Hedge Fund Accounting Trade Life Cycle of OTC Derivatives - Trading Events - Pre-trade ( Part – 1 )

Trade Lie Cycle in OTC Derivative Markets The continued growth in OTC derivatives volumes combined with inflexible and manual processing has led to confirmation backlogs, regulatory attention and constraints on the front office’s ability to allocate assets or capital to these instruments. OTC derivative trade life cycle events. This life cycle is defined worldwide by the existing operational practices of most institutions, and the processes are more or less similar. The emphasis is on getting the orders transacted at the best possible price and on getting trades settled with the least possible risk and at manageable costs. Designated employees in the member’s office ensure that each trade that takes place through them or in their house account gets settled properly. Unsettled trades lead to liability, risk, and unnecessary costs. Trading Events - Pre-trade ( Part – 1 ) Introduction Every trade has its own life cycle. The entire Life Cycle of a trade can be broken down into pre-trade and post-trade events. Before going into the details of the trading events, let me explain how a trading deal is being struck between two entities. We know that one of the primary usages of derivative contract is to hedge the risk. Let us consider that a company has got a floating rate liability in LIBOR (London Inter Bank Offered Rate) and it wants to convert its liability into a fixed rate. The feasible option would be to enter into an Interest Rate Swap. The company would strike a deal with a bank and enter into a swap where it would pay fixed rate to the bank and receive floating rate. The company and the bank would enter into a trade and the trade passes through various stages. The various trade events can be categorized into Front Office, Middle Office and Back Office activities which are explained below: Front Office: The FO forms the stage where the trade gets initiated. Here, the order gets placed and the entity will price the instrument and give the quote to the counterparty. If the counterparty agrees to the details of the trade and is willing to enter into the deal, the trade gets executed. The trade is then captured in the trading desk usually using a deal capture system. The deal capture system validates all the necessary trade economics before assigning a trade reference number. Subsequent trade events like amendment, cancellation would refer to the trade with the help of the identifier. An acknowledgment is being sent to the counterparty with the trade details who confirms it back. Middle Office: The important function that MO performs is to do the Limits and Risk Management. The Limits are being calculated at a business hierarchy level. The usual hierarchy would be at a Portfolio level and subsequently aggregating to a Trader Level, a Desk Level, an Entity Level, and finally to a Group Level. Validations are being done on the trade captured, and in case of any discrepancy, an exception is being raised. The MO plays a vital role in the exception management. The trade gets enriched by static data like the standard settlement instructions of the counterparty, Custodian details, City holidays, etc. Such static data details are important for the completion and settlement of the trade. The allocation of the trade is done in the MO and finally the trade is being pushed to the BO and the trade goes live. Back Office: The BO is the back bone of the entire life cycle of the trade. The BO mostly deals with the operational activities like record keeping, confirmation, settlement and regulatory reporting. In most cases, BO activities are being outsourced to cheaper sources to cut down on costs for the company. The Life Cycle of such a trade can be categorized into pre-trade events and post-trade events which are discussed below: - Pre-Trade Events Setting up a Master Agreement: It is a standardized contract between the counterparties and should be there in place before the two parties enter into a deal. For derivative contracts, the Master Agreement is drafted according to ISDA protocols Define Product Characteristics: Every Deal has to be defined by some primary characteristics called the primary economics of the trade. In case of a Plain Vanilla Interest Rate Swap, the economics of trade would be as follows: - Pre-Trade Negotiation: In this stage the client tries to reach a preliminary agreement with the bank. This stage may include documentation, indication of the interest rate and defines the criteria for executing a trade which may include the credit support and the bank policies which the counterparty has to abide by. Request for Quote: The client will ask for a quote to the bank, say the fixed rate against LIBOR. Provide Quote: The bank will provide the quote which may be through their traditional channels like phone, fax and email, or through standardized channel as provided by Swaps wire. Request Trade Pricing Inputs: The Client will ask inputs which will help to price the product. It may relate to volatility of the underlying in some cases. The trade is priced after matching every detail of the trade. For an IRS, both the parties will agree to the rates when the Net Present Value of the swap is zero. Setting up master agreement/master confirmation. Know Your Client (KYC) Define product characteristics. Pretrade negotiation - Present term sheets to clients/ preliminary agreement. Request/provide documentation / governing law. Indication of interest. Provide indicative price/rate/value. Request/define criteria for executing trade (conditionality,credit support, bank policies. RFQ - Product Details - Request Quote. Provide Quote - Price/Rate/Value - Request Quote Response. Chek Credit - Client Product Details. Request Trade Pricing inputs - Price Input Values(Vol,etc.)