capital markets july09

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NSIGHTS

CAPITAL MARKETS

A Domain Consulting Publication

1st July 2009 : Volume XLIX


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The recent events in the securities industry have left a long lasting impression on the global economy, regulators andparticipants alike. In the industry, the sea change has been the renewed interest in synthesizing information for agreater understanding of risk. The world's leading investment banks, have adopted the route of cooptition (co-operative competition) in sharing information which are non competitive in nature. We observe that industry playersare increasing their attention to the back office functions to

?Stream line the process to enable greater STP between front, middle and back office?Redefine the source of cost to align the process to emerging business realities such as willingness of customer to

pay for the execution service is hard to come by. Operating margins need to be improved by furtherstreamlining supporting functions?Support cross border trades and new products innovation to achieve scale to support the effort to gain the

market share

One of the key components of these united efforts has been further progress towards automation of the middle and backoffice processes. The recent events have highlighted the importance of efficient market practices, integration of capitalmarkets to achieve economies of scale and lower cost of operations. Initiatives like London Stock Exchange'scompetitive clearing offerings for European Multilateral trading facilities and Fixed Income Clearing Corporation'splanned launch of CCP services for mortgage backed securities will transform the face of Clearing and Settlement(C&S) domain in particular and the securities industry in general.

Advancements in technology will continue to play a very important role in driving these initiatives. Technology hasenabled industry participants to achieve cost efficiencies through flexible and scalable automation solutions. Todaytechnologies such as cloud computing and SAAS (Software as a Service) are taking the IT world by storm. This will notonly help reduce operational costs but also importantly support focusing on the core competencies. With the advent of

such technologies, a whole new world of unexplored opportunities has been presented to the securities industry,especially in the middle and back office areas.

In this issue we cover the various aspects of Clearing and Settlement (C&S) in a trade lifecycle. We go on toextrapolate the current C&S trends and attempt to provide a view on the future of C&S back office. A key highlight ofthis issue is a detailed article on an esoteric concept called Strange Nets. We also highlight the importance of CloudComputing and its application in one of the important element of the securities industry - asset management.

We are confident that you will have a very pleasing experience of reading this issue. Happy reading!

Ranajeet Shriniwas DewasthaleeMember Clearing & Settlement Domain Focus Group

Ashwinikumar MaslekarAmit Kumar ChoudharyBhargavi HemanthMeeta Ajit SardesaiPraveena Sai SubramaniamRanajeet DewasthaleeSanjay MoolchandaniSrinivasan VenkataramanUnnikrishnan Marar

I n s i g h t s t e a m

Your feedback & suggestionsare most welcome. Please mailyour inputs [email protected]

F e e d b a c k

NSIGHTS

CAPITAL MARKETS

A Domain Consulting PublicationE d i t o r i a l


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CAPITAL MARKETS


A r t i c l e s o f t h e M o n t h

Adoption of Business Process Management

By Investment BanksArvind Venkatesan

This article provides aprimer on use for BPMin investment banks andthe key considerations toselect the right BPMtool based on theorganization's processand technologylandscape.

Arvind Venkatesan

[email protected]

is a Sr Consultant inthe Clearing &Settlement - Domain

Focus Group within the Securities &Capital Markets DomainConsulting Group and has variedexperience across Trading,Operations, and Business Analysisfunctions. He is based in New York,USA. Email:

Today's competitive landscape brings sharp focus oncost optimization, process efficiency, and customercentricity Business Process Management (BPM) as amanagement practice/approach promotes businesseffectiveness and efficiency at one end and strives forbetter innovation, flexibility, and integration with

technology on the other.BPM provides tremendous gains through efficientuse of technology. It brings greater transparency in theprocess lifecycle, facilitates continuous improvement,and provides a holistic view of the organization'sprocesses. The five stages in a BPM lifecycle are Design,Modeling, Execution, Monitoring, and Optimization.

There are a number of BPM systems (BPMS) thatbring flexibility and efficiency to the organization.While each system may have its core strengths and areasof focus, there are a standard set of components in offer.The below diagram provides the BPM referencearchitecture applicable to most BPMS products.

While the adoption of BPM has become quiteuniversal in manufacturing sectors and even financialservices to a certain extent, investment banks have beenslow to warm up to the idea. In most cases, the banks

have been deterred by factors like disparate processes,proprietary back office systems that are difficult tointegrate, and manually run processes.

It is important to understand that the world ofinvestment banks is extremely complex, encompassinga range of service and product offerings, global andcross border markets, increasing regulatorycompliance, and changing corporate governance rules.An integrated approach to business processes,technology, applications, and data will be the key tomanaging this complexity and ensure future success.

Among the investment banks, one of the mores t a n d a r d i z e d p r o c e s s e s i s t h e a c c o u n topening/onboarding process. Of late, this has been thefirst process to be initiated into BPM.

Through the trade lifecycle, from trade capture toexecution to settlement, the information and processesrun seamlessly in certain places while it is quitedisjointed in other. The primary objective of BPMS is to

minimize the extent of manual intervention and makethe whole process more streamlined.

The entire back office operations function is one goodcandidate for leveraging the strengths provided byBPMS in bringing efficiency and efficacy to the processflow.

Easy set up of businessrules allows the user to configure rules for all knownscenarios.

IB Processes Suitable For BPM

Back Office Operations

Business rules management:

DESIGN MODELING EXECUTION MONITORING OPTIMIZATION

PROCESS FLOW

STANDARDOPERATINGPROCEDURE

SERVICE LEVELAGREEMENT

WHATIF ANALYSIS

INTRODUCECOMBINATION OFVARIABLES

PROCESSAUTOMATION

DEVELOP SOFTWARETOAUTOMATEPROCESS

TRACKINGOF PROCESS

STATISTICS ONPERFORMANCE OFPROCESS

PROCESS MINING

RETRIEVE PROCESSPERFORMANCE

INFORMATION

IDENTIFY POTENTIALBOTTLENECKS

POTENTIALOPPORTUNITIES FOR

COSTSAVINGS AND

OTHER IMPROVEMENTS


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Ice Trust Clearing the Credit Default Swaps

Hasim Sheik Noohu

ICE Trust Credit DefaultSwaps (CDS) ClearingHouse provides the firstdynamic operational

platform for clearing theCDS products. The articlelooks at the background,operational aspects andinteroperability with otherservice providers, market

participants andregulatory agencies for thisCDS Clearing platform.

Hasim Sheik Noohu

[email protected]

is a Business Analyst inthe Clearing andSettlement - Domain

Focus Group within theSecurities & Capital MarketsDomain Consulting Group. Hissignificant achievements are projectson implementation of Over-The-Counter (OTC) pricing engine,clearing and settlement solution formultiple brokers in India and MIFIDcompliance reporting for EquityBusiness. He is based in London,United Kingdom.Email:

OverviewThe post credit crisis regulatory environment has beenextremely stringent on the Over The Counter (OTC)Derivatives market and is continuously exertingpressure on the participants to make it more organizedand regulated. In this situation, market participantshave responded emphatically by initiating andparticipating in programs which will work in

accordance with the regulatory policies and also ensuresustainable development of financial markets for thefuture. One such important initiative has been the fullyfunctional operations of the central clearing house forOTC credit default swap (CDS) products launched byIntercontinental Exchange (ICE) under the umbrella ofICE Trust.

The aim has been not only to comply with regulatoryrequirements but also provide a full-bodied, world-wide program for clearing of CDS. The idea had beenforming a shape and with the acquisition of The ClearingCorporation in March 2009 which had a strongparticipant base of world's largest investment banks andleading service providers, it finally has been realized.

Currently launched for the North American marketsthrough the ICE Trust, this will be run in tandem withto-be-launched ICE Clear Europe which will provideCDS clearing service to European markets. This willensure that the CDS clearing house is a truly globalinitiative while at the same time being serving to preciseneeds of the local markets.

Certain guiding operational tenets underlying theclearing house solution can be highlighted are strong

linkage with market participants and service providersacross the trade life cycle, compliance to regulatorypolicies, abiding the protocols and standards andtransparent and flexible operations.

The ICE Trust Clearing House works on the well-known principle of 'Novation'. ICE Trust steps in ascounterparty for the parties to a CDS contract, thereby

becoming the Protection buyer to the 'ProtectionSeller and vice-versa. This helps in netting out theoverall positions of each participant and it would thusreceive payments from and make payments to eachparticipant on a net basis. The obvious benefit from thisis the reduction in the counterparty default risk, butother benefits which flow in are reduction in volume ofsettlement payments and transaction costs.

The Clearing Corporation which was acquired by ICE

had the World's leading investment banks as itsshareholders. This helped the launch of this initiative asthey could be roped in as the Initial Clearingparticipants. Another important contributing factor isthat more than 80% of the CDS trading volume iscontrolled by these leading banks. The initial clearingparticipants of this service are Bank of America,Barclays Capital, Citigroup, Credit Suisse, DeutscheBank, Goldman Sachs, JPMorgan Chase, Merrill Lynch,Morgan Stanley, and UBS. Recently, The Royal Bank ofScotland plc (RBS) and then HSBC Bank USA have beenadded to the list of clearing participants.

How does it work

Participants

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Product scope

Clearing & Settlement Cycle

Linkages With Service Providers

THE ICE Trust CDS Clearing house based on a resilient system architectureand support along with strong risk management capabilities houses all theproducts that are supported by the DTCC Trade Information Warehouseand include CDS indexes, single names and tranches. ICE Trust is clearingSeries 8, 9, 10 and 11 and 12 of those indices. Even though, it is robustenough to support the clearing of all North American CDS indices, it iscurrently attempting it on a phased manner and thus presently hosts themost active indices, including:

Currently the CDS Clearing House is in the process of clearing all thehistorical trades which are uploaded in the system through the process ofbackloading. This ensures clearing of large positions in a quicker andefficient way but on the other hand requires it to operate on a weeklyclearing cycle on Friday. Margin collections are performed daily using adirect settlement model which allows settlement of transactions directly inanother settlement bank or the Fed Account. Currencies of the G7 countries

like USA, UK, Japan are acceptable as initial margin deposit but for postingMark-to-market margin, only the currency of the underlying traded

product is permitted. The linkage with CLS Bank via DTCC route aids inprocessing the coupons and final cash settlements through its netsettlement system and in the currency of the underlying traded product. Ituses the multi-lateral netting methodology

ICE Trust structure has a completely integrated but still flexible modelcommanding strong interoperability with DTCC's Trade InformationWarehouse via DTCC's trade matching and confirmation service

Deriv/SERV, the leading price distribution service provider Markit, CLSBank via DTCC and the buy side firms through T

-Zero.

The diagram below illustrates the linkages between ICE Trust andvarious service providers and participants in the CDS Clearing process

Markit provides settlement prices to ICE Trust for calculating daily mark-to-market which will be settled with clearing members. It also providessettlement prices to clearing members in order to calculate margin for theirclients. ICE Trust validates the settlement prices provided by Markit.

DTCC's Deriv\SERV, the trade matching and confirmation service andTrade Information Warehouse which holds the Golden copy of the tradeare the leading service providers in the clearing and post trade processing ofOTC Credit derivatives especially CDS. ICE Trust through its linkages withthem leverages these capabilities for its clearing solution.

Markit & Ice Trust

Dtcc & Ice Trust

Index Name Index Description Index Term

CDX.NA.IG North American, Investment Grade (Series 11, 10) 5 Year, 10 Year

CDX.NA.IG.HVOL North American, Investment Grade, High Volatility

(Series 11, 10)

5 Year

CDX.NA.HY North American, High Yield(Series 11, 10)

5 Year

TRADES CLEARED DTCC provides positions to ICE Trust after matching

and confirmed the trades.

ICE Trust becomes CCP between the buyer and sellerof CDS protection.

SETTLEMENT PRICES FOR MARK TO MARKET Markit provides intra day and End of Day settlement

Prices to ICE Trust

ICE Trust validates the settlement prices Markit provides the End of Day settlement prices to

clearing members ICE Trust uses settlement prices for daily mark -to-

market calculations.

ICE Trust CDS Clearing Process

RISK MANAGEMENT Initial Margins based on portfolio methodology that

comprises of Portfolio Risk Margin, Physical Settlement

Margin and Special Margin Variation Margin or Mark-to-Market calculations

Clearing participants maintain Collateral deposit in theGeneral Guarantee Fund

End of Day Processing Reports to Clearing Participants Initial Margin

requirements, Mark-to-Market requirements

Payment instructions to settlement banks includecoupon payments, mark-to-market credits and debits,

final settlement payments and guarantee fundadjustments

DTCC

MARKIT

Clearing Participants

Settlement Banks


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6

?Transactions stored in the Trade Information Warehouse confirmedvia Deriv\SERV are cleared through CDS clearing house. Thenovation and netting of these transactions creates new positionscreated between Clearing House and the clearing members. Theseare then passed back to Trade Information Warehouse which replacethe old ones. .?DTCC-CLS Bank centralized settlement platform is the only

centralized multicurrency CDS settlement service. Settlement of thetrades cleared through ICE Trust CDS Clearing house is managedthrough this platform.

ICE Trust has built a robust risk management framework for tackling CDS,undoubtedly a very risky product. ICE Trust uses portfolio marginingapproach, where it calculates initial margin based on clearing member netpositions. Clearing member must deposit collateral with ICE Trust to coverthe initial margin. Apart from initial margin, ICE Trust calculatesmark-to-market margin in End of Day which must be settled by clearing

members on day-to-day basis. ICE Trust has created a guarantee fundstructured on the basis of losses expected under severe but reasonablemarket conditions and requires its members to contribute in proportion tothe risk of their cleared positions.

Ice Trust Risk Management Framework

VARIATION MARGIN (MTM) INITIAL MARGIN

Mark-to-market valuations are based on the

official EOD settlement price, arrived throughICE Trusts proprietary process.

The mode of payment of MTM margin is eithercash or credit to clearing members settlementaccount on a daily basis

Initial Margin includes

Portfolio Risk margin related to the size and risk ofopen positions

Physical Settlement margin covering the physicalsettlement of the contract

Super or Special Margin additional margin by ICE

Trust based on market conditions.

Cash and debt securities issued by Governments ofG7 countries are acceptable as collateral

End-of-Day margin deficit after adjusting against the

collateral deposited by clearing members will becovered by cash the following morning.

Clearing Volume By Ice Trust

Conclusion

References

With first month of operations resulting in clearing of trades worth notionalmore than USD 70 billion. ICE Trust CDS Clearing House has started on apositive note. With the increase in volumes and further addition ofproducts, it will become a force to reckon with in the CDS trade processing

space. Considering the strong membership base, resilient infrastructureand compliance with regulatory agencies and standards, ICE Trust CDSClearing House will provide positive impetus in creating the necessarytrust in the current situation.

- https://www.theice.com/ice_trust.jhtml- www.dtcc.com- www.fincad.com- www.shearman.com- www.treasurydirect.gov

Source: www.theice.com

7478

646

106

2493

25730

613

71 12.70

1000

2000

3000

4000

5000

6000

7000

8000

N o O f Tr an sa ct io ns N otio na l Va lu e(USD in billion)

Open InterestValue (USD in billion)

Till 22nd May 2009

End of April 2009

End of March 2009


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7

Clearing and Settlement of Depository Receipts at

the London Stock ExchangeVishakarajan Rajendran

The London StockExchange (LSE), on30th March, announcedthe introduction ofCentral Counterparty(CCP) Clearing service

for 50 most heavilytraded securities on itsInternational OrderBook (IOB) LSE's

platform for trading ofDepository Receipts.

VishakarajanRajendran

[email protected]

is a Business Analystin the Clearing andSettlement - Domain

Focus Group within the Securities &Capital Markets DomainConsulting Group. He has been partof engagements on Equities Clearingand Settlement ApplicationDevelopment and Operational areas.He is based in Bengaluru, India.Email:

Background: The article explains the mechanics ofDepository Receipts and their Clearing & Settlement at LSE.

A Depository Receipt (DR) is created when a companywants to list its already publicly traded securities in a foreignexchange. This can be done only when the company meetsthe DR listing requirements. The diagram depicts the

interactions between different participants involved increation and trading of DRs.

When any DR is traded, the broker has to determinethe price of the DR. To determine the price, the brokercompares the price of the DR and the price (foreigncurrency equivalent) of the securities in the local market.If the DR is trading at a higher price, the broker wouldbuy more securities from the local market and issueadditional DRs. If it is other way around, the broker

would sell securities in the local market. This act wouldbring the prices on par. When selling of securitieshappens, the DR is cancelled and the equivalent numberof securities is released into the local market. Theclearing and settlement process would be the same as itis for the local securities traded in the foreign market.

The London Stock Exchange (LSE)provides trading services through two major platforms:

SETS and IOB. SETS is LSE's order book facilitatingtrades in UK and Irish securities. It is a powerfulplatform through which LSE provides automatic,transparent and flexible order driven trading system forconstituents of the FTSE Index, Exchange TradedFunds, Exchange Traded Commodities, along with UKand Irish securities. LSE provides competitive clearingof these trades through LCH Clearnet and X-Clear.Another platform, the International Order Book (IOB) isLSE's electronic order book that provides cost efficientaccess for traders to invest in fast growing markets like

Asia, Middle East, and Eastern Europe via depositoryreceipts. Trading on the IOB started in 2001 and sincethen the volumes have grown rapidly. The impressiveincrease in volume needs to be supplemented withincrease in efficiency and mitigation of risks. To addressthis need, LSE has introduced CCP service initially to 50most liquid securities by value traded on IOB.

?On execution, LSE sends the trades to its posttrade router X-TRM?X-TRM registers the trade and routes it to the CCP

Trading at LSE:

Post-Trade Processing:

Broker DR Market

Local Broker

DR Depository

Local Market

Broker

Local Broker

Buy Sell

Local Custodian

Issue Cancel

BuyShares

SellShares

Deposit Shares Release Shares

Deposit Shares Release Shares

Buy Sell


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8NSIGHTSCAPITAL MARKETS


LCH Clearnet. It provides trade information to the tradingparticipants and clearing members?LCH Clearnet registers trades for clearing and sends confirmations

to the members?LCH Clearnet performs risk management & optional netting and

instructs Euroclear?Settlement will be at Euroclear and will be as per the process between

LCH Clearnet & Euroclear?All trades will be settled against LCH Clearnet.

Members, which have direct or indirect relationship with LCH,willing to trade these 50 CCP eligible securities should continue the same

relationship and need to register by submitting the prescribed static dataform. Any other members willing to utilize this service should establish adirect or indirect relationship and submit the prescribed static data form.However, these members will still be able to trade on the non-CCP eligiblesecurities without the direct/indirect relationship.

LCH, as a CCP, provides robust risk management so that in the event ofmember's default, the non-defaulter's positions are not affected. This isdone by collecting initial and variation margins. LCH calculates intra-dayand end-of-day margins using the Equity Risk Analysis (ERA) algorithm.This is done in the same way as the other securities, part of the Equity Clearbusiness of LCH. If any member is uncovered of an intra-day margin, LCH

will contact the member over phone and will advise the member to pay therequired amount. Before 02.30pm UK time, members can pay the margincalls in EUR, GBP or USD. Post 02.30pm, only USD payments are accepted.Debit instructions are sent to the member's bank and the same must beconfirmed by the bank within 1 hour. Overnight margin calls sent to themember's bank must be confirmed by the bank before 09.00 am.

LCH provides an optional trade confirmation service where themembers would receive confirmations in the form of MT518 messages on agross trade basis. LCH also provides an optional netting service. Formembers willing to settle on net basis, Trade Date Netting (TDN) is offered.Every end of day, post gross trade reconciliation by LSE the trades flagged

Clearing:

for TDN are netted and theinstructions are sent toEuroclear.

LCH instructsg r o s s s e t t l e m e n t t oEuroclear throughout theday and net settlement atend of the day at 17.45 to18.00. Members need to signP o w e r o f A t t o r n e yagreements with LCH to

allow LCH to deliver ontheir behalf in Euroclear Bank. In case of settlement failures resulting in buy-ins, LCH will input a new transaction against the liable party to include therelevant securities, costs, etc. This will be used to settle against the originaltransaction.

By introducing CCP services to 50 most heavily tradedsecurities on IOB, LSE brings in post-trade anonymity, robust riskmanagement and settlement netting to the trades done on its IOB tradingplatform. The participants gain complete counterparty risk protection. Thisannouncement is in line with the European Code of Conduct for Clearing

and Settlement. Also LSE is utilizing X-TRM, the trade routing service, sothat at a later point in time multiple CCPs can be brought in to provideclearing services. This is considered to be a move towards increasingparticipants' interoperability, reducing costs and paving a way foremergence of efficient providers.

- http://www.finextra.com/fullstory.asp?id=19847- http://www.londonstockexchange.com/traders-and-brokers/products-

services/trading-services/international-order-book/order-book.htm- http://www.lchclearnet.com/cash_equities/lse/how_it_works.asp

Settlement:

Conclusion:

References

IOB

XTRM

Euroclear

EOD Netting

LCH Account

Member Bank Account

MemberReport

Member

LSE

Margining

MT 518 or Accessvia LCH website

Margin Calls

MarginMovement

TradeExecution

Traderegistration

Ownership

transfer

Buy-Ins

Gross/Net Instructions

Trades

Traderouting

LCH


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9

Continuous Linked Settlement (CLS) for Clearing and

Settlement of Non Deliverable Forwards (NDF)Vaibhav Khare

Non DeliverableForwards (NDF) as ahedging and speculationtool in Foreign

Exchange (FX) markets,has long been the fancyof Investors. Clearingand Settlement (C&S)in these instrumentswas plagued by ills likemanual processing,verbose documentationand absence of common

messaging standards.CLS Bank via its CLSservices has managed tostreamline these C&S

processes.

Vaibhav Khare

[email protected]

is aSenior BusinessAnalyst in the Clearingand Settlement DFG

within the Securities and CapitalMarkets Domain ConsultingGroup. He is based in Boston, USA.E-mail:

Introduction

Understanding Hedging using NDF

Non-Deliverable Forward (NDF) is a class of short termForeign Exchange (FX) derivative product traded Overthe Counter (OTC). It is popularly used to hedgeexposures by portfolio investors, hedge funds andmultinational corporations in emerging marketcurrencies, which are subject to convertibility

restrictions or in currencies wherein a conventionalforward market does not exist. Examples of suchcurrencies are Korean Won (KRW), Taiwan Dollars(TWD), Philippine Peso (PHP), and Indian Rupee (INR).Besides hedging purposes, NDF are also majorly usedfor taking speculative positions in the local currency.

Although they are similar to FX Forwards in thatthey allow hedging currency exposure, one notabledifference is that a NDF is always cash settled (usuallyin U.S. dollars) and there is no physical exchange ofprincipal sums of the foreign currencies, hence the

name, 'Non Deliverable Forwards'.The difference between the contracted forward rate

(decided at the start of the deal) and the spot referencerate at maturity (referred to as 'NDF Fixing rate') is theamount of profit or loss for the counterparty whichconstitutes the net cash settlement in US dollars, on the'Settlement date'.

Consider an example of an investor who has taken longposition of USD $2 million in the Taiwanese stock

market for a year. His position is implicitly 'long' in theTaiwanese Dollar (TWD). In the absence of a forwardmarket where he would have 'locked' his USD/TWDposition rate with a 1 year forward position; he hedgeshis exposure using a NDF instead. A NDF rate ofUSD/TWD of 31.65 is agreed (short TWD position)between the investor and the counterparty, whereinpositions would be cash settled between this rate and

the prevailing USD/TWD fixing rate (i.e. spot rate atthe fixing date) after 1 year.Assuming a scenario after a duration of a year,

wherein fixing rate turns 32 (i.e. TWD depreciates), theCustomer's stock market position loss due to TWDdepreciation is offset by the NDF proceeds [(since hereceives $21,875 (i.e. $2,000,000-$1,978,125)]. In anotherscenario wherein the fixing rate turns 31.25, thecustomer benefits in his stock market position exposuredue to TWD appreciation, although he loses on theNDF position [since he would have to pay the bank$25,600 (2,00,0000-2,025,600)].

Besides hedging NDF are also used for speculation bymarket players. Operators, regardless of actualexposure, may take long/short positions in a localcurrency depending on their perceived future outlookfor the currency.

The conventional settlement of NDF involves thebilateral settlement between the counterparties like

Speculation Purposes of NDF

Limitations of Traditional Post Trade Processing of NDF


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any other OTC Derivative contract involving Master Agreement, with the

net settlement in US Dollars being exchanged on the settlement date usingNostro and Vostro accounts. This traditional Post Trade processing of NDFhas many limitations and shortcomings as seen below:?Intensive post-trade manual processes like documentation in the

form of 'ISDA Long Form confirmations' for NDF, which are timeconsuming and costly.?Low STP rates and thereby scope for error. The subsequent error

rectification itself is cost prohibitive.?Lack of standardization across industry participants.

These factors led to increase in post trade processing costs of NDF. With

rising volumes of NDF trades and increasing popularity, Industrystandardization to streamline post trade NDF processes was clearly theneed of the hour. CLS seized this opportunity and added NDF Settlement toits growing product clientele (FX, OTC products).

CLS Bank is a private sector special purpose bank that offers theContinuous Linked System (CLS), the world's first simultaneous andirrevocable global multi-currency settlement system to settle paymentsassociated with a foreign exchange (FX) transaction. CLS Bank providessettlement services by maintaining a central bank account with each of theeligible currencies.CLS resolves the problem of counterparty default risk in FX transactions by

acting as an intermediary and releasing the payments on the principle ofpayment-versus-payment (PvP). This differs from the more traditionalDelivery versus Payment (DvP) process where the two sides to a foreignexchange transaction (Buy & Sell) are settled separately. Due to time zonedifferences, transactions using the DVP process are vulnerable to the risk ofone party defaulting before both sides of the trade are settled. PvPeliminates time zone risk because CLS settles both sides of a transactionsimultaneously and not separately i.e. a final transfer in one currency occurswhen, and only when, a final transfer of the other currency also takes place.Settlement via CLS removes the settlement risk on all transactions settledvia the service.

Clearing and Settlement of NDF by CLS

Advantages of CLS for NDF Settlement

1. On the Trade date, the NDF Trade details like currency involved,Fixing/Valuation date, Settlement date exchanged betweencounterparties are sent to CLS

2. Matching/Confirmation done by CLS3. On NDF Fixing/Valuation date the cash flows to be settled on

settlement date are computed.

4. On Settlement date the cash flows are settled via CLSCLS in its quest to increase its coverage of OTC products has extended itssettlement service to NDF transactions in order to streamline, automate andstandardize post-trade processes for this instrument. Existing users of CLSSettlement can leverage CLS Bank's existing infrastructure for NDFsettlement thereby minimizing implementation costs. CLS Settlementoffers STP service from NDF confirmation to NDF settlement.

?CLS has established a NDF Protocol incorporating the 'MultilateralMaster Confirmation Agreement' for NDF. This Protocol does away

Counter part 1 (May use CLS Service as Settlement Member, User Member or Third Party)

Counter part 2 (May use CLS Service as Sett lement Member, User Member or Third Party)

NDF

Fixing

Date

1)

NDF

Trade

Sent to CLSCLS

Fixing

InstructionsSent to CLS

CLS

NDF

Settlement

Date

Cash flows

settled

CLS

4) Settled3) Valued/Fixed2) Matched byCLS

(Source: www.cls-group.com)


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with the need for members to exchange 'long-form confirmations'.

The guidelines for the 'long-form confirmations' documentation areprescribed by ISDA generally for new OTC products like NDF. Longform confirmations necessitate reconciliation and have a longer, timeconsuming and extensive documentation process involvingconfirmation of economic terms like the transaction date, notionalamount of currency, spot exchange rate and non economicinformation like NDF Fixing source and date.?Automation introduced by CLS has scored, in that it has done away

with netting agreements which were drafted using legal help andmade after to and fro exchange of information betweencounterparties. CLS Settlement for NDF has eliminated this manual

intensive process, allowed to free up these resources and reducecosts in this area.?CLS in collaboration with SWIFT has brought about standardization

in message standards in the form of SWIFT Net Fin and ISO 20022XML?Provision of existing time tested CLS infrastructure to NDF

settlement thereby contributing to Cost savings, Operational riskreduction and settlement efficiencies.

Besides speculative trading, the tremendous interest and increase in

volumes of NDF is the direct result of non-availability of a hedging platformfor investors in these currencies. The trend in restrictions in internationaltrading in these currencies or transition to full convertibility of currenciessuch as INR would determine the future growth and sustenance of NDFmarkets. With increasing popularity and volume growth, it's a matter oftime before more players jump in to the space of automation in NDFclearing and settlement. Already CLS with its initiatives in this space hassucceeded in streamlining a lot of processes and bringing instandardization in settlement, besides reducing operational and settlementrisks and lowering processing costs. The boom in these instrumentscoupled with upswing in the emerging markets economies should prove

Future Trends and Challenges

enticing for vendors to jump in the Clearing and Settlement space.

- http://www.cls-group.com/Publications/NDF.pdf- www.isda.org- http://www.newyorkfed.org/fxc/annualreports/ar2004/fxcar04.html

References


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Strange Nets (Settlement)

Girish Nayyar

Strange Nets are thosepeculiar net positionswhere stock and cashmove in the same

direction or one of themdoes not move at all. Wewill discuss here thereasons why trades canresult into such strangenets and subsequentlyhow these are settled.

Girish Nayyar

[email protected]

is aBusiness Analyst inthe Clearing andSettlements DomainFocus Group within

the Securities & Capital MarketsDomain Consulting Group.He has worked on a number ofprojects in the domains of corporatebanking and investment banking.He is based in London, UnitedKingdom.Email:

not

found

1. What is a Strange Net?Strange Net is an argot used exclusively in clearing andsettlement (C&S) back office. It is a slightly obscureterm; googling it will fetch no meaningful results. It hasno definition in Investopedia, and any use outside thegroup will yield a questioning stare back, so much sothat even front office guys do not recognize it. Equallyelusive is its synonym odd net. Sounds odd, isn't it?

Read on to get some understanding of this peculiarshenanigan.

Let's take a step back and introduce its hypernymfirst Net position. Sounding familiar already? Netposition is the difference between total open long andopen short positions in a given security. This is bestillustrated with an example. Below are some tradesdone by Tom on a single day in one stock.

The Net position for all the above trades could beworked out at the end of day as Buy 20 @ $400(difference between buys of 160 @ $1900 and sell of 140@ $1500).

Tom has a couple of options to settle these trades. Hecan settle them individually as 3 independent trades, inwhich case he will need to have adequate quantity ofstock and cash in his account to support the settlement

Action

Buy

BuySell

Quantity

+100

+60-140

Amount ($)

-1200

-700+1500

Trade #

T1

T2T3

Time

10:00

10:3011:00

i.e. 140 quantity of stock and $1900 in cash. The secondoption is to settle a single net position pay $400 andreceive 20 units of stock.

The stock price starts to move up and Tom decides tosquare off his position by selling his balance 20.

What will be the Net position now? Tom has made aloss of $150 and he has to pay this amount withoutreceiving any stock in return.

On the face of it, this net transaction can be easilysettled by making the cash payment of $150. But, willthis transaction settle normally at the CSD? The answeris no in most of the cases. Why? Because there is noexchange of securities involved. A CSD is a repositoryfor securities and normally effects settlements thatinvolve exchange of securities. For making pure cashpayment, you need to go to a bank.

Stock price moves up significantly in the next half anhour and Tom decides to go short on the market.

Tom has covered his cash loss, but he has to nowdeliver 10 quantity of the stock without receivinganything in return. He has to deliver the securities Freeof Payment (FOP).

1.1 Strange Net Scenario #1 Cash only settlement

1.2 Strange Net Scenario #2 Stock only settlement

Trade #

T4

Time

11:30

Action

Sell

Quantity

-20

Amount ($)

+250

Trade #

T5

Time

11:30

Action

Sell

Quantity

-10

Amount ($)

+150

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This net transaction too has a problem in its settlement. Some of the

CSDs do not support FOP settlements.

The stock price keeps moving higher and Tom shorts a further 15 quantity.There is flashing news at 12:15 about profit warning by the management ofthe company and its share price takes a nosedive. Tom quickly covers uphis shorts and in fact goes long by a small quantity.

Tom's net position stands at a surplus of 5 quantity and he does not evenhas to pay for it. To top it, the big surprise is that he will be paid a cool $100for his purchase!

Tom has done his job and made a profit, but the back office guys willhave some difficulty in settling this net transaction. Apparently, thisparticular CSD does not allow instructing a settlement with same directionstock and cash.

In summary, below is a matrix of net positions that will result in eithernormal Delivery versus Payment (DvP) settlement or Strange Netsettlement. Out of 9 possible combinations of stock and cash, only 2 are fit tobe termed as normal DvP nets, remaining all are strange nets.

1.3 Strange Net Scenario #3 Same side stock and cash

Trade # Time Action

T6 12:15 Sell

T7 12:30 Buy

Quantity Amount ($)

-15 +300

+30 +200

Stock

Receive Deliver Zero

Cash

Strange Normal Strange

Normal Strange Strange

Receive

Deliver

Zero Strange Strange Strange

2. Settlement of a Strange Net

2.1 Settlement Option A - Aggregate Buys and Sells

2.3. Settlement Option C Settle Stock FOP and Cash DvP

Perhaps, the simplest way of settling a strange net is by aggregating buysand sells. Both the shapes can then settle as normal DvP transactions.Though the solution is simple, it has one problem. It requires a largeramount of stock and cash to successfully settle the two transactionsindependently.

An innovative solution to work around the problems in Option B is to settle

the cash as a normal DvP transaction in exchange of a nominal 1 quantity ofstock. Remaining quantity of stock is then settled as a FOP transaction.

Scenario

#1 Cash only

#2

Stock only

#3 Same direction stock and cash

Sell 18

Settlement

Buy 160 @ $1900

Sell 160 @ $1750

Buy 160 @ $1900

Sell 170 @ $1900

Buy 190 @ $2100

5 @ $2200

All the CSDs support this model since these are effectively two normal settlements.CCPs that settle strange nets using this model :

- European Multilateral Clearing Facility, CCPs for Chi-X, Nasdaq-OMX andBATS

- Eurex, CCP for Xetra

Scenario

#1 Cash only

#2 Stock only

#3 Same direction stock and cash

Settlement

Receive Stock 1, Deliver Cash $150

Deliver Stock 1, Receive Cash $0


Receive Stock 6, Deliver Cash $0


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2.4. Settlement Option D Settle as is

3. Conclusion

Wouldn't it be so much better if the CSDs just support the settlement of thenet in its arithmetically accurate form in the single shape? CREST andEuroclear Bank are two such CSDs which support strange net settlements in1 shape.

Strange Net is a net position where either stock or cash is zero or both stockand cash are moving in the same direction. There are practical problems insettlement of such strange nets owing to CSDs not supporting FOP, or cashonly or same direction stock and cash transactions. To work around theseissues, each CCP has designed its own way of settling strange nets.Splitting the net into aggregated buys and sells is the simplest and mostpopular strange net settlement method, but it may require exchange of largequantities of stock and cash and if any of the counterparties does not havethe adequate quantity in his account, the settlement will fail. To avoid this,some CCPs split the strange net into stock only and cash only componentsand then settle the two shapes independent of each other. In this case, thetwo transactions are reflected in two separate statements and so, can bedifficult to reconcile. Recently, the most innovative solution that has

evolved is to settle cash in exchange for a nominal quantity of stock so that itgoes through as a DvP transaction and settle the balance quantity of stock asa FOP settlement.

Almost all CSDs support FOP settlements. So, this model will work in most of the markets.

CCPs that calculate strange nets in this model :- SIS X-Clear, for trades on NYFX

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Sanjay Mittal

[email protected]

is aBusiness Analyst inthe Clearing &Settlement - Domain

Focus Group within the Securities

& Capital Markets DomainConsulting Group.His significant achievements incareer include successfulimplementation of a C&S systemand an options client exercisesand assignments notificationsystem for a large broker dealer inthe US. He is based in NewJersey, USA.Email:

Continuous Net Settlement -

The NSCC Way to deal with Fail-To-Deliver TradesSanjay Mittal

CNS is a serviceoffering by the NSCCthat centralizes thecalculation of the net

position of theparticipant at firmlevel and allows it toborrow securities fromother participants whoare willing to loan anddeliver the same to thebuyers, therebymeeting its obligation

of being the CCP.

Introduction: According to the recent report publishedby US Government Accountability Office, theaggregated fail-to-deliver (FTD) value stood at $7.5billion at December 31st 2007 1. According to DTCC,99.9% of daily dollar value of trades settles within theUS standard settlement period of three days and theremaining accounts for the FTD. Although it is believedthat many FTDs are caused by processing delays ormechanical errors, naked short selling for manipulatingthe markets is also considered an important factor, andis thus closely monitored by the regulating agencies.NSCC is required (by SEC) to report all FTDs for eachclearing participant in each security to SEC and SROs ona daily basis. The CNS system helps the NSCC to meetits obligation (as a central counter party) to deliversecurities to those participants with long positions bydebiting the participant's account at DTC. This is anautomated process through NSCC's Stock Borrow

Program.Continuous Net Settlement (CNS) is a service

offering by the NSCC that centralizes the calculation ofthe net position of the participant at firm level for alltraded securities at the settlement date. On the otherhand, the Stock Borrow Program (SBP) that is anancillary service offering by NSCC through CNSSystem, allows the DTC to automatically borrow stockand fixed income securities from the participants'account and lend the same to NSCC to clear the openposition. (Note: All participants express their

willingness to loan securities, in the event of anyshortfall being faced by NSCC, to DTC by participatingin the SBP. The participant's money settlement accountis credited with the full market value of the borrowedsecurities. In the event of the availability of more thanone lender, an algorithm which is a function of random

number, participant's average loans and clearing fees,is used to select the lender.) The participant is thenrequired to cover the loaned securities by buying fromthe market during the early trading hours on the dayfollowing the settlement date or by borrowing.Borrowing, however, does not discharge the FTDparticipant from its obligation to deliver.

1. Broker B sells 100 shares of XYZ to the Broker Aand FTD on the Settlement Date. Furthermore,Broker B has a flat account at DTC (implying

thereby that there are no XYZ securitiesavailable to lend to cover the short position).

2. Broker C has 100 long position for XYZ at DTCand is willing to loan.

3. NSCC borrows 100 shares of XYZ from Broker Cand delivers to Broker A, and thereby meets itsobligation as CCP.

4. Broker B continues to have short position unlessit buys or loans. Moreover, it shall not be allowedto go further short in that security withoutbuying or borrowing.

How it works:

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Position Movements on Settlement Date within participants account's at

NSCC & DTC1As visible from the below table, the long 100 position of lender is moved

to buyer's account at DTC which makes the NSCC position as net flat for thebuyer. But, simultaneously, it also creates a long position for lender atNSCC. Hence, the seller continues to have a short position until it deliversits obligation to NSCC.

According to SEC's Regulation SHO (Aug 2004), Emergency orders(Sept 2009) and Interim Final Temporary Rule (Oct 2008), SEC requiresparticipants with FTD on the third settlement day after trade date, in anyequity security, to take action on the next morning to close out theirposition, with limited exceptions3.

NSCC submits all fails data to SEC on the Settlement Date. SEC closelymonitors all short positions that failed to settle at T+3. Any

broker/participant carrying short position in any security shall not beallowed to go further short until it covers the short position either bybuying-in or by borrowing. This not only adversely impacts the business ofthe participant with the short position, but also the image of the participantfirm goes down in the eyes of its clients. The reason is that the participantbeing short in one client account will not be allowed to trade (short-sell) forrest of the clients as well even though the other clients would be holdinglong positions in the same security.

The listed equity options, where the participant exercises a put optionand is net short, can have a similar tendency of not being able to meet itsobligation to deliver the underlying assets (equity security in this case), are

TD/SD NSCC/DTCC

Participant

Broker A

Buyer: FTR

Broker B

Seller: FTD

Broker C

Lender

TD NSCC Position Long 100 Short 100 Flat

TD DTC Position Flat Flat Long 100

SD NSCC Position Flat Short 100 Long 100

SD DTC Position Long 100 Flat Flat

also required to be reported through the CNS system. Similarly, if the writer

of a call affects a short sale (if the buyer exercises its option), this needs to bereported as well. Options and other instruments like single stock future arealso being considered by the regulating agencies to extend the short saledisclosure rules.

According to DTCC, in the normal course of business, 15-20% of FTD arefilled through the SBP automatically. The NSCC allocates the long position(those available for loans) to cover the short positions. Allocation priority isat the discretion of NSCC although it considers the age of fails, security andquantity. Participants with remaining open long position not filled throughthe Stock Borrow Program have option to request for priority in CNSallocation by NSCC. Alternatively, it can file papers with NSCC requesting

the net short member to deliver those securities to net long member2.In the coming years, the market environment is expected to be even

tougher as newer stringent rules are imposed by the regulatory agencies inorder to improve the market efficiencies and safeguard investor interests.

- http://www.gao.gov/htext/d09318r.html (Site accessed June 9, 2009)- http://www.dtcc.com/products/cs/equities_clearance/cns.php (Site accessed

June 9, 2009)- http://www.sec.gov/rules/final/2008/34-58785.pdf (Site accessed June 9,

2009).

References

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Repo Settlement and Market Practice

Anuj Gupta

Recently issued MarketPractice for Reposettlement will providethe much needed clarity

on Repo terminology,clearing process and thesettlement instructions.Due to absence of thismarket practice, theRepo industry wasdevoid of a suitabletechnologyinfrastructure, which is

essential for a seamlesstrade processing.

Anuj Gupta

[email protected]

is abusiness analyst in

the clearing andsettlement - domain

focus group within the securities& capital markets domainconsulting group. He has workedin projects spanning across fixedincome trade processing, portfolioanalytics and fund valuationdomain. He is based in LosAngeles, USA.Email:

In first half of 2009, ISITC (International SecuritiesAssociation for Institutional Trade Communication),the industry trade group for standards in tradeprocessing, released three new settlement MarketPractices. One of these market practices was for 'Repoand Reverse Repo agreements'.

This market practice would facilitate in resolvingsome of the vital issues that participants come across

during the settlement of a Repo trade in U.S. securitiesmarket. In the words of ISITC Settlements WorkingGroup, "by utilizing these market practices, industryparticipants will be able to produce consistentlyformatted messages for instruction and confirmation ofsettlement. Specifically, this will create improvedoperational efficiencies and reduce error-related risks."

Repo is among the highest traded financial productsin US securities market. As it is mainly an OTC product,there are no official figures released. However, thesurvey statistics released by latest SIFMA Research

Quarterly says, the average daily volume of totaloutstanding repurchase and reverse repurchaseagreement contracts totaled $ 7.06 trillion in the firstquarter of 2008, a 21.5 percent increased over the $ 5.81trillion during the same period in 2007.

Let's start with at a real life incident from a buy-side firm(an Investment Management firm), where a team wasformed to define a process for the Repo trading. Theobjective was to create a process, so that the firm can

What is addressed in this Market Practice?

leverage on the existing IT infrastructure for over-nightRepo trading. (The initial scope was to consider onlyRepo not the Reverse Repo).

After many rounds of discussions which spanned acouple of weeks, the team was stuck on a veryfundamental question. Are we talking about Repo orReverse Repo?

Repo has a fine peculiarity the way it is christened.

Let us try to appreciate this peculiarity.Let's assume that there is a regular bond trade

between two parties. In this case, one party will buy thebond and another will sell the bond. However, for aparallel Repo transaction; instead of buy or sell, oneparty trades in Repo and another party trades inReverse Repo.

So, the peculiarity of the terminology is thatindustry identifies them as two different assetcategories i.e. Repo and Reverse Repo. However, theyare nothing but two different facets of a same financial

security. It was intriguing to know that in this kind ofhigh volume market there is still a fundamentalquestion that remains to be answered.

After rounds of discussions, the team realized thatthe business requirement is to start trading in ReverseRepo and not in Repo. The existing industry definition,that the team was referring to, was written from a sell-side (Dealer/Broker)'s stand point.

To resolve these subtle operational gaps, ISITCbrought all market players to a round table and tried toreach a common understanding. The outcome of that

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activity is the emergence of best practice (market practice) documents that

will be used across the market for Repo trade settlement. Some of the pointsrevolve around how to use MT541 and 543 for Repo and Reverse Repotransactions? What is the precise definition of Repo and Reverse Repo? etc.

Discussions during the Repo working group were an eye opener to thefact that despite being a trillion dollar market, there is such a poortechnology infrastructure in place. Some of the statements made by thecoordinators who were part of the working group point in this direction:

There is a very less automation in Repo settlement area, Custodians'systems are not built to handle the Repo trade settlement, and they arestill using ancient ways of settling the Repo trades via Fax and FTP.

One of the main reasons behind the technology backwardness in the

Repo market was that there was no consistent understanding of theterminology and the process among the market participants before thismarket practice. The release of this market practice will bring the muchneeded understanding and Repo market would see more automation incoming future.

- http://www.isitc.org/- http://www.bobsguide.com/guide/news/2009/Apr/7/Key_Settlements_Market

_Practices_Finalized_at_ISITC%27s_15th_Annual_Industry_Forum.html- http://www.sifma.org/research/pdf/RRVol3-6.pdf

References

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Risks in Wholesale Payment Systems

Joydeep Dutta

The payment systemsare associated withvarious levels of riskslike credit risk, systemic

risk, liquidity risk, et al.The major controversyconcerns the riskexposure of the

payments system due tothe existence of daylightoverdrafts.

Joydeep Dutta

[email protected]

is aBusiness Analyst inthe Clearance and

Settlement - DomainFocus Group within

the Securities & Capital MarketsDomain Consulting Group. Hissignificant achievements in careerincludes successfulimplementation of a FIX enabledSell Side FO application at aleading Investment Bank.He is based in Singapore.Email:

Introduction

Daylight Overdrafts

Wholesale payment systems can broadly be classified as:net periodic settlement systems (NPSS) and real-time grosssettlement (RTGS) systems. Both the NPSS and RTGSsystems are coupled with a set of risks. The magnitude ofexposure a bank has and the delay in the final settlementfrom the time settlement instruction has come in determinethe settlement risk a bank faces. A customer of the sendingbank (read sender) makes a payment to the customer of a

receiving bank (read receiver) using the WholesaleElectronic Funds Transfer system.

Net Periodic Settlement Systems (NPSS) - Here thepayments between the banks are netted for a particularorganization and final settlement is made either throughreceipt or payment with respect to that organization atcertain point of time. For e.g. end of the day

Real Time Gross Settlement (RTGS) systems Herethe payment occurs on an immediate basis in the form ofa bilateral transfer i.e. An instantaneous credit for a debit

Both these systems have their own pros and cons,

whereas the NPSS reduces the transaction costs andeven numbers by combining them and createseconomies; RTGS systems provide instantaneous creditthus reducing settlement risks. But at the same time, itleads to increase in costs due to high volume oftransactions. Though NPSS solve this issue, they don'tmake the funds immediately available.

A daylight overdraft as the name suggests refers to paymentmade during the course of a business day even though there

is no credit in the account to cover the transaction. In otherwords, at least one of the institutions involved extends freecredit that will be repaid before the end of the day. Thenature of daylight overdrafts on gross settlement networksand net settlement networks are different.

In case of Net Settlement Systems, the settlement occursonly after a particular time period generally at the end ofthe day. Here the overdraft occurs in following ways

1. Transfer effected by the sending bank even thoughno funds have been provided by the sender.

2. Allowing usage of funds to the receiver eventhough funds are yet to be received.

In the gross settlement network, a daylight overdraftrefers to a final and irrevocable transfer of funds in theabsence of adequate balance in the sending bank's account.

Irrespective of whether the settlement is gross or net, ifin case daylight overdrafts are allowed, they need to besupported by some assurance of settlement in case ofdefault. This can be emphasized by the fact that a financialsystem which is permitting daylight overdraft but not

guaranteeing settlement will give rise to risks associatedwith uncertainty of settlement. The adverse impact of thiswill be that the end users of the system will have to bear thecosts arising out of these risks.

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Customer A (Sender)

Customer B (Receiver)

As Bank (Sending Bank)

Bs Bank (Receiving Bank)

Central Bank

Promises payment

Against an Overdraft

Allows fund usage,

without receiving good funds

Overdraft 1

Overdraft 2

Banks net debit position exceeds its

reserve account balance with Central Bank

Sending banks reserve account

balance has gone negative

Any of these risks may lead to failure of the payment system if the overdrafts are not

covered with good funds by the End of Day


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Risks In Wholesale Payment Systems And Connected Costs

Private V/s External Costs

Credit risk is the risk of non-receipt of the funds which are expected to becredited and has two sides sender risk and receiver risk. Sender risk occurswhen the sender of the funds is not able to cover funds for which theoverdraft has been provided. Receiver risk is referred to as the risk faced bythe receiving bank in the event of non-settlement by the sending bank. Thethird sub-set of the credit risk is the cost to the receiver, in case the receivingbank revokes the funds made available to him based on expected credit.

Systemic risk as the name suggests is the risk of failing of partial or entirebanking system due to settlement failure of one bank. This is even biggerrisk because it might lead to the collapse of the entire system. This situationmay occur if the payments have a dependency on the receipts. If the

particular receipt is huge, it might lead to non-settlement with other banksand in turn these banks will face similar problem. The aftermath of such acrisis will be that the entire payment network might have to bear the costsassociated with such settlement failure.

Liquidity risk is a settlement failure occurring due to non-settlement ontime. This type of risk has a possibility of mitigation in case the senderhonors the payment at a later date \time. But even then it would haverelated costs associated with it as there has been a breach of contract on timebasis. Also this will have impact on any future transactions with the samebank. The receiving bank may not consider transacting with the sendingbank due to such bad previous experience.

The connected costs associated with the risks as discussed above can beseparated as private and external. It is worth noting the dissimilarity betweenprivate and external costs.

Private costs These are internal to the bank and can be managed in a wayspecific to the banks through its internal controls. Also the bank would have itsown benefits for controlling these costs. E.g. Costs associated with receiver risk.

External Costs These are due to a settlement failure with other banksand cannot be controlled by a particular bank. Also the bank may not beincentivised to put in place appropriate controls on its part for managingthese costs as these are not entirely borne by them.

Possible Alternatives For Risk Mitigation

Conclusion

References

Pricing: Probably the best alternative to ensure settlement finality would beto have insurance or guarantee fund supported by participants of thepayment network. It needs to be made certain that consensus of allparticipants be bought in for setting up such a fund or buying insurance forprotection in the event of default.

Net bilateral credit: In this alternative, exposure of receiving bank to asending is limited based on the already established credibility of thesending. This alternative is plausible in case where the transactions are notexpected to go beyond a particular limit but will become a hassle for a userwho needs to send more funds to a receiver via these banks.

Finality of Payment: The receiving bank will be responsible for all the

payments accepted. This is based on the premise that receiving bank is in thebest position to monitor and avoid such costs.

Based on the discussion above, it can be easily understood that all paymentnetworks with allowance for daylight overdrafts settling via gross or netmechanism will have inherent risks and costs associated with such risks. Tomanage these risks, wholesale payment systems risk managementframework should include rules and processes for identification,measurement, mitigation, and management of such risks. Appropriatecontrols and sound economic policy will ensure proper mitigation of risksthat arise out of settlement failures due to daylight overdrafts.

- Wholesale Payment Systems Handbook Federal Financial InstitutionsExamination Council

- Federal Register / Vol. 73, No. 248 / Wednesday, December 24, 2008 / Notices -Docket No. OP1345

- h t t p :/ / w ww . t h ec l e a ri n g ho u s e . or g / r e fe r e n c e /c o m me n t _ le t t e r s/2008cl/034784.pdf

- h t t p: / / ww w .r i c h mo n d fe d . or g / pu b l ic a t io n s /r e s e ar c h / ec o n om i c_review/1985/pdf/er710302.pdf

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The Brokerage Back Office of the Future

Kanishka Dasgupta

How would the backoffice of brokerage firmslook in the future? Thearticle highlights three

key areas that woulddefine post trade

processing.

Kanishka Dasgupta

[email protected]

is a Business Analystin the Clearing &

Settlement DomainFocus Group within

the Securities & Capital MarketsDomain Consulting Group. Hissignificant achievements in careerinclude setting up one of the largestback office processing centers inIndia for a leading investment bank.He is currently based in Hong Kong.Email:

The rapid advances in market structure including newtrading venues, introduction of new products,globalization and regulatory pressures are some of thechanges that have been buffeting brokerage firm's backoffices in the recent times. Front office developmentslike Direct Market Access and Algorithmic Trading arehaving an impact on trading volumes while a focus oncost means that the back offices have to manage more

with fewer resources at disposal.The current structure of the back offices of most

brokerage firms does not always adequately representthe significant changes that are taking place in thesurrounding environment. The reasons behind thisrange from a lower priority focus on back officeoperations and systems to historical factors as a result ofmergers and acquisitions. All of these point towards theneed for a fundamental relook at the back officestructure so that it is both nimble and robust enough toefficiently discharge its responsibilities in the days to

come. Theback office structure of the future would be centralized, withfocus on a product agnostic and round the clock processingcapabilities.

Currently the back office functions of mostbrokerage firms are normally modeled to mirror thefront office structure which is typically by productclass/business lines and geography. These result indistinct vertical silos, with each silo handling post tradeprocessing for a different product class within a

1. From Product Silos towards a Unified Back Office:

geography. Such a structure leads to multiple points ofcontact within the firm for a client dealing in differentproducts and in turn means that the brokerage firm hasseparate relationship threads with the same clientacross various product classes.

In the future, brokerage firms would implement aunified back office structure for the back office centeredaround the adoption of cross product strategy where

each person needs to have knowledge of multipleproducts. The back office would be a centralizedprocessing hub providing a 24 by 5 seamless service toclients and traders across the globe. Brokerage firmswould also look to explore leveraging third partyvendors providing such services out of offshorelocations especially for their more standardizedfunctions. Such a structure is also expected to bringsignificant benefits around process standardizationbesides providing a holistic view of the client and firmwide risk.

Equity

FixedIncome

Derivatives

FX/MM

Equity

FixedIncome

Derivatives

FX/MM

Front Office

Middle Office

Product Based Back Office

Middle Office

Unified Back Office

Current Structure Future Structure

Front Office

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2. From System Fragmentation towards Integration:

3. From Partial Automation towards STP:

The back office of the

future would center around a few core enterprise wide systems supported bycomponentized local market processing capabilities and interfaces.

The current application landscape of most brokerage firms consist ofsystems dedicated to specific asset classes. This is often a direct outcome ofthe time to market demands placed by the front office to remain competitiveby trading in new products and the inability of existing systems toaccommodate these new instruments. Furthermore most of these systemsare legacy applications that had not been built to take care of the evolvingmarket infrastructure. They normally would require significantdevelopment costs to improve STP and ensure that customer serviceremains at consistently high levels. The fragmentation of systems also

means that commonality of processes cannot be leveraged across theorganization.While a single application handling all asset classes and processes might

look attractive, no such system exists today. Furthermore such a solitarycolossal system, even if it had the required features to support front to backflow for different instruments would in all probability be unable toaccommodate the time to market requirements of new flows.

Instead the brokerage back office of the future would consist of a limitednumber of specific enterprise wide solutions providing coverage acrossdifferent business lines and product classes. Such applications wouldconsolidate and handle similar processes across the enterprise forexample a cash settlement function which involves comparable stepsirrespective of the instrument being traded or MIS.

The architecture of such systems would be componentized with the coresolution separate from local processing modules which would handlemarket specific requirements. The solution needs to be dynamic andconfigurable to cope with changes in market infrastructure along with theability to handle large volumes across the organization.

The back office of the future wouldfunction with a high degree of operational efficiency involving real time controlsand automated exception management.

While the concept of STP has been around for quite some time, the

progress in increasing STP rates in brokerage firms has not always beensignificant. The reasons are often due to the substantial effort, cost andcomplications involved in transforming processes. But the recent marketturbulence has brought the spotlight and focus back on STP projects. Firmsare viewing investment in STP projects as obligatory and crucial towardsbuilding more efficient processes, effective risk management and above allproviding differentiated customer service.

Back offices of the future would have minimum manual intervention intheir front to back process. To achieve this state the firm would integratepeople, process and technology, make use of business process managementtools and display an obsessive focus towards data quality. They would use

and insist on common protocols in their interactions with clients andmarket participants and be first movers to align themselves with industrytrends that focus on STP among other things.

Exceptions when raised in such a process would be handled in anautomated fashion wherever possible. In the case of reference data issuesfor example, this could involve automatic triggering of alerts to the Datadivision and to the concerned back office department responsible formonitoring the exception. The system would have in built rules to attemptand restart processing on its own from the point where it stopped bylooking up the reference data system after a pre determined time. In case ofexceptions where manual intervention is required the system would

automatically allocate and prioritize exceptions to ensure relevant actioncan be taken as quickly as possible to resolve the issue.

The processes and systems of back offices of brokerage firms are currentlynot always aligned or equipped to optimally meet the wants of a constantlyevolving market place and demanding customers. Brokerage firms wouldneed to put in place a strategy and structure for their back office focusedaround the ability to provide continuously differentiated customer serviceat the lowest cost.

Conclusion

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Cloud computing in the Asset Management World

A soothing remedyShishir Gupta

In the aftermath of thefinancial meltdown,revival in the Asset

Management industry

lies in the usage of thepower of cloudcomputing and itscollaboration withservices like Software asa Service (SaaS),Infrastructure as aService (IaaS) andPlatform as a Service

(PaaS).

Shishir Gupta

[email protected]

is aBusiness Analyst inthe Asset ManagementPractice group withinthe Securities &

Capital Markets DomainConsulting Group. He hasexperience in SWIFT and AssetManagement functions. He is basedin Bangalore, India. E-mail:

It is believed that Every cloud has a silver lining. After everyfinancial crisis, like a sphinx from the ashes, have arisennewer business strategies, operational technologies, financialproducts and pricing techniques. This time around too, in theaftermath of the financial destruction that has left Americaand the world in shambles, there is a ray of hope for the assetmanagement industry. The hope lies in the usage of thepower of cloud computing and its collaboration with services

like Software as a Service (SaaS), Infrastructure as a Service(IaaS) and Platform as a Service (PaaS). This article intends tothrow light on the opportunities that are available on thehorizon for the asset management industry players throughthe use of the untapped potential of cloud computing.

The global financialservices industry spent $558.4 billion in 2008 on IT(hardware, software, IT services, internal services andtelecommunications) (Roster, 2009). A major component ofthe $558.4 Billion was spent on infrastructure maintenance,

payroll costs, capital expenditure on acquisition on newhardware and software licensing costs. This implies thatfinancial institutions are trying to spend much money in thedelivery and servicing systems rather than investing in theircore business. High spends in delivery and servicingapplications are because these applications comprise mainlyof products, both purchased and in-house developed. Theseproducts have high maintenance costs, licensing cost andare perilously dangling on becoming outdated.

In the front office world, portfolio management systems(PMS) are a classic case. With the introduction of newer

The Asset Management world today:

products, newer trading techniques and newer pricingmethods in the market, the PMS application needs toundergo a change not only in functionality but also in theoverall look and feel of the application. It should have theability to assist the fund manager to create winning portfolioswith timely identification of risks and portfolio re-balancing.Take the case of data management function in the middleoffice this involves maintenance and storage of reference,pricing and market data along with ability to leverage data tosupport trade execution, performance, compliance, andreporting. This means that the fund needs to ensure that thedata is scrubbed regularly, checksum is maintained and dataremains secure and reliable. In the back office world, fundaccounting is an important function this involvescalculation of the Net Asset Value (NAV) including thecalculation of the funds' income and expense accruals,Maintenance of the fund's financial books and records,reconciliation of daily and Monthly Broker Statement etc. It isa critical function and any lapse in this area affects thevaluation of the assets and the mark-to-market calculation fornot only the fund itself but also for all the investors.

The above functions are just a few examples where we

find that the AM world is trying to come to terms withnewer needs and changing critical requirements.

To comply with the need of theAM industry to be innovative and profitable, high capitalexpenditure is required in acquiring new applications alongwith the intricate process of hiring of scarce, right skilled andhigh wage employees to operate those applications. There areother operational issues in relation to management of deviceand location dependencies, under utilization of resources andthorny aspects of reliability, security, scalability and

Intricacies in the AM world:

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sustainability. The integration of newer applications, enhancement of current

applications, introduction of newer devices, newer platforms, compliance to newregulations etc leads to issues such as high application down time, longer integrationcycles, high maintenance cost, large regression errors etc, which might impact damagea financial institution's reputation and image as well as land it into legal troubles. Sowhat can help AM industry in this situation and time?

A recent Gartner report states that the currentSaaS market is a paltry $6.4 Billion; this pales in comparison to the $558.4 Billionspent on IT. (Roster, 2009). This piece of information should whet the appetite ofany investment fund manager. In the case of data management function, cloudcomputing provides the ability to the fund manager to store his data at a remoteplace accessible through the cloud network. The database would be acquired and

maintained by a service provider and licensed to the fund manager for a fee. Thefund manager would be able to use the database without incurring the cost ofmaintaining it. He would not be required to acquire the hardware, upgrade itperiodically or hire a large employee base. Any additional requirement ofadditional space would be fulfilled by the service provider for a fee.

Applications providing services like fund management or corporate action ortransfer agency functions can be acquired by a service provider and thenprovided to different funds for a fee. This would resolve the issue of under

1utilization of resources and help save costs. If we consider regulatorycompliance, it is a need common across players. If compliance monitoring andreporting can be hosted by a common service provider, then the cost of frequent

upgrades and patches to the applications can be eliminated altogether.Most of the applications under cloud computing would be device and

location independent as the software would be available through the web. Even ahandheld phone or laptop can easily be used to execute the applications. Theservice providers would also offer the option of customization to the service andinfrastructure provided to each fund. Funds would have the option to terminatethe services of a provider anytime and switch to the next provider.

This disdain for cloud computing may not be dueto lassitude but is attributable to a number of concerns, especially from the assetmanagement point of view:

Cloud computing to the rescue:

Concerns in Implementation:

a. Security concerns:

b. Availability concerns:

c. Portability concerns:

Conclusion:

References:

Data in the asset management industry typically consists of

security positions, cash positions, trade positions etc, which is highly confidential andas the data under cloud computing is in the hands of a third party, it stands exposedand is prone to fraud or breach. The fund would require the service provider toprovide proper data security, periodic consistency checks, proper business continuityplan in the advent of disaster and has a proper business day support.

In case the applications at the service provider'slocation go down at the prime time, it can lead to probable losses and penalty forthe fund. Say, at EOD, the NAVs need to be calculated and at that point of time,the fund accounting application goes down for a long period. The NAVcalculations would not be completed and fed to the markets in time; this couldlead to dissemination of wrong information in the market. Some of other pain

areas could be non-compliance to laws like AML (anti-money laundering)monitoring and improper reporting.Today, most of the big IT firms like Microsoft, Google,

Amazon, Yahoo etc. are engaged in developing platforms and applications forcloud computing. The worst bit is that all of them are trying to sell their ownproprietary code and network, so in case a fund engaged with one providerdecides to shift its services from one network to another, there could be a problemin portability. The change in platform or application may affect the dataconsistency and reliability or even loss of data.

Cloud computing would be a boon to the Asset Management worldin these financially difficult times, provided the concerns in implementation are

met. A concerted effort by both the investment fund and providers (initiativeslike open source development) is required to bring about a successful cloudcomputing revolution to the Asset Management world.

- Roster, Jeff, IT Spend by Industry Worldwide, Gartner, 2009,- Wikipedia, http://en.wikipedia.org/wiki/Cloud_computing, 2009

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1. Depends on the kind of charging methodology utilized time based (subscription model) oramount of resource based (Utility model). There are different charging methodologies that can beused in cloud computing. Further reading recommended.


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