While there has been tremendous progress in the standardisation and electronic representation of over-the-counter (OTC) derivatives, there remains a population of exotic trades that do not fit into standard templates. The lack of industry standard templates for exotic trades is more driven by the differences in how these trades are represented by the two counterparties to the trade for their own effective risk management purposes, as opposed to lack of an industry language to be able to share the transaction details between the two counterparties to the trade. Consequently neither operations departments nor regulators can efficiently process nor monitor these transactions.
What is the standard method of communicating OTC derivatives across market participants?
FpML (Financial products Markup Language) is the industry communication standard for sharing information on, and dealing in, financial derivatives and structured products between market participants. It is based on XML (Extensible Markup Language), the standard meta-language for describing data shared between applications.
What are the benefits of industry communication standards?
Standardisation and electronic trade representation has increased regulatory visibility over trading volume and exposure between market participants, whilst enabling electronic matching of trades between industry participants, increasing control, timeliness and processing efficiency. However, FpML has not yet achieved standardisation and electronic trade representation for exotic trades.
Why do non-standard trades exist in the industry?
Non-standard trades are customised swaps used by commercial end-users to hedge or mitigate their commercial risk that standard trades would fail to adequately mitigate.
Why can they not be standardly represented?
Exotic trades are often captured and represented in the booking infrastructures of the two counterparties significantly differently. These differences are typically influenced by each counterparties risk management infrastructure requirements. For example, one counterparty may be able to risk manage the trade with numerous exotic trade data components contained in one trade, whereas the other counterparty may require multiples trades which when added together represent the same value as the other counterparties single trade. While these both refer to the same transaction, the trades will not match as one side describes the transaction as one trade and the other as multiple trades.
What is the impact of them not being able to be standardly represented?
These differing representations result in mismatches in downstream operation processes (trade pairing, confirmation, settlement) and reporting to regulators. Moreover, the timeframes imposed by reporting regimes resulted in counterparties shoe-horning these trades into the FpML “exotic” category providing limited granularity on the requisite product specific detail. In addition, the dual-sided EMIR transaction reporting regime, requiring each counterparty to report their own side of the transaction, has resulted in trade pairing breaks due to the one to many relationship on these exotic transactions. While regulatory reporting regimes, in particular the dual-sided model, were developed to provide regulators greater transparency, the unintended consequence may be a reduction in transparency.
Are there other industry communication standards?
The energy industry developed the Commodities product Mark-up Language (CpML) in parallel to FpML. In contrast to FpML being broad in its product coverage, CpML was designed to represent energy trades only. It therefore provides a more detailed electronic representation of exotic trades but faces the same challenges when trades are captured and represented differently across counterparties.
The industry will continue to drive standardisation and electronic representation of more OTC products in FpML by identifying those products that have sufficient activity or other characteristics that can be standardised. This will continue to reduce the number of exotic trades that cannot be processed or reported efficiently. However, this will be of limited benefit if the industry does not in parallel identify and drive standards around trade capture and trade representations. Now is the time to not only collaborate on how you communicate externally with each other but also how you book internally compared to each other.