DTCC and CLS launch central settlement service for OTC credit derivatives

The service, provided through DTCC's Trade Information Warehouse, is the OTC derivatives industry's only automated solution for calculating, netting and issuing payments between counterparties to bilateral contracts. The new service greatly reduces operating risks for users by replacing manually processed bilateral payments with automated, netted payments.

In the first quarterly central settlement cycle for the new service on December 20, 2007, the amount of trading obligations requiring financial settlement was reduced by 98%, from $14.3 billion gross in aggregate U.S. dollar terms to $288 million net. Gross settlements by the 14 participating OTC derivatives dealers were consolidated from 340,000 to 123 net settlements. Payments were made in five currencies: the US dollar (USD), euro (EUR), Japanese yen (JPY), British pound (GBP) and Swiss franc (CHF).

"There are few opportunities of this magnitude in the OTC derivatives market to reduce operational risks while at the same time increase operating efficiencies," said Diane Schueneman, head of Global Infrastructure Solutions, Merrill Lynch & Co., Inc. "The central settlement service developed by DTCC and CLS represents a tremendous advance for the operations area of this industry."

"Central settlement provides the credit derivatives market with infrastructure that assures certainty of payment and processing scalability to address the explosion of credit derivatives transaction volume and the inherent operational risk of the previous highly manual processes," said Randolph Cowen, co-Chief Administrative Officer, Goldman Sachs. "The central settlement process, which leverages DTCC's Trade Information Warehouse, has produced full straight-through processing, allowing us to go all the way from confirmation to payment calculation to settlement with virtually no manual intervention."

How the central settlement service works

With the new service, bilateral netting and settlement is completed and reports generated for counterparties early in the morning on settlement day. The function has been designed to enable payments associated with transactions confirmed through Deriv/SERV and residing in the Warehouse's global contract repository to be netted by value date, currency and counterparty. Payments eligible for settlement include initial payments and one-time fees, coupon payments and payments associated with post-trade events.

The Warehouse generates bilaterally netted payment instructions and sends them to CLS for settlement. CLS automatically notifies its Settlement Members, who effect settlement through CLS on a multilateral, netted basis. Over time, the number of currencies in which payments can be made will be expanded from the initial five.

"The settlement service breaks new ground in OTC derivatives operations," said Michael C. Bodson, DTCC executive managing director, Business Management, Strategy and Marketing for all DTCC businesses. "Counterparties used to manage payment reconciliations and funds transfers for thousands of payments on a bilateral basis using manual processes. Now, once trades are fed into the Trade Information Warehouse, these steps are handled automatically and, for the first time, counterparties obtain a full audit trail. The results in terms of cost savings, risk mitigation and efficiency gains are tremendous."

During the initial launch, which followed an extensive testing period, the participating dealers settled with each other in defined clusters. During 2008 additional dealers will go live on the service, and participants will begin settling among each other outside of their defined clusters. Also during 2008 the Warehouse's settlement capabilities will be expanded in preparation for bringing buy-side firms on board.

Market transformation through industry collaboration

"By combining CLS's multi-currency liquidity management capability with DTCC's automated processing platform for OTC derivatives, the new central settlement service demonstrates how industry utilities working together can provide enhanced value to the market," said Rob Close, President and CEO, CLS Bank International. "The synergies between our organizations and the efforts of our Member banks have enabled us to deliver this important new service in record time and at low cost."

DTCC and CLS initiated their partnership to build the central settlement solution in December 2006.

CLS Bank International is an integral part of the foreign exchange market, settling more than 400,000 instructions equivalent to approximately $4 trillion each day. The bank provides global settlement services in 15 currencies.

DTCC Deriv/SERV was established in late 2003 to reduce operational risks and increase operating efficiencies for participants in the OTC derivatives market by automating the post-trade processing of OTC financial derivatives transactions. Deriv/SERV is the only post-trade service provider used by all major global derivatives dealers to process transactions in the three primary asset classes—credit, interest rates and equity--which enables market participants to manage these instruments on a single platform.

With a customer base of more than 1,050 dealers and buy-side firms in 31 countries, Deriv/SERV has the world's largest community of users of automated post-trade processing services for OTC derivatives transactions. In 2007, Deriv/SERV processed more than 5.8 million OTC derivatives transactions.

The central settlement function was launched one year after creation of the Trade Information Warehouse. During that year dealers completed the backloading into the Warehouse of their inter-dealer credit derivative contracts and the Warehouse introduced payment calculation as well as its credit event processing capability, which industry participants now rely on to verify credit events under various scenarios. Warehouse backloading and payment calculation, along with the settlement infrastructure and global reach of CLS, were essential building blocks to bring the settlement service to market.