Eighteen years after the credit default swap (CDS) was created to help firms hedge against the risk of default of a given asset, TABB Group estimates that the average notional value at risk (the total value of a leveraged position's assets) of trades novated monthly will exceed USD 45.2 trillion by 2010, an 88% CAGR (compound average growth rate) from 2005.  

According to senior analyst Kevin McPartland, author of new TABB Group research published this weekl, "Credit Default Swaps: The Risk of Inefficient Markets," 90% of all CDS trades are confirmed electronically, but same-day matching of new trades and novations is rare and error rates are unacceptably high.  "This is a lot of money to risk on a phone call," suggests McPartland.

TABB Group forecasts that nearly USD 170 million will be spent in 2010 by major sell-side broker-dealers to automate the affirmation process and mitigate the potential risk resulting from trade exceptions.   

Despite current available technology, details of most CDS trades are still not affirmed between counterparties on trade date.  The delay is not in legally confirming or settling trades, but simply in agreeing that each party recorded the same basic trade details such as the reference entity or notional amount.  Where overnight batch jobs were once accepted solutions, with 2008 trading volumes and market volatility levels, explains McPartland, "the risk created by not understanding your market and counterparty exposure until the next morning makes this standard practice rather unacceptable."  

While it is not the job of any single regulatory, technical or financial entity to solve the counterparty risk problem, all firms must create an automated, timely process ensuring decisions are based on accurate information.

Technology exists to raise accuracy levels above 99% and with so much to gain for all involved, McPartland asks, "Why not take that step?  Trade processing backlogs must not simply be reduced, they must be eliminated entirely."

According to McPartland, affirmation of trade details by front-office systems on trade date will result in a positive downstream affect.  Accuracy will allow for a considerably higher rate of confirmations on trade date and more timely settlement.  Even more critical than for new trades, automating this process for novations will increase transparency and reduce risk for the entire industry.  

"The benefits gained will far outweigh the money spent," adds Andy Nybo, senior analyst and head of TABB Group's derivatives research service.  "The number of staff needed to manage the novation process will decrease dramatically.  Although difficult to measure, savings will also be realized through reduced capital requirements, lower potential for costly litigation due to unconfirmed trades and a reduction in losses resulting from operational errors in the trade process."

       

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