Credit derivative dealers were considering unilateral action last week to persuade hedge fund clients to adhere to the International Swaps and Derivatives Association's novation protocol. The protocol, issued Sept. 12, attempts to improve the process of confirming trades that dealers or hedge funds assign to third parties. So far, dealers have been more amenable to the initiative than hedge funds, who generally object to costs and restrictions associated with regulation.
Dealers will propose to the regulators that they submit to Depositary Trust and Clearing Corporation a list of five hedge funds with whom they trade each week. The DTCC would then compile the top 100 most-frequently-traded-with funds and require them to sign up to the protocol/DTCC by January. Any hedge fund on the list that did not agree to sign up would be subject to dealer boycott.
Regulators would presumably go along with such a proposal, as it would greatly advance their desire for transparency. Dealers, of course, would be running the risk of clients calling their bluff--a risk, apparently, they are willing to take.
Since Sept. 15, when the Federal Reserve met with 14 major banks and other regulatory agencies about concerns related to the growing backlog of unconfirmed trade assignments, dealers have been discussing strategies for improving trade-settlement infrastructure and processes. The Fed asked dealers to propose their own solutions and dealers are doing that in a letter which they planned to submit to regulators last Friday.
Mark Davies, senior managing director and global head of credit derivatives trading at Bear Stearns, said the letter will provide a timeline for dealers to clear the backlog, propose metrics for regulators to monitor confirmations and offer a practical description for implementing the protocol. The exact timeline for confirming all outstanding trades keeps changing, but the general goal is June 2006.
At press time, 49 institutions had signed up to the ISDA protocol, but only four hedge funds. "ISDA is working with participants from all sides of the industry in an attempt to coalesce market practice around the standards embodied in the protocol," said Louise Marshall, spokeswoman for ISDA in New York.
While lawyers expressed skepticism that dealers would refuse to trade with unsigned clients, Davies said he thinks refusal is "extremely realistic." David Thompson, managing director and global head of Credit Suisse First Boston's CDO group, agreed. "The introduction of regulators is making it more credible and feasible for dealers to draw that line in the sand," he said. Jim Healy, head of fixed income, and Wilson Ervin, head of strategic risk management, CSFB's two representatives to the meeting, were not available for comment.
