Extending FIX implementations to support OTC trading and clearing
Clearing houses make stride
Over the last 18 months regulators have aggressively pushed OTC markets toward standardization in order to achieve price transparency and eliminate bilateral counterparty risk. Clearing is a key component of this plan. Central counterparties such as CME Group, ICE Clear and the London Clearing House (LCH) provide clearing services which can greatly reduce the risk of default and systematic failure across the markets as well as the major players who are the investment banks, asset managers and hedge funds.
Central counterparties run clearing houses which set policies for settling markets and limiting risk. Clearing houses offer a safe harbor from this risk by ensuring that OTC markets are sufficiently collateralized and that in the unlikely event of a default the market impact is minimized. The clearing process involves carefully setting margin rates which are high enough to protect the market but not so high that trading is squashed. Margin is held in the form of collateral which can be called on in case of default. Additionally, clearing members must contribute to a default fund over and above basic margin requirements which also serves as a buffer should a default occur.
Beyond providing a safety net for the OTC high wire act, clearing houses perform other critical day to day functions that are necessary for ensuring stable markets. Valuation (also known as mark to market), cash flow calculations, and settlement price determination are part of an overall clearing service that allows all trades and positions to be fully settled each day. Taking CDS as an example, clearing houses calculate what is referred to as variation margin which is a combination of the change in the market value of a CDS position as well as the coupon accrued on a daily basis. Clearing houses hold variation margin until the CDS position matures or a coupon payment date is reached. Other types of cash flows include the full payment/receipt of a coupon on a quarterly basis and the handling of the upfront amount that is included with trades. All such cash flows are immediately banked rather than being held on a collateralized basis.
Daily settlement price
Determination is a critical process which underlies all functions of the clearing house. Without it, trades and positions could not be valued or margined. For OTC products, this tends to be a democratic process which involve “voting” on the value of a financial instrument by key participants in the form of price submission. Both bids and asks are submitted. The clearing house receives these prices, removes outliers, converges on the settlement price and publishes them to the market.
Another area worth a mention that is specific to CDS clearing is the handling of credit events. A credit event occurs when the issuer of a bond on which a CDS instrument is based fails to make payment. In effect, this is the fundamental purpose of a CDS instrument; to protect the buyer of a bond from exposure to default by the bond issuer. When this happens the clearing house must ensure that the CDS buyer is made whole and receives the unrecoverable portion of the amount held. Likewise, the clearing house must also ensure that the CDS seller delivers on the unrecoverable portion. The recoverable portion is determined by an ISDA auction. Generally, this transaction is cash settled.
Up to this point we have discussed only the back-end aspects of a central clearing service offered via the clearing house. Let’s discuss how trades are actually submitted to the clearing service by market participants. Most participants transact their deals on a third-party trading platform designed to support an affirmation and matching process. Once a deal has been matched it is submitted to the clearing service. This requires that the trading platform know the valid set of instruments, parties, and accounts which are accepted by a clearing service. Taking the CDS market as an example again, trade reports specifying the buyer, the seller, their respective accounts, the contract, price and upfront amount are submitted for clearing. The designated clearing members (DCM) for each party must also be specified. When received by the clearing service the trade is validated and credit limits are checked. If all checks are passed, the clearing service returns a cleared trade confirmation to the trading platform and the trade can be considered “cleared”. In the case of a credit failure the platform will be informed that the deal cannot be cleared.
Now let’s turn to the question of how FIX can be used effectively throughout the OTC trade submission and clearing process as has been described above, keeping in mind that the recent standardization of OTC products makes FIX a relevant player in the OTC arena.
FIX- A relevant player indeed
Firstly, FIX provides an effective mechanism for OTC trade submission. The rich trade reporting workflow allows either single sided or two sided trades to be submitted with all requisite OTC trade attribution. Both models are commonin the OTC market; single sided trades for affirmation and matching, two sided trades if matching has already taken place and immediate submission to the clearing service is desired. CDS, FX, Energy, and other types of OTC commodities such as gold forwards can be fully described using the recently extended FIX Instrument definition. Trade status and report types can be used to concisely convey the trade state at any point in the workflow. CME uses FIX for the purpose of receiving OTC trades submitted for clearing in the aforementioned products from trading platforms. Several of these commercial platforms have been able to leverage existing FIX implementations.
FIX may also be effectively applied in the reconciliation and cash flow reporting aspects of OTC clearing. The Position Report message allows OTC trades which have been multilaterally netted to be expressed as positions and reported for reconciliation purposes at the end of each day. In the same vein, FIX has recently been extended to represent all the cash flows that are relevant to CDS. Reset to par, Initial Coupon, Daily Accrued Coupon, Quarterly Coupon Payment, and Collateralized Mark to Market are all cash flow amounts that are supported in the FIX lexicon. Additionally, the same FIX workflow used to submit trades to clearing can be used for static trade reporting. In the case of CDS, the FIX Trade Capture Report carries all fields necessary for the DTCC Copper trade reports. CME uses FIX in exactly this capacity in order to provide clearing firms with all details of a clearing cycle.
Reporting of OTC settlement prices on a consistent and timely basis can be accomplished through the use of the FIX Protocol. FIX allows settlement prices to be expressed in a number of terms required by market participants including percent of par, points and spread. This is done using the Market Data Snapshot message. FIX price reporting also provides support for secondary OTC pricing needs, including discount rate which is used to determine the present value of forward style instruments as well as the recovery rate used during a CDS credit event.
Reference data has become another important area with the advent of OTC clearing. Service providers must have a robust model for providing product reference and party reference data. Product reference data represents that set of instruments which are acceptable for submission and can be generically consumed by all market participants. Party reference data is generally unique per market participant and represents the set DCMs and accounts for which each participant is given permission to trade. Many standardized OTC instruments can be neatly defined using FIX. The Security Definition message allows product definitions to be concisely communicated using elements that are common across the FIX model, presenting opportunities for re-use and reduced development effort. The Party Detail List Report message allows a large array of parties to be fully elaborated as well as the relationships that exist between them. Reference information can be delivered either statically in file form or dynamically as real time messages. CME uses FIX to define a broad set of OTC instruments including CDS, FX forward and swaps, commodity forwards, and Energy swaps. CME also uses FIX to report the accounts and the DCMs that can be traded by a given party.
As the OTC world continues to change and regulators develop new requirements for trading, clearing and reporting of OTC products, FIX is emerging as a viable interface. We are starting to see a convergence of two worlds that were formerly separate, as the behavior of OTC markets start to come into alignment with exchange-listed and cleared markets. This provides an opportunity for FIX users to apply a common model to new types of products. Granted, there are areas where FIX will need to be extended and enriched in order to provide the necessary support for OTC users. However, FIX offers a fundamentally sound framework and has already taken strides toward becoming a useful solution in the OTC space.
Extending FIX implementations to support OTC trading and clearing