (see
item 300 of FIG. 3) to use several different brokers. One broker
may be used for execution of trades (see item 304 of FIG. 3) but
another broker may be used for clearing (see item 306 of FIG. 3).
The assigned filled orders are transferred from the responsibility
of the executing member to the clearing member within the clearing
house (see item 310 of FIG. 3) via a process called a "give up"
(see item 308 of FIG. 3), governed by a so called give up agreement
(see item 302 of FIG. 3). Such give up instructions are usually
handled by post-trade exchange or clearing house software. The give
up process for short positions is not shown in FIG. 3 but is
identical.
[0101] Other documents shown in FIG. 2 include the exchange's
trading rules (see item 206 of FIG. 2) and master product
specification (see item 212 of FIG. 2). Such incorporation by
reference is extremely efficient allowing for example the contract
specifications of all existing positions in a product to be
efficiently updated if necessary from time to time. A final
contractual link that is worth mentioning is that between an
exchange and its clearing house (see item 228 of FIG. 2), for
although this relationship is traditionally very stable exchanges
such as the Chicago Board of Trade have been known to switch from
one clearing house to another.
[0102] Overall the exchange's legal structure is extremely robust
and therefore beloved of regulators. In these circumstances and in
stark contrast to ISDA based derivatives, legal battles from
disgruntled end users trying to recover losses made on exchange
traded derivatives are practically unheard of and never affect the
exchange itself.
Trade and Risk Management Information
[0103] FIG. 4 shows a logical representation of operational
information flow in existing exchange based derivatives. Item 400
of FIG. 4 represents just one of the many dealers trading on the
exchange. The dealers decisions will be informed by general
activity observable across various markets and news as published by
quote vendors (see item 402 of FIG. 4) such as Reuters, Bloomberg
etc. The dealer shown also has direct access to the market place
and via their own front office trading system (see item 404 of FIG.
4) they are therefore likely to be a broker or a high volume
trader. Low volume traders will tend to place orders by telephone
via a broker (not shown). The front office trading system typically
connects to the exchange via a so called exchange gateway (see item
408 of FIG. 4) which forms the physical and logical boundary to the
exchange maintained systems.
[0104] There are typically two methods through which a trade can be
occur on the exchange a) a pre-matched bilaterally negotiated pair
of trades can be registered directly via so called wholesale
trading facilities; or b) orders can be placed in the matching
engine (see item 414 of FIG. 4) in the hope that a counterparty can
be found. In either case valid half trades are entered into the
trade registrations system (see item 418 of FIG. 4) which forms
part of the logical boundary between the exchange and the clearing
house systems. Whilst within the trade registration system "give
ups" can be executed by the appropriate back office (see item 416
of FIG. 4) before half trades are passed to the appropriate
accounts within the clearing house (see item 422 of FIG. 4).
[0105] To assist with generating a steady flow of matched trades
the matching technology also calculates market status information
(see item 412 of FIG. 4) such as the lowest unmatched sell orders
known as the best ask or offer and the highest unmatched buy orders
known as the best bid. These are published via quote vendors (see
item 402 of FIG. 4) and of course to the trading screens themselves
(see item 404 of FIG. 4). The volumes of unfilled bids and asks at
each permissible price respectively below and above the best bid
and ask are known as the orderbook and are often also publish. The
market supervision function (see item 410 of FIG. 4) is one of the
most important in the exchange. This is usually performed by
skilled individuals in the exchange's market control centre who
continually monitor the market status and whose principle roles are
a) to enforce exchange rules; b) maintain an orderly market and c)
set the daily settlement prices (see item 420 of FIG. 4). For
example market supervisors will be able to reject attempts to
register wholesale trades that do not conform to the appropriate
exchange rules.
[0106] Daily settlement prices (see item 420 of FIG. 4) are used by
the clearing house (see item 422 of FIG. 4) to calculate variation
margin calls to or from members (see item 416 of FIG. 4) and
because of their importance are also published by quote vendors
(see item 402 of FIG. 4). Another important set of published
information is related to total outstanding contracts on which
initial margin is collected and is known as open interest (see item
424 of FIG. 4).
[0107] Perhaps most importantly straight through processing (STP)
is completely standard and in fact mandatory in the modern
electronic futures exchange model. The back office trading reports
(see item 406 of FIG. 4) are these days likely to be in electronic
format and both these and the front office trading systems can
therefore be linked into front office position keeping, risk
management and reconciliation systems if deemed necessary (not
shown). Much of the infrastructure for STP is nonetheless provided
by the exchange and its clearing house for relatively modest and
totally transparent fees per lot charges. The modern electronic
futures exchange model therefore not only provides good cost
effective STP infrastructure but upgrades are automatically
enforced across the user base as they are centrally managed by the
exchange and its clearing house.
[0108] In addition a free risk management service is provided via
daily settlements greatly reducing internal risk management costs
of smaller or less sophisticated financial institutions. Exchanges
also publish certain trading information and so their markets are
generally far more transparent than their OTC equivalents
[0109] The supervisory environment of a genuine exchange is such
that a customer is protected by the exchange's trading rules and
members are appropriately punished for breaches of best practice
conduct. This protection is not available in the OTC derivatives
markets.
Margining and Anonymity
[0110] Margining is the deposit of cash or collateral placed with
the clearing house when you create a futures or options position.
Unlike ISDA's collateral management and other independent
initiatives within the OTC based market the use of clearing and
central counterparty services provided by the clearing house is
mandatory at a futures exchange. In a process known as novation the
web of bilateral counterparty credit exposures is first replaced by
all members' contracts becoming with the clearing house. In a
process known as margining collateral is then deposited at the
clearing house and topped up on an as needed basis to guarantee
performance of the contract and thus eliminate counterparty credit
risk.
[0111] The exchange's margining system provides important
protection to the market. This protection is arranged by the
clearing house which guarantees performance of contracts registered
with it by its members. Any exchange member who is not a member of
the clearing house must therefore have a clearing agreement with a
clearing member in order to transact business on the exchange. To
become a clearing member certain minimum financial requirements
laid down by the exchange and clearing house must be met. Members
are monitored to ensure that they continue to meet specified
criteria. There are usually different categories of clearing
membership depending on whether the member clears only its own
business or can act as a broker etc.
[0112] After novation the clearing house ensures the financial
performance of trades through to final cash settlement or delivery.
To assess and control the risk associated with its position as
central counterparty, the clearing house calculates and collects of
initial and variation margin payments. These are explained
below.
[0113] Novation and margining together put all exchange trades in a
single product on the same footing regardless of originating
counterparties and derivative contracts therefore behave just like
negotiable securities when viewed from within the exchange's
membership and clearing structure. The combination of the clearing
house with electronic trading means that anonymous trading is
standard practice when dealing on a modern futures exchange and
this is especially attractive to larger customers. The anonymous
trading advantage cannot be replicated in the traditional
bilaterally negotiated market. Margining services were once a
unique distinction between exchange traded futures and options and
the way the OTC derivatives market worked. However new post trade
central counterparty utilities, such as the DTCC Matching Service
and SwapsClear, have emerged in recent years and blurred this
distinction.
Variation Margin and Daily Settlement Prices
[0114] At a fixed time of the trading day, usually after the close
of trading of in a contract series, the exchange determines and
then publishes so called daily settlement prices for each expiry
(and where applicable strike) within the series. Daily settlement
prices are simply a set of reference prices consistent with market
activity at settlement time. The key to the variation margin
process is the exchange's determination of an accurate daily
settlement price for each and every futures and options contract.
If at settlement time there is insufficient trading activity to
observe a settlement price directly, market supervision can use
prices generated by a relevant pricing model based on prices from a
related market. Settlement prices are automatically transmitted to
member back offices.
[0115] Based on the daily settlement prices the open positions all
participants are market to market and money to cover losses is
collected by clearing member firms and presented to the clearing
house. Such accounting and collection is followed by a disbursement
of day to day gains to clearing member firms. This process ensures
that all members' customers receive the gains (and pay the losses)
associated with their positions each day. This process is known as
variation margining and means that all historical profits and
losses are immediately realised. Hence the stresses caused by past
negative performance on losing positions are not allowed to build
unchecked to levels that may threaten the good performance of
profitable positions going forward. The protection afforded by
variation margin is augmented by the collection of initial margin
which effectively eliminates the residual counterparty credit
exposure between the clearing house and any of its members.
Fungible Contracts and Regular Trading Hours
[0116] It is worth noting the fact that different exchanges can use
the same clearing house which allows positions to be initiated on
one exchange and closed on another.
[0117] The most straight forward example of fungible contracts in
practice is the way in which the Options Clearing Corp (OCC) has
since 1975 been used as the central clearing corporation for all US
exchange-listed equity options. The Chicago Board Options Exchange
(CBOE), The American Stock Exchange (AMEX), The Philadelphia Stock
Exchange (PHLX), The Pacific Exchange (PCX) New York Stock Exchange
(NYSE), The National Association of Securities Dealers (NASD), The
International Securities Exchange (ISE) and The Boston Stock
Exchange are all OCC participant exchanges. Where contracts are
dual listed a position initiated on one exchange can be closed on
another.
[0118] A more interesting example of fungible contracts is the
system of Mutual Offset (MOS) pioneered in 1984 by the Chicago
Mercantile Exchange (CME) and the then Singapore International
Monetary Exchange (SIMEX). This electronic linkage effectively
allows give-ups between the two exchanges so for example a
Eurodollar future executed in Singapore can be cleared in Chicago
and hence closed out against an open position already established
there. The two exchanges remained separate with distinct clearing
houses and because of their different closing times distinct daily
settlement prices. As a result of the mismatch of regular trading
hours between the two exchanges daily variation margin call
imbalances must be absorbed by the two clearing houses.
Initial Margin
[0119] The collection of initial margin provides protection to
members and the clearing house in the event that sufficient client
funds are not readily available to satisfy day to day variation
margin requirements. Both longs and shorts must have paid initial
margin in order to hold open a position. In effect initial margin
is the prepayment of worst case variation margin calls associated
with all members' customers positions.
[0120] Initial margin thus guarantees in advance that all those due
to receive gains will continue to get them even on a day when
someone defaults. In this way the initial margin acts as a deposit
which may be used by the members and the clearing house to satisfy
the customer's or clearing member's obligations if the customer or
clearing member fails to do so.
[0121] The amount of this initial margin is set by the clearing
house based on historical trends in terms of market price
volatility as well as forthcoming events which may further affect
volatility. An account's initial margin requirement is calculated
as the largest possible loss (including all futures and options
positions) that a trading account would face in the worst case
scenario of market events. The details of these calculations vary
from clearing house to clearing house but often recognise that
customers' portfolios may hold offsetting positions. However
clearing houses must remain conservative as excessively low levels
of initial margin risk the integrity of the exchange. If on the
other hand offsetting positions are not recognised appropriately,
traders may not be able to make the most efficient use of their
resources, which may lead to their exiting the market in favour of
OTC or another exchange venue. Good quality margining is thus
essential to maintaining liquidity.
Cheap Custody and Valuation Services
[0122] Typically exchanges and their clearing houses charge a per
lot fee at time of trade as do their members when acting as
brokers. However there are services that are provided effectively
for free. For example the futures clearing house is not only a
central counterparty but acts ipso facto as a central depository
with members acting as custodians for their clients. No direct fees
are charged for holding positions however. Also the calculation of
variation margin calls represents a free valuation service and the
calculation of initial margin represents a free value at risk
calculation (albeit often an overly conservative one).
Competition Between ISDA and Financial Exchanges
Increasing ISDA Dominance?
[0123] The story of exchange based financial derivatives trading is
that of enormous growth but also of decline relative to OTC
derivatives. It is true that exchange traded interest rate products
have apparently shown strong growth in absolute terms, but their
relative decline is remarkable. The OTC Interest Rate Swaps market
has ballooned into by far the biggest derivatives markets in the
world. Thus, apart from a one-off boost to liquidity when rate
futures became electronic, the picture of increasing
marginalisation is clear. As ISDA continues its crusade to
streamline the OTC market microstructure by setting STP standards
the value add of electronic futures exchanges will be further
eroded.
[0124] Already some exchange traded equity options are increasingly
under threat from competing OTC `look alike` business which is also
quoted in exactly the same way as the exchange options. However
this is largely an artefact of investment bank equity options
dealers not being properly charged for the full cost of their OTC
back office whilst being fully charged for exchange brokerage.
Nonetheless certain futures and options exchanges appear unable to
promote the true benefits of exchange derivatives over bilateral
negotiation of contracts in this particular product group.
[0125] If as a result of operational streamlining electronic
trading of Interest Rate Swaps takes hold in the ISDA based markets
an absolute decline in exchange traded interest rate products could
also result. The conservative market microstructure retained by
exchanges since their open outcry days would be strongly implicated
in this sorry state of affairs if that happened.
Liquidity and the Exchanges
[0126] Despite the apparent negative picture from historical trends
a proper analysis of these shows that ISDA based OTC markets are
actually evolving towards the electronic futures and options
exchange central markets model or at least as closely as they can
to it. Thus OTC markets now have (a) centrally designed contract
specifications via the ISDA definitions; and (b) some central
clearing via SwapsClear, the DTCC etc; and even (c) a centrally
designed API's via the FpML and FIX protocols. Clearly the
derivatives exchange model has some true merit. By contrast ISDA
based negotiation of contracts clearly has scalability problems
from both the mountain of confirmations and the bilateral master
agreements required. These scalability problems have recently come
very sharply into focus with the advent of credit derivatives but
are also present in more established ISDA based products.
[0127] Whilst the back office operational difficulties with
confirmations can be addressed via STP the bilateral master
agreements required pose a more fundamental scalability problem.
The setting up of ISDA master agreements and the monitoring of
bilateral counterparty credit risk are both costly non trivial
tasks. There are therefore many smaller traders excluded from the
ISDA based market.
[0128] The contrast with exchange traded financial futures could
not be more stark where even in the electronic age office based
independent traders (the modern `locals`) can constitute up to 40%
of the daily turnover.
[0129] One can therefore remain quite optimistic for futures
exchanges as a group. They remain structurally better positioned to
deliver superior scalability of participation and in the electronic
age have vastly increased their reach and distribution. With broad
participation and distribution can come superior liquidity and
liquidity is key in any competition between derivatives
markets.
[0130] Unfortunately many for futures exchanges have used the
opportunity of electronic trading simply to compete with exchanges
in other financial centres. However most exchanges have also worked
hard to offer alternative access to their infrastructure via so
called wholesale trading facilities that allow dealers to agree
transactions over the phone OTC-style and then register these as
futures or options on the exchange.
[0131] The true benefits of exchange derivatives over bilateral
negotiation of contracts are best observed in the growth of
electronic foreign exchange futures, most notably at the CME. It is
no mere coincidence that foreign exchange futures already meet the
needs of forex hedgers and speculators properly as evidenced a) by
the fact that OTC foreign exchange forwards are quoted in exactly
the same way as them; and b) the universe of currency pairs is
small enough to be fully represented on exchange (contrast equities
at most exchanges).
The Exact Context of the Present Invention
[0132] The exact context of the present invention can only be
properly understood in the context of the legal and operation
structure of the modern electronic futures exchange and its ISDA
rival, as already described. The well known historical inability of
futures exchanges to deliver product innovation has also already
been alluded to. Yet it is a very poorly understood fact that many
operational, legal and organisational advantages existing in a
futures exchange model cannot easily be recreated even in the best
practice bilateral OTC model. The true context of the present
invention is simply the observation that the converse is not true
i.e. exchanges can be adapted to recreate the advantages of OTC
products even though this has never been done before.
[0133] The invention aims to reengineer the existing electronic
futures exchange model in order to establish convenient on exchange
access to spot and forward derivatives normally only available on
the ISDA based OTC market. Thus electronic futures and options
exchanges can become truly worthy of the title `derivatives
exchanges` by fully meeting the exact needs of hedgers and
speculators for the first time as ISDA has now been doing for the
past twenty years.
[0134] The ability of office based independent traders to
participate in the invention's new ISDA-like derivatives products
plus the release of existing OTC participants from ISDA's
scalability problems (particularly in credit derivatives) can be
expected to lead to an explosion in liquidity. In short the
invention aims to deliver a far better way of trading. Also the
problems of exchange traded equity options will come to be seen as
a temporary aberration and an artefact of a mispricing of
infrastructural services.
[0135] Given the stated aim of the present invention it can only be
properly understood together with some basic details of the major
ISDA based derivatives markets as compared to existing exchange
traded financial futures and options products. We therefore now
turn to these matters.
Major Exchange Traded and ISDA Based Debt Derivative Products
Interest Rate Financial Futures and Options
[0136] There are two established types plus one less established
type: [0137] Short Term Interest Rate (STIR) futures such as CME
three month Eurodollar, LIFFE three month EURIBOR etc; and [0138]
Bond futures such as the CBoT ten year T-note and the EUREX Bund
[0139] The relatively new swap related futures like the LIFFE
Swapnote.
[0140] There are other less typical types like the SyFE
products.
Short Term Interest Rate (STIR) Futures
[0141] Mainstream STIR futures are cash settled futures (see FIG.
5) and we therefore will take this opportunity to explain how this
process works in general. In step 500 of FIG. 5 the exchange
determines whether the last trading day has arrived. If the last
trading day has not arrived then normally daily settlement occurs
and the position remains as a futures or options one as indicated
at endpoint 502 of FIG. 5. However if the last trading day has
arrived then the final daily settlement price known as the Expiry
Day Settlement Price (EDSP) is set at step 504 of FIG. 5 via a
predefined formula (see 506 of FIG. 5) linked to external data
related to the underlying market. As a result of this at the
endpoint 508 of FIG. 5 the final variation margin is called, the
position is deleted from the clearing house register and initial
margin is returned.
[0142] For mainstream STIR futures the external underlying market
data for cash settlement is an appropriate fixing taken from the
deposit market. For example CME Eurodollar futures EDSP at 11 am
London time to a price related to the London Inter-Bank Offer Rate
(LIBOR) for three month dollar deposits trading at that time as
calculated by the British Bankers Association and published as a
benchmark fixing. Specifically the formula linked to this external
underlying (see 506 of FIG. 5) is simply: CME Eurodollar EDSP=100
minus BBA 3-month $ LIBOR
Deliverable Bond Futures
[0143] Mainstream bond (or note) futures are physically delivered,
see FIG. 6. In step 600 of FIG. 6 the exchange determines whether
the last trading day has arrived. If the last trading day has not
arrived and there is no option to make early delivery as indicated
at step 602 of FIG. 6, or indeed the option exists but is not
exercised then position remains as a bond future (see 604 of FIG.
6).
[0144] The specified criteria for the bonds deliverable into a
futures contract listed on an exchange can be found in its contract
specifications. The exchange will publish an initial list of the
bonds, as shown at step 612 of FIG. 6, which it believes form the
complete list of deliverables in time for market feedback. Such a
list is commonly known as the basket. The basket contains different
bonds which vary in their characteristics but match a set of
criteria specified by the exchange for each different type of bond
future.
[0145] Most often the bonds in a particular futures basket will
only differ in their coupons and times to maturity. The bonds
deliverable will be of the credit quality defined in the contract
specifications of the particular bond future under consideration.
This usually means a restriction to a single named issuer for each
bond futures contract. In principle the issuer could be anything
from a small entity up to the US government but a contract will
only maintain its integrity if the supply of the underlying is
sufficiently great i.e. it becomes hard to engineer a "short
squeeze". For this reason and because of their benchmark status in
the cash bond markets, government bond futures predominate in their
domestic futures exchanges around the world.
[0146] Having published the initial list of deliverables and taken
into account market feedback (see 610 of FIG. 6), any errors made
can be corrected or new issues included in the deliverable list.
Eventually the exchange will close the basket at the time it
publishes the final list of deliverables (see 608 of FIG. 6). This
final list is definitive and any remaining mismatches with the
official selection criteria for picking deliverables as laid out in
the contract specifications become moot.
[0147] The process of delivery established by the exchange gives
traders holding a short futures position the choice to deliver any
bond from the list of deliverables. Each bond is assigned a
conversion factor which is applied to the final invoice price
calculation should it be delivered and is also published in the
lists of deliverables together with accrued interest information
(see 608 and 612 of FIG. 6). This conversion factor is the
mechanism which brings the maturity and coupon differences of the
deliverable bonds onto a common base and is intended to make all of
the bonds almost equally attractive for delivery. In practice
however difference remain and a particular bond known as the
cheapest to deliver is the most attractive.
[0148] If the last trading day has arrived or an early delivery
option has been exercised then the short futures holder must notify
the clearing house which deliverable from the list they have
elected to deliver (see 606 of FIG. 6). The clearing house can then
assign a long futures holder (see 614 of FIG. 6) either at random
or according to some other rule to take delivery.
[0149] During the deliverable period of the futures contract, which
may be a month or just a single day, the daily settlement price is
known as the Exchange Delivery Settlement Price (EDSP) but is set
by the market supervisor according to prevailing conditions in the
futures market as normal (see 616 of FIG. 6). For each lot short
the bond seller delivers the same face value of bond as the
notional size of the futures contract (e.g. $100,000 for CBoT ten
year T-note future) in return for the proceeds of the sale as
calculated by the clearing house (see 618 of FIG. 6). The proceeds
of the sale resulting from a single delivery are determined by the
EDSP multiplied by the delivered bond's conversion factor and
adjusted for accumulated accrued interest at delivery. This is
called the invoice amount: Invoice amount=Nominal Size*(EDSP
%*Conversion factor+accrued interest %)
[0150] Finally as shown at the endpoint 620 of FIG. 6, the long
futures holder pays this invoicing amount to short futures holder
in exchange for elected bonds, relevant futures positions are
closed and initial margin is returned. This transaction in the cash
bond market prompted by the choice of bond to deliver by the short
futures holder is called making delivery.
[0151] It is worth noting that when a bond futures contract is
bought or sold, it is not always with the intention of holding the
contract until expiry and then making or taking delivery of an
underlying bond. A considerable proportion of the market use bond
futures only for exposure management. Accordingly as a deliverable
futures contract nears expiry, the open interest (number of open
positions) in the contract begins to decline as positions are
transferred into the next available contract. This is known as the
`roll`.
Swap Related Futures
[0152] These products are relatively new and are cash settled (see
FIG. 5).
[0153] Swap related futures give cash settled exposure akin to what
would be achieved by a bond future whose underlying CTD carried the
credit quality of the OTC Interest Rate Swap market and also had a
perfect maturity match i.e. CBoT ten year Swap future is linked to
an exact 10 year term of the swap market.
[0154] There are actually two competing designs but both behave
essentially similarly:
[0155] 1. The CBoT Swap future design; and
[0156] 2. "Swapnote"--Arguably the most sophisticated futures
contract in the world.
[0157] Swapnote is traded under license (see the U.S. Pat. No.
6,304,858 B1, Oct. 16, 2001 ) on the LIFFE and TIFFE markets and
exactly emulates the exposure already described.
[0158] By contrast the M-year CBoT Swap future design has a much
simpler expiry day settlement formula (see 506 of FIG. 5): CBoT
.times. .times. Swap .times. .times. Future .times. .times. EDSP =
C S + ( 1 - C S ) * ( 1 + S .times. .times. % 2 ) 1 2 * M ##EQU1##
where, [0159] S represents the ISDA Benchmark Rate for the M-year
U.S. dollar interest rate swap on the last day of trading,
expressed in percent terms; and C represents the notional coupon
for the future, expressed in percent terms (currently C=6 for both
the 5-year and 10-year Swap futures that are listed)
[0160] The advantage of both Swapnote and CBoT Swap futures over
deliverable bond futures is the fact that being cash settled there
is no possibility of a short squeeze of the cheapest to deliver
cash bond . . . However there can be problems with cash settlement
too--These swap futures are designed to give access to swap
exposures for participants who cannot normally trade ISDA IRSs (see
below). Such participants will normally want continuing exposure
after futures expiry and the only way to achieve this for them is
to rollover rather than go to cash settlement. Because of this
captive market `the roll` has a tendency to be priced away from
fair value as market makers cash in on their relative advantage,
caused by the fact they can trade OTC whilst their captive
counterparties cannot.
Cash Settled Options
[0161] Often options are cash settled as in FIG. 5 with the EDSP
for calls being the premium quotation equal to the maximum of zero
or the value of a purchase at strike followed by a sale at the
underlying reference fixing. Thus if the options tick size is the
same as the futures as is often the case the formula (see 506 of
FIG. 5) is: Call EDSP=Max(0,Reference Price-Strike Price)
[0162] Likewise the EDSP formula (see 506 of FIG. 5) for a put is:
Put EDSP=Max(0, Strike Price-Reference Price)
Deliverable Options
[0163] The alternative to cash settlement for options is physical
delivery into futures (see FIG. 7) which is for example used in so
called serial and mid-curve options in the CME Eurodollar and also
in most options on bond futures. In step 702 of FIG. 7 the exchange
determines whether the option is in the money at expiry using a
reference price (see 700 of FIG. 7). This check is simply the same
as checking if the option EDSP would be greater than zero were it a
cash settled one. If not the option reaches endpoint 704 of FIG. 7,
remains as an option and expires worthless. Alternatively for
American exercise style options, the option holder has the
additional right to manually exercise at any time prior to expiry
(see 706 of FIG. 7) but if the option is not exercised in this way
either we are again at endpoint 704 of FIG. 7.
[0164] Exercise of options either automatically or manually has
different delivery implications depending on whether the option
held is a put or a call (see 708 of FIG. 7). Call option holders
receive upon exercise a long futures position at the option's
strike price from the call options sellers, who therefore has a
short futures position, and at the same time the call options
positions are deleted from the clearing house register and initial
margin returned (see 710 of FIG. 7). Likewise put option holders
receive upon exercise a short futures position at the option's
strike price from the put options sellers, who therefore has a long
futures position, and at the same time the put options positions
are deleted from the clearing house register and initial margin
returned (see 712 of FIG. 7).
Financial Futures Quotation and Design Standards
[0165] In traditional futures exchanges products are highly
standardised. Generally speaking the contract quotation for front
office trading purposes and its valuation for back office purposes
are identical up to a constant factor i.e. what you see is what you
get.
[0166] Thus short term interest rate futures such as CME Eurodollar
futures and options products have a constant tick value i.e. a move
in price of a single lot of 0.005 is always worth $12.50
regardless. No proper account is taken of: [0167] a) Convexity so
overall forward interest rate levels are ignored (in fact given the
design of the CME Eurodollar futures in the unlikely event of three
month rates going above 100% the futures would be trading at
negative price); and also [0168] b) Time value of money is ignored
so tick value is the same regardless of how far away an expiry is
and what the relevant spot interest rate levels would be to
properly value a corresponding forward; and also [0169] c) The
actual days in the deposit market fixing that underlies each
contract expiry is ignored i.e. day count is simplified to three
months equals 1/4 of a year.
[0170] Even in the exceptional case of the Sydney Futures Exchange
(SyFE) where convexity has been included the relationship between
quotation and valuation remains relatively simple, inflexible and
standardised. Any variable parameters however relevant are ignored
and specifically factors b) and c) are not taken into account.
[0171] Such conventional constraints on financial futures price
quotations and valuations can largely be put down the exchanges'
history as open outcry markets where what you see is what you get
was the most appropriate model. Also before the advent of computers
more sophisticated quotations would have been difficult to
implement manually. The limitation to one expiry per calendar month
per product is also a relic from those bygone days. In the age of
computer based trading such constraints can be set aside.
[0172] A final constraint that is certainly counterproductive and
again merely conventional is the fact that all term futures
products are listed as so called forward-forward products. Thus for
example every point on the price curve defined by the CME
Eurodollar future represents a three month term exposure. If
forward-forward curves are filled in to include all possible expiry
dates you will have a single contract going to final completion
each day. By contrast spot market curves will contain different
maturity terms but all for `immediate` delivery whilst true forward
market curves will also contain different maturity terms but all
for deferred delivery on the same forward date.
OTC Interest Rate Derivatives
[0173] There are three mainstream interbank OTC interest market
types: [0174] The money market derivatives known as Overnight
Indexed Swaps (OISs) and their associated options; plus [0175] The
money market derivatives known as Forward Rate Agreements (FRAs).
[0176] The long term derivatives known as Interest Rate Swaps
(IRSs).
[0177] There are a large number of other less actively quoted
products or variants on the above e.g. asset swaps which are simply
a variant of standard IRSs linked to the cash flows of a particular
bond.
[0178] According to ISDA the total notional outstanding in OTC
interest rate derivatives grew almost 16 percent in the first half
of 2004 to $164.49 trillion, mirroring growth in the second half of
2003.
Overnight Indexed Swap (OIS)
[0179] In an OIS one side pays a money market term deposit interest
at a level negotiated at time of trading and the other side the
relevant overnight index (e.g. the Fed funds rate) compounded over
the same term. An OIS thus replicates off-balance sheet a
mismatched deposit position of 1) a short term loan funded by an
overnight deposit; or 2) an overnight loan funded by a short term
deposit, depending on whether you are receiving or paying the term
rate. Both rates are calculated on an agreed notional principal
which does not however change hands.
Forward Rate Agreement (FRA)
[0180] In a FRA one side pays a term deposit interest at a level
negotiated at time of trading and the other side a market rate for
the deposit at contract maturity. On the day the FRA is priced the
market rate is defined by the relevant interest rate fixing (e.g.
the BBA 1-month $ LIBOR rate). Crucially both payments are
discounted using this same interest rate fixing. Because of this a
FRA, as the name implies, truly allows traders to lock in a forward
rate as they can simply use the deposit market to complete their
hedge. Both rates are calculated on an agreed notional principal
which does not however change hands. Three month and six month FRAs
are the most common.
Interest Rate Swap (IRS)
[0181] In an IRS one side regularly (e.g. every three months) pays
a fixed interest rate while the other side makes regular payments
based on a floating interest rate (e.g. the BBA 3-month $ LIBOR
rate). The fixed interest rate is struck at a level negotiated at
time of trading and depends on the term of the contract. Both rates
are calculated on an agreed notional principal which does not
however change hands at final maturity. An interest rate swap is
thus very similar to a sequence or strip of FRAs all struck at the
same fixed rate.
[0182] The purpose of an IRS is these days usually to manage fixed
income (i.e. bond) portfolios effectively. However the earliest
transactions of this type where used by issuers to take advantage
of imbalances between their standing amongst investors in the
capital and money markets respectively i.e. to achieve minimum cost
of funds.
The Money Market Convention and Beyond
[0183] As might be expected both FRAs, OISs and certain forex
derivatives known as swap points are quoted based on the money
market convention as used in the cash depo and repo markets. This
has a number of advantages for users: [0184] No need to remember
complicated expiry date formulas (contrast with CME Eurodollars
which expire two business days prior to third Wednesday of delivery
month!) [0185] Liquidity is concentrated at the same on-the-run
points across different product types thereby maximising the
ability to arbitrage. For example forward swap points versus depo
market versus spot FX and outright FX forwards form a so called box
trade arbitrage.
[0186] IRSs are also quoted in this manner but at longer term
maturities. Thus the IRS market will only quote active two way
markets at maturities of a whole number of years i.e. spot plus 1
year, spot plus 2 years etc. out to 30 or even 50 years in the
futures.
OTC Credit Derivatives
[0187] In the traditional debt markets poorer credit (higher risk)
borrowers must pay higher rates than lower risk borrowers.
Conversely investors may generally assess the risk of a particular
borrower in terms of the higher or lower market rates prevailing
for their debt. However prevailing rates have to be seen in the
context of the general supply and demand conditions that affect all
debt. In particular the general level of riskless government or IRS
yields will underlay movements in market rates for all other
borrowers' debt. For this reason liquidity has tended to
concentrate in these two markets at the expense of corporate
debt.
[0188] Credit derivatives have become increasingly popular since
the mid-1990s and according to ISDA notional outstanding grew 44
percent in the first half of 2004 to $5.44 trillion, compared with
33 percent growth reported during the second half of 2003. These
are impressive growth rates but the market is still small compared
to OTC interest rate derivatives.
[0189] As a result of these growth rates the theory and
quantitative measurement of credit has had a tremendous boost in
recent years and it is now apparent to bank strategists that credit
derivatives have only just begun to create truly liquid markets in
pure credit exposure. As understanding of these products has grown
the market has come to realise that pure credit exposure represents
a separate asset class from both equity and interest rate products
and due the large amount of outstanding underlying debt the
potential of this sector is vast in principle.
[0190] The main credit derivative market types are:
[0191] Single name Credit Default Swaps (CDSs)
[0192] Index CDSs, tranched indices and correlation
[0193] Synthetic CDOs
Although there are several other we will not discuss here.
Single Name Credit Default Swap (CDS)
[0194] Most of these products are first created at the 5 year
maturity point. In a single name CDS one side (protection seller)
regularly pays a fixed rate called the "spread" (e.g. every three
months) while the other side (the protection seller) makes payments
only in the event of a credit default. As the name implies the
spread premium of a single name CDS is closely associated with the
credit spread over benchmark for the same borrower's actual debt.
In return for receiving the spread premium the protection seller
contracts to pay the buyer the full face value plus accrued
interest for whichever qualifying debt (i.e. the loans, bonds,
convertibles etc from the defaulting issuer) the protection buyer
chooses to deliver after a credit event i.e. in the event of a
default by the issuer.
Index CDSs, Tranched Indices and Correlation
[0195] A CDS Index is just a set of single name CDSs traded as a
group. However the importance of this class of derivatives arises
from their being designed to promote liquidity. Indeed credit
derivative index products are comprised of the most liquid names in
the single name market at the time they are first issued. Another
liquidity promoting feature is that every six months the existing
benchmark CDS index is rolled into a new five year CDS index "on
the run" benchmark at which time also newly active names can enter
the index. Indices of this type have therefore become liquid
benchmarks and have thus become essential tools for managing risk
in other credit derivatives.
[0196] The index tranche market is also very interesting. The
concept is the same as for cash CDOs i.e. tranches are defined by
two percentage face value numbers with the attachment point
defining the minimum losses to which the protection seller is
exposed and the detachment point defining the maximum losses.
[0197] As the attachment and detachment points are standard (i.e.
0%-3%, 3%-6%, 6%-9% etc in Europe, 0%-3%, 3%-7%, 7%-10% etc in
North America) a liquid market for correlation has developed.
[0198] The fair spread premium for an index depends on the overall
risk which is a function of the individual names in the underlying
portfolio and how diversified the it is. In other words the default
correlation must be known in order to fair value an index CDS.
Interestingly index tranches have different exposures to
correlation. For example higher correlations makes the risk within
different tranches more equal which benefits investors in the most
junior tranche whilst hurting investors in the higher seniority
tranches.
The Credit Market Convention
[0199] Since Q2 2003 market makers decided to concentrate CDS
liquidity by quoting only four value dates in the year namely March
20th, June 20th, September 20th and December 20th or the next
available business day if the standard date falls on a weekend or
holiday. Despite this you can in principle trade any dates
according to ISDA documentation.
Synthetic CDOs
[0200] The development of synthetic CDOs is a logical extension of
securitisation and credit derivatives. A synthetic CDO is then
simply a tranched portfolio-linked credit derivative (i.e. non
standard CDS index) packaged inside an SPV and rather confusingly
isn't directly collateralised with actual debt. The first synthetic
CDOs were reported as typically being used in order to exploit
regulatory and tax arbitrages of one kind or another. However by
2000 the profile of deals changed from balance sheet driven to
value driven. In a synthetic CDO, no legal or economic transfer of
bonds or loans take place, with the underlying reference pool of
assets remaining on the balance sheet of the originator. The impact
on the single name CDS market has been to build up liquidity in
those names that were common reference names in synthetic CDOs.
SUMMARY OF THE INVENTION
[0201] The invention is based on the modification of the components
that make up a modern electronic futures exchange in order to
vastly extend the range of products and services supported.
Although some of the new products described are designed to mimic
existing products the modified electronic futures exchange has
significant structural advantages in any case over rival methods of
delivering similar exposures.
[0202] Accordingly, it is an object of the present invention to
provide a novel and highly efficient method for accessing and
managing exact OTC ISDA type credit default swap like exposures
within a fully integrated broad based organized credit derivatives
market that also includes novel recovery based product and novel
options.
[0203] It is an additional object of the present invention to
provide a novel and highly efficient method for accessing and
managing exact OTC ISDA type interest rate swap and FRA like
exposures
[0204] It is an another object of the present invention to provide
a novel hybrid bond like futures that deliver exact OTC ISDA type
interest rate and credit exposure upon expiry.
[0205] It is a further object of the present invention to provide a
novel and highly efficient method for accessing and managing exact
OTC ISDA type overnight index swap exposures
[0206] It is yet another object of the present invention to provide
an upgraded clearing cycle capable of dealing with these new
products and existing exchange traded products in a truly global
market place.
[0207] Additionally, it is another object of the present invention
to provide a novel and highly efficient interbank deposit market
that removes the need for counterparty credit calculations.
[0208] Furthermore it is another object of the present invention to
provide a new kind of securities market based for a broad range of
products including those normally only issued by so called special
purpose vehicles.
[0209] Ultimately it is the aim of this invention to provide a
fully integrated, operationally efficient, broad based and
organized market for the full spectrum of financial
instruments.
BRIEF DESCRIPTION OF THE DIAGRAMS
[0210] A more complete appreciation of the invention and many of
the attendant advantages thereof will be readily obtained as the
same becomes better understood by reference to the following
detailed description when considered in connection with the
accompanying drawings, wherein:
[0211] FIG. 1 is a schematic representation of the legal structure
of ISDA based derivatives trading;
[0212] FIG. 2 is a schematic representation of the legal structure
of exchange based derivatives trading;
[0213] FIG. 3 is a schematic representation of the give up/in
process of exchange based derivatives trading;
[0214] FIG. 4 is a logical representation of information flow in
existing exchange based derivatives;
[0215] FIG. 5 is a flow diagram representing existing cash settled
exchange traded futures and options;
[0216] FIG. 6 is a flow diagram representing the physical delivery
process for exchange traded futures as used for existing bond
futures;
[0217] FIG. 7 is a flow diagram representing existing physical
delivery into futures of exchange traded American options;
[0218] FIG. 8 shows the transformation of information flow in the
invention based derivatives exchange;
[0219] FIG. 9 shows how a front office screen for an exchange
traded credit derivative might appear on 3.sup.rd Oct. 2005;
[0220] FIG. 10 shows the Adapted For Exchange New Credit Derivative
invention mapping of Traded Spread Product orders onto Internal
Matching Product orders;
[0221] FIG. 11 shows the Adapted For Exchange New Credit Derivative
invention mapping of Internal Matching Product orderbook for
display as Traded Spread Product;
[0222] FIG. 12 shows the Adapted For Exchange New Credit Derivative
invention mapping of Internal Matching Product fills into front
office Traded Spread Product fills;
[0223] FIG. 13 shows the Adapted For Exchange New Credit Derivative
invention flow diagram for pro rata Credit Coupon Product pricing
breakdown;
[0224] FIG. 14 shows the Adapted For Exchange New Credit Derivative
invention flow diagram for Credit Coupon Product pricing breakdown
from market prices;
[0225] FIG. 15 shows the Adapted For Exchange New Credit Derivative
invention flow diagram for Credit Coupon Product daily settlement
calculation;
[0226] FIG. 16 shows a schematic overview of the event protection
products and processes which generate credit protection within the
Adapted For Exchange New Credit Derivative invention, including the
calling of a notional credit event and its consequences;
[0227] FIG. 17 shows the Adapted For Exchange New Interest Rate
Swap invention flow diagram for Floating and Fixed Coupon Product
position breakdown;
[0228] FIG. 18 shows the Adapted For Exchange New Interest Rate
Swap invention flow diagram for Floating and Fixed Coupon Product
daily settlement calculation;
[0229] FIG. 19 shows the Adapted For Exchange New Money Market
Derivatives invention flow diagram for Overnight Indexed and Fixed
Rate OIS Product position breakdown;
[0230] FIG. 20 shows the Adapted For Exchange New Money Market
Derivatives invention flow diagram for Overnight Indexed and Fixed
Rate OIS Product daily settlement and indexation calculation;
[0231] FIG. 21 shows the Exchange Traded Pooled Deposit Market
Invention flow diagram for mapping and reverse mapping; and
[0232] FIG. 22 shows a schematic Representation of the trading of
Clearing House Securities.
DETAILED DESCRIPTION OF THE INVENTION AND OF THE PREFERRED
EMBODIMENTS
Overview of the Whole Invention
[0233] The invention consists of a number of linked innovations in
product design, product management processes, pre and post trade
systems design, product settlement processes and the role of the
clearing house that when applied to an existing electronic futures
exchange lead to the establishment of convenient on exchange access
to spot and forward derivatives normally only available on the ISDA
based OTC market. Not all products will rely on all the
innovations.
[0234] In addition an innovation which involves the role and
business processes of the exchange's clearing house can also be
extended to a number of further inventive applications distinct
from the trading of ISDA-like products on exchange yet potentially
extremely useful to the financial markets.
Introduction to the ISDA-Like Derivatives Product
Exchange Part of the Invention
Description of this Part of the Invention
[0235] Specifically the ISDA-like invention exists in three forms
Adapted For Exchange New Credit Derivatives, Adapted For Exchange
New Interest Rate Swaps and Adapted For Exchange New Money Market
Derivatives.
Novelty of this Part of the Invention
[0236] The invention can be clearly distinguished from all others
which merely try to create exchange-like electronic central market
trading systems and/or post trade clearing systems that remain
within the ISDA based OTC markets' legal structure or analogues to
it. Existing inventions of this first type typically show no
recognition of the advantages of the traditional futures exchange
model. There are numerous examples such as those dealing with
central markets for ISDA based products (e.g. the patent
application USPA 20040143535, Jul. 22, 2004) or those dealing with
counterparty credit arising from the ISDA market structure (e.g.
the patent U.S. Pat. No 5,802,499, Sep. 1, 1998) or those dealing
with the post-trade confirmation process so unnecessary in a
futures market model (e.g. the patent U.S. Pat. No. 6,274,000, Jun.
21, 2001).
[0237] The invention can also be clearly distinguished from all
others which merely try to create genuine exchange traded futures
that indirectly reference the ISDA based OTC markets either via a
cash fixing on those markets or indeed via structured negotiable
securities with ISDA based products embedded in them e.g. via
credit linked notes. Inventions of this type have typically shown
complex innovations in product design and product settlement
processes whilst retaining the historically straightforward link
between pre and post trade of traditional futures markets. A
leading example of this approach is "Swapnote" (see the patent U.S.
Pat. No. 6,304,858 B1, Oct. 16, 2001 ) which although it is traded
under license on the fully electronic futures exchanges of LIFFE
and TIFFE would have been perfectly capable of being traded in the
old open-outcry markets. It is basically an advanced type of cash
settled bond future. There is also a more recent example involving
credit linked futures which is nonetheless equally traditional and
equally dependant on the ISDA market to provide a credit linked
note underlying (see the patent application USPA 20050080734, Apr.
14, 2005).
[0238] The invention can also be distinguished from certain already
existing exchange traded futures which merely introduce convexity
into the standard futures environment in a non-parametrical and non
time-valued way e.g. interest rate futures and options as currently
traded on the Sydney Futures Exchange.
General Note on Novelty
[0239] The CFTC glossary on their web site has the following
relevant entries:
[0240] Exchange: A central marketplace with established rules and
regulations where buyers and sellers meet to trade futures and
options contracts or securities. Exchanges include designated
contract markets and derivatives transaction execution
facilities.
[0241] Futures Contract: An agreement [on exchange] to purchase or
sell a commodity for delivery in the future: (1) at a price that is
determined at initiation of the contract; (2) that obligates each
party to the contract to fulfil the contract at the specified
price; (3) that is used to assume or shift price risk; and (4) that
may be satisfied by delivery or offset."
[0242] Traditional exchange derivatives (i.e. futures and options
contracts) trading in a single product can therefore have been
expected to always result in: [0243] a single type of post trade
contract (c.f. "An agreement") but this is not the case with the
present invention. [0244] contracts that have a standard fixed
notional term (c.f. "a commodity for delivery" e.g. CME Three month
Eurodollar) but this is not the case with the present invention.
[0245] either physical or cash settled deliverables (c.f. "by
delivery or offset" but not both) but this is not the case with the
present Adapted For Exchange New Credit Derivatives invention.
[0246] a definite not merely a potential underlying delivery or
offset (c.f. "a commodity for delivery in the future" i.e. both the
commodity and the time of delivery are normally known at time of
trading) but this is not the case with the present Adapted For
Exchange New Credit Derivatives invention.
[0247] The invention is therefore clearly innovative in all these
dimensions at the least.
The General Advantages of this Part of the Invention
[0248] The object of this part of the invention is to give access
to genuinely ISDA-like derivative exposures within a purely
electronic futures exchange-like environment. Two key points to
notice about this invention are: [0249] Spot market--That it gives
daily spot not forward exposure for the first time on a futures
exchange-like environment. Most ISDA based credit, interest rate
swaps and money market products are spot derivatives not forwards.
This means that they give exposure to the relevant term structure
from the very beginning of the curve. This contrasts with futures
which are analogous to ISDA based forwards. [0250]
Flexibility--That it dramatically increases the flexibility of a
purely electronic futures exchange-like environment to play host to
products whose quotation value and tick value are not immediately
deducible from the quotation itself without reference to any
external variable parameters.
[0251] The general view has been historically that ISDA-like
derivative exposures cannot be transferred onto a genuine exchange.
This invention is significant in that it shows this perception to
be wrong and that all the advantages of a futures exchange-like
environment can be brought to bear for a significant fraction of
ISDA based products.
[0252] The advantages of using a genuine exchange for trading are
readily apparent from the "Background To The Invention" section
above. Specifically the advantages include but are not necessarily
limited by the following: [0253] Quasi-negotiable securities--By
moving away from the current ISDA based bilateral model onto a
futures exchange-like environment the products behave similarly to
negotiable securities when viewed from within the exchange's
membership and clearing structure. However a `transfer` of title
when it happens is in fact achieved by one client closing their
position with the clearing house while their counterparty opens an
identical new position. [0254] Robustly fair marketplace--The
supervisory environment of a genuine exchange is such that a
customer is protected by the exchange's trading rules and members
are appropriately punished for breaches of best practice conduct.
Both the central marketplace at the exchange and also the central
depository at the exchange's clearing house provide easy access to
the audit trails required whenever an investigation is commenced.
[0255] Comprehensive access to central counterparty--Unlike certain
existing initiatives that seek to provide clearing and central
counterparty services within the ISDA based market the exchange's
clearing house will provide these services to all users of
ISDA-like products based on the invention. This is because it is
impossible to access the invention based products except via the
exchange. [0256] Anonymous trading--The combination of a universal
central counterparty and electronic trading means that anonymous
trading is standard. [0257] Decreased systematic risk--Regulators
and central banks have often voiced concerns over the non
transparent nature of the existing ISDA based derivatives markets.
The web of bilateral counterparty credit exposures is so complex
and vast that it is impossible to rule out a domino effect of
defaults via contagion within the financial system should a major
institution get into serious difficulties. A large scale move to
the alternatives created by ISDA-like products based on the
invention would eliminate these fears. Also in the event of extreme
financial stress there would be a single point of application for
the injection of funds from lenders of last resort, namely into the
exchange's clearing house. [0258] Decreased operational risks and
costs--The legal and operational structure of a genuine exchange
decrease operational risks to a minimum compared to the existing
cumbersome ISDA based market. A large scale move to the
alternatives created by ISDA-like products based on the invention
would dramatically reduce costs as key operational processes cease
to be duplicated across the industry instead becoming centralised.
[0259] Efficient product structure--The legal structure of a
genuine exchange is such that all positions in a product exist by
reference to a master product specification. This allows the
contract specifications of all existing positions in a product to
be efficiently updated if necessary from time to time. [0260] Risk
management via daily settlements--A key concern of regulators is
that derivatives positions may be mispriced by uninformed or indeed
fraudulent dealers within less sophisticated or indeed careless
financial institutions. The exchange's mark to market procedures
via daily settlements should greatly reduce this problem for
internal compliance officers of smaller or less sophisticated
financial institutions. [0261] Efficient counterparty
structure--The legal structure of a genuine exchange is such that
access to all the exchanges products can be achieved via any member
that is allowed to offer such a service under the exchange and
clearing house rules and any other relevant regulatory constraints.
The prospective customer must simply sign a single brokerage
agreement with that member to access all products. [0262] Access
via brokers--As many brokers are members of several different
exchanges a single brokerage agreement can give a customer access
to the entirety of exchange traded derivative products regardless
of exchange. Exchanges also typically allow customers to use a
different broker for execution purposes than for clearing purposes
via an assignment process called a "give up". There is therefore a
broad competitive market for both execution and clearing brokerage
services which will typically result in low brokerage costs. [0263]
Permission to trade--Many regulators recognise the high quality of
markets provided by exchanges in allowing broader access to them
than to the ISDA based market. In addition the rules of many funds
themselves forbid trading in OTC derivatives while allowing trading
on exchanges. [0264] Liquid and transparent central
market--Historically for all the above reasons those financial
futures and options products that became moderately successful on
derivatives exchanges have gone on to become extremely liquid
indeed. Of course not all products are successful. A significant
uptake of the alternatives created by ISDA-like products based on
the invention seems likely to lead on to a large scale move onto
exchange and eventually far superior liquidity than currently
exists in ISDA based products.
[0265] Exchanges are thus by virtue of this revolutionary invention
able to mimic the advantages of the existing ISDA based market
whilst deepening liquidity, broadening access and reducing
operational, counterparty, legal and systematic risks. Two final
points to note concern how relatively undisruptive this invention
can be: [0266] OTC-style trading--Many exchanges have worked hard
to offer alternative access to their trade registration
infrastructure via so called wholesale trading facilities,
including block trades and basis trades. Wholesale trading
facilities allow dealers to agree transactions over the phone
OTC-style and then register these in a timely fashion as futures or
options on the exchange. They are particularly suited for
transactions contingent on a cash trades or transactions where
liquidity is too limited to absorb a very large order in a
continuously quoted market or indeed wherever market makers quote
on an ad hoc basis. Thus where appropriate the new ISDA-like
products based on the invention can still be traded in an
OTC-style. [0267] Risk management--Intraday risk management systems
will need very little modification to deal with ISDA-like products
based on the invention rather than the existing ISDA based products
they mimic.
[0268] Furthermore specific advantages are included in the relevant
sections below.
Outline of System Changes Required for the ISDA-Like Derivatives
Exchange Part of the Invention
[0269] In traditional futures exchanges generally speaking contract
quotation is identical for front office and back office purposes.
Where occasional exceptions to this rule do exist they consist of
trivial or at least deterministic transformations taking no account
of the actual term of the cash product underlying the traded
derivative.
[0270] The present invention does away with this traditional
futures exchange constraint thus allowing ISDA-like debt related
products to be listed on a genuine exchange for the very first
time. This is achieved via modifications to the trade information
flow diagram as shown in FIG. 8 at the points indicated by the
circles numbered 1-5.
[0271] FIG. 8 is essentially a modified version of FIG. 4. It
therefore shows a logical representation of operational information
flow in trading the adapted exchange based derivatives. Item 800 of
FIG. 8 represents just one of the many dealers trading on the
adapted exchange. The dealers decisions will be informed by general
activity observable across various markets and news as published by
quote vendors (see item 802 of FIG. 8). The dealer shown also has
direct access to the market place and via their own front office
trading system (see item 804 of FIG. 8). The front office trading
system connects to the adapted exchange via a so called exchange
gateway (see item 808 of FIG. 8) which forms the physical and
logical boundary to the exchange maintained systems. Orders can be
placed in the matching engine (see item 814 of FIG. 8) in the hope
that a counterparty can be found and valid half trades are entered
into the trade registrations system (see item 818 of FIG. 8) and
are passed to the appropriate accounts within the clearing house
(see item 822 of FIG. 8). Market status information is calculated
and published (see item 812 of FIG. 8) and monitored by the market
supervision function (see item 810 of FIG. 8) who also set the
daily settlement prices (see item 820 of FIG. 8) used by the
clearing house (see item 822 of FIG. 8) which calculates variation
margin calls to or from members (see item 816 of FIG. 8) and open
interest (see item 824 of FIG. 8). Finally trading reports (see
item 806 of FIG. 8) are produced by the member back office.
[0272] We now considered the modifications proposed by the present
invention which take the form of mappings and reverse mappings
between three separate groups of products: [0273] A front office
product that is used on dealer trading and information systems. The
quotation convention here is the one most suitable for the dealers
in the product. [0274] An internal matching product that exists
only within the infrastructure of the electronic exchange. The
representation here is the one most suitable for the matching
engine when combining strategy and outright orders. [0275] One or
more back office products that exists only within the clearing
infrastructure of the clearing house, it's members and the dealer's
back office. The representation here is the one most suitable for
expressing profit or loss and risk exposure.
[0276] Returning to FIG. 8 we see that each mapping exists between
the boundary of the above products at points indicated by circles
numbered 1-5. Since the exact boundary is to some extent arbitrary
the mappings can be implemented in different places yet have the
same effect. As shown: [0277] 1. Mapping 1 (see circle point 1 in
FIG. 8) is a two way mapping that converts the dealer's front
office quotation orders into the internal matching representation,
and the dealer's fills back from this representation into the front
office product. [0278] 2. Mapping 2 (see circle point 2 in FIG. 8)
is similar to the dealer's fills mapping but converts the whole
order book from the internal matching representation back into the
front office product. [0279] 3. Mapping 3 (see circle point 3 in
FIG. 8) is the conversion from the internal matching representation
into the back office product. [0280] 4. Mapping 4 (see circle point
4 in FIG. 8) is similar to the dealer's orders mapping but converts
wholesale trades agreed over the telephone into the back office
product representation directly. [0281] 5. Mapping 5 (see circle
point 5 in FIG. 8) is the conversion of front office product
settlement reference prices into actual back office product daily
settlement prices. The former are set by the market supervisor each
day from front office market activity on the close but the latter
are what are actually needed for variation margin calls.
[0282] The details of the mappings will vary with the particular
ISDA-like invention i.e. Adapted For Exchange New Credit Derivative
or Adapted For Exchange New Interest Rate Swap or Adapted For
Exchange New Money Market Derivatives. Indeed not all the
inventions require all the mappings. The mappings may also vary
with the particular money market product. We now go on to describe
the details of these mappings and the associated products for each
ISDA-like invention subset.
Reconciliation, Efficient Give Ups and Open Interest Markers
[0283] Where a product design leads a single front office trade to
be split into several back office positions this may pose
operational difficulties. It should be noted therefore that for
reconciliation purposes between front office and back office
systems and for open interest reporting purposes the preferred
embodiment of the invention will conserve information
appropriately.
[0284] It is envisaged that all front office product fill reports
on a dealer's trading system (see item 804 of FIG. 8) are
accompanied by the relevant back office product breakdowns to help
with front office versus back office reconciliation.
[0285] It is also envisaged that front office product matched
trades will be passed through to the clearing house (see item 822
of FIG. 8). These matched front office trades will appear on the
clearing house's trade register as normal contracts simply for
convenience. However the economic significance of these trades is
carried by the associated back office products and not by these
front office position markers themselves e.g. matched front office
trades will not be charged margin.
[0286] Front office position markers held at the clearing house can
be used to assist with front office versus back office
reconciliation. They will also be used for calculating open
interest reports (see item 824 of FIG. 8) for front office systems.
Another important usage is for efficient give ups. The preferred
embodiment of the invention will allow back office managers (see
item 816 of FIG. 8) to give up and take in products by reference to
the front office position markers held in the clearing house's
trade registration systems (see item 818 of FIG. 8) alone i.e. the
associated back office products referenced to a particular front
office trade would be transferred as a group simply by transferring
their front office position marker.
The Details of the Adapted for Exchange New Credit Derivatives
Invention
Overview
[0287] The Adapted For Exchange New Credit Derivatives invention
falls naturally into two halves: [0288] 1. The Traded Credit
Product that exists whether or not there is a credit event; and
[0289] 2. The Event Protection Products and Processes that are
created in order to generate efficient credit protection if there
is a credit event.
[0290] Recovery Rate Products can be viewed as part of point 2 but
could also in principle be listed independently to assist hedging
in existing ISDA based credit derivatives.
Advantages
[0291] Several of the advantages already mentioned in the general
advantages section will be of particular benefit in tackling
barriers to growth in the existing ISDA based Credit Derivatives
market. For example great benefits can be expected in the following
areas: [0292] Permission to trade--Customer orders flowing towards
large banks within the existing ISDA based Credit Derivatives
market are limited by regulatory restrictions. In particular access
tends to be restricted from large but traditional funds. Often the
managers of such funds will nonetheless recognise the benefits of
credit derivatives, so if access were improved a significant uptake
of the invention would seem likely. [0293] Daily settlements and
counterparty structure--Barriers to entry caused by concerns over
marking to market and other concerns internal to smaller less
sophisticated banks or large but traditional funds are very large
in the existing market. A significant uptake of the invention
therefore seems likely and will result in slashed documentation
overheads and middle office costs. [0294] Access via brokers--The
existing ISDA based market has shown tremendous growth even though
it is relatively hard to access. The Adapted For Exchange New
Credit Derivatives invention will however bring to bear the already
broad and competitive network of futures brokers and the already
broad end user access to exchange trading screens. A significant
uptake of the invention therefore seems likely and will result in
reduced brokerage costs in the longer term. [0295] Decreased
operational risks and costs--No fully established straight through
processing standard exists in the current ISDA based market. By
contrast futures exchanges have had straight through processing as
part of their standard business model for decades. A significant
uptake of the invention therefore seems likely and will result in
slashed back office costs.
[0296] As a result of the above benefits as well as those set out
below a step change in market turnover growth is likely to
result.
[0297] Other advantages already mentioned in the previous section
will result in significant but less dramatic benefits over the
existing ISDA based market. Some examples of these include: [0298]
Quasi-negotiable securities--Although the new ISDA-like products
based on the invention will appear familiar to dealers used to
trading their ISDA based equivalents post trade anonymity will be
possible for the first time via the exchange's membership and
clearing structure. This should encourage larger orders to be
placed. [0299] Efficient product structure--The development of the
existing ISDA based Credit Derivatives documentation has been an
iterative process as the market gradually became aware of
definitional issues that might lead to legal and market risks. The
need to refine documentation will no doubt continue. A significant
uptake of the invention will result in the market benefiting from
the exchange's ability to efficiently update contract details of
all open positions in a product simultaneously if necessary.
[0300] The benefits already mentioned in this section are generally
applicable to exchange traded derivatives although they may be of
particular importance for credit derivatives. However such benefits
can only come into play when a workable Adapted For Exchange New
Credit Derivative design exists.
[0301] In addition are benefits that result from the product
designs, product management processes, pre and post trade systems
design, product settlement processes and the enhanced role of the
clearing house that are specific to the Adapted For Exchange New
Credit Derivatives invention itself. Several other major weakness
of the existing ISDA based Credit Derivatives market are addressed
by the invention. These additional advantages include the
following: [0302] Legal certainty--In the ISDA based market legal
costs can be particularly high as credit events result in high
value obligations which are worth contesting in the courts if as a
result payment can be avoided. The Adapted For Exchange New Credit
Derivatives invention does not allow for such opportunistic legal
challenges. [0303] Robustness in pricing--The product designs give
both the convenience of cash settlement and the robustness of
physical delivery to market participants. Also by virtue of the
product designs certain participants who cannot or do not want to
take physical delivery are insulated from the risk of delivery
being made. [0304] Reference Obligations--The product designs bring
to an end the need for the trade confirmations that form an
important part of the legal structure of the existing bilaterally
negotiated ISDA based market. Trade confirmations are a particular
problem for Credit Derivatives where the reference obligation named
by counterparties often do not match exactly. The real problem is
that the exact choice of reference obligation is in many, but
crucially not all, cases to some extent arbitrary. This problem is
completely eliminated by virtue of the product designs which give
the exchange sole authority to define deliverable obligations.
[0305] Central treatment of credit events--The product designs
bring to an end bilateral manual exercise of rights after a credit
event. Instead by virtue of the product designs the exchange has
sole authority to call a credit event. [0306] Consistent treatment
of credit events--In the existing ISDA based Credit Derivatives OTC
market relative value trading can be affected by definitional
mismatches between deliverable obligations from the same reference
entity. Also cumbersome delivery cascades can result from credit
events being triggered. Such problems are eliminated in the Adapted
For Exchange New Credit Derivatives invention which should
therefore boost relative value and arbitrage trading opportunities.
[0307] Consistent treatment of credit events in options--In the
existing ISDA based Credit Derivatives OTC market, default swap
options treat credit events differently depending on whether the
option have a single name or multiple names underlying it. Single
name European style credit options are designed to help manage
movements in the spread not to give exposure to default itself and
so they `knock out` if a credit event occurs in the referenced
entity. By contrast European style index options deliver the entire
index upon exercise at expiry to avoid complications close to
expiry time but as a result retain exposure to defaults themselves
thereby creating the potential for complexities arising further
from expiry. Such problems are eliminated in the Adapted For
Exchange New Credit Derivatives invention which should therefore
boost credit index option trading. [0308] Gaps in the term
structure--Apart from the 5 year (and increasingly 10 year) point
in the credit term structure the existing ISDA based Credit
Derivatives market is said to be illiquid. The product and trade
systems designs of the Adapted For Exchange New Credit Derivatives
invention will generate forwards and hence help create a full
credit term structure. [0309] Pure par credit spreads in and
out--Cash adjustments are common practice in the existing ISDA
based Credit Derivatives market whenever coupons have already been
fixed e.g. when trading out of existing single name positions or
indeed when trading both in and out of index positions. The cash
adjustments are calculated using an assumed recovery rate
convention and this clouds the pure credit exposure of the
position. By contrast the product and trade systems designs of the
invention will generate pure par credit spreads in and out. [0310]
Six monthly index rollovers--Every six months the bulk of the index
market rolls from one index series to the next one but not all
positions are rolled. One embodiment of the invention solves the
problem of stale "off-the-run" series.
Traded Credit Products
[0311] The first part of the Adapted For Exchange New Credit
Derivatives invention is the Traded Credit Product which makes full
use of the three representations concept described in general terms
above: [0312] The front office product is called the Traded Spread
Product (TSP) that appears on trading and information systems is
expressed in annualised basis points according to market
convention. The quotation convention here is the one most suitable
for showing this product's relationship to the spread between risky
and riskless (i.e. government) debt. The Traded Spread Product can
be traded as spot or forwards along the credit term structure.
[0313] The Internal Matching Product is basically the full
de-annualised premium expressed in price percentage points and
allows the simply creation of front office forwards using existing
exchange implied book matching technology. [0314] The back office
product is the splitting of the Internal Matching Product into so
called Credit Coupon Products (CCPs) for the clearing house etc.
Credit Coupon Products are particularly suitable for making sure
forward trades are margined efficiently.
[0315] There are many varieties of the Traded Credit Product
depending on the protection exposure they yield if a credit event
occurs i.e. depending on the Event Protection Products that are
created by them. These include but are not limited to: [0316]
Single name traded spreads [0317] Industry standard indices and
their sector indices [0318] Nth to default baskets and standard
indices [0319] Tranched standard indices and synthetic CDOs [0320]
Resetting Indices
[0321] However all these Traded Credit Products have basically the
same structure.
[0322] When on exchange options of the above are also consider it
becomes clear that Adapted For Exchange New Credit Derivatives can
give dealers equally and possibly more comprehensive exposure to
leveraged credits than does the existing ISDA based market.
Constituent Products Design Overview
[0323] Item 900 of FIG. 9 shows how a traded credit product might
appear in the front office as a Traded Spread Product. Contract
volume available on the bid and offer are not shown in the Figure
but as with other exchange traded contracts the Traded Spread
Product will have a standard notional unit of trading (e.g. $1 mln,
1 mln etc).
[0324] The Traded Spread Products also obey a standard listing and
expiry cycle. As the ISDA based market has already standardised to
a large extent the appropriate listing cycle will mirror this i.e.
ten years of products available for trading via March and September
expiries plus one additional quarterly month so the nearest three
expiry months are consecutive quarterly expiries. The market
convention is that default protection expires on the twentieth
calendar day of the expiry month or if such a day is not a business
day on the next following business day.
[0325] Both the Internal Matching Products and Credit Coupon
Products follow the same expiry cycle as the Traded Spread Products
obey but include all consecutive quarterly expiries i.e. March,
June, September and December and not just March and September plus
one additional quarterly month expiry at the front of the
curve.
[0326] In any exchange traded product concentration of liquidity is
an important by-product of standardisation. One part of
standardisation is the tick size which is the minimum price
increment between different order price levels. The preferred
embodiment of the Adapted For Exchange New Credit Derivatives
invention has an orderbook tick size to help concentrate liquidity
and displayed implied orders.
Two Step Implied Order Linkage in the Traded Spread Product
[0327] Consider a dealer interacting with the market as shown in
FIG. 9 by lifting the 18.00 basis points per annum offer 25 times
in the March 2006 expiry. The dealer would be buying 169 days worth
of protection from 3Oct. 2005 to 20Mar. 06 on the relevant credit
in $25 mln, assuming a standard notional unit of $1 mln. Conversely
if the same dealer hit the 22.50 basis points per annum bid 25
times in the September 2006 expiry they would have sold 353 days of
protection in $25 mln. The dealer is then net neutral for the first
169 days but a seller of protection for the next 184 days i.e. he
has sold the March 2006/September 2006 forward.
[0328] One of the stated advantages of the Adapted For Exchange New
Credit Derivatives invention is that the product and trade systems
designs will generate forwards automatically and hence help create
a full credit term structure. This is achieved by harnessing in a
novel way the implied order book technology already available for
certain existing electronic futures exchanges via the mappings that
will shortly be described below. Thus the dealer could have simply
placed an order to hit the 26.50 bid also shown in FIG. 9 25 times
to sell the same March 2006/September 2006 forward directly.
[0329] Unlike existing exchange traded products the orderbook tick
size does not apply beyond front office orderbook purposes and in
particular does not apply to filled orders. This allows the spot
and forward markets in Traded Spread Products to be properly linked
via the internal matching representation's implied orderbook. Thus
if the dealer places the order to hit the March 2006/September 2006
forward directly as described above they would probably get an
improvement to at least 26.633 (or better if it was available in
the actual implied order book). The relevant mappings to achieve
this will shortly be described below.
Traded Spread Product, Internal Matching Product, Credit Coupon
Product and Associated Mappings
[0330] The mappings that are part of the Traded Credit Product link
the front office Traded Spread Product with the back office Credit
Coupon Product via the Internal Matching Product as already
described in general terms above. We now turn to specifics and
describe these with reference to FIG. 8 where each mapping exists
between the boundary of the three sub-products at points indicated
by circles numbered 1-5.
Mapping 1--Inbound
[0331] Mapping 1 occurs at the numbered circle point 1 in FIG.
8.
[0332] FIG. 10 shows the details of the inbound mapping process as
applied to the dealer's front office Traded Spread Product Orders
(see 1000 of FIG. 10) which turns them into Internal Matching
Product Orders (either 1008 or 1010 of FIG. 10). The first step
consists of an initial check that the Traded Spread Product Order
obeys the orderbook tick size as shown in branch point 1002 of FIG.
10 and if not the order is rejected as shown in endpoint 1004 of
FIG. 10. If the orderbook tick size is legitimate there is next a
branch point depending on whether the order is for the spot or a
forward market (see 1006 of FIG. 10).
[0333] Traded Spread Product Orders (TSOS) that are spot orders are
mapped onto outright Internal Matching Product Orders (IMOs) as
outright orders and as follows (see 1008 of FIG. 10): [0334] IMO
Lot volume=TSO Lot volume [0335] IF TSO=Buy THEN IMO=Buy, ELSE IF
TSO=Sell THEN IMO=Sell [0336] Define, Relevant Days=Expiry
Date--Trade Date+1 [0337] IMO Price %=(TSO Price/100)*(SNP
%)*(Relevant Days)/360
[0338] However Traded Spread Product Orders (TSOs) that are forward
orders are mapped onto Internal Matching Product Orders (IMOs) as
calendar spread strategy orders and as follows (see 1010 of FIG.
10): [0339] IMO Lot volume=TSO Lot volume [0340] IF TSO=Buy THEN
IMO=Sell, ELSE IF TSO=Sell THEN IMO=Buy [0341] Define, Relevant
Days=Back Expiry Date--Front Expiry Date [0342] IMO Price %=-1*(TSO
Price/100)*(SNP %)*(Relevant Days)/360
[0343] The mappings have to be parameterised by the expiry dates of
the products, the trade date and the Surviving Notional Principal
(SNP) as stored in dynamic databases shown as 1012 and 1014 of FIG.
10 respectively. The SNP starts at 100% and drops after each
notional credit event in the underlying basket or index. It is
described in more detail later when we describe notional credit
events. It is also not really relevant for the single name version
of the Traded Credit Product where it can be taken to be 100% prior
to a credit event having occurred and 0% after.
Mapping 1--Outbound Orderbook Reporting
[0344] Mapping 1 occurs at the numbered circle point 1 in FIG.
8.
[0345] FIG. 11 shows the details of the outbound orderbook mapping
which converts each Internal Matching Product Orderbook Element
(see 1100 of FIG. 11) into a Traded Spread Product Orderbook
Element (either 1112 or 1114 of FIG. 11) for display purposes.
[0346] The first step is a branch point depending on whether the
orderbook element is an outright or a calendar spread strategy
order (see 1102 of FIG. 11). This is because there is a different
mapping depending on whether, an outright Internal Matching Product
Orderbook Element (IMOE) is being converted into the relevant spot
Traded Spread Product Orderbook Element (TSOE), see 1104 of FIG.
11: [0347] TSOE Lot volume=IMOE Lot volume [0348] IF IMOE=Buy THEN
TSOE=Buy, ELSE IF IMOE=Sell THEN TSOE=Sell [0349] Define, Relevant
Days=Expiry Date--Trade Date+1 [0350] TSOE Price=(100*IMOE Price
%)*360/(Relevant Days)/(SNP %) or whether a calendar spread
Internal Matching Product Orderbook Element (IMOE) is being
converted into the relevant forward Traded Spread Product Orderbook
Element (TSOE), see 1106 of FIG. 11: [0351] TSOE Lot volume=IMOE
Lot volume [0352] IF IMOE=Buy THEN TSOE=Sell, ELSE IF IMOE=Sell
THEN TSOE=Buy [0353] Relevant Days=Back Expiry Date--Front Expiry
Date [0354] TSOE Price=-1*(100*IMOE Price %)*360/(Relevant
Days)/(SNP %)
[0355] As for the inbound mapping already described the two
different mappings have to once again be parameterised by the
expiry dates of the products, the trade date and the Surviving
Notional Principal (SNP) as stored in dynamic databases shown as
1108 and 1110 of FIG. 11 respectively.
[0356] In either case there is a final rounding and aggregation
step to make Traded Spread Product Orderbook Elements aggregate and
appear to respect the orderbook tick size for front office display
purposes which depends on whether the displayed orderbook element
is a buy or a sell (see 1116 of FIG. 11). Bid prices are rounded
down and volumes aggregated (see 1112 of FIG. 11): [0357] 1. Round
down the Traded Spread Product Orderbook Element price of bids for
front office display purposes to the nearest whole traded spread
orderbook tick. [0358] 2. Aggregate lot volume from different
rounded Traded Spread Product Orderbook Elements if they have been
rounded to the same front office display price to give total volume
on that price
[0359] Offer prices are rounded up and volumes aggregated (see 1114
of FIG. 11): [0360] 1. Round up the Traded Spread Product Orderbook
Element price of offers for front office display purposes to the
nearest whole traded spread orderbook tick. [0361] 2. Aggregate lot
volume from different rounded Traded Spread Product Orderbook
Elements if they have been rounded to the same front office display
price to give total volume at that price
Mapping 1--Outbound Filled Orders
[0362] Mapping 1 occurs at the numbered circle point 1 in FIG.
8.
[0363] The outbound filled orders mapping converts order fills in
the Internal Matching Product into front office fill reports in the
Traded Spread Product. FIG. 12 shows the details of the outbound
filled order mapping which converts each Internal Matching Filled
Element (see 1200 of FIG. 12) into a Traded Spread Product fill
(see 1210 of FIG. 12) for display purposes. It is essentially the
same mapping as the outbound orderbook one minus the final rounding
and aggregation step, but carrying additional information to help
with front office versus back office reconciliation where
relevant.
[0364] The first step is a branch point depending on whether the
filled element is an outright or a calendar spread strategy order
(see 1202 of FIG. 12). This is because there is a different mapping
depending on whether, an outright Internal Matching Filled Element
is being converted into the relevant spot Traded Spread Product
Filled Element (see 1204 of FIG. 12), or whether a calendar spread
Internal Matching Filled Element is being converted into the
relevant forward Traded Spread Product Filled Element (see 1206 of
FIG. 12). As for the other mapping already described both these
mappings have to be parameterised by the expiry dates of the
products, the trade date and the Surviving Notional Principal (SNP)
as stored in dynamic databases shown as 1208 and 1210 of FIG. 12
respectively.
Mapping 2
[0365] Mapping 2 occurs at the numbered circle point 2 in FIG.
8.
[0366] This is identical to the first outbound mapping at numbered
circle point 1 in FIG. 8 but for quote vendor screens. FIG. 11
shows the details.
Mapping 3
[0367] Mapping 3 occurs at the numbered circle point 3 in FIG.
8.
[0368] This is the conversion from the Internal Matching Product
into the relevant back office Credit Coupon Products. It is
typically a one to many mapping and is basically the splitting of
the full de-annualised premium represented by the Internal Matching
Product into an equal total premium value of Credit Coupon
Products. As long as total premium value is unaltered by the split
the details of the mapping do not actually matter too much.
[0369] FIG. 13 shows for example the pro rata Credit Coupon Product
pricing breakdown converting the Internal Matching Filled Element
shown as item 1300 in FIG. 13, into the relevant Credit Coupon
Products shown as a set spanned by 1306 and 1308 in FIG. 13. The
mapping itself is detailed in module 1304 in FIG. 13 which is
parameterised as usual by the expiry dates of the products and the
trade date as stored in database shown as 1302 in FIG. 13, the
Surviving Notional Principal (SNP) having been already incorporated
indirectly at time of matching. The advantage of this technique is
that partial fills of Traded Spread Product Orders will all have
the same leg prices for their respective Credit Coupon
Products.
[0370] If a sequence of instantaneous reference prices is available
from the matching engine and that sequence covers the whole Credit
Coupon Product sequence (possibly using interpolation) then the
pricing breakdown method shown in FIG. 14 can be applied instead.
This more advanced technique converts the Internal Matching Filled
Element shown as item 1400 in FIG. 14, into the relevant Credit
Coupon Products shown as a set spanned by 1406 and 1408 in FIG. 14.
The mapping itself is detailed in module 1404 in FIG. 14 and is
parameterised by the sequence of real-time reference prices shown
as 1402 in FIG. 14, which already incorporated indirectly the
expiry dates of the products, the trade date and the Surviving
Notional Principal as they are related to the current Traded Spread
Product market in the same way that daily settlement prices are
related to the Traded Spread Product market on the close, see
Mapping 5 below. The advantage of this technique is that traded leg
prices for Credit Coupon Products will show less scatter and hence
contain information suitable for front office predictive and
historical analysis.
Mapping 4
[0371] Mapping 4 occurs at the numbered circle point 4 in FIG.
8.
[0372] This is identical to the inbound mapping at numbered circle
point 1 followed immediately by the mapping at numbered circle
point 3 in FIG. 8. It is used to convert wholesale trades agreed
over the telephone into the back office representation
directly.
Mapping 5
[0373] Mapping 5 occurs at the numbered circle point 5 in FIG.
8.
[0374] FIG. 15 shows the details of the mapping which converts of
the set of front office Traded Spread Product Daily Reference
Prices (TSDRP.sub.i) as set by the market supervisor (see 1500 in
FIG. 15) into the actual back office Credit Coupon Product daily
settlement prices (CCPDSP.sub.i) needed for variation margin calls
(shown as spanned by 1510 through to 1512 in FIG. 15). The Traded
Spread Product daily reference prices do not need to respect the
orderbook tick size. The conversion mapping is of course once again
parameterised by the expiry dates of the products, the trade date
and the Surviving Notional Principal (SNP) as stored in dynamic
databases shown as 1502 and 1504 of FIG. 15 respectively.
[0375] The first step is to interpolate any missing TSDRPi's so the
expiry sequence matches Credit Coupon Product sequence (see 1506 in
FIG. 15). This is needed as most June or Dec expiries are not
listed for front office or matching purposes in the preferred
embodiments of the invention.
[0376] The mapping itself is shown as module 1506 in FIG. 15. Thus
for the first quarterly expiry (i=1): [0377] Relevant Days=1st CCP
Expiry Date--Trade Date+1 [0378] CCPDSP.sub.1
%=(TSDRP.sub.1/100)*(SNP %)*(Relevant Days)/360
[0379] Whilst for all other quarterly expiries up to the maximum
listed CCPDSP i .times. % = ( TSDRP i / 100 ) * ( SNP .times.
.times. % ) * ( Relevant .times. .times. Days ) / 360 - Sum .times.
.times. { CCPDSP j .times. % , j = 1 .times. .times. to .times.
.times. i } ##EQU2##
[0380] The mapping is essentially a bootstrapping combination of
the inbound mapping at numbered circle point 1 and the FIG. 14
version of the mapping at numbered circle point 4 in FIG. 8
including an initial interpolation step to ensure a full sequence
of Traded Spread Product settlement prices is available.
Daily Remapping of GTC Orders
[0381] This mapping occurs within the matching engine and its
associated databases.
[0382] Because the mappings linking Traded Spread Product orders
with Internal Matching Product orders are parameterised by the
expiry date of the products, the trade date and the Surviving
Notional Principal the persistence of Good Till Cancelled (GTC)
Traded Spread Product orders must be handled carefully.
Specifically these orders should be stored overnight in their
Traded Spread Product order format and remapped into Internal
Matching Product orders with the revised daily parameters prior to
the open of each following trading day.
Expiry of Credit Coupon Product
[0383] Each Credit Coupon Product is a cash settled product (see
FIG. 5) but with the unique feature that its Expiry Day Settlement
Price (see 506 of FIG. 5) is predefined to be exactly zero and not
linked by a formula to any external underlying market fixing. The
Credit Coupon Product's value arises from the fact that it confers
ownership rights of Event Protection Products that are created in
order to generate efficient credit protection if there is a credit
event. We discuss these Event Protection Products and Processes in
the next section.
Event Protection Products and Processes
[0384] The second part of the Adapted For Exchange New Credit
Derivatives invention is formed from the event protection products
and processes which generate credit protection far more efficiently
than the existing ISDA based market. These are shown schematically
in overview in FIG. 16.
Credit Event Committee and the Calling of Notional Credit Events
etc
[0385] The Adapted For Exchange New Credit Derivatives invention
depends on certain key product management processes namely the
Credit Event Committee (CEC) (see 1600 of FIG. 16) and the Notional
Credit Events (NCEs) (see 1604 of FIG. 16) it calls.
[0386] The Credit Event Committee is a body established by the
Exchange in cooperation with significant market participants in a)
the existing ISDA based market such as the shareholder banks of the
IIC and CDS IndexCo; and b) the Adapted For Exchange New Credit
Derivatives made possible by the invention.
[0387] The Credit Event Committee will generate and from time to
time revise its own definitions, rules and principles concerning
credit events that are nonetheless analogous to those existing in
the current ISDA Credit Derivatives Definitions document (see 1602
of FIG. 16).
[0388] The Credit Event Committee in cooperation with open interest
holders continuously monitor the entities referenced by Traded
Credit Products listed on the Exchange and its Clearing House. By
use of its own definitions, rules and principles concerning credit
events but in any case entirely at its own discretion the Credit
Event Committee will decide if and when a Notional Credit Event has
been triggered (see 1604 of FIG. 16).
[0389] The Notional Credit Event decision is defined as final in
the contract specification and cannot be changed. Dealers are
generally aware of the fact, but in any case are obliged by the
contract specification to accept the risk, that Notional Credit
Events and "real" (or ISDA defined) credit events are technically
distinct.
[0390] Since by the act of trading on Exchange dealers accept the
risk that a Notional Credit Event may be called by the Credit Event
Committee "inappropriately" the Adapted For Exchange New Credit
Derivatives invention does not allow for legal challenges arising
from the details of such credit events. This is a highly
significant advantage over the existing ISDA based market but does
put a heavy onus on the Credit Event Committee to develop a strong
reputation as a trusted "calculating agent" of whether a credit
event has occurred.
[0391] It should also be noted that the use of the Credit Event
Committee as a central authority to call a Notional Credit Events
is operationally far more efficient than the bilateral manual
exercise of rights after a credit event that exists in the current
ISDA based market. Since there can be several different Traded
Credit Products listed on a single referenced entity, a single
Notional Credit Event can affect a group of distinct products
listed on the Exchange and its Clearing House in a consistent way
(see for example products 1606, 1610, 1616, 1622, 1628 and 1634 of
FIG. 16). This is also far more operationally efficient than
existing ISDA based market.
[0392] The Credit Event Committee's definitions, rules and
principles (see 1602 of FIG. 16) will also explain how the list of
deliverables is set for the Recovery Auction Product or Recovery
Rate Product (see 1606 of FIG. 16) as described below following a
Notional Credit Event (see 1604 of FIG. 16). Thus the committee
also acts as a trusted third party "calculating agent" for
consequent obligations of derivative position holders after an
event is called. By contrast the bilaterally negotiated ISDA based
market places strong emphasis and often redundant effort in
predefining reference obligations for what in practice often turn
out to be strictly operational rather than economic purposes. This
represents another important advantage of the Adapted For Exchange
New Credit Derivatives invention over the existing market
structure.
Consequences of Notional Credit Events
[0393] Regardless at what time of day a Notional Credit Events is
announced in the preferred embodiment nothing happens until
overnight after the market shuts normally. There are three
immediate consequences of a Notional Credit Event: [0394] a. The
assignment of the correct number and type of Event Protection
Futures (EPFs) to each effective Credit Coupon Product holder (see
for example products 1614, 1620, 1626, 1632 and 1638 of FIG. 16);
and [0395] b. The de-listing where relevant of Traded Spread
Products with a final mark to market of the corresponding Credit
Coupon Product to exactly zero (see 1612 of FIG. 16); and [0396] c.
The reduction of each Surviving Notional Principal (SNP) number for
each basket, index, sector index or synthetic CDO that includes the
relevant reference entity (see for example products 1618, 1624,
1630 and 1636 of FIG. 16). Thus a Notional Credit Event one name
from within an equally weighted 125 name index will result in that
index's SNP dropping by 0.8%= 1/125.sup.th e.g. from 100% to
99.2%.
[0397] The role of the Credit Event Committee's as a trusted third
party "calculating agent" may be contrasted against automatic
options exercise in the existing exchange traded futures and
options market (see FIG. 7) where the exchange acts as "calculating
agent" of the reference prices (see 700 of FIG. 7), which though a
far simpler calculation is nonetheless the closest analogous
process prior to the present invention
Assignment of Event Protection Future
[0398] Event Protection Futures are cash settled products (see FIG.
5 ) with the unique feature that Expiry Day Settlement Price (see
506 of FIG. 5) is defined with reference to another physically
delivered exchange traded product namely the Recovery Auction or
Rate Product (see 1606 of FIG. 16).
[0399] The exact EDSP formulae will be explained in a later section
but here we discuss the assignment process. Event Protection
Futures positions are only ever assigned to the `effective` Credit
Coupon Product i.e. to the front expiry on the day the Notional
Credit Event is called. Holders of long positions in the effective
Credit Coupon Product receive long positions in Event Protection
Futures from the holders of short positions in the effective Credit
Coupon Product who take the corresponding short positions in Event
Protection Futures. The Event Protection Futures are assigned at
zero price on the day after the Notional Credit Event is called.
These facts have important consequences for margin efficiency which
we will discuss in due course.
[0400] The assignment of the correct number of Event Protection
Futures to each effective Credit Coupon Product is based on the
notional size of contracts and the weight of the reference entity
in the basket underlying the particular Credit Coupon Product
(obviously the weight=100% for single names): Number of EPFs
long=Number of effective CCP lots long*weight*Notional CCP lot
size/Notional EPF size
[0401] In the case of an equally weighted 125 name index, the
reference entity weight would be 0.8% of original notional for each
name within the index. Assuming a standard notional unit of $1 mln
for the Credit Coupon Product and $1,000 for the Event Protection
Futures, we can see that 8 lots of Event Protection Futures will be
assigned to every 1 lot of Credit Coupon Product on the day after
the Notional Credit Event occurs.
[0402] The overnight assignment of Event Protection Futures to each
effective Credit Coupon Product is an important design feature that
allows next day trading of basket Traded Spread Product `clean` of
the Notional Credit Event.
Recovery Auction Product
[0403] A Recovery Auction Product is a bond-like physically
delivered exchange traded product (see FIG. 6 ). Unusual features
include the fact that the Recovery Auction Product a) is listed
only as a result of a Notional Credit Event; and b) is listed for
only a short single trading day a fixed number of business days
after the Notional Credit Event; and c) can in principle contain
loans in its list of deliverables as well as bonds; and d) has all
the conversion factors in its list of deliverables set to exactly
1.
[0404] The initial list of deliverables with accrued interest (see
612 of FIG. 6) is published as soon as possible after the Notional
Credit Event (see 1604 of FIG. 16) is announced and the final list
of deliverables with accrued interest (see 608 of FIG. 6) is
published the day before the Recovery Auction Product is listed for
trading. Indeed the fixed number of business days after the
Notional Credit Event defining when a Recovery Auction Product is
listed for trading will have been set in cooperation with the
market by the Credit Event Committee in its definitions, rules and
principles (see 1602 of FIG. 16) concerning credit events so as to
allow sufficient time for market feedback (see 610 of FIG. 6).
[0405] The deliverability of loans will be discussed as part of the
details of the clearing house securities part of the invention
section below.
[0406] The Exchange Delivery Settlement Price for a Recovery
Auction Product may be used to cash settle Event Protection Futures
(the products assigned at 1614, 1620, 1626, 1632 and 1638 in FIG.
16) either directly or for certain basket products indirectly via
Total Event Loss Indices (see 1608 of FIG. 16) as described in
detail below.
Recovery Rate Product
[0407] The Recovery Rate Product is a variant of the Recovery
Auction Product that is listed for trading even before a Notional
Credit Event and has no pre-set expiry date. The Recovery Rate
Product's expiry date only becomes set after a Notional Credit
Event happens according to the definitions, rules and principles
concerning credit events as laid down by the Credit Event Committee
from time to time.
[0408] As with Recovery Auction Products the initial and then the
final list of deliverables for The Recovery Rate Product are only
announced after the Notional Credit Event but always so as to allow
sufficient time for market feedback.
[0409] Where an pre-existing Recovery Rate Product is already
listed The Exchange Delivery Settlement Price needed to provide
fair cash settlement Event Protection Futures will be set by
reference to that existing product and no Recovery Auction Product
need be listed.
EDSP of Event Protection Futures
[0410] There are two kinds Event Protection Futures known as the
Standard and Attached forms.
[0411] Standard Event Protection Futures (SEPF) are designed to
give full protection and are delivered into non-tranched Traded
Credit Products. Their EDSP (see 506 of FIG. 5) is given by: SEPF
EDSP=Max(100-EDSP of Recovery Product, 0) in which the Max function
serves to prevent the Event Protection Futures ever giving negative
protection.
[0412] By contrast an Attached Event Protection Future is designed
to give protection only after a certain threshold of principal has
been exposed to loss for the underlying basket, index, sector index
or synthetic CDO. Because of these thresholds we will now need to
define a Total Event Loss Index (TELI) number for each index or
basket etc for which thresholds will be relevant.
[0413] Total Event Loss Indices depend on the historic EDSPs of the
Recovery Auction or Rate Products referenced by each index or
basket etc as shown schematically in item 1608 of FIG. 16. When a
new basket is officially launched its TELI starts at 0% and is just
the sum of the Max(100-EDSP of Recovery Product, 0) terms already
described above multiplied by the weight of the relevant reference
entity in the basket for all the Recovery Auction or Rate Products
that have occurred since the basket's launch i.e. TELI for
basket=Sum{Max(100-EDSP of Recovery Product, 0)*weight of
entity}
[0414] The TELI is used as described in detail below.
[0415] For Attached Event Protection Future the threshold is known
as the attachment point. Their EDSP (see 506 of FIG. 5) is given
by: AEPF EDSP for basket=Max(new TELI-Max(Attachment Point, old
TELI), 0)/weight of reference entity in the basket in which The old
TELI is just the Total Event Loss Index as it stood before the
latest Recovery Auction or Rate Product EDSP whilst the new TELI
includes the latest Recovery Auction or Rate Product EDSP.
[0416] Once the old TELI exceeds the attachment point the Attached
Event Protection Future behaves exactly like a Standard Event
Protection Future so under these circumstances the preferred
embodiment of the Adapted For Exchange New Credit Derivatives
invention will allow the clearing house to net off standard Traded
Credit Products and the relevant attached Traded Credit Products
for margin efficiency.
[0417] In the current ISDA based market tranched products are very
common. A tranched product has both an attachment point and a
detachment point which is a threshold above which protection
ceases. We have described only Attached Event Protection Futures as
this is the preferred embodiment of the invention with tranched
products being created from long versus short spread positions of
attached products with different attachment points. Attached Event
Protection Futures will therefore delivered into both attached and
tranched Traded Credit Products.
Varieties of Adapted for Exchange New Credit Derivatives
[0418] As already stated there are many varieties of the Traded
Credit Product depending on the protection exposure they yield if a
credit event occurs i.e. depending on the Event Protection Products
that are created by them. There are also some useful variants of
the Recovery Rate Product to consider. The following is a survey of
some of these different kinds of product.
Single Name Traded Credit Products
[0419] Single name Credit Default Swaps form the majority of
trading activity in the existing ISDA based market. Single name
Traded Spread Products will be de-listed after a Notional Credit
Event in the reference name, Standard Event Protection Futures will
be delivered against the relevant effective Credit Coupon Product
positions and all relevant Credit Coupon Products will be expired
early with EDSP set to exactly zero as usual. After the fixed
number of business days defined in the Credit Event Committee's
definitions, rules and principles the Recovery Auction or Rate
Product will expire and the required EDSP will be set.
Explicit Name Recovery Rate Products
[0420] In today's existing OTC market participants have tried to
create an active market in so called recovery swaps to meet genuine
hedging need but trading has failed to take off due to design and
market structure issues. Explicit Name Recovery Rate Products are
simply Recovery Rate Products as already described previously for
which the underlying reference entity is fully specified explicitly
at time of listing. These products and especially the options on
them described below should better meet the needs of hedgers than
the existing moribund recovery swaps market.
Standard Index and Sector Traded Credit Products
[0421] An obvious first application of the Adapted For Exchange New
Credit Derivatives invention would be the listing of indices such
as the Dow Jones CDX North America and iTraxx Europe.
[0422] A probable next step would be to list sub-sectors of these
indices i.e. Autos, Consumer cyclicals, Consumer non-cyclicals,
Energy, Industrials, Financials, Non-Financials and TMT. In the
preferred embodiment of the invention sector Traded Credit Products
would have notional contract sizes commensurate with the main index
of which they form a part in order to facilitate spread trading.
Thus for example a 1 lot short main index position versus a full
set of 1 lot long sub-sector indices would carry zero event risk by
design and would attract minimal or zero initial margin.
[0423] Index and sub-index Traded Credit Products will have their
Surviving Notional Principal number reduced appropriately after a
Notional Credit Event in a relevant reference entity and Standard
Event Protection Futures will be delivered against the relevant
effective Credit Coupon Product positions. After the fixed number
of business days defined in the Credit Event Committee's
definitions, rules and principles the Recovery Auction or Rate
Product will expire and the required EDSP will be set.
Nth to Default Basket Traded Credit Products
[0424] 1.sup.st to default, 2.sup.nd to default, 3.sup.rd to
default etc Traded Credit Products on baskets or indices of
reference entities are common in the existing ISDA based market.
They can of course just as easily be traded by application of the
Adapted For Exchange New Credit Derivatives invention.
[0425] For an equally weighted index the different N.sup.th to
default Traded Credit Products will have predefined Surviving
Notional Principal numbers from when they were first listed. For
example for N.sup.th to default Traded Credit Products on an
equally weighted 125 name index the 1.sup.st to default Traded
Credit Products will have an SNP of 100%, the 2.sup.nd to default
Traded Credit Products will have an SNP of 99.2%, the 3.sup.rd to
default Traded Credit Products will have an SNP of 98.4%, etc.
[0426] After a Notional Credit Event in the N.sup.th relevant
reference entity the N.sup.th to default Traded Spread Products
will be de-listed, Standard Event Protection Futures will be
delivered against the relevant effective Credit Coupon Product
positions and all relevant Credit Coupon Products will be expired
early with EDSP set to exactly zero as usual. After the fixed
number of business days defined in the Credit Event Committee's
definitions, rules and principles the Recovery Auction or Rate
Product will expire and the required EDSP will be set.
Tranched Index and Synthetic CDO Traded Credit Products
[0427] Synthetic CDOs were discussed in the background to the
invention section and are clearly closely related to tranched index
products. A full discussion of CDOs will be included as part of the
details of the clearing house securities part of the invention
section below.
[0428] The preferred embodiment of the invention has tranched
Traded Credit Products being created from long versus short spread
positions of Attached Traded Credit Products with different
attachment points.
[0429] The index or sub-index on which Attached Traded Credit
Products are listed will have its Surviving Notional Principal
number reduced appropriately after a Notional Credit Event in a
relevant reference entity. Also Attached Event Protection Futures
appropriate to the defined attachment point will be delivered
against the relevant effective Attached Credit Coupon Product
positions. After the fixed number of business days defined in the
Credit Event Committee's definitions, rules and principles the
Recovery Auction or Rate Product will expire and the required EDSP
will be set. This will be used to update the index or sub-index
Total Event Loss Index number allowing the Attached Event
Protection Futures to cash settle to their EDSP. Finally if the new
Total Event Loss Index number exceeds the attachment point for
listed Attached Traded Credit Products the clearing house will
de-list them transferring all open Attached Credit Coupon Product
positions and GTC orders into standard Traded Credit Products and
allow netting to occur where possible.
Resetting Index Traded Credit Products
[0430] Every six months the bulk of the existing ISDA based index
market is encouraged by market makers to roll from one index series
to the next one. However not all positions are in fact rolled
leading to older "off-the-run" series having to be operationally
maintained in risk management systems etc until these stale
positions expire. This costs resources for little practical
benefit.
[0431] One embodiment of the invention is called the Resetting
Index Traded Credit Product and solves the problem of stale
off-the-run series by defining an index's current constituent names
plus substitutes in the event of names dropping out after Notional
Credit Events. As the old effective Resetting Index Credit Coupon
Product expires the next effective Resetting Index Credit Coupon
Product will reference the index's composition as it existed on at
this date. Thus underlying index remains undefined until the
effective date and is not set in advance on the date that the index
was first created.
[0432] This Resetting Index Traded Credit Product will thus
automatically keep track of changes in the index composition and
will not need to be rolled. The design means that the Surviving
Notional Principal number will only apply to mappings involving the
effective Credit Coupon Product with all other Resetting Index
Credit Coupon Products using 100% instead of the Surviving Notional
Principal number. Also the Surviving Notional Principal number will
be reset to 100% as each new effective Credit Coupon Product is
finally referenced to the index's composition on its effective
date. Otherwise this type of index product and its sub-sectors
behave just like standard indices.
Tranched and Nth to Default Products
[0433] Tranched products are not really possible with the Resetting
Index Traded Credit Product design but variants of Nth to default
products are.
Implicit Name Recovery Rate Products
[0434] In today's existing OTC market participants have tried to
create an active market in so called recovery swaps to meet genuine
hedging need but trading has failed to take off due to design and
market structure issues. The market has certainly not evolved
beyond the point where the underlying reference entity is not full
defined and only known implicitly at time of trade. However we
anticipate a hedging need for traders of N.sup.th to default Traded
Credit Products on baskets or indices of reference entities.
Implicit Name Recovery Rate Products are therefore Recovery Rate
Products as already described previously for which the underlying
reference entity is not fully specified at time of listing. For
example using a 1.sup.st to default Recovery Rate Product will
allow traders to take a view on the recovery rate of the first
reference entity to default within a given basket or index or
sector index etc. These products and especially the options on them
described below should better meet the needs of hedgers than the
existing moribund recovery swaps market.
Traded Spread Options
[0435] Options on the Traded Spread Product are another possible
extension of the listing of Traded Credit Products. Of the possible
designs both cash settled and deliverable European style options on
forward Resetting Index Traded Spreads (or equivalently on options
referencing the index's composition as prevailing at expiry) are
likely to be attractive to the market as they neither suffer from
adverse premium loss after or excess volatility just before a
Notional Credit Event in a relevant reference entity is
announced.
Traded Spread Premium Protected Options
[0436] Similarly so called Premium Protected Knock Out Options on
single name Traded Credit Products should be popular because of the
premium return feature. As with normal options the time value
component of the premium will decay as expiry approach whilst the
intrinsic value will be a function of the prevailing spread. These
products are designed to cope with the complication that after a
credit event a single name Traded Spread Product effectively ceases
to exist and is replaced by its corresponding Event Protection
Future. There is therefore a `knock out` if a credit event occurs
in the referenced entity but as the name implies for Premium
Protected Options no premium is lost at this point as a result of
the knock out. This can be achieved in the exchange listed
environment because Premium Protected Options can be traded in
margined premium and not premium paid format there. Specifically
the Premium Protected Knock Out Options simply expires early with
no further variation margin calls being imposed, rather than the
final variation margin call to zero that would be expected in a
more traditional knock out variety.
Contingent Exercise Recovery Rate Options
[0437] Another potentially very popular product will be Recovery
Rate Options. These have a new event contingent exercise style
similar to European style options but with the exercise date left
undefined unless a notional credit event occurs. If a relevant
notional credit event occurs prior to option expiry, the Recovery
Rate Option resets its exercise date and expiry date to be the same
as the expiry date set for its underlying Recovery Rate Product and
then becomes a European style option. If a relevant notional credit
event does not occur prior to option expiry, all options knock out
in the traditional manner i.e. with loss of premium.
Recovery Rate Premium Return Options
[0438] Traders who want to use standard Recovery Rate Product
Options to trade their view on recovery rates should a credit event
occur will be frustrated by the high premium time decay that occurs
as knock out approaches i.e. if no credit event has occurred.
Recovery Rate Premium Return Options solve this problem in a simple
yet creative way by having as their name implies a premium return
feature should no credit event occur by expiry time. As an example
consider all the buyers throughout the lifetime of trading of a set
of one year options struck on a 3.sup.rd to default Recovery Rate
Product. If at expiry after the one year has passed only two or
less defaults have occurred in the referenced basket these buyers
would have all their premium returned. Obviously these Recovery
Rate Premium Return Options would have to be listed and traded in
premium paid format. A further encouragement to trade would be if
the premium paid attracted interest or could be posted with the
clearing house through over collateralising with T-bills as is
often done today with initial margin.
A Note on Other Event Driven Products
[0439] Credit event protection products can be viewed as just a
another form of insurance. Other insurance products such as those
that payout in the event of loss of life, accident etc rather than
in the event of a default can therefore be generated using similar
design principles. We therefore define a Post Event Contract to be
any contract that is assigned to holders of another contract
according to an objective triggering event. We also define Premium
Return Knock Out Options as the generalized form of Recovery Rate
Premium Return Options.
A Note on Initial Margin Calculations for the Adapted for Exchange
New Credit Derivatives Invention
[0440] Consider first an isolated single name Credit Coupon
Product. Unless it is the effective Credit Coupon Product no Event
Protection Futures can be assigned against the position so
margining can simply be based on a statistical analysis of
historical price movements as with existing exchange traded
futures. However short positions in the effective Credit Coupon
Product will require very large initial margin known as a spot
month charge to cover for the large adverse variation margin call
that might result if a Notional Credit Event in the reference name
is announced. Since the member earns interest on initial margin
held at the clearing house the short position holder is holding
something closely akin to an on exchange credit-linked note.
Construction of a genuine credit-linked note is discussed in the
details of the clearing house securities part of the invention
section below.
[0441] Now consider multiple short positions in effective Credit
Coupon Products covering divers single names. Clearly the
percentage initial margin requirements should plummet for even a
small portfolio in full proportion to the low probability
associated with two or more distinct Notional Credit Events in the
relevant referenced names being announced on the same day i.e. as
diversification kicks in.
[0442] In the example of Traded Credit Products on an equally
weighted 125 name index the short position initial margin spot
month charge is likely to be similar to the 0.8% weighting of each
name in the index.
[0443] Clearly to deliver full benefit from the Adapted For
Exchange New Credit Derivatives invention the exchange's clearing
house will need to become sufficiently sophisticated at
understanding diversification within portfolios of these products
for cross margining purposes.
The Details of the Adapted for Exchange New Interest Rate Swaps
Invention Overview
[0444] The Adapted For Exchange New Interest Rate Swaps invention
does not require any Event Protection Products and Processes and so
is fundamentally less complex than the Adapted For Exchange New
Credit Derivatives invention. It does however involve two distinct
back office product types and in this sense is more complex.
Advantages
[0445] The ISDA based interest rate swap markets have been
established far, longer than the ISDA based credit derivative
market. The former are thus correspondingly far more efficient than
the latter. The invention nonetheless brings the significant
benefits in the fields of: [0446] Counterparty credit risk--The
invention will effectively remove the need for counterparty credit
lines via central clearing of the ISDA-like exchange traded
products. It will therefore eliminate a costly and complicated part
of the trading and risk management process and broaden access to
these markets still further. This will find particular
applicability in emerging market economies where counterparty
credit issues are generally speaking far more significant than in
the developed world. Indeed the invention will make the creation of
benchmark rates for burgeoning corporate debt markets in such
countries possible without the need for significant and costly
government bond issuance. [0447] Netting--The invention is
particularly efficient in netting exposures. This is because of
both the breakdown into coupons and more significantly the
separation of the fixed and floating exposures into separate
products. [0448] Daily settlements and straight through
processing--A significant uptake of the invention will result in
slashed back office and middle office costs. [0449] Position and
risk management--Perhaps the most striking feature of the invention
is the simplifications the design brings to position and risk
management with an entire 50 year curve covered in the preferred
embodiment by as few as 400 separate Coupon Products. Even if the
current ISDA market convention of quoting on-the-run spot plus one
year, spot plus two years, etc. with a new on-the-run spot curve
every trading day the Adapted For Exchange New Interest Rate Swaps
invention design still ensures that individual trade ticket history
does not dominate position accounting so that both within a large
client portfolio and at the clearing house itself netting and
margining will take place very efficiently
[0450] The implications of a significant uptake of the invention
for financial market stability are clearly great indeed.
Par IRS Product
[0451] The Standard Par IRS Product is the preferred embodiment of
the Adapted For Exchange New Interest Rate Swaps invention. It does
not utilise the full potential mapping points available in the
generic ISDA-like invention design (see FIG. 8 ) there being no
distinction between the front office and internal matching product:
[0452] The front office product is called the Traded Swap Rate
(TSR) that appears on trading and information systems is expressed
in annualised percentage points according to market convention. The
quotation convention here is the one most suitable for showing this
product's relationship to the yields in the long term debt markets.
[0453] There are two distinct back office product types formed by
the splitting of the front office Traded Swap Rate into so called
Fixed Coupon Products (XCPs) and Floating Coupon Products (FCPs)
for booking at the clearing house etc. The combination of Fixed and
Floating Coupon Products are particularly suitable for making sure
trades within a large client portfolio are netted and margined
efficiently.
[0454] On exchange options of the above (a.k.a. Standard Par IR
Swaptions) are included in the preferred embodiment of the Adapted
For Exchange New Interest Rate Swaps invention.
Constituent Products Design Overview
[0455] The Traded Swap Rates as quoted in the front office
represent the on exchange equivalent of ISDA based interest rate
swaps (IRSs). IRS rates vary with the term of the obligation and
are simply the market price for a zero cost exchange of interest
rate exposure from fixed to floating or vice versa. More
specifically IRS deals commit traders to enter into a) a periodic
obligation to receive (or pay) a fixed interest rate in exchange;
in exchange for b) a periodic obligation to pay (or receive)
amounts based on a floating interest rate index (e.g. 3 month BBA
LIBOR), where all the interest rate amounts payable are calculated
based on the notional size of the deal.
[0456] As with other exchange traded contracts the Traded Swap Rate
in its preferred embodiment will have a standard notional unit of
trading (e.g. $1 mln, 1mln, 100 mln etc).
[0457] In the Standard Par IRS Product the Traded Swap Rates obey a
listing and expiry cycle modelled on the Traded Credit Product
cycle of the Adapted For Exchange New Credit Derivatives invention.
The appropriate length of the listing cycle will mirror the demand
from dealers in each currencies. Thus major currencies such as $,
or may have thirty to fifty years of Traded Swap Rates available
for trading whilst emerging markets may not have products listed
beyond three to five year terms. The standard listing cycle will
also mirror the Traded Credit Product cycle with March and
September expiries plus one additional quarterly month so the
nearest three expiry months are consecutive quarterly expiries. The
Standard Par IRS Product expiries will be x business days prior to
the effective date which is defined as the twentieth calendar day
of the expiry month or if such a day is not a business day on the
next following business day. The x business days depends in
principle on the currency in question but is typically 2 days (e.g.
in $, , etc).
[0458] Both the Fixed and Floating Coupon Products follow the same
expiry cycle as the Traded Swap Rates obey but include all
consecutive quarterly expiries i.e. March, June, September and
December and not just March and September plus one additional
quarterly month expiry at the front of the curve. Each Coupon
Product has a notional maturity that is the effective date of the
following Coupon Product expiry.
[0459] The standard notional unit size of the Floating Coupon
Products will be the same as the notional unit of trading for
Traded Swap Rates (e.g. $1 mln, 1 mln, 100 mln etc). However the
standard notional unit size of the Fixed Coupon Products will be
the smallest unit size of the currency i.e. only $0.01, 0.01, 1
etc.
Non-Standardised Dates and Spot
[0460] Towards the front of the curve there may be demand for
non-standardised dates and it is envisaged that this could be
accommodated by listing these non-standard expiries only for
OTC-style telephone trading with access to clearing via a wholesale
trading facility.
[0461] At present the current ISDA market trades spot plus one
year, spot plus two years, etc. It may be necessary in order to
meet demand to list a new spot curve every trading day as well as
the standard expiry cycle described above.
[0462] It may happen that there is also a demand for trading in
non-standard notional units and this can be accommodated simply by
shrinking the notional unit sizes until the Trade Swap Rate
notional unit of trading reaches the appropriate granularity.
Implied Calendar Spread Pricing and the Outright Traded Swap
Rate
[0463] Traded Swap Rate forwards cannot easily be traded along the
interest rate term structure in a manner analogous to the Adapted
For Exchange New Credit Derivatives invention. However, one
embodiment of the invention would separately list certain forward
Traded Swap Rate curves on the matching engine in order to
encourage relative value trading against normal calendar spreads of
the outright Traded Swap Rate curve. These calendar spreads
together with butterfly spreads etc will be available just as they
are in existing standardised Short Term Interest Rate futures
markets provided the matching engine supports them.
Traded Swap Rate, Fixed Coupon Products, Floating Coupon Products
and Associated Mappings
[0464] The mappings that are part of the Standard Par IRS Product
link the front office Traded Swap Rate with the back office Fixed
and Floating Coupon Products directly. We now give a detailed
description of these with reference to FIG. 8 where each mapping
exists between the boundary of the sub-products at points indicated
by circles numbered 1-5. In this case circles 1 and 2 can be
ignored as no mappings take place there for the Adapted For
Exchange New Interest Rate Swaps invention.
Mapping 3
[0465] Mapping 3 occurs at the numbered circle point 3 in FIG.
8.
[0466] FIG. 17 shows the details of the one to many mapping which
converts from the Traded Swap Rate Fill Element (TSRFE.sub.m) (see
1700 of FIG. 17) into the relevant back office Floating Coupon
Products (FCP.sub.i) (shown as a set spanned by 1708 and 1710 in
FIG. 17) on the one hand and the offsetting positions in back
office Fixed Coupon Products (XCP.sub.i) (shown as a set spanned by
1712 and 1714 in FIG. 17) on the other.
[0467] The Floating Coupon Product positions (FCP.sub.i) are
assigned with opposite long/short sign as the Traded Swap Rate but
in exactly the same lot volume for all quarterly expiries i up to
and including m (see 1702 of FIG. 17): [0468] All i=1 to m,
FCP.sub.i Lot volume=TSRFE.sub.m Lot volume [0469] All i=1 to m,
FCP.sub.i Price=0 [0470] IF TSRFE.sub.m=Buy THEN All
FCP.sub.i=Sell, ELSE IF TSRFE.sub.m=Sell THEN All FCP.sub.i=Buy
[0471] The Fixed Coupon Product positions (XCP.sub.i) are assigned
with the same long/short sign as the Traded Swap Rate but in
proportion to lot volume and traded price for all quarterly
expiries i up to and including m (see 1704 of FIG. 17): [0472] All
i=1 to m, XCP.sub.i Lot volume=TSRFE.sub.m Lot
volume*A.sub.i*TSRFE.sub.m Price %*Traded Swap Rate notional size
[0473] All i=1 to m, XCP.sub.i Price=0 [0474] IF TSRFE.sub.m=Buy
THEN All XCP.sub.i=Buy, ELSE IF TSRFE.sub.m=Sell THEN All
XCP.sub.i=Sell
[0475] The accrual factor, A.sub.i, are simply the fraction of a
year that the number of days between the i.sup.th effective date
and the i.sup.th notional maturity date represent. The accrual
factor calculation method will vary with currency and will probably
be specified in the particular Par IRS Product design. The
calculation will often be made consistent with the conventional
quotation method in any existing ISDA based swap markets in that
currency. Thus for a $ or product for example the A's would be
defined in day fractions of a 30/360 day count basis. The mappings
therefore have to be parameterised by the expiry calendar for
product so that a full strip of both types of Coupon Product are
assigned (see 1706 of FIG. 17).
Mapping 4
[0476] Mapping 4 occurs at the numbered circle point 4 in FIG. 8.
This is identical to the mapping at numbered circle point 3 as
described above and in FIG. 17. It is used to convert wholesale
trades agreed over the telephone into the back office
representation directly.
Mapping 5
[0477] Mapping 5 occurs at the numbered circle point 5 in FIG.
8.
[0478] FIG. 18 shows the details of the conversion of the front
office Traded Swap Rate Reference Prices (see 1800 of FIG. 18) as
set by the market supervisor into the actual back office back
office Floating Coupon Product (shown as a set spanned by 1814 and
1816 in FIG. 18) and Fixed Coupon Product daily settlement prices
(shown as a set spanned by 1818 and 1820 in FIG. 18) needed for
variation margin calls. This is a relatively complex process which
also requires a daily stub rate reference price (see 1804 of FIG.
18) and is key to the product design as a Par IRS Product.
[0479] The Traded Swap Rate Reference Prices do not in principle
need to respect the Traded Swap Rate Tick and may be calculated
from some objective averaging function of trading conditions just
prior to the daily settlement time.
[0480] Module 1804 of FIG. 18 illustrates the bootstrapping process
used to calculate the required discount factors. The first step in
module 1804 of FIG. 18 is to use interpolation to determine Traded
Swap Rate settlements in time periods for which an express rate
does not exist i.e. at the June and December points. Linear
interpolation, exponential interpolation, cubic spline
interpolation, exponential spline interpolation, or any other
desired type of interpolation may be used. The result is that a
Traded Swap Rate Reference Price is available for every Fixed
Coupon Product and Floating Coupon Product effective date i. By
definition of the product design the Traded Swap Rate Reference
Prices form a par swap curve.
[0481] In the next step of module 1804 of FIG. 18 we calculate two
series of forward zero coupon discount factors. The first series,
d.sub.i, are from the first effective date to every notional
maturity date i. The second series, f.sub.i, are from every
effective date i to the corresponding notional maturity date i. The
discount factor d.sub.i represents the zero coupon discount factor
calculated from the par swap rate applicable for the period between
the first effective date and the i.sup.th notional maturity date.
For time period i=1, the following formula is used to determine
d.sub.1: d 1 = f 1 = 1 1 + A 1 .times. C 1 ##EQU3## where A.sub.1
and C.sub.1 are the accrual factor and the swap rate, respectively,
for the first time period (i=1).
[0482] For all time periods from i=2 to i=m, bootstrapping is
applied, using the following formula to determine d.sub.i: d i = 1
- C i .times. j = 1 i - 1 .times. A j .times. d j 1 + A i .times. C
i ##EQU4## where j is a positive integer, and A.sub.i and A.sub.j
are the accrual factors in time period i and j, respectively. This
process is commonly known as bootstrapping because d.sub.i-1 has to
be determined in order to determine d.sub.i just as boot and skate
laces need to be tightened from the bottom before they can be
tightened at the top.
[0483] The f.sub.i can then be determined directly from the d.sub.i
as follows: f i = d i d i - 1 ##EQU5##
[0484] We also need the stub discount factor D.sub.0 which is the
zero coupon discount factor calculated from the money market stub
reference rate applicable for the period between trade date plus x
business days (typically 2 days) and the first effective date (see
1806 of FIG. 18): D 0 = 1 1 + a 0 .times. S 0 ##EQU6## where
a.sub.0 and S.sub.0 are the money market accrual factor and the
stub rate, respectively, for the period from spot to the first
effective date. Preferably, the stub rate source is a identical to
the floating rate used in the swap market (e.g. the BBA $ LIBOR
panel for $ Traded Swap Rates). The accrual factor a.sub.0 is
calculated using the daycount basis conventional in the relevant
money market e.g. Actual/360 for a $ or product. The mappings
therefore have to be parameterised by the expiry calendar for
product so that a full strip of both types of Coupon Product are
assigned (see 1808 of FIG. 18).
[0485] We may now finally give the formulae for the Floating Coupon
Product, FCP.sub.i, and Fixed Coupon Product, XCP.sub.i, daily
settlement prices needed for variation margin calls: FCP i = ( 1 f
i - 1 ) * d i * D 0 ##EQU7## XCP i = d i * D 0 ##EQU7.2##
respectively shown in modules 1810 and 1812 of FIG. 18.
Expiry of Fixed and Floating Coupon Products
[0486] Fixed and Floating Coupon Products are cash settled at
expiry (see FIG. 5). The settlement uses a standard floating rate
benchmark, L, that varies according to currency e.g. the $ Traded
Swap Rates will use 3 month BBA $ LIBOR.
[0487] The Floating Coupon Product is cash settled using the
formula (see 506 of FIG. 5): FCP .times. .times. EDSP = a * L 1 + a
* L ##EQU8## where a is the relevant money market convention
accrual factor.
[0488] The Fixed Coupon Product is cash settled using the formula
(see 506 of FIG. 5): XCP .times. .times. EDSP = a * L 1 + a * L
##EQU9## where a is the relevant money market basis accrual
factor.
A Note on Margin Calculations for the Adapted for Exchange New
Interest Rate Swaps Invention
Granularity
[0489] The very small notional unit size of the Fixed Coupon
Products poses some technical issues to do with rounding error in
both the calculations of daily settlement price and indeed EDSPs.
If rounding errors are not addressed the invention will deliver
random variations from a true par swap. It is therefore a
requirement of the invention that variation margin calls are
calculated for each position holder using Fixed Coupon Product DSPs
and EDSPs of high accuracy i.e. not rounded to the nearest cent,
pence, yen etc. Only after the relevant mark to market has been
calculated in this way should total position variation margin calls
be calculated with rounding.
[0490] In the circumstances described above there is however a
possibility that the clearing house will end up with a small
shortfall of variation margin cashflows. Three solutions present
themselves: [0491] 1. Ignore the issue as even in the case of many
thousand position holders the mismatch of cashflows is likely to be
exceedingly small and insignificant relative to initial margin
held; and/or [0492] 2. Reduce and for practical purposes eliminate
the risk of a shortfall when final cash settlement margin calls are
calculated by rounding the EDSP differently for net long and net
short positions i.e. in the clearing house's favour; or [0493] 3.
Handle rounding errors in detail via the front office position
markers held in the clearing house's trade registration systems
(see Reconciliation, efficient give ups and open interest markers
).
[0494] Which of these options is adopted depends on the commercial
considerations of customers and the clearing house.
Give Ups
[0495] As the preferred embodiment of the invention has both Fixed
and Floating Coupon Products created at zero price and in
offsetting pairs there will be a one-off pair of large but
offsetting variation margin calls calculated for each different
type of coupon upon their first daily settlement. It is therefore
important to keep the coupon products together prior to this point
and not allow them to be allocated to different accounts (see
Reconciliation, efficient give ups and open interest markers
Second Generation Deliverable Bond-Like Futures
Overview
[0496] The Adapted For Exchange New Interest Rate Swaps invention
and the Adapted For Exchange New Credit Derivatives invention can
be used to create deliverable bond-like futures. These would
therefore be second generation products very much in the mould of
traditional bond futures but that give robust exposure to the two
aforementioned inventive products in a convenient form.
Advantages
[0497] This second generation deliverable bond-like futures
invention brings significant practical benefits: [0498] Convenience
of trading--As already explained in the event that the market
prefers the current ISDA market spot plus one year, spot plus two
years, etc format for listings it would be necessary to list a new
spot IRS product curve every trading day every day. Rather than in
addition to this listing the standardised Par IRS Product on a
March, June, September, December expiry cycle as described
previously, it may be more convenient to list 2-year, 5-year and
10-year deliverable swap future as described below. [0499]
Convenience of hedging--Listing a complex of 2-year, 5-year and
10-year deliverable credit-linked futures as described below will
create a very convenient hedge for non government (i.e. risky) bond
positions. [0500] Appropriate fee structure--The exchange listing
more traditional 2-year, 5-year and 10-year deliverable bond-like
futures will be able to charge an appropriate bond future-like fee.
The low fee will allow the very cost sensitive independent scalpers
(i.e. office based locals) to participate in providing liquidity as
effectively as they do for existing bond futures. Meanwhile those
who want continuing exposure to the actual Adapted For Exchange New
Interest Rate Swaps and the Adapted For Exchange New Credit
Derivatives products can do so at a higher fee appropriate to the
long term nature of these derivatives.
Deliverable Swap Futures
[0501] We have already described in the "Background to the
Invention" section how the M-year CBoT Swap future design has a
cash settlement upon expiry formula: CBoT .times. .times. Swap
.times. .times. Future .times. .times. EDSP = C S + ( 1 - C S ) * (
1 + S .times. .times. % 2 ) 1 2 * M ##EQU10## where, S represents
the ISDA Benchmark Rate for the M-year U.S. dollar interest rate
swap on the last day of trading, expressed in percent terms; and C
represents the notional coupon for the future, expressed in percent
terms (currently C=6 for both the 5-year and 10-year Swap futures
that are listed)
[0502] An alternative approach would be to reverse the above
formula and create a deliverable design. This would set the EDSP by
reference the market close of the swap future on the last trading
day in the same way that bond futures are expired. Once the EDSP is
known the EDSP Swap Rate, S, is calculated. Finally delivery is
made via the Adapted For Exchange New Interest Rate Swaps
invention. Specifically the delivery counterparties are assigned by
the normal bond future method. Then a front office trade in the
Traded Swap Rate is delivered with traded price set to the EDSP
Swap Rate, S, adjusted as necessary for coupon and compounding
consistency.
Deliverable Credit-Linked Futures
[0503] In exact analogy to the deliverable swap futures just
described other futures could be listed linked to credit indices
such as the Dow Jones CDX North America and iTraxx Europe or even
sector indices.
[0504] These would set the EDSP by reference the market close of
the relevant future on the last trading day in the same way that
the corresponding swap futures was expired and crucially do so at
the same time. Once the EDSP is known the EDSP Credit-linked Rate,
R=S+P, is calculated in the same way. Finally delivery is made via
the Adapted For Exchange New Interest Rate Swaps and the Adapted
For Exchange New Credit Derivatives inventions. Specifically the
delivery counterparties are assigned by the normal bond future
method. Then a front office trade in the Traded Swap Rate is
delivered with traded price set to the EDSP Swap Rate, S. In
addition a front office trade in the relevant Traded Spread Product
is delivered with traded price set to the EDSP Credit-linked Rate
minus the EDSP Swap Rate, R-S=P. There may be better more
sophisticated ways to calculate, P, but the principle will be the
same.
[0505] One problem for deliverable credit linked futures is how to
deal with a relevant notional credit event prior to expiry, and
perhaps the best solution for a single name product is simply to
suspend trading in the linked future and force an early expiry and
delivery based on its most recent daily settlement price. The
problem is more complex for multi-name products such as indices and
baskets and perhaps the best solution here is to avoid the problem
by construction--The problem would not arise these credit linked
futures reference either a resetting index or a newly composed
index at its expiry.
The Details of the Adapted For Exchange New Money Market
Derivatives Invention
Overview
[0506] The Adapted For Exchange New Money Market Derivatives
invention as both OIS and/or FRA Product are similar in complexity
to the Adapted For Exchange New Interest Rate Swaps invention. On
the one hand these products have a single expiry and do not need
the breakdown into coupon type products. On the other hand the
introduction of the money market convention and non-standard
notional units of trading add considerable complexity.
Advantages
[0507] The ISDA based money market derivatives have been
established far longer than the ISDA based credit derivative
market. The former are thus correspondingly far more efficient than
the latter. The invention nonetheless brings significant benefits
in the fields of: [0508] Counterparty credit risk--The invention
will effectively remove the need for counterparty credit lines via
central clearing of the ISDA-like exchange traded products. It will
therefore eliminate a costly and complicated part of the trading
and risk management process and broaden access to these markets
still further. This will find particular applicability in emerging
market economies where counterparty credit issues are generally
speaking far more significant than in the developed world. [0509]
Forwards and spot--The invention is particularly effective in
meeting end user needs. Whereas the existing standardised Short
Term Interest Rate futures markets are professional forward-forward
markets with esoteric expiry dates unrelated to business needs, the
invention makes forward and spot money market derivatives available
within a genuine exchange for the first time. [0510] OTC-style
trading--By virtue of the product designs continuously quoted
central markets will only be available on the exchange at money
market conventional on-the-run points. Block trades and basis
trades thresholds will therefore be zero for off-the-run points
allowing them to be freely traded in an OTC-style phone market yet
still benefit from the exchange's infrastructure. [0511] Daily
settlements and straight through processing--A significant uptake
of the invention will result in slashed back office and middle
office costs. [0512] Position and risk management--Both leg types
of the OIS Product are designed to make sure trade ticket history
does not dominate position accounting so that both within a large
client portfolio and at the clearing house itself netting and
margining will take place very efficiently.
Listing Convention and Units of Trading
Implied Pricing and the Money Market Convention
[0513] Both OIS and FRA Product varieties of the Adapted For
Exchange New Money Market Derivatives invention use the money
market convention that has already been described in the
"Background to the invention" section. Thus each trading day a
restricted subset of on-the-run points will be made available for
trading on the matching engine even though the full set will remain
available for trading via OTC-style wholesale trading facilities.
This will require: [0514] daily listing and delisting of product
for matching engine trading; and [0515] daily adjustments to block
trade thresholds for listed and delisted product.
[0516] The latter point is required so that traders can if they
wish trade where no matching engine listing exists i.e. the block
trade threshold must be zero for off-the-run points.
Non-Standard Notional Units of Trading and Rounding Issues
[0517] When managing short term exposures the exact notional sizes
required tend to be known with greater accuracy. It is therefore
appropriate to allow greater flexibility in the notional units of
trading in the Adapted For Exchange New Money Market Derivative
invention than for the other longer dated ISDA-like derivative
products.
[0518] The preferred embodiment of this Adapted For Exchange New
Money Market Derivatives invention for both OIS and FRA Product
would therefore allow notional front office trading lot size to be
to the smallest unit size of the currency i.e. only $0.01, 0.01, 1
etc. The very small notional unit size of the traded product might
in principle raise fears of some technical issues to do with
rounding error. However as with the Adapted For Exchange New
Interest Rate Swaps Invention this is not ultimately a problem as
long as all positions and variation margin calls are calculated to
high accuracy (i.e. not rounded to the nearest cent, pence, yen
etc). This is especially true of back-office products who's
notional size is a function of on screen traded price and not just
front office volume.
[0519] Only after the relevant mark to market has been calculated
to high accuracy should total position variation margin calls be
calculated with rounding per product. Specifically when margin
calls or final cash settlement are calculated the rounding should
be done differently for net long and net short positions i.e. in
the clearing house's favour.
OIS Product
[0520] The OIS Product is one embodiment of the Adapted For
Exchange New Money Market Derivatives invention. It does not
utilise the full potential mapping points available in the generic
ISDA-like invention design (see FIG. 8) there being no distinction
between the front office and internal matching product: [0521] The
front office product is called the Traded OIS Rate (TOR) that
appears on trading and information systems is expressed in
annualised percentage points according to market convention. The
quotation convention here is the one most suitable for showing this
product's relationship to rates in the cash money markets. The
Traded OIS Rate is also important for audit trail purposes. [0522]
There are two distinct back office product types formed by the
splitting of the front office Traded OIS Rate into a so called
Fixed Rate OIS Product (FROP) and an Overnight Indexed Product
(OIP) for booking at the clearing house etc. Both the Fixed Rate
OIS and the Overnight Indexed Products are designed to make sure
trade ticket history does not dominate position accounting so that
within a large client portfolio netting and margining takes place
efficiently.
[0523] On exchange options of the above (a.k.a. OI Swaptions) are
included in the preferred embodiment of the Adapted For Exchange
New Money Market Derivatives invention.
Traded OIS Rate, Fixed Rate OIS Product, Overnight Indexed Product
and Associated Mappings etc
[0524] The mappings that are part of the OIS Product link the front
office Traded OIS Rate with the back office Fixed Rate OIS and
Overnight Indexed Products directly. We now give a detailed
description of these with reference to FIG. 8 where each mapping
exists between the boundary of the sub-products at points indicated
by circles numbered 1-5. In this case circles 1 and 2 can be
ignored as no mappings take place there for the Adapted For
Exchange New Money Market Derivatives invention.
Mapping 3
[0525] Mapping 3 occurs at the numbered circle point 3 in FIG.
8.
[0526] FIG. 19 shows the details of this one goes to two mapping
that converts from the Traded OIS Rate Fill Element (TORFE) (see
1900 of FIG. 19) into the relevant back office Overnight Indexed
Product (OIP) (see 1902 of FIG. 19) and offsetting back office
Fixed Rate OIS Product (FROP) (see 1904 of FIG. 19).
[0527] The Overnight Indexed Product (OIP) position is assigned
with the opposite long/short sign as the Traded OIS Rate but in
exactly the same lot volume and for exactly the same expiry (see
1902 of FIG. 19): [0528] OIP Lot volume=TORFE Lot volume [0529] OIP
Price=0 [0530] IF TORFE=Buy THEN OIP=Sell, ELSE IF TORFE=Sell THEN
OIP=Buy
[0531] The Fixed Rate OIS Product (FROP) position is assigned with
the same long/short sign as the Traded OIS Rate both in proportion
to lot volume and also as a function of actual matched Traded OIS
Rate price as de-annualised for the appropriate expiry (see 1904 of
FIG. 19): [0532] FROP Lot volume=TORFE Lot volume*(100% +a *TORFE
Price %) [0533] FROP Price=0 [0534] IF TORFE=Buy THEN FROP=Buy,
ELSE IF TORFE=Sell THEN FROP=Sell
[0535] The accrual factor, a, is simply the fraction of a year that
the number of days between the spot date (T+x, where x is most
typically 2 business days) and the expiry date represent. The
accrual factor calculation method will vary with currency and will
be specified in the particular OIS Product design. The calculation
will usually be made consistent with the conventional quotation
method in the existing ISDA based OIS markets in that currency.
Thus for a $ or product for example the a's would be defined in day
fractions of an Actual/360 day count, spot=T+2 basis. This mapping
therefore has to be parameterised by the expiry calendar for
product so that this accrual factor can be calculated (see 1906 of
FIG. 19).
Mapping 4
[0536] Mapping 4 occurs at the numbered circle point 4 in FIG. 8.
This is identical to the mapping at numbered circle point 3 as
described above and in FIG. 19. It is used to convert wholesale
trades agreed over the telephone into the back office
representation directly.
Mapping 5
[0537] Mapping 5 occurs at the numbered circle point 5 in FIG.
8.
[0538] FIG. 20 shows amongst other things the details of the
mapping that converts the front office Traded OIS Rate Reference
Prices (see 2002 of FIG. 20) as set by the market supervisor into
the actual back office back office Fixed Rate OIS Product (see 2010
of FIG. 20) and Overnight Indexed Product (see 2008 of FIG. 20)
daily settlement prices needed for variation margin calls.
[0539] The Traded OIS Rate Reference Prices do not in principle
need to respect the Traded OIS Rate tick and may be calculated from
some objective averaging function of trading conditions just prior
to the daily settlement time.
[0540] Module see 2006 of FIG. 20 illustrates the two steps needed
to calculate the discount factors required to settle the Fixed Rate
OIS Product. The first step is to use interpolation to determine
Traded OIS Rate settlements in time periods for which an express
rate does not exist i.e. at off-the-run points. Exponential
interpolation, cubic spline interpolation, exponential spline
interpolation, or any other desired type of interpolation may be
used. The result is that a Traded OIS Rate Reference Price,
O.sub.i, is available for every possible expiry date i.
[0541] In the next step we calculate zero coupon discount factors,
d.sub.i, calculated from Traded OIS Rates, O.sub.i, for the period
between the spot date and the relevant expiry date. The following
formula is used: d i = 1 1 + a i .times. O i ##EQU11## where the
a.sub.i are the accrual factor for the relevant period. For the
period up to the spot date we set the d's=100%. This mapping
therefore has to be parameterised by the expiry calendar for
product so that this accrual factor can be calculated (see 2004 of
FIG. 20).
[0542] The formulae for the daily settlement prices needed for
variation margin calls for the Overnight Indexed Product,
OIP.sub.i, and Fixed Rate OIS Product, FROP.sub.i, are thus:
OIP.sub.i=100% FROP.sub.i=d.sub.i as indicated in modules 2008 and
2010 of FIG. 20 respectively.
Overnight Indexation
[0543] Module 2008 of FIG. 20 also shows the process required for
indexation to a daily overnight index rate, X, such as the Fed
Funds rate. It is key to the product design as a true OIS Product.
Although the daily settlement prices of the Overnight Indexed
Products, OIP.sub.i, remain 100% for the entire life of a position,
each evening the position size is augmented as follows: [0544] For
all j=1 to m, non-compounding positions, OIP1.sub.j, less than x
days old: New OIP1.sub.j position=Old OIP1.sub.j position [0545]
For all i=1 to m, compounding positions, OIP2.sub.i, x or more days
old: [0546] New OIP2.sub.i position=Old OIP2.sub.i
position*(100%+A.sub.O/N*X %) [0547] i.e. Addition OIP2.sub.i
volume=Old OIP2.sub.i position*A.sub.O/N*X % [0548] and Addition
OIP2.sub.i price=0 where A.sub.O/N is the accrual factor applied to
the overnight index rate, X, is (in $'s usually a 1/360 or a 3/360
for a Friday etc). Also x is the number of business days defining
spot (T+x) for this currency (usually x=2). Notice that the
accuracy to which the Overnight Indexed Product position will be
held is higher than the smallest unit size of the currency i.e.
only $0.01, 0.01, `etc. even though this is the notional trading
lot size. This process therefore requires the calendar so that the
overnight accrual factors can be calculated (see 2004 of FIG.
20).
Position Keeping Efficiency
[0549] We have stated without explanation that both position and
risk will be more efficiently managed in the current design than in
the existing ISDA-style one.
[0550] As previously explained the on-the-run market exists at
maturities of a whole number of weeks, months or years i.e. spot
plus 1 week, spot plus 2 weeks, spot plus 3 weeks, spot plus 1
months, spot plus 2 months, spot plus 3 months, spot plus 4 months,
spot plus 5 months, spot plus 6 months, spot plus 7 months, spot
plus 8 months, spot plus 9 months, spot plus 10 months, spot plus 1
months, spot plus 1 year etc. In all this makes 15 or more
different classes of trade ticket. For each given expiration day
there are therefore an increasing density of different classes
expiring with reducing time to expiry each of which have to be
valued separately. Furthermore the lack of unbundling of the legs
will further multiply the position and risk management overhead and
ticket management burden.
[0551] By contrast there is only one Fixed Rate OIS Product (FROP)
for each expiry and one compounding Overnight Indexed Product
(OIP2) for each expiry plus .about.15 times x non-compounding
Overnight Indexed Product (OIP2) for newer positions where x is the
number of business days defining spot.
Give Ups
[0552] As the preferred embodiment of the invention has both Fixed
Rate OIS Product and Overnight Indexed Product created at zero
price and in offsetting pairs there will be a one-off pair of large
but offsetting variation margin calls calculated for each different
leg type upon their first daily settlement. It is therefore
important to keep the two product types together prior to this
point and hence restrict give ups (see Reconciliation, efficient
give ups and open interest markers).
Expiry of Fixed and Overnight Indexed Products
[0553] Fixed Rate OIS and Overnight Indexed Products are both cash
settled to 100% at expiry (see 506 of FIG. 5).
FRA Product
[0554] The FRA Product is extremely closely related to the Par IRS
Product (see page 75). In fact the FRA product is identical to the
front quarterly Par IRS Product which breaks down into a single
pair of back-office products (i.e. no strip) except that: [0555]
The equivalent of the Traded Swap Rate known as the Traded FRA Rate
will be quoted using the money market day count convention and not
the swap market convention. [0556] FRA Products are not restricted
to quarterly terms. [0557] As with the OIS Product daily listing
and delisting of product for matching engine trading of on-the-run
points will occur.
[0558] In practice only three month and six month terms will need
to be listed as these are the most liquid in the ISDA based market.
Thus on any given day 1.times.4 (=one month forward for three
months), 2.times.5, 3.times.6, 4.times.7, 5.times.8 and 6.times.9
will be listed amongst the three month FRA Products and 1.times.7,
2.times.8, 3.times.9, 4.times.10, 5.times.11 and 6.times.12 will be
listed amongst the six month FRA Products. Hence six different stub
rates will be needed.
[0559] To prevent duplication we won't recast the discussion of the
Par IRS Product here for the sake of the FRA product which is
identical to it.
Introduction to the Enhanced Clearing House Flexibility
Invention
Description and Novelty of this Part of the Invention
[0560] Some clearing house changes have already been discussed as
part of the ISDA-like invention above. However the Enhanced
Clearing House invention takes the standard futures exchange's
clearing house and with a few minor changes transforms it into
something far broader i.e. a) a central cash money market; or b) a
securitisation of loans venue; or indeed c) a rival to existing
securities depositories; and in particular d) a rival issuance
venue for securities normally issued by special purpose
vehicles.
[0561] The extent to which some of these innovations are attractive
to the market remains to be seen. However to broaden the role of
the traditional futures and options exchange trading and clearing
venue in order to streamline the operations of the financial
industry is entirely consistent with the preceding ISDA-like
product part of invention. The first part of the invention sought
to replace ISDA's coordinating role with a truly central market in
the main derivative products traded by the market. This part of the
invention concerns the well-worn yet untested assumption that
operational risk can best be managed by coordination of piecemeal
projects distributed across the industry. The harnessing of
existing efficiencies within futures exchanges and the clearing
house's in a broader context to create a truly central provider of
operational services across the industry challenges orthodoxy. It
is this contrasting approach that is presented here and not
surprisingly it is linked to the first part of the invention in
several places.
The Details of the Clearing House System Innovations Already Needed
for the First Part of the Invention
Order of Margining Calculations and Rounding
[0562] The small notional units of trading in the invention require
that margin calls and position sizes are calculated with high
accuracy i.e. not rounded to the nearest cent, pence, yen etc.
during intermediate steps. Only after the relevant mark to market
and positions have been calculated to high accuracy in this way
should total position margin calls be calculated with rounding.
Reconciliation, Efficient Give Ups and Open Interest Markers
[0563] As already stated since the product designs of the first
part of the invention lead to each individual front office trade
being split into two or more back office positions this will
require system changes for efficient post trade management. Thus
the preferred embodiment of the invention will conserve information
appropriately and allow for efficient manipulation of it: [0564]
All front office product fill reports on a dealer's trading system
will be accompanied by the relevant back office product breakdowns
to help with front office versus back office reconciliation. [0565]
All front office product matched trades will be passed through to
the clearing house. These filled front office trades will appear on
the clearing house's trade register as normal contracts but will
not be charged any initial or variation margin. [0566] Front office
position markers held at the clearing house can be used to assist
with front office versus back office reconciliation. They will also
be used for calculating open interest reports for front office
systems. [0567] Front office position markers held at the clearing
house will also be used for efficient give ups. The preferred
embodiment of the invention will allow back office managers to give
up and take in products by reference to the front office position
markers held in the clearing house's trade registration systems
alone. The associated back office products referenced to a
particular front office trade would be transferred as a group that
moves wherever their front office position marker goes.
The Delivery of Loans into the Recovery Auction or Rate Product
[0568] The delivery of loans into the Recovery Auction or Rate
Product of the Adapted For Exchange New Credit Derivatives may be
deemed essential by the market. How this can be achieved is
discussed separately in the details of the clearing house
securities part of the invention section below.
The Details of the Internal Fungibility Invention
Overview
[0569] A modern futures and options exchange is a highly efficient
primary market in a certain subset of derivatives contracts.
However even these modern electronic exchanges must have predefined
trading hours and times when the market is closed. This contrasts
with the flexibility of the OTC ISDA based market which trades on
demand at any time globally.
[0570] Electronic linkages with foreign exchanges have been
attempted to solve this problem. The lead example is the CME/SIMEX
MOS link but other similar linkages followed. However this approach
has hit some genuine limitations. No single link-up can sensibly
cover the entire 24-hour trading period yet competitive
considerations between different financial centres makes a
worldwide linkage system almost impossible to set up, with attempts
to do so hit by regulatory and legal complications.
[0571] Given the opportunities of electronic trading to give access
to the same exchange across global time zones in recent years
exchanges have attempted to expand their trading sessions to become
near 24-hour a day markets. The idea is to preserve local business
flows and attract business generated on foreign shores. However
these exchanges have failed to address the operational difficulties
caused by the long day markets they have created.
[0572] By intelligently introducing three or more different daily
settlement times for each near 24-hour a day market operational
difficulties can be fully addressed.
Advantages
[0573] This part of the invention introduces three or more
different daily settlement times for each near 24-hour a day market
which has the advantage of: [0574] Avoiding all clearing members
being forced to either a) maintain expensive 24 hour back offices;
or b) outsource part of their back offices coverage to a costly
global service provider; and [0575] Allowing traders and
institutions to sensibly mark to market across product classes
within each region; and [0576] Avoiding many of the regional
competition pitfalls that lead to politically motivated regulatory
and legal complications.
Internal Fungibility and Multiple Daily Settlement Times Membership
Structure
Basic Structure
[0577] This part of the Enhanced Clearing House invention requires
simple but significant changes that introduce: [0578] a) Three or
more different daily settlement times within the same clearing
house for each near 24-hour a day market e.g. an Asian close, a
European close and an Americas close; and [0579] b) Hence three or
more different daily variation margin collection cycles; and [0580]
c) A clearing membership qualification by region. Any clearing
member would have to demonstrate the capacity to staff it's back
office for the relevant daily settlement and clearing cycle before
being qualified. Thus ABC Corp might be a clearing member only for
the European close for example. However XYZ bank might be a
clearing member for all time zones. [0581] d) Each individual
clearing house account reference will also carry a time zone
designation and all trades within that individual clearing house
account will settle in the same time zone. Note that a clearing
member cannot own account references for regions in which it is not
qualified e.g. ABC Corp cannot own Asian close account references.
[0582] e) A system for monitoring variation margin mismatches over
the trading day caused by the splitting of settlement times and
open positions across regions.
[0583] The clearing house needs only to be confident that its own
capital fund or credit lines will not be exhausted by variation
margin mismatches over the trading day caused by the splitting of
settlement times in order to provide such a service. With the above
changes a truly global exchange that is operationally efficient is
finally possible.
Introduction to the Pooled Risk Deposit Market Invention
Description and Novelty of This Part of the Invention
[0584] Bank lending has been the corner-stone of financial activity
for centuries and an active interbank market is considered vital to
any modern economy. There are however periodic crises in which a
bank may fail and the ensuing chaos takes a considerable amount of
time to unwind and for the risk of contagion to pass.
[0585] There are two separate streams of effort attempting to keep
the financial system in order: [0586] 1. Individually the banks
expend a large amount of resources setting counterparty credit
exposure limits amongst themselves which helps to control risk of
contagion; and [0587] 2. Also regulatory authorities focus
considerable resources setting and policing capital adequacy rules
and reserve requirements to prevent bank failures in the first
place.
[0588] The present invention recognises that these two streams of
effort should be overhauled, modernised and replaced by a single
fully robust system springing from an adapted futures exchange type
environment.
The Details of the Pooled Risk Deposit Market Invention
Overview
[0589] A modern futures and options exchange is a highly efficient
primary market in a certain subset of derivatives contracts.
Because of the central counterparty services created by the
exchange's clearing house these derivatives contracts behave almost
like securities. By introducing immediate cash currency payments
plus an alternative method of handling default risk as compared to
the current margin based system a highly operationally efficient
central money deposit market can be created.
Advantages
[0590] The object of this part of the invention is to: [0591]
repackage and vastly simplify counterparty credit exposures amongst
the top tier banks; and [0592] reduce the operational risks
associated with traditional cash money markets i.e. depos.
[0593] This is done by once again harnessing the efficiency of the
electronic futures exchange-like environment. Apart from the
obvious and extensive advantages associated with removing the need
to separately manage large fractions of the overall counterparty
risk in these markets this part of the invention allows the
efficient intervention of central banks in times of a bank
failure.
Pooled Risk Deposit Product Market Structure
[0594] This part of the Enhanced Clearing House invention requires
system changes that introduce `payment versus delivery` into
primary market for the first time. We are therefore moving away
from leveraged products to fully funded products and indeed away
from derivatives towards the underlying cash. This Pooled Deposit
Product nonetheless is very similar to the previous products
described though it does not utilise the full potential mapping
points available in the modified exchange design (see FIG. 8) there
being no distinction between the internal matching product and back
office product: [0595] The front office product is called the
Traded Rate Product (TRP) that appears on trading and information
systems its price is expressed in annualised percentage points
according to the money market day count convention. The Traded Rate
Product volume is basically the amount of money being borrowed or
lent and so its notional lot size has to be the smallest unit size
of the currency i.e. only $0.01, 0.01, 1 etc. [0596] The internal
matching product is called the Forward Value Product (FVP) and
remixes the price and volume information of the Traded Rate Product
into the most appropriate form for use of existing exchange implied
book matching technology. The Forward Value Product price is the
same as the discount factor associated with the Traded Rate Product
price and term expressed to high accuracy. The Forward Value
Product volume is basically the amount of money being repaid at the
forward date given the Traded Rate Product price, term and volume.
Thus the notional lot size must also be the smallest unit size of
the currency i.e. only $0.01, 0.01, 1 etc.
[0597] All expiries going out to two years will be listed for back
office purposes.
Traded Rate Product, Forward Value Product and Associated
Mappings
[0598] The mappings that are part of the Pooled Deposit Product
link the front office Traded Rate Product with the internal
matching and back office Forward Value Product as already described
in general terms above. We now turn to specifics and describe these
with reference to FIG. 8 where each mapping exists between the
boundary of the sub-products at points indicated by circles
numbered 1-5. However in this case circle 3 can be ignored as no
mapping takes place there for the Pooled Deposit Product
invention.
Mapping 1--Inbound
[0599] Mapping 1 occurs at the numbered circle point 1 in FIG.
8.
[0600] The top half of FIG. 21 shows the details of the one to one
inbound mapping that converts a dealer's front office Traded Rate
Product Orders (see 2100 of FIG. 21) into an Forward Value Product
Order (see 2102 of FIG. 21) for internal matching.
[0601] Traded Rate Product orders (TROs) are mapped onto outright
Forward Value Product order (FVOs) for internal matching as follows
(see 2102 of FIG. 21): [0602] FVO Lot volume=TRO Lot
volume*(100%+a*TRO Price %) [0603] IF TRO=Buy THEN FVO=Sell, ELSE
IF TRO=Sell THEN FVO=Buy [0604] FVO Price=100%/(100%+a*TRO Price
%)
[0605] The mapping has to be parameterised by the expiry dates of
the products and the trade date (see 2104 of FIG. 21). The accrual
factor, a, is simply the fraction of a year that the number of days
between the spot date (T+x) and the expiry date represent (x is
usually 2 days). The accrual factor calculation method will vary
with currency consistent with the conventional quotation method in
the existing markets. Thus for a $ or product for example the a's
would be defined in day fractions of an Actual/360 day count
basis.
Mapping 1--Outbound Orderbook and Fill Reporting
[0606] Mapping 1 occurs at the numbered circle point 1 in FIG.
8.
[0607] The bottom half of FIG. 21 shows the details of the one to
one outbound mapping converts the Forward Value Product Order or
Fill (see 2106 FIG. 21) as used during internal matching back to
the Traded Rate Product (see 2108 of FIG. 21) in the natural
reverse mapping mapping: [0608] IF FVO=Buy THEN TRO=Sell, ELSE
[0609] IF FVO=Sell THEN TRO=Buy [0610] TRO Price=(100% /FVO Price
%-100%)/a [0611] TRO Lot volume=FVO Lot volume/(100%+a*TRO Price
%)
[0612] Where again the mapping has to be parameterised by the
expiry dates of the products and the trade date (see 2104 of FIG.
21), with `a` being the relevant accrual factor. It may be simpler
computationally to simply store the front office product details
with the Forward Value Product orderbook or fill as used for
internal matching rather than calculate the reverse mapping.
Mapping 2
[0613] Mapping 2 occurs at the numbered circle point 2 in FIG.
8.
[0614] This is identical to the first outbound mapping at numbered
circle point 1 in FIG. 8 but for quote vendor screens.
Mapping 4
[0615] Mapping 4 occurs at the numbered circle point 4 in FIG.
8.
[0616] This is identical to the inbound mapping at numbered circle
point 1 in FIG. 8. It is used to convert wholesale trades agreed
over the telephone into the Forward Value Product for back office
use directly.
Mapping 5
[0617] Mapping 5 occurs at the numbered circle point 5 in FIG.
8.
[0618] This is the conversion of the front office Traded Rate
Product settlement prices as set by the market supervisor into the
actual back office Forward Value Product daily reference prices
needed for mark to market if required. No variation margin nor
initial margin calls are however applied to the Forward Value
Product.
[0619] The Traded Rate Product settlement prices do not in
principle need to respect the Traded Rate Product tick and may be
calculated from some objective averaging function of trading
conditions just prior to the daily settlement time.
[0620] The first step is to use interpolation to determine Traded
Rate Product settlements in time periods for which an express rate
does not exist i.e. at off-the-run points. Exponential
interpolation, cubic spline interpolation, exponential spline
interpolation, or any other desired type of interpolation may be
used. The result is that a Traded Rate Product settlement price,
I.sub.i, is available for every possible expiry date i.
[0621] In the final step we calculate zero coupon discount factors,
d.sub.i, which are used as the actual daily reference prices for
the Forward Value Product, FVP.sub.i. The discount factors are
calculated from Traded Rate Product settlement prices, I.sub.i, for
the period between the spot date and the relevant expiry date. The
following formula is used: FVP i = d i .times. 1 1 + a i .times. I
i ##EQU12## where the a.sub.i are the accrual factor for the
relevant period.
Initial Payment Versus Delivery, Forward Value Product Expiry
Payments, Credit Pooling and a Potential Role for Central Banks
[0622] Whenever a Traded Rate Product trades it results in a
`immediate` delivery from TRP shorts to TRP longs of cash currency
equivalent to the Traded Rate Product lot size traded. In this case
immediate means spot dated except for overnight and tom-next trades
etc. Likewise when a Forward Value Product position expires it
results in a delivery from FVP shorts to FVP longs of cash currency
equivalent to the Forward Value Product position size held.
[0623] Now this Pooled Deposit Product market will have rules only
allowing top quality banks of highest creditworthiness to
participate. For each exchange member all payments due would be
made net to the clearing house. Should a default occur and a cash
currency payment not be made available by an exchange member to the
clearing house the shortfall in funds to pay-out to other members
would be distributed pro rata after netting. This is the essence of
credit pooling and any trade in this Pooled Deposit Product market
would therefore carry the same credit rating.
[0624] If the market's rules allow a short grace period after a
default then the defaulting member might be able to make good the
shortfall of funds plus interest. However after a true default the
culpable member would be expelled and the clearing house would
trade out of their remaining Forward Value Product position as
quickly and efficiently as possible. Again any loss incurred in
unwinding or transferring positions would be distributed among the
other members according to principles established at the time of
the market's founding.
[0625] One variant of this invention would reintroduce the concept
of initial margin to cover borrowing (i.e. short Forward Value
Product) positions. This would then be used as a cushion against
default. There is an interesting analogy with reserve requirements
here. One advantage the Pooled Deposit Product market approach is
that it allows the central bank to efficiently monitor the market
at normal times and intervene quickly at times of a member bank
failure. Thus for example as a defaulting bank is expelled from the
system instead of the clearing house unwinding or transferring
positions to other normal members it could in principle transfer
the entire defaulting bank's position to the central bank.
The Money Market Convention and Implied Pricing
[0626] Pooled Deposit Product invention uses the money market
convention that has already been described in the "Background to
the invention" section. Thus each trading day a restricted subset
of on-the-run points will be made available for trading on the
matching engine even though the full set will remain available for
trading via OTC-style wholesale trading facilities. This will
require: [0627] daily listing and delisting of product for matching
engine trading; and [0628] daily adjustments to block trade
thresholds for listed and delisted product.
[0629] The latter point is required so that traders can if they
wish trade where no matching engine listing exists i.e. the block
trade threshold must be zero for off-the-run points.
[0630] Ratio calendar spreads constructed so that there is zero
immediate delivery of funds are basically the same as deliverable
forward trades. No doubt an implied orderbook of these forwards
could be constructed from the Forward Value Product internal
matching spot market orderbook. These would then compete with FRAs
to some considerable extent, at least for Pooled Deposit Product
market members.
Introduction to the Enhanced Give Up Invention
Description and Novelty of this Part of the Invention
[0631] The thrust of all the inventions presented so far have been
to broaden the role of the traditional futures and options exchange
trading and clearing venue in order to streamline the operations of
the financial industry. The first part of the invention sought to
replace ISDA's coordinating role with a truly central market in the
main derivative products traded by the market. The second part
concerned supporting innovations in the clearing house itself in
order to achieve a more efficient global coverage and greater
accuracy in the product margining and settlement. The third part of
the invention concerned overhauling and replacing the centuries old
architecture of the interbank deposit market.
[0632] To complete the picture we now look at incorporating genuine
securities within the traditional futures and options exchange
trading and clearing venue in order to complete this central
provider of operational services across the industry we envisage.
The extent to which some of these innovations will be attractive to
the market remains to be seen but the advantages of having a single
coherent system linking derivatives, structured products,
traditional securities and interbank lending must surely be obvious
from an operational and regulatory efficiency point of view.
The Details of the Clearing House Securities Part of the
Invention
Overview
[0633] A modern futures and options exchange is a highly efficient
primary market in a certain subset of derivatives contracts.
Because of the central counterparty services created by the
exchange's clearing house these derivatives contracts behave almost
like securities. However during a give up there is genuine transfer
of title and if payment versus delivery methodology was introduced
into this process a secondary market in `Clearing House Securities`
could be created. A genuine secondary market would of course
require a new trading platform to be linked into this modified give
up process of a normal futures clearing house. The resulting
central securities marketplace will be highly operationally
efficient as it will already be deeply linked to the derivatives
markets. For example this Clearing House Securities invention
allows for the securitisation of loans and hence their efficient
delivery into the Adapted For Exchange New Credit Derivatives
Recovery Auction or Rate Product. Other applications include the
entire range of existing securities and in particular a rival
issuance venue for securities normally issued by special purpose
vehicles such as credit-linked notes and synthetic CDOs.
Advantages
[0634] The advantages of further operational consolidation are
hopefully self evident and include: [0635] Cost savings; and [0636]
More efficient risk management; and [0637] Greater ease of market
monitoring for regulators, especially of SPVs.
[0638] The above is not an exhaustive list. However the extent to
which this part of the invention is attractive to the market
remains to be seen.
Clearing House Securities
Issuance and Payment versus Delivery for Give Ups
[0639] FIG. 22 shows this part of the invention schematically. In
the preferred embodiment of the invention only the issuing member
(see 2202 of FIG. 22) acting on behalf of the issuing client (see
2200 of FIG. 22) has access to the generation market of a Clearing
House Security. This securities generation market is just what was
the normal market of the futures and options exchange (see 2202 of
FIG. 22). The open interest (see 2206 of FIG. 22) in the Clearing
House Security is created by one or more cross-transactions in the
primary market (see 2202 of FIG. 22).
[0640] Having been created on securities generation market a
primary issuance (or float) of the Clearing House Security occurs
when the first payment versus delivery `give ups` occur via the new
securities trading engine (see 2210 of FIG. 22) between the member
acting for the issuer in this forum (see 2208 of FIG. 22) and other
members acting for their clients (see 2212 of FIG. 22). Technically
the new securities secondary trading exchange will look very
similar to the existing tradition futures market (see FIG. 4) with
access via exchange gateways and straight through processing linked
to the clearing house.
[0641] All trades in this market are only really modified give ups
and only concern long positions with the orphaned short position
obligations being passed by the issuing member directly to a
specially created account (or indeed membership) at the clearing
house. The issuing member (see 2202 of FIG. 22) passes the cash
created by the primary issuance to the ultimate issuer (see 2200 of
FIG. 22) for which it is acting as agent. The ultimate issuer
retains the responsibility for servicing the payments (e.g. coupons
or dividends) of their Clearing House Security and must make these
payments directly to the clearing house according to the legal
terms underlying the security.
[0642] In the secondary market payment versus delivery `give ups`
also occur via the securities trading marketplace created as part
of the Clearing House Securities invention.
Securitisation and stripping of Loans
[0643] Some market participants may not be able to take delivery of
loans at the expiry of an Adapted For Exchange New Credit
Derivatives Recovery Auction or Rate Product. This can be solved as
already stated by restricting participation in these products. An
alternative is for the clearing house to act as a pass through
intermediary: [0644] The receiving long makes the cash payment to
the clearing house but receives not the loan but a series of
cashflow clearing house securities at zero price and of notional
size and payment dates corresponding to the loan repayment dates;
[0645] The short chooses to deliver the loan and the clearing house
takes delivery itself in return for passing through the cash
payment; [0646] The cashflow clearing house securities remain
marked to market at zero price until clearing house receives a loan
repayment when it is obligated to take appropriate action i.e. if
the payment is made in full mark to market the relevant cashflow
clearing house securities to 100% and fund the variation margin
call from the obligation (short leg) to the float (long leg) with
the cash received from the loan repayment.
[0647] An interesting feature is that a secondary market can occur
the moment the cashflow clearing house securities have been created
allowing for a fully efficient secondary market in the entire loan
or indeed in stripped out components of it.
The Details of the Clearing House Special Purpose Vehicles Proxy
Invention
Overview
[0648] The example of securities loans can be generalised to
include other assets held at the clearing house. In particular this
could include the entire range of existing securities and hence
generating a rival issuance venue for products normally issued by
special purpose vehicles such as credit-linked notes and synthetic
CDOs.
Special Purpose Vehicles, Credit-Linked Notes and Synthetic
CDOs
[0649] Collateralised issuance can simply be performed by
delivering the appropriate collateral to the clearing house which
in return issues the float at zero price in order that it may be
resold as a primary issuance. This collateral could include cash;
or treasury bills, notes or bonds; or even derivatives and clearing
house securities contracts from the same exchange. In this way the
clearing house can act as a special purpose vehicle and generate
credit-linked notes, synthetic CDOs, etc., etc. As a trusted pillar
of the financial system the exchange and its clearing house could
also perform those supervisory activities normally undertaken by
the trustees of SPVs.
* * * * *