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New Direction for Equity Derivatives (June 29, 2007)

Location: New York
Author: Lenny Broytman
Date: Friday, June 29, 2007

One area of finance that's really begun to gain momentum among various dealer banks and industry groups has been the equities derivatives market and experts are pointing to the International Swaps and Derivative's Association's latest figures as a cause for the growing level of interest.

According to, the organization's latest findings from the second half of 2006 found equity derivative's notional value outstanding at $7.2 trillion. This number represents roughly a fifth of the credit derivative's total, which was reported to be around $34.5 trillion. Experts agree that the data points to the fact that the problems within the equity derivatives market are a lot less severe.

Nevertheless, the concern was still big enough for 17 major equity derivatives dealers to pen a letter to the Federal Reserve Bank of New York's President Timothy Geithner, voicing their rising concern with their market's stability.

When you consider all of the derivatives assets classes, the equity derivatives instruments are the ones with the longest elapsed time between trade date and confirmation execution. The 17 dealers addressed the issue in the letter, an issue that became a top priority for many banks in 2007.

What the dealers were hoping to secure was a new standard - one which would require confirmations executed within five days of the transaction to be placed on electronic platforms and within 30 days for ones that are either new or happen to be ones that rely on long-form confirmations.

The most crucial part for the dealer would be to properly standardize documentation for products that are traded at a frequent rate. This would be achieved with the use of master confirmation agreements. It would result in the dealers being able to process as many transactions as possible electronically.

"Many products don't have standardized documentation, so [the process] is slower than on the credit side," says Stephanie Price, vice president and senior legal counsel for the Managed Funds Association. "We're starting from further back in terms of getting onto electronic platforms."

One other thing that has grown increasingly important in the differences between the equity and credit derivatives backlog has been the difference found among counterparties. When it comes to the credit derivatives side, inter-dealer transactions make up a vast majority of the trading volume. On the other hand, equity derivatives see trades which are between dealers and buy-side counterparties such as hedge funds. In other words, both equity derivatives buyers and hedge funds alike are capable of playing a fairly large role in improving the market's efficiency.

The dealers' November letter to the bank stated that each bank would be required to reduce the number of equity derivative trade confirmations which are outstanding for more than 30 days by 25 percent. It is a requirement which was to be met by January 31 of this year but according to a May 15 letter issued by the New York Fed, the requirements were not met.

In another May 15 letter (this one issued once again by the dealers), the newly-stated targets were made for the electronic execution of 55 percent of eligible trades between major dealers beginning this June. By September, the dealers hope that the number will rise to 70 percent and then even higher, to 80 percent in November. The letter also maintained that they would continue their efforts to reduce the number of outstanding equity derivative trade confirmations by 40 percent as of June 30 and by September, expect to see a reduction by 50 percent.

A roadmap for improvement in electronic processing should be presented by the dealers as early as September 30. As the letter states, the dealers are very mindful of the market standard confirmation processing guidelines and plan to stick to the necessary requirements. If all goes according to plan, the new guidelines foresee a trading environment in which confirmations will be issued within one business day of the transaction for all electronic trades and within 10 days for the non-electronic ones. There will also be matches issued within five days on electronic platforms and 30 days for on-paper execution.

The dealer's clients should circle July 31 on their calendars; a presentation designed to bring them up to speed with the new changes is currently scheduled for that day.

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