Lifecycle Event Processing

During the life of a trade, processing such as obtaining rate fixings and confirming consent to a change of counterparty is needed. The results are reflected in the trade record and the reporting data.

Events during the life of a trade

An OTC derivative trade still needs processing after it is executed and the trade confirmation is exchanged, all the way to maturity. An event that occurs between the start and end of a trade and changes its payments or status is called a lifecycle event. A typical example is one that recurs throughout the contract, such as the quarterly payment on a credit default swap (CDS). Before 2005, the CDS market had no central record of trades, which made these events hard to manage¹.

Recorded trades are revalued periodically during their life and eventually leave the books when they mature or are sold, unwound, exercised, or expire worthless². What happens to a trade next depends on the event. The table below sets out the main events, based on the event types that the Financial Services Agency (FSA) guidelines list for trade reporting³.

Maturity is when a trade ends on the date set in the contract, and reporting treats it separately from termination before maturity⁴.

Interest payment events

In a floating rate trade, the benchmark rate to be used for each interest period is set, and that value determines the amount to be paid or received. Setting the benchmark rate value used for an interest period is called rate fixing.

When a floating rate is set depends on the benchmark. TIBOR and TORF are set in advance, while TONA compounded in arrears is set in arrears, just before the interest payment date⁵. In a trade set in arrears, the amount is not known until just before the payment date. As of May 2022, market participants in Japan were still preparing their systems, operational workflows, and staffing for trades using compounding in arrears, which had been unfamiliar in the domestic market until then⁶.

For scheduling, fixing dates and payment dates are set by the business day convention and by which city's holidays apply (the calendar). The conditions for interest rate swaps cleared by Japan Securities Clearing Corporation (JSCC) list the calendar for interest payments and the calendar for rate fixing as separate items⁷.

The fixing procedure (an FX example)

Like interest rates, foreign exchange trades also have fixings. The fixing procedure is set out in concrete terms in the operational best practices of the Foreign Exchange Committee in the United States (2010 revision, the "best practices" below). They are industry goals for foreign exchange trades, not binding rules⁸. For FX trades that need a fixing, such as NDFs and average rate options, the steps below are recommended. Obtaining the fixing and notifying the counterparty is the job of back-office (operations and settlement) staff independent of the front office (sales and trading)⁹.

1. On the trade date, review the confirmation to identify the source of the fixing rate, and record that information in the back-office system.
2. Review outstanding trades every day so that no trade reaching its fixing date misses its fixing.
3. On the fixing date, back-office staff obtain the rate from the source set in the confirmation.
4. Back-office staff send the counterparty a notice showing the fixed rate and the settlement amount, electronically where possible.

Example: calculating the interest amounts

Consider a hypothetical example in which a financial institution and Company Z have an interest rate swap with a notional amount of 10 billion yen. The financial institution pays a fixed rate of 1% a year, and Company Z pays 6-month TIBOR. Both legs use the Actual/365 (Fixed) day count convention. The floating rate leg of swaps cleared by JSCC also uses this convention⁷. Under this convention, you divide the actual number of days in the interest period by 365 to express it in years. You then multiply by the notional amount and the rate to get the interest¹⁰. The period in this example has 182 days. Each interest amount is calculated as follows.

$$\text{Interest} = \text{Notional amount} \times \text{Rate} \times \frac{\text{Days}}{365}$$

The table shows the amounts when TIBOR fixes at 0.8% and at 1.2%. Amounts are rounded down to the nearest yen.

The fixed value decides which party pays more. If the fixing were mistakenly taken as 0.85% instead of 0.8%, Company Z's interest would be 42,383,561 yen, off by 2,493,151 yen.

The steps for paying and receiving the amounts once they are set (payment instructions, matching incoming payments, and so on) are covered in Settlement.

Processing exercise, early termination, novation, and other events

Unlike interest payments, exercise, early termination, and novation either end a trade or replace it with another trade. A credit event moves the trade to the settlement process, and after a change of terms the trade continues.

Option exercise and expiry

For the exercise and expiry of currency options, the best practices recommend the following. At expiry, the strike price is compared with the market rate to determine the intrinsic value and whether exercising pays off (whether the option is in the money). Because an in-the-money trade could fail to be exercised, senior operations management defines roles and responsibilities in advance¹¹. Determining whether an option is in the money and notifying the counterparty are done through an independent electronic system. Exercise is kept separate from the front office (segregation of duties) and handled by staff who communicate between the front and back offices. Systems are designed to exercise in-the-money trades automatically, and exercise is checked against market rates to confirm that it was done correctly¹².

For a trade that can be exercised at any time during its life, such as an American option, the date on which the exercise takes effect becomes the date of termination before maturity. Whether the financial institution exercised as the buyer or was exercised against as the seller, reporting treats it as termination by exercise¹³. Exercising a swaption creates the underlying interest rate swap as a new trade¹⁴. When an equity barrier option knocks out and the trade disappears, reporting also treats it as termination before maturity⁴.

Early termination

Around 2006, most OTC derivatives could only be canceled by agreement with the counterparty¹⁵. Early termination can be negotiated between the parties, triggered by an early termination clause in the contract, exercised under a clause set in the original contract such as in a callable swap, or done through compression. A trade can also be partly terminated¹⁶.

Novation (change of counterparty)

A novation is when one party to a trade steps out and a third party takes its place¹⁷. The original trade ends, and a new trade is formed between the remaining party and the party that stepped in. When only part of a trade is transferred, the original trade also remains³¹⁸. The steps, divided among the party stepping out, the party stepping in, and the remaining party, are as follows¹⁹.

1. The party stepping out agrees to transfer the trade to the party stepping in.
2. The remaining party is informed that the party stepping in will take over, and consents to the other party stepping out.
3. A new trading relationship is formed between the remaining party and the party stepping in.

Consider a hypothetical example in which Bank X steps out of its trade with Company Z and transfers it to Company Y. Company Z is the remaining party, Bank X is the party stepping out, and Company Y is the party stepping in.

Figure description

First, Bank X agrees to transfer the trade to Company Y (step 1). Next, Company Z is told that Company Y will step in, and agrees to Bank X's exit (step 2). A new trade is then formed between Company Y and Company Z (step 3), and when the whole trade is transferred, the original trade between Bank X and Company Z ends.

A novation changes the counterparty whose credit risk you bear. Transferring trades to another counterparty is one way to reduce exposure to a particular counterparty²⁰.

According to 2008 testimony before the US Congress by the Federal Reserve Board, the master agreements for OTC derivatives require the party stepping out to obtain its counterparty's prior written consent. Around 2005, in the CDS market, dealers often accepted novations without evidence of that consent, unconfirmed trades piled up, and it became unclear who the counterparties were¹⁷. Counterparty changes made without informing the counterparties also led to failed reconciliations and breaks in payment flows¹.

Submitting a trade to a central counterparty also ends the original parties' trade and replaces it with trades against the central counterparty³.

Credit events

For a CDS, a credit event at the reference entity moves the trade to the settlement process. At first, CDS were settled by delivering bonds of the reference entity. Because the outstanding amount of CDS was large compared with the amount of bonds in the market, a scramble for bonds could occur, so an auction process was created that allows settlement without delivering bonds²¹.

Changes to terms

When the parties negotiate a change to the terms, the trade continues and only the terms are updated⁴.

Documents and data used

Event processing is based on documents that set out the terms of the trade. Bookkeeping entries and settlement during the life of a trade are supported by copies of the trade agreement, and payment or receipt orders at maturity are initiated from those copies². For foreign exchange trades, the rate used for fixing and its source are set in the confirmation⁹.

Rows 2 to 5 of the table are data items that the FSA guidelines specify for trade reporting²².

Departments and their roles

The table below arranges the division of work shown in the US Federal Reserve Board's examination manual (2003 edition) and the best practices (2010 revision) in terms of the front and back offices. How departments are organized and how work is divided differ from one financial institution to another²³. The overall roles of each unit are covered in Front, Middle and Back Office Roles.

Common problems and how to prevent them

The main problems, and the preventive measures that are recommended, are listed below.

Related regulation and contracts

On the contract side, master agreements are said to require the prior written consent of the counterparty for a novation (2008 US congressional testimony)¹⁷. An interest rate swap submitted to JSCC must meet the conditions JSCC sets, such as the day count convention and calendars⁷.

On the regulatory side, trade reporting covers lifecycle events. In Japan, financial instruments business operators, etc. provide trade information to a trade repository or other recipients²⁵. Lifecycle events are also reported, tagged with a type such as exercise, early termination, or novation⁴³.

Notes

1. Duffie, Li, and Lubke, "Policy Perspectives on OTC Derivatives Market Infrastructure" (Federal Reserve Bank of New York Staff Report no. 424, revised March 2010; "Staff Report 424" below), page 3, the explanations in Table 1 of the new central repository and of counterparty transparency. ↩ ↩² ↩³

2. Board of Governors of the Federal Reserve System, "Trading and Capital-Markets Activities Manual" ("examination manual" below), Section 2060.1 "Operations and Systems Risk (Back-Office Operations)" (February 1998), page 3. ↩ ↩²

3. Financial Services Agency, "店頭デリバティブ取引等の規制に関する内閣府令第４条第１項で定める作成・保存・報告事項 ガイドライン" (Guidelines on the items to be prepared, retained, and reported under Article 4, paragraph 1 of the Cabinet Office Order on the regulation of OTC derivatives transactions, our translation; December 2022; "FSA guidelines" below), item 102 "Event type" in the table of reporting items (page 27) (in Japanese). ↩ ↩² ↩³ ↩⁴

4. FSA guidelines, definition and notes of item 101 "Action type" in the table of reporting items (page 26) (in Japanese). ↩ ↩² ↩³ ↩⁴ ↩⁵

5. Bank of Japan et al., "円LIBOR移行対応の振り返りと今後の取り組み" (Bank of Japan Review 2022-J-8, May 2022, in Japanese), page 3, Chart 2, the row "金利決定のタイミング" (Timing of rate fixing). English version: "Review of JPY LIBOR Transition and Future Initiatives" (Review 2022-E-4), page 3, Chart 2. ↩

6. Bank of Japan Review 2022-J-8 (in Japanese), page 7. English version: "Review of JPY LIBOR Transition and Future Initiatives" (Review 2022-E-4); the page number refers to the Japanese version. ↩

7. Japan Securities Clearing Corporation, "清算対象取引（金利スワップ）" (Transactions eligible for clearing: interest rate swaps, in Japanese), conditions for transactions whose obligations JSCC assumes, items 11 to 14 (day count fraction, business day adjustment, and the calendars for interest payments and for rate fixing). The calendar for rate fixing is called 金利更改 in the Japanese conditions. English version: "Clearing Products," items 11 to 14. ↩ ↩² ↩³

8. The Foreign Exchange Committee, "Management of Operational Risk in Foreign Exchange" (November 2004, revised November 2010; the best practices), "The History of This Document" (page 5) and "What Are 'Best Practices'?" (page 6). ↩

9. Best practices, "Process Description" under "Unique Features of Foreign Exchange Options and Non-Deliverable Forwards" (page 39), and Best Practice no. 46 (page 40). ↩ ↩² ↩³ ↩⁴

10. European Banking Federation, supplement on interest rate transactions (Edition 2020), Section 4(1) (page 2) and Section 4(7)(g) "Actual/Fixed 365" (page 3). ↩

11. Best practices, "Process Description" under "Unique Features of Foreign Exchange Options and Non-Deliverable Forwards" (page 39). ↩ ↩²

12. Best practices, Best Practice no. 45 (pages 39–40). ↩ ↩² ↩³ ↩⁴ ↩⁵

13. FSA guidelines, notes to item 3 "Early termination date" (page 4) and to item 101 "Action type" (page 26) in the table of reporting items (in Japanese). ↩

14. FSA guidelines, Attachment 2 (approach to assigning UTIs), page 6, footnote 8 (in Japanese). ↩

15. Examination manual, Section 2030.1 "Market Liquidity Risk of Trading Activities" (September 2006), page 1. ↩

16. FSA guidelines, definition of item 3 "Early termination date" in the table of reporting items (page 4), and Attachment 2, page 7, footnote 9 (in Japanese). ↩

17. Board of Governors of the Federal Reserve System, "Over-the-counter derivatives" (testimony by Patrick M. Parkinson before a subcommittee of the U.S. Senate, July 9, 2008), "Supervisory Efforts to Strengthen the Infrastructure of the OTC Credit Derivatives Market," second paragraph. ↩ ↩² ↩³ ↩⁴

18. FSA guidelines, Attachment 2, pages 6–7, "５．その他の論点" (5. Other issues), item (1), and footnotes 8 to 10. The CCP attaching the prior trade's UTI is in the notes to item 26 "Prior UTI" in the table of reporting items (page 9) (in Japanese). ↩ ↩²

19. Staff Report 424, page 26 (page 29 of the PDF), Appendix D "Novation." ↩

20. Examination manual, Section 2020.1 "Counterparty Credit Risk and Presettlement Risk" (March 1999), page 10. ↩

21. Staff Report 424, pages 3–4, the explanation of CDS settlement in Table 1. ↩

22. FSA guidelines, table of reporting items: early termination date, item 3 (page 4); prior transaction identifier (Prior UTI), item 26 (page 9); fixing date, item 30, and floating rate reset frequency period, item 31 (page 11); strike price, item 75 (page 20); first exercise date, item 84 (page 22) (in Japanese). ↩

23. Examination manual, Section 2060.1 (April 2003), page 1. ↩

24. Examination manual, Section 2060.1 (April 2003), page 2. ↩ ↩²

25. FSA guidelines, Attachment 2, page 1, "１．背景・概要" (1. Background and overview) (in Japanese). ↩