What is a Hedge Fund?
A hedge fund is a loosely regulated private investment fund that charges a management and performance fee.
A hedge fund collects its funds from private wealthy individuals and large institutions and uses funds to trade securities with the hope of capital and income appreciation. Unlike other investment vehicles, hedge funds concentrate on making a consistent absolute return rather than a relative return to a benchmark index. One important distinguishing factor a hedge fund has compared to traditional mutual funds and asset management companies is that a hedge fund is allowed to use almost any structured product. This means that they are allowed to engage in leveraged derivative positions as well as shorting securities, a method usually forbidden at mutual funds. Hedge funds traditionally identify inefficiencies in the financial markets and trade to capture profits from them.
Growth of Hedge Funds
In the last 9 years hedge funds have grown in number by approximately 20% every year.
Currently there are an estimated 9000 hedge funds in the world managing over 1.1 trillion USD. The assets within each hedge fund are also growing every year. Performance is said to account for a third of this increase.
Hedge funds are said to account for around 50 billion USD of fees on Wall Street and City investment banks. They make up more than 50% of US bonds trading, 40% of equity trades and over three quarters of distressed debt trading (explanations of these terms come at a later section).
Laws Relating to Hedge Funds
Hedge funds by all reasonable definitions fall under the definition of an investment company
This means that according to the Investment Company Act of 1940 they need to be registered with the SEC as an investment advisor. There are two exemptions which hedge funds elect however. The first one is under Section 3(c) (1) and the other under Section 3 (c) (7). A 3 (c) 1 fund is simply one that has no more than 100 investors and is not making or planning to make a public offering of its securities. A 3(c) (7) fund is one where the investors of the fund are at the time of the acquisition “qualified purchasers”, meaning that they have more than 5 million USD of assets.
Given these two restrictions the hedge fund can sell its “shares” under what is called Regulation D. Regulation D allows companies to sell shares of the company under private placements. This is a direct private offering of securities to a limited number of sophisticated investors. This is unlike a public offering of stock which can be even sold to the retail. A company can issue shares and sell it as a private placement if it wants to avoid dealing with all the legal mess and financial costs of investment banking fees and registration. The drawback is however that they can only sell them to limited investors with a net worth of at least 1 million USD or minimum income of 200’000 USD in each year in the past two years and expecting it to continue in the future. Given these exemptions a hedge fund can sell itself to wealthy individuals and institutions without the need to register.
Hedge Funds in India
An interesting link to track progress about Hedge Funds in India : http://www.hedgefundsindia.com/
HFG India Continuum Fund
Hudson Fairfax Group (HFG) is an investment partnership focused on India’s aerospace, defense, homeland security and other strategic sectors. It is based in New York with an advisory office in New Delhi. Its team has five decades of focused experience in the sector combining investment and industry expertise. Hudson Fairfax Group, through its predecessor company, started as an investment advisory firm in 2005. It ran an investment fund, the HFG India Continuum Fund, which invested in publicly traded Indian securities. During the operation of its fund, HFG was a Registered Investment Advisor (RIA) with the U.S. Securities & Exchange Commission and a Foreign Institutional Investor (FII) with the Securities & Exchange Board of India.
Avatar Investment Management
Avatar Investment Management is the investment advisor to three funds. Headquartered in Mauritius, the funds are focussed on the Indian public and private equity markets. In order to meet the approval of various regulatory bodies around the world, only accredited investors may apply to invest.
India Deep Value Fund
India Investment Advisors, LLC was founded by Robin Rodriguez and Raj Agarwal in 2006 to pursue the number of significant investment opportunities presented by the burgeoning Indian capital and real estate markets. As a result, the India Deep Value Fund was launched in April 2006. The Fund's Managers seek to achieve long-term capital gains by acting as pro-active deep value investors in publicly-traded Indian stocks.
Fair value
Fair Value Capital is a highly specialized and exclusive Investment Advisory Firm focused on Deep Value Investment opportunities primarily in Indian equity markets. It seek absolute, long-term returns for its investments while minimizing investment risks using a Value oriented approach towards our investments. Fair Value specializes in Deep Value Investments in the Indian equity markets.
Indea Capital Pte Ltd
Indea Capital Pte. Ltd (Indea) is a Singapore based investment advisor. Indea was formed in 2002 to provide boutique fund management services to institutions, foundations, family offices and high net-worth individuals. In July 2003, Indea launched the Indea Absolute Return Fund (IARF), a directional fund investing in India and Indian companies globally. The principals have a combined over 30 years of experience in researching and investing in India. In addition to the Singapore office, Indea has a research presence in Mumbai, India.
Thursday, April 7, 2011
Tuesday, April 5, 2011
American and European Options
The most basic difference between an American option and a European option is that a European option may only be exercised on the expiration date, while an American option may be exercised at any point before that date. All options give the holder the option, but not the obligation, to buy (in the case of a call) or sell (in the case of a put).
All options on individual stocks are American style. Options on the major indexes (OEX is an exception) are European. Some examples of actively traded European style options:
SPX: Standard & Poor’s 500 Index
DJX: Dow Jones
Industrial Average
NDX: NASDAQ 100 Index
RUT: Russell 2000 (small cap) Index
Differences in Value
Typically, because an option’s value is based largely on the amount of time left until expiration, the holder of an option usually prefers to close the option position rather than exercise the option. There are rare instances, however, when the owner of an American option will prefer to exercise the option rather than close the position.
For example, just before the underlying stock pays a dividend, if the option’s value falls by more than the remaining value, it is advantageous to exercise the option. Because of the anomalous instances, calculating the value of an American option can be difficult.
Essentially, while a European option can be accurately valued using the famous Black-Scholes pricing model, American options require a more complex pricing model. What most traders need to understand is that an American option will always be worth at least what a European option is worth.
**Asian Options**
An Asian option (or average value option) is a special type of option contract. For Asian options the payoff is determined by the average underlying price over some pre-set period of time. This is different to the case of the usual European option and American option, where the payoff of the option contract depends on the price of the underlying instrument at maturity; Asian options are thus one of the basic forms of exotic options.
One advantage of Asian options is that these reduce the risk of market manipulation of the underlying instrument at maturity. Another advantage of Asian options involves the relative cost of Asian options compared to European or American options. Because of the averaging feature, Asian options reduce the volatility inherent in the option; therefore, Asian options are typically cheaper than European or American options. This can be an advantage for corporations that are subject to the FASB revised Statement No. 123, which requires that corporations expense employee stock options.
All options on individual stocks are American style. Options on the major indexes (OEX is an exception) are European. Some examples of actively traded European style options:
SPX: Standard & Poor’s 500 Index
DJX: Dow Jones
Industrial Average
NDX: NASDAQ 100 Index
RUT: Russell 2000 (small cap) Index
Differences in Value
Typically, because an option’s value is based largely on the amount of time left until expiration, the holder of an option usually prefers to close the option position rather than exercise the option. There are rare instances, however, when the owner of an American option will prefer to exercise the option rather than close the position.
For example, just before the underlying stock pays a dividend, if the option’s value falls by more than the remaining value, it is advantageous to exercise the option. Because of the anomalous instances, calculating the value of an American option can be difficult.
Essentially, while a European option can be accurately valued using the famous Black-Scholes pricing model, American options require a more complex pricing model. What most traders need to understand is that an American option will always be worth at least what a European option is worth.
**Asian Options**
An Asian option (or average value option) is a special type of option contract. For Asian options the payoff is determined by the average underlying price over some pre-set period of time. This is different to the case of the usual European option and American option, where the payoff of the option contract depends on the price of the underlying instrument at maturity; Asian options are thus one of the basic forms of exotic options.
One advantage of Asian options is that these reduce the risk of market manipulation of the underlying instrument at maturity. Another advantage of Asian options involves the relative cost of Asian options compared to European or American options. Because of the averaging feature, Asian options reduce the volatility inherent in the option; therefore, Asian options are typically cheaper than European or American options. This can be an advantage for corporations that are subject to the FASB revised Statement No. 123, which requires that corporations expense employee stock options.
Clean Shell/Public Shell
Clean Shell/Public Shell
A reporting company. It has its filings current. It doesn't have debt. There are no lawsuits, nor reasonable prospects of a lawsuit against the company. The insiders retain control of 80%-90% of the issued shares.
Public shell is a viable alternative to going public. In more formal circles they can be referred to as public shell company or public shell corporation.
Public shell transactions are a widely accepted, alternative mean for a private company to go public. A necessary component to a completed reverse merger transaction is the public shell. The public shell is a publicly listed company with no assets or liabilities. It is called a "shell" considering all that exists of the original company is its corporate shell structure. By merging into such an entity, a private company becomes public.
The primary benefits of doing a Public shell, as opposed to an IPO, is the following:
• You will receive a higher valuation for your company.
• The company does not require an underwriter.
• The costs are significantly less than the costs required for an initial public offering.
• The time required is considerably less than for an IPO.
• IPOs generally require greater attention from top management.
• There is less dilution of ownership control.
• While an IPO requires a relatively long and stable earning history, the lack of an earning history does not normally keep a privately-held company from completing a reverse merger.
The fees associated with a standard IPO are also extremely high. The company must pay for underwriting fees, legal fees, accounting fees, printing costs, and filing fees. With a public shell merger, the costs are much less to go public.
A reporting company. It has its filings current. It doesn't have debt. There are no lawsuits, nor reasonable prospects of a lawsuit against the company. The insiders retain control of 80%-90% of the issued shares.
Public shell is a viable alternative to going public. In more formal circles they can be referred to as public shell company or public shell corporation.
Public shell transactions are a widely accepted, alternative mean for a private company to go public. A necessary component to a completed reverse merger transaction is the public shell. The public shell is a publicly listed company with no assets or liabilities. It is called a "shell" considering all that exists of the original company is its corporate shell structure. By merging into such an entity, a private company becomes public.
The primary benefits of doing a Public shell, as opposed to an IPO, is the following:
• You will receive a higher valuation for your company.
• The company does not require an underwriter.
• The costs are significantly less than the costs required for an initial public offering.
• The time required is considerably less than for an IPO.
• IPOs generally require greater attention from top management.
• There is less dilution of ownership control.
• While an IPO requires a relatively long and stable earning history, the lack of an earning history does not normally keep a privately-held company from completing a reverse merger.
The fees associated with a standard IPO are also extremely high. The company must pay for underwriting fees, legal fees, accounting fees, printing costs, and filing fees. With a public shell merger, the costs are much less to go public.
Accrued Interest
A term used to describe an accrual accounting method when interest that is either payable or receivable has been recognized, but not yet paid or received. Accrued interest occurs as a result of the difference in timing of cash flows and the measurement of these cash flows.
The interest that has accumulated on a bond since the last interest payment up to, but not including, the settlement date.
The process of calculating the amount of interest accrued depends on identifying the number of days that have passed since the last disbursement of accrued interest to the owner of the bond. At the same time, it is important to know the rate of interest that is compounded at each schedule coupon date.
Accrued Interest = Interest payment * Number of days since last payment /Number of days between payments
Example:
Calculating the Purchase Price for a Bond with Accrued Interest
You purchase a corporate bond with a settlement date on September 15 with a face value of $1,000 and a nominal yield of 8%, that has a listed price of 100-08, and that pays interest semi-annually on February 15 and August 15. How much must you pay?
The semi-annual interest payment is $40 and there were 31 days since the last interest payment on August 15. If the settlement date fell on a interest payment date, the bond price would equal the listed price: 100.25% x $1,000.00 = $1,002.50 (8/32 = 1/4 = .25, so 100-08 = 100.25% of par value). Since the settlement date was 31 days after the last payment date, accrued interest must be added. Using the above formula, with 184 days between coupon payments, the actual purchase price for the bond will be $1,002.50 + $6.74 = $1,009.24
The interest that has accumulated on a bond since the last interest payment up to, but not including, the settlement date.
The process of calculating the amount of interest accrued depends on identifying the number of days that have passed since the last disbursement of accrued interest to the owner of the bond. At the same time, it is important to know the rate of interest that is compounded at each schedule coupon date.
Accrued Interest = Interest payment * Number of days since last payment /Number of days between payments
Example:
Calculating the Purchase Price for a Bond with Accrued Interest
You purchase a corporate bond with a settlement date on September 15 with a face value of $1,000 and a nominal yield of 8%, that has a listed price of 100-08, and that pays interest semi-annually on February 15 and August 15. How much must you pay?
The semi-annual interest payment is $40 and there were 31 days since the last interest payment on August 15. If the settlement date fell on a interest payment date, the bond price would equal the listed price: 100.25% x $1,000.00 = $1,002.50 (8/32 = 1/4 = .25, so 100-08 = 100.25% of par value). Since the settlement date was 31 days after the last payment date, accrued interest must be added. Using the above formula, with 184 days between coupon payments, the actual purchase price for the bond will be $1,002.50 + $6.74 = $1,009.24
Dynamics in payment processing for OTC derivatives trades
Introduction:
Payment processing is a critical function within the lifecycle of OTC trades. The majority of trades in the $465 trillion OTC derivative trading market are cash-settled. Too often settlement breaks in OTC trades occur as a direct result of mismatching cash flows between the receiving and paying entities on a bilateral agreement. A settlement break directly impacts books and records of a firm. In the new era of post regulation, with a mix of OTC cleared and non-cleared trades, as well as the increase in the number of bilateral contracts using cash as collateral, payment processing will emerge as one of the key operational areas for process efficiency.
However, if both parties establish an agreement on the payment amount to be settled, then they are ensured fixed trade economic details. Thus, a settled payment exchange between the two parties guarantees that both are capable of meeting their trade obligations.
Current payment process for OTC trades:
A payment transaction occurs during an OTC trade’s lifecycle process for the exchange of regular periodic cash flow, coupon payment, upfront payment, termination and innovation fees, credit events; rate reset fees, margin, collateral movement (including interest on collateral), claims and charges. Similar to the OTC trade confirmation process, every payment between the two counterparties is agreed, confirmed and matched before the payment value date. The bilateral netting process reduces the number of cash movements and lowers the cost of payment processing. To achieve the benefits of netting, a single payment instruction is linked to multiple underlying trade details. Firms’ internal systems record the payment history for OTC trades.
In addition, to store the golden and copper record of a credit default swap trade, the Depository Trust & Clearing Corporation Trade Information Warehouse (DTCC TIW) also processes payments for credit derivatives trades via a link with CLS Bank for settlements. Also the new DTCC cash flow matching system for equity derivatives will streamline the payment notices affirmation and confirmation process for OTC equity derivatives. Both initiatives support the industry drive towards standardization and transparency.
The fact that settlement matching and exception payment processing is still the least automated function in an OTC life cycle process highlights the multiple issues that exist within the OTC settlement function. Processing structured and collateralized debt securities has proved challenging ever since their inception in the market. Some of the payment processing issues facing firms include:
• Non standardization of collateralized-based asset types which, with their unique life cycle events, create payment processing inaccuracies
• Late and inaccurate notifications of payment reset rates for CMO’s, CLO’s and ABS Asset Types
• Higher payment processing failure rates due to a steep decline in the value of the assets
• Numerous post-value date adjustments, causing higher risk rates with lower efficiency returns
• Reversal of additional or initial payment due to change in reset rates
Account setup
To streamline regular payment processes, firms maintain standard payment instruction details for each currency, counterparty, account and payment type. This information is exchanged between counterparties on a regular basis usually by fax or email. Firms employ dedicated teams to set up new accounts for counterparties as well as to maintain all static data. When information is incorrect and/or must be changed, the manual process causes delays. A time delay occurs in verification of the changes and updates across all relevant systems, as well as across multiple payment processing platforms. There is no centralized platform or standard messaging to update the standard settlement instruction between the dealers, buy-side firms and custodian.
Payment notices
Payment notices are sent out by firms giving details of the upcoming payment and the various trade elements which are used in the calculation. The payment notice highlights the currency, value date, amount, payer, receiver, account details, rate, period, trade identifiers and trade details used in the calculation. Though payment notices are typically auto-generated from internal proprietary systems, the communication with counterparty is still manual, through telephone, fax and email. The verification of payment notices is also manual and time consuming from the receiver of the payment notices side. Without uniformed payment notice templates available to communicate the details, there becomes a need for multiple interpretations. The variation of the payment notices for each asset class adds more spice to this process.
Life cycle events
A consistent challenge exists to maintain a single copy of an OTC trade across its life cycle. An event in the life cycle involves a cash movement between two counterparties. A correct identification of the life cycle event ensures correct payment calculation. There is no industry data available to identify the number of payments across each payment type. Any change in the benchmark floating rate triggers a control point to validate the payment. Every incoming or outgoing payment due before the value date is sent to the Treasury unit for funding. The Treasury group in an organization ensures that the required amount is made available in the Nostro account for outgoing payments and earns interest on the additional funds by investing in the overnight market.
Payments related to collateral movement and initial margin
Cash is the most preferred asset used as collateral against a counterparty risk. Initial margin is typically referred to as a good faith deposit or a cushion payment to cover initial day market movement and can be requested intra-day on volatile market days. Thresholds and minimum transfer amounts are other parameters used to identify whether payment transactions should be made. Thresholds allow counterparties to take a certain amount of unsecured credit risk equal to the threshold without requiring collateral to cover the additional risk. Though cash by nature is fungible, collateral management process demands that independent amount, initial margin and variation margin can be tracked to each customer. The recent financial crisis, regulations and industry initiatives have ensured that this traceability is necessary for the financial system.
The effect of incorrect payments
The majority of firms have write-off policies to protect against failed transactions, which can occur for multiple reasons. Amounts to be written off can include back valuation charges, interest compensation, loss on funding and overdraft charges. Such charges directly impact the firms’ P&L. Depending on the trade situation an incorrect payment can be back-valued. When payments are back-valued, there are two outcomes:
• The paying party pays the back valuation charges and the receiving party receives the payment on a specified good value date
• The paying party chooses to make a late payment in which the payment is delivered to the receiver with a new value date and the paying party pays the late payment fees
Then, there is also the manual process involved with the reversal of incorrect payments and the cumbersome reconciliation process that must take place to re-receive and or re-send a payment. While incorrect payments vary based on the particular product specification, and in general represent only a small fraction of all payments made, the losses associated with incorrect payments can be substantial. A missed or incorrect payment may lead to complete portfolio reconciliation. There are no industry wide guidelines for OTC products. Thus each institution has set its own policies and guidelines for processing interest compensation claims.
The effect of central clearing
Clearing houses mediate every buy and sell of member firms. The member firm pays membership fees and posts collateral for every trade cleared at a clearinghouse. With the Dodd-Frank Act mandating more centrally cleared trades, there will be increased transparency (mark-to-market pricing) all of which can be monitored. Cash flow and collateral reports for OTC trades from clearing houses are still evolving. Firms using clearing members should demand added transparency on their collateral and payment flows. In addition the clearing members’ demand for fees to clear the trade should be negotiated. The back loading of the trades from the traditional OTC cleared world should include updating of the payment process and instructions.
Reconciliation
Reconciliation of payments for OTC derivatives poses some of the greatest business challenges due to their definite economic impact. Un-reconciled payments directly increase firms’ liability. Firms monitor their Nostro accounts closely to make sure that no unidentified counterparty cash is left sitting in them. The reconciliation process is extremely manual and labor intensive, consisting of excel spreadsheets and novated agreements between counterparties. Reconciliation methodologies are usually proprietary to firms and reconciliation break accounting is manual.
Industry initiatives such as trade netting and portfolio compression are used to reduce the number of trades and payments to be processed. The number of breaks reconciled within two days has increased across asset classes.
Conclusion
Payment settlement matching is one of the least automated functions in the OTC trade lifecycle function. Payment processing for certain trade events should not be automated due to trade complexity, counterparty complexity or the nature of the payment. With the renewed focus on risk management, counterparty exposure calculation is one of the prime functions in credit risk management including payments in transit, failed payments, past due and currently unsettled payments with the counterparty. A non-payment incident immediately triggers the risk management team to re-evaluate the counterparty exposure risk. Settlement functions are performed in a low cost centre. However, increasing value additional services in payment processing for OTC derivatives either through process efficiency or automation still remains the major factor.
Payment processing is a critical function within the lifecycle of OTC trades. The majority of trades in the $465 trillion OTC derivative trading market are cash-settled. Too often settlement breaks in OTC trades occur as a direct result of mismatching cash flows between the receiving and paying entities on a bilateral agreement. A settlement break directly impacts books and records of a firm. In the new era of post regulation, with a mix of OTC cleared and non-cleared trades, as well as the increase in the number of bilateral contracts using cash as collateral, payment processing will emerge as one of the key operational areas for process efficiency.
However, if both parties establish an agreement on the payment amount to be settled, then they are ensured fixed trade economic details. Thus, a settled payment exchange between the two parties guarantees that both are capable of meeting their trade obligations.
Current payment process for OTC trades:
A payment transaction occurs during an OTC trade’s lifecycle process for the exchange of regular periodic cash flow, coupon payment, upfront payment, termination and innovation fees, credit events; rate reset fees, margin, collateral movement (including interest on collateral), claims and charges. Similar to the OTC trade confirmation process, every payment between the two counterparties is agreed, confirmed and matched before the payment value date. The bilateral netting process reduces the number of cash movements and lowers the cost of payment processing. To achieve the benefits of netting, a single payment instruction is linked to multiple underlying trade details. Firms’ internal systems record the payment history for OTC trades.
In addition, to store the golden and copper record of a credit default swap trade, the Depository Trust & Clearing Corporation Trade Information Warehouse (DTCC TIW) also processes payments for credit derivatives trades via a link with CLS Bank for settlements. Also the new DTCC cash flow matching system for equity derivatives will streamline the payment notices affirmation and confirmation process for OTC equity derivatives. Both initiatives support the industry drive towards standardization and transparency.
The fact that settlement matching and exception payment processing is still the least automated function in an OTC life cycle process highlights the multiple issues that exist within the OTC settlement function. Processing structured and collateralized debt securities has proved challenging ever since their inception in the market. Some of the payment processing issues facing firms include:
• Non standardization of collateralized-based asset types which, with their unique life cycle events, create payment processing inaccuracies
• Late and inaccurate notifications of payment reset rates for CMO’s, CLO’s and ABS Asset Types
• Higher payment processing failure rates due to a steep decline in the value of the assets
• Numerous post-value date adjustments, causing higher risk rates with lower efficiency returns
• Reversal of additional or initial payment due to change in reset rates
Account setup
To streamline regular payment processes, firms maintain standard payment instruction details for each currency, counterparty, account and payment type. This information is exchanged between counterparties on a regular basis usually by fax or email. Firms employ dedicated teams to set up new accounts for counterparties as well as to maintain all static data. When information is incorrect and/or must be changed, the manual process causes delays. A time delay occurs in verification of the changes and updates across all relevant systems, as well as across multiple payment processing platforms. There is no centralized platform or standard messaging to update the standard settlement instruction between the dealers, buy-side firms and custodian.
Payment notices
Payment notices are sent out by firms giving details of the upcoming payment and the various trade elements which are used in the calculation. The payment notice highlights the currency, value date, amount, payer, receiver, account details, rate, period, trade identifiers and trade details used in the calculation. Though payment notices are typically auto-generated from internal proprietary systems, the communication with counterparty is still manual, through telephone, fax and email. The verification of payment notices is also manual and time consuming from the receiver of the payment notices side. Without uniformed payment notice templates available to communicate the details, there becomes a need for multiple interpretations. The variation of the payment notices for each asset class adds more spice to this process.
Life cycle events
A consistent challenge exists to maintain a single copy of an OTC trade across its life cycle. An event in the life cycle involves a cash movement between two counterparties. A correct identification of the life cycle event ensures correct payment calculation. There is no industry data available to identify the number of payments across each payment type. Any change in the benchmark floating rate triggers a control point to validate the payment. Every incoming or outgoing payment due before the value date is sent to the Treasury unit for funding. The Treasury group in an organization ensures that the required amount is made available in the Nostro account for outgoing payments and earns interest on the additional funds by investing in the overnight market.
Payments related to collateral movement and initial margin
Cash is the most preferred asset used as collateral against a counterparty risk. Initial margin is typically referred to as a good faith deposit or a cushion payment to cover initial day market movement and can be requested intra-day on volatile market days. Thresholds and minimum transfer amounts are other parameters used to identify whether payment transactions should be made. Thresholds allow counterparties to take a certain amount of unsecured credit risk equal to the threshold without requiring collateral to cover the additional risk. Though cash by nature is fungible, collateral management process demands that independent amount, initial margin and variation margin can be tracked to each customer. The recent financial crisis, regulations and industry initiatives have ensured that this traceability is necessary for the financial system.
The effect of incorrect payments
The majority of firms have write-off policies to protect against failed transactions, which can occur for multiple reasons. Amounts to be written off can include back valuation charges, interest compensation, loss on funding and overdraft charges. Such charges directly impact the firms’ P&L. Depending on the trade situation an incorrect payment can be back-valued. When payments are back-valued, there are two outcomes:
• The paying party pays the back valuation charges and the receiving party receives the payment on a specified good value date
• The paying party chooses to make a late payment in which the payment is delivered to the receiver with a new value date and the paying party pays the late payment fees
Then, there is also the manual process involved with the reversal of incorrect payments and the cumbersome reconciliation process that must take place to re-receive and or re-send a payment. While incorrect payments vary based on the particular product specification, and in general represent only a small fraction of all payments made, the losses associated with incorrect payments can be substantial. A missed or incorrect payment may lead to complete portfolio reconciliation. There are no industry wide guidelines for OTC products. Thus each institution has set its own policies and guidelines for processing interest compensation claims.
The effect of central clearing
Clearing houses mediate every buy and sell of member firms. The member firm pays membership fees and posts collateral for every trade cleared at a clearinghouse. With the Dodd-Frank Act mandating more centrally cleared trades, there will be increased transparency (mark-to-market pricing) all of which can be monitored. Cash flow and collateral reports for OTC trades from clearing houses are still evolving. Firms using clearing members should demand added transparency on their collateral and payment flows. In addition the clearing members’ demand for fees to clear the trade should be negotiated. The back loading of the trades from the traditional OTC cleared world should include updating of the payment process and instructions.
Reconciliation
Reconciliation of payments for OTC derivatives poses some of the greatest business challenges due to their definite economic impact. Un-reconciled payments directly increase firms’ liability. Firms monitor their Nostro accounts closely to make sure that no unidentified counterparty cash is left sitting in them. The reconciliation process is extremely manual and labor intensive, consisting of excel spreadsheets and novated agreements between counterparties. Reconciliation methodologies are usually proprietary to firms and reconciliation break accounting is manual.
Industry initiatives such as trade netting and portfolio compression are used to reduce the number of trades and payments to be processed. The number of breaks reconciled within two days has increased across asset classes.
Conclusion
Payment settlement matching is one of the least automated functions in the OTC trade lifecycle function. Payment processing for certain trade events should not be automated due to trade complexity, counterparty complexity or the nature of the payment. With the renewed focus on risk management, counterparty exposure calculation is one of the prime functions in credit risk management including payments in transit, failed payments, past due and currently unsettled payments with the counterparty. A non-payment incident immediately triggers the risk management team to re-evaluate the counterparty exposure risk. Settlement functions are performed in a low cost centre. However, increasing value additional services in payment processing for OTC derivatives either through process efficiency or automation still remains the major factor.
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