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FpML for Credit Derivatives (Part I)

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1 FpML for Credit Derivatives (Part I)
Ben Lis Chairman of the FpML Credit Derivatives Working Group 1

2 What we will cover Business Case The Working Group Subschema Tour
Getting Involved 2

3 Business Case State of the Market State of the Technology
Credit Default Swap: What and Why Let’s take a look at the business case for forming a credit derivatives working group. A quick look at the market and the technology supporting it will make it clear why this was a good call. There are several different credit derivative instruments, but as you will see the working group is focusing on the credit default swap. We will do a quick review of the credit default swap and offer a justification for why it was the natural first choice. 3

4 State of the Market The market is relatively new in comparison to other OTC derivatives such as interest rates, but it is undergoing rapid growth. The need to manage your interest rate and FX risk is well understood. The financial products that enable you to manage that risk effectively have been available for quite some time. The tools for effectively managing credit risk, credit derivatives, have been developed only relatively recently. And the default of highly rated companies has definitely made clear the need to manage your credit risk. Interest rate derivatives, with $90 trillion in outstandings, were again the largest component of the OTC business Background: Russia crisis identified the issues with CD documentation and led to ISDA standard definitions Conseco restructured debt, led to new definition in ISDA contract for modified restructuring. Handled by creditex on its platform highly rated companies defaulted Main points is Credit derivatives market handled the crisis (passed the market test) leading to more liquidity - products standardised and refined to meet market needs 4

5 Alan Greenspan’s Comments on Credit Derivatives
“New financial products have enabled risk to be dispersed more effectively to those willing, and presumably able, to bear it… A significant amount of exposure to telecom debt had been laid off through credit risk mitigation instruments, such as credit default swaps… The still relatively small, but rapidly growing, credit derivatives market has to date functioned well, with payouts proceeding smoothly for the most part.“ Quoted from a speeches made at the Institute of International Finance in New York on April 22, 2002 and at the Bank of England on September 25, 2002. Key is the appreciation of the need to manage risk, even at the regulatory level. CDS will be a key component to manage that risk 5

6 State of the Technology
More systems support for vanilla swaps and FRAs than for credit derivatives. Front-office trade data errors are most common for credit derivatives. Outstanding Confirms (sent not finalized): FRAs – 7 days Vanilla Swaps – 9 days Credit Derivatives – 21 days Of respondents with no current automation, 80% said they would automate credit derivatives. (Source: 2002 ISDA Operations Benchmarking Survey) Front office trade-errors: Twenty-one percent of these errors relate to credit derivatives, while 10% involve FRAs and 17% involve vanilla swaps. Looks like we need to do some work on our credit derivatives systems. Really, a great opportunity for FpML to have an impact: a rapidly growing area that does not yet have the system infrastructure that it requires. Rapidly Growing Market + Automation Opportunities = Fertile Ground for a new FpML Standard 6

7 Why focus on the Credit Default Swap?
Which credit derivative product to focus on? The credit default swap is the natural choice. Since the credit default swap is the basic building block of both baskets and synthetic CDOs, if anything, this graph perhaps understates the importance of the credit default swap. Background: Three main – CDS, Basket (just collection of many CDS) and portfolio (explained later) All others have cash component AS – Bond and swap TRS – financing approach CLN – cash asset related 7

8 What is a Credit Default Swap?
Buyer pays fixed rate to Seller in consideration for Protection against a Credit Event experienced by a Reference Entity. Two possible outcomes: No Credit Event occurs. Protection Buyer pays all required premiums. Swap terminates on maturity with no additional cash flows. A Credit Event occurs. Protection Seller compensates Protection Buyer and contract terminates. Basis Points per annum Tie to insurance on a house. Credit Event is like a hurricane. Contingent payment based on Credit Event of Reference Entity * * Failure to pay, bankruptcy, restructuring (modified restructuring for US credits). 8

9 Credit Default Swap Challenges
Documentation laden: 120+ terms on the ISDA confirm. Market Practices Evolving: Reference Entity Identification Restructuring Greater Standardization 9

10 What we will cover Business Case The Working Group Subschema Tour
Getting Involved 10

11 The Working Group Scope Timeline Keys to Success Participants
Full Confirm vs Economics of the Trade 11

12 Credit Derivatives WG Scope (4.0)
Extend product coverage of the FpML standard to include credit default swaps. Produce an XML Schema together with supporting documentation. Determine whether it’s best to represent only the economics of the trade or the full ISDA confirm. Compatible with the ISDA 2002 Credit Derivatives Definitions. Consistent with the rest of FpML. Recommend other credit derivative products to include in future versions of the standard. Directly lifted from the charter. 12

13 Timeline May ’02: Proposal to add credit derivatives to FpML submitted by JP Morgan, UBS Warburg and creditex. June ’02: ISDA issues a call for participation in an FpML credit derivatives working group. July ’02: Credit derivatives WG begins meeting on a weekly basis. November ’02: Rough draft of FpML credit default swap schema completed. January ’03: Working draft of FpML 4.0 credit derivatives completed. Spring ’03: FpML 4.0 Last Call Working Draft Summer ’03: FpML 4.0 Trial Recommendation 3rd Qtr ’03: Work commences on FpML credit derivatives II. 13

14 Keys to Success Aggressive milestones.
Well defined target: 2002 ISDA Confirmation Agreement. Reuse of existing FpML components. Organizational expertise. Excellent group of people on the working group. An aggressive timetable was set for the working group to deliver a working draft. We are on target. What were the key factors that contributed to this target? 14

15 Active Participants AIG (Daniel Partlow)
Bank of America (Elain Bannerman, Kurt Vile) BNP Paribas (Geoff Norris) Credit Suisse First Boston (Gareth Connolly, Ian Thomas) creditex (Ben Lis, Mazy Dar) Deutsche Bank (Kathy Andrews) JP Morgan Chase (Ben McGill) Goldman Sachs (Christina Yeung, John Weir) ISDA (Karel Engelen, Tony Hernandez) SunGard (Amir Khwaja, John Cobbledick) SwapsWire (Guy Gurden) UBS Warburg (Tim Black) 15

16 Full Confirm vs. Economics of the Trade
What is the universe of data items that we will model? Full Confirm Exhibit A of the 2002 ISDA Credit Derivatives Definitions Long Form Economics of the Trade: Exhibit B.II. of the 2002 ISDA Credit Derivatives Definitions (?) Short Form Transaction Supplement Economics of the Trade subset of Full Confirm 16

17 Advantages Full Confirm: Comprehensive
Consistent with FpML philosophy. Economics of the Trade Simpler Complete enough to handle a large % of interdealer trades. 17

18 Decision: Best of Both Worlds
Do Full Confirm. Subschema should also support specifying Economics of the Trade. Strong consensus amongst the WG members. Not substantially more work than Economics of the Trade by itself. 18

19 What we will cover Business Case The Working Group Subschema Tour
Getting Involved 19

20 Subschema Tour Big Picture Reference Entity: Standardization
Credit Events: Schema 20

21 Start at the root. <FpML> root element of all FpML documents
<party> and <trade> key child elements of <FpML> <FpML version=“4-0” currencySchemeDefault = “http://www.fpml.org/ext/iso4217”...> <trade> ... </trade> <party> …. </party> </FpML> 21

22 <party> One party element for each trade participant – principals & 3rd parties (e.g. broker). S.W.I.F.T. Bank Identifier Code (BIC) is the recommended coding scheme for identifying business entities for inter-firm communication. <party id=”JPMORGAN"> <partyId>CHASGB2L</partyId> </party> <party id="BARCLAYS"> <partyId>BARCGB2L</partyId> 22

23 <trade> 23

24 <tradeHeader> Contains non-product specific information, e.g. trade date. <tradeHeader> <partyTradeIdentifier> <partyReference href="#JPMORGAN" /> <tradeId tradeIdScheme="http://www.jpmorgan.com/id">SW123</tradeId> </partyTradeIdentifier> ... <tradeDate> </tradeDate> </tradeHeader> 24

25 <creditDefaultSwap> is a <product>
Like the other financial instruments covered by FpML, the credit default swap is defined as an extension of product. <complexType name = "CreditDefaultSwap"> <complexContent> <extension base = "Product"> <sequence> <element ref = "generalTerms"/> <element ref = "feeLeg"/> <element ref = "protectionTerms"/> <element ref = "settlementTerms"/> </sequence> </extension> </complexContent> </complexType> 25

26 <creditDefaultSwap>
26

27 <generalTerms>
27

28 General Terms in the 2002 ISDA Definitions
Trade Date: [                ] Effective Date: [                ]   Scheduled Termination Date: 11:59 p.m. Greenwich Mean Time on [insert date]   Floating Rate Payer: [Party A][Party B] (the "Seller").    Fixed Rate Payer: [Party A][Party B] (the "Buyer").   Calculation Agent: [                ]   Calculation Agent City: [                ]   Business Day: [                ]   Business Day Convention: [Following][Modified Following][Preceding] (which shall apply to any date referred to in this Confirmation that falls on a day that is not a Business Day).   Reference Entity: [                ]   [Reference Obligation(s):] [                ] [The obligation[s] identified as follows:   Primary Obligor: [ ]   Guarantor: [ ]   Maturity: [ ]   Coupon: [ ]   CUSIP/ISIN: [ ]   All Guarantees: [applicable][not applicable]   Reference Price: [ %] 28

29 Reference Entity Identification: An Industry Issue
Legal disputes have occurred over what issuer the credit default swap agreement covers. Armstrong Holdings vs. Armstrong World Industries. A widely available database of standard reference entities names and reference obligations would be a big step forward for the market. Project RED under development by Goldman Sachs, JP Morgan Chase and Deutsche Bank. UBS Warburg and Deutsche Bank over Armstrong Holdings, and its subsidiary Armstrong World Industries, a US company supplying building materials, including asbestos. In December 2000, the latter company, with most of the outstanding debt, filed for bankruptcy, but the former continued to operate. Deutsche Bank had sold UBS Warburg protection on one of the two Armstrong companies in a relatively small deal of about $5m or $10m. A disagreement, over which one, was settled out of court. 29

30 FpML & Reference Entity Standardization
FpML’s goal: XML-based definition of the credit default swap. Reference entity needs to be part of that definition. Standard reference entity database being developed outside of FpML. FpML allows reference entities to be specified by: Legal name (I.e. text string). Reference to an external database. FpML is compatible with RED. UBS Warburg and Deutsche Bank over Armstrong Holdings, and its subsidiary Armstrong World Industries, a US company supplying building materials, including asbestos. In December 2000, the latter company, with most of the outstanding debt, filed for bankruptcy, but the former continued to operate. Deutsche Bank had sold UBS Warburg protection on one of the two Armstrong companies in a relatively small deal of about $5m or $10m. A disagreement, over which one, was settled out of court. 30

31 <referenceInformation>
31

32 FpML Schemes Mechanism for defining a permitted list of values.
Used extensively in FpML: CUSIPs BIC Business day convention Identified by a URI. Similar to enumeration. Continue to be used in the schema version of XML where: # of valid values large enough to make enumeration impractical. List of valid values is apt to change. 32

33 <referenceInformation>
Reference entity scheme is not required. A default scheme can be specified on the root element.  A scheme is defined as an attribute of an element or type. <referenceInformation> <referenceEntity referenceEntityScheme = "http://www.creditex.com/reference-entity-1-0">CITIGROUP INC.</referenceEntity> <referenceObligation> <obligationId instrumentIdScheme = "http://www.fpml.org/spec/2002/instrument-id-CUSIP-1-0">172967BJ9</obligationId> </referenceObligation> </referenceInformation> 33

34 Fixed Rate Payer Information
Represented in the feeLeg element. Supports the following schedules: Fixed Rate, Regular Schedule Fixed Amount, Regular Schedule Fixed Rate, Month-End Rolls Fixed Rate, Initial (Short) Stub Fixed Rate, Initial (Long) Stub Fixed Rate, Final (Short) Stub Fixed Rate, Final (Long) Stub Fixed Amount, Single Payment Upfront Fee and Fixed Rate, Regular Schedule Irregular Payment Schedule Allows optional cashflows representation. 34

35 <feeLeg> 35

36 feeLeg: example The FpML in the next slide represents the following payment schedule: Effective Date: 1 November 2002 Scheduled Termination Date: 1 November 2007 Notional Amount: USD 5MM Fixed Rate: 85 bp Payment Frequency: Quarterly Day Count Fraction: ACT/360 Fixed Rate – Regular Schedule 36

37 <feeLeg> example
<creditDefaultSwap> <generalTerms> <effectiveDate> </effectiveDate> <scheduledTermination> </scheduledTermination> . </generalTerms> <feeLeg> <periodicPayment> <paymentFrequency> <periodMultiplier>3</periodMultiplier> <period>M</period> </paymentFrequency> <rollConvention>1</rollConvention> <fixedAmountCalculation> <fixedRate>.0085</fixedRate> <dayCountFraction>ACT/360</dayCountFraction> </fixedAmountCalculation> </periodicPayment> </feeLeg> 37

38 <protectionTerms>
Information contained in the Floating Rate Payer section of the ISDA Credit Derivatives confirm is contained in the protectionTerms element of the FpML creditDefaultSwap. 38

39 creditEvents: XML schema
Representing credit events in XML presents an interesting design challenge: Some are simply applicable or not (e.g. bankruptcy). Some are applicable or not, but if applicable have additional data (e.g. failure to pay with a grace period). The restructuring credit event is a focal point of industry discussion and may continue to evolve. Ideally, our representation should be able to gracefully support the evolution of market practice. 39

40 <creditEvents>
40

41 creditEvents: substitution group
Example of how the adoption of XML schema allows for better design. XML schema provides a construct called a substitution group that is very similar to inheritance in a programming language: <xsd:element name = "creditEvent" type = "CreditEvent" abstract = "true"/> <xsd:element name = "failureToPay" type = "FailureToPay" substitutionGroup = "creditEvent"/> <xsd:element name = "bankruptcy" type = "CreditEvent" substitutionGroup = "creditEvent"/> <xsd:element name = "obligationDefault" type = "CreditEvent" substitutionGroup = "creditEvent"/> 41

42 creditEvents: example
The FpML in the next slide indicates that these credit events apply: Bankruptcy Failure to Pay with a 30 day grace period and payment requirement of USD 1,000,000. Repudiation/Moratorium Obligation Acceleration Restructuring (R) Default Requirement of USD 10,000,000. That these conditions to credit event notice settlement apply: The Seller is the notifying party. Notice of Publicly Available Information is a Condition to Payment – defaults apply for Public Source(s) and Specified Number. 42

43 <creditEvents> example
<bankruptcy/> <failureToPay> <gracePeriodExtension> <gracePeriod> <periodMultiplier>30</periodMultiplier><period>D</period> </gracePeriod> </gracePeriodExtension> <paymentRequirement> <currency>USD</currency><amount> </amount> </paymentRequirement> </failureToPay> <repudiationMoratorium/> <obligationAcceleration/> <restructuring>R<restructuring> <defaultRequirement> <currency>USD</currency><amount> </amount> </defaultRequirement> <creditEventNotice> <notifyingParty>Seller</notifyingParty> <publiclyAvailableInformation/> </creditEventNotice> </creditEvents> 43

44 creditEvents: restructuring
No restructuring: no restructuring element Restructuring applies: restructuring element Form of restructuring specified in the element’s content. Valid values defined by an FpML scheme: R modR modmodR Change to the scheme doesn’t allow require a change to the standard. 44

45 What we will cover Business Case The Working Group Subschema Tour
Getting Involved 45

46 Getting Involved Staying in the Loop WG’s Goals & You
Learning Resources 46

47 Staying in the Loop: Email
list of the credit derivatives WG: Chairman’s General FpML: FpML Discussion Group: General discussions about FpML efforts. FpML Announcements: News and announcements about the FpML standard, organization, working groups, etc. 47

48 WG Goals & You: Approval Process
The WG’s deliverables (I.e. subschema and documentation) go through various phases: Working Draft Last Call Working Draft Trial Recommendation Recommendation A basic understanding of these phases is needed to appreciate our short-term goals. 48

49 Approval Process: Working Draft
Work in progress. Where we are today. Documentation needs to be completed. Minor changes to schema. Completion date: January 15th, 2003. 49

50 Approval Process: Last Call Working Draft
WG feels it’s done. Working Draft published. Input solicited from interested parties. Standards committee promotes to this status. Spring ‘03 50

51 Approval Process: Trial Recommendation & Recommendation
Stable working draft. Implementation feedback and experience from the community. Summer ’03 Recommendation: Appropriate for widespread deployment & adoption. Standard 51

52 Getting Involved Short Term (next six months)
Sign up for the credit derivatives WG list. Review the standard and provide comments during the Last Call Working Draft phase. Be an early implementer and provide feedback during the Trail Recommendation phase. Longer Term (Summer ’03 and beyond) Become an active participant in the credit derivatives WG and help us expand the standard. 52

53 XML Learning Resources
IBM’s developerWorks XML Zone: O’Reilly XML.com: W3C XML site: Robin Cover site: Books on XML Schema: XML Schema Eric Van Der Vlist Definitive XML Schema Priscilla Walmsley 53

54 FpML Learning Resources
Access to Specs, Working Papers and Presentations: No 4.0 documents published yet. Most recently published spec: Architecture 1.0 spec: Schema Technical Notes: Migration to XML Schema: FpML 3.0 XML Schema Release Notes: 54


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