CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
1st July 2009 : Volume XLIX

E d i t
In sig h t s t e a m
Ashwinikumar Maslekar
Amit Kumar Choudhary
Bhargavi Hemanth
Meeta Ajit Sardesai
Praveena Sai Subramaniam
Ranajeet Dewasthalee
Sanjay Moolchandani
Srinivasan Venkataraman
Unnikrishnan Marar
F e e d b a c k
Your feedback & suggestions
are most welcome. Please mail
your inputs to
securities-newsletter@wipro.com
CAPITAL MARKETS
NSIGHTS
o r i a l A Domain Consulting Publication
The recent events in the securities industry have left a long lasting impression on the global economy, regulators and
participants alike. In the industry, the sea change has been the renewed interest in synthesizing information for a
greater understanding of risk. The world's leading investment banks, have adopted the route of cooptition (co-
operative competition) in sharing information which are non competitive in nature. We observe that industry players
are increasing their attention to the back office functions to
?
Stream line the process to enable greater STP between front, middle and back office
?
Redefine the source of cost to align the process to emerging business realities such as willingness of customer to
pay for the execution service is hard to come by. Operating margins need to be improved by further
streamlining supporting functions
?
Support cross border trades and new products innovation to achieve scale to support the effort to gain the
market share
One of the key components of these united efforts has been further progress towards automation of the middle and back
office processes. The recent events have highlighted the importance of efficient market practices, integration of capital
markets to achieve economies of scale and lower cost of operations. Initiatives like London Stock Exchange's
competitive clearing offerings for European Multilateral trading facilities and Fixed Income Clearing Corporation's
planned launch of CCP services for mortgage backed securities will transform the face of Clearing and Settlement
(C&S) domain in particular and the securities industry in general.
Advancements in technology will continue to play a very important role in driving these initiatives. Technology has
enabled industry participants to achieve cost efficiencies through flexible and scalable automation solutions. Today
technologies such as cloud computing and SAAS (Software as a Service) are taking the IT world by storm. This will not
only help reduce operational costs but also importantly support focusing on the core competencies. With the advent of
such technologies, a whole new world of unexplored opportunities has been presented to the securities industry,
especially in the middle and back office areas.
In this issue we cover the various aspects of Clearing and Settlement (C&S) in a trade lifecycle. We go on to
extrapolate the current C&S trends and attempt to provide a view on the future of C&S back office. A key highlight of
this issue is a detailed article on an esoteric concept called “Strange Nets”. We also highlight the importance of “Cloud
Computing” and its application in one of the important element of the securities industry - asset management.
We are confident that you will have a very pleasing experience of reading this issue. Happy reading!
Ranajeet Shriniwas Dewasthalee
Member – Clearing & Settlement Domain Focus Group
 CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
A r t i c l e s
Adoption of Business Process Management
By Investment Banks
Arvind Venkatesan
Today's competitive landscape brings sharp focus on
cost optimization, process efficiency, and customer
centricity Business Process Management (BPM) as a
management practice/approach promotes business
effectiveness and efficiency at one end and strives for
better innovation, flexibility, and integration with
technology on the other.
BPM provides tremendous gains through efficient
use of technology. It brings greater transparency in the
process lifecycle, facilitates continuous improvement,
and provides a holistic view of the organization's
processes. The five stages in a BPM lifecycle are Design,
Modeling, Execution, Monitoring, and Optimization.
DESIGN MODELING EXECUTION
• PROCESS FLOW
o f t h e M o n t h
This article provides a
primer on use for BPM
in investment banks and
the key considerations to
select the right BPM
have been deterred by factors like disparate processes, tool based on the
proprietary back office systems that are difficult to
organization's process
integrate, and manually run processes.
It is important to understand that the world of and technology
investment banks is extremely complex, encompassing landscape.
a range of service and product offerings, global and
cross border markets, increasing regulatory
compliance, and changing corporate governance rules.
An integrated approach to business processes,
technology, applications, and data will be the key to
managing this complexity and ensure future success.
IB Processes Suitable For BPM
Among the investment banks, one of the more
standardized processes is the account
opening/onboarding process. Of late, this has been the
first process to be initiated into BPM.
MONITORING OPTIMIZATION Through the trade lifecycle, from trade capture to

• STANDARD
• WHAT IF ANALYSIS

• INTRODUCE
• PROCESS
AUTOMATION
• TRACKING OF PROCESS • RETRIEVE PROCESS
PERFORMANCE
execution to settlement, the information and processes
• STATISTICS ON INFORMATION
OPERATING
PROCEDURE
COMBINATION OF
VARIABLES
• DEVELOP SOFTWARE
TO AUTOMATE
PROCESS
PERFORMANCE OF
PROCESS • IDENTIFY POTENTIAL
BOTTLENECKS
run seamlessly in certain places while it is quite
• SERVICE LEVEL • PROCESS MINING
AGREEMENT • POTENTIAL
OPPORTUNITIES FOR disjointed in other. The primary objective of BPMS is to
COST SAVINGS AND
Arvind Venkatesan
OTHER IMPROVEMENTS
minimize the extent of manual intervention and make
is a Sr Consultant in
There are a number of BPM systems (BPMS) that the whole process more streamlined.
the Clearing &
bring flexibility and efficiency to the organization. Settlement - Domain
While each system may have its core strengths and areas Back Office Operations
Focus Group within the Securities &
of focus, there are a standard set of components in offer. The entire back office operations function is one good Capital Markets Domain
The below diagram provides the BPM reference candidate for leveraging the strengths provided by Consulting Group and has varied
architecture applicable to most BPMS products. BPMS in bringing efficiency and efficacy to the process experience across Trading,
While the adoption of BPM has become quite flow. Operations, and Business Analysis
universal in manufacturing sectors and even financial Business rules management: Easy set up of business functions. He is based in New York,
services to a certain extent, investment banks have been rules allows the user to configure rules for all known USA. Email:
slow to warm up to the idea. In most cases, the banks scenarios. arvind.venkatesan@wipro.com
 CAPITAL MARKETS

3 NSIGHTS
A Domain Consulting Publication

BPM Journey & Adoption

Sales Business Brokers Customer
One needs to plan the adoption of BPM carefully into the organization
Groups
based upon process, technology, application, landscape and participation
Business Presentation Services Process
Activity Web Portals, Mobile and other
display channels
Modeling of key stakeholders.
Monitoring
ü ü ü
Event IDE for ia- Platform ia- SDLC ia- Architecture

Correlation & Business

Monitoring Process Execution Engine ( Rules, Collaboration & Event Services) Rules
Secure
Project
Product
selection
Project delivery
methodology
BPM
architecture
þ
Identify the project with the appropriate
Sponsorship

System Dynamic
IDE to
Next prioritized
processes
Business Rules Based Event develop
Monitoring
Rules
Resource
Assignment Access Generation Processes Continuous process improvement
process
þ
Select the right product-Have a thorough
Process Process Initial process
analysis of the existing off-the-shelf
Rules Manual / Work Item Event focus group
Project Monitor and Project Project
Monitoring
Taxonomy
Automatic
Workflow Management Capture
Modeling formation
selection Control Sustenance Implementation
ü
ia-Discovery
products
Dashboards Simulation
ü
ia- Analysis ü
ia- Sustain
Implement Continuous
Model þ
Have the right execution methodology
& Analytics Transaction Task Event & Analysis process
Routing Rules improvement
Management Delegation Distribution
Analyze
Improve
Business Business Path followed 2nd Iteration Onwards
Dynamic Collaboration & Event Rules
Monitoring Escalation Sequencing Admin
Rules Orchestration Aggregation
Source: Wipro BPM-SOA practice
Enterprise Services
Business Technical Utility
Services Services Services þ
PROJECT PRIORITIZATION & BUSINESS þ
SELECT ING THE RIGHT TOOL
CASE
Conduct a preliminary investigation
ERP, CRM Content Databases & Legacy
Integration
Source: It is important to define the business priorities ü
based on vendor ’s suitability to the
Systems Management Mainframes Applications
Hub
Wipro BPM-SOA practice
ü upfront so that the process automation delivers domain, analyst recommendations, and
the desired results . past preference
Select the process that will be adaptable enough Cr eate an initial shortlist through vendor
Workflow management: From the time a trade exception is detected in the ü
to make for successful automation ü
presentations
Need to ensure that the existing IT infrastructure M a p priorities and client’s needs to
system, the workflow module provides smart routing to the exception ü
supports the process adequately ü
evaluate product
resolver, based upon the configured business rules, and facilitates quick ü
Should be flexible enough to change based on
ü
Finalize product based on vendor’s
the requirements of BPM performance on identified use case
resolution.
þ
HAVE THE RIGHT EXECUTION METHODOLOGY
Business Activity Monitoring: The business activity monitoring module
ü
Develop an iterative methodology that can incorporate feedback and refine the original equirement
provides a detailed report to managers on the status of each exception and ü
Ensure the involvement of all key stakeholders

provides alerts. This can be configured based on the need.

In summary, there is great potential through usage of BPM within
Client Communication Processes
investment banks. However, there is need to have a holistic review of the
This function is not yet fully integrated in most firms. As a result, sales
organization before attempting this journey. It is critical to make sure that the
support, traders, middle office, and back office users engage with the client
first project is a success as this paves way for further adoption within the firm.
through a combination of email, fax, and phone.
Workflow management: Communication received from the client is
Reference
entered as a ticket in the system. All subsequent steps related to this - Jayantha KS. 2009, Presentation on Business Process Management- Wipro's
communication can be linked to the ticket. Point of view.
Consistent level of service: The ticket can be linked to multiple applications - Oracle.com. 2008, Business Process Management in the Finance sector.
across business units ensuring that the client gets consistent level of support.
 CAPITAL MARKETS
NSIGHTS
A Domain Consulting Publication
Ice Trust – Clearing the Credit Default Swaps
Hasim Sheik Noohu
Overview
The post credit crisis regulatory environment has been
extremely stringent on the Over The Counter (OTC)
Derivatives market and is continuously exerting
pressure on the participants to make it more organized
and regulated. In this situation, market participants
have responded emphatically by initiating and
participating in programs which will work in
accordance with the regulatory policies and also ensure
sustainable development of financial markets for the
future. One such important initiative has been the fully
functional operations of the central clearing house for
OTC credit default swap (CDS) products launched by
Intercontinental Exchange (ICE) under the umbrella of
ICE Trust.
The aim has been not only to comply with regulatory
requirements but also provide a full-bodied, world-
wide program for clearing of CDS. The idea had been
forming a shape and with the acquisition of The Clearing
Corporation in March 2009 which had a strong
participant base of world's largest investment banks and
leading service providers, it finally has been realized.
Currently launched for the North American markets
through the ICE Trust, this will be run in tandem with
to-be-launched ICE Clear Europe which will provide
CDS clearing service to European markets. This will
ensure that the CDS clearing house is a truly global
initiative while at the same time being serving to precise
needs of the local markets.
Certain guiding operational tenets underlying the
clearing house solution can be highlighted are strong
4
ICE Trust Credit Default
Swaps (CDS) Clearing
House provides the first
dynamic operational
platform for clearing the
linkage with market participants and service providers CDS products. The article
across the trade life cycle, compliance to regulatory looks at the background,
policies, abiding the protocols and standards and operational aspects and
transparent and flexible operations.
interoperability with other
How does it work service providers, market
The ICE Trust Clearing House works on the well- participants and
known principle of 'Novation'. ICE Trust steps in as
regulatory agencies for this
counterparty for the parties to a CDS contract, thereby
becoming the “Protection buyer” to the 'Protection
CDS Clearing platform.
Seller” and vice-versa. This helps in netting out the
overall positions of each participant and it would thus
receive payments from and make payments to each
participant on a net basis. The obvious benefit from this
is the reduction in the counterparty default risk, but
other benefits which flow in are reduction in volume of
settlement payments and transaction costs. Hasim Sheik Noohu
is a Business Analyst in
Participants the Clearing and
The Clearing Corporation which was acquired by ICE Settlement - Domain
had the World's leading investment banks as its Focus Group within the
shareholders. This helped the launch of this initiative as Securities & Capital Markets
they could be roped in as the Initial Clearing Domain Consulting Group. His
participants. Another important contributing factor is significant achievements are projects
that more than 80% of the CDS trading volume is on implementation of Over-The-
controlled by these leading banks. The initial clearing Counter (OTC) pricing engine,
participants of this service are Bank of America, clearing and settlement solution for
Barclays Capital, Citigroup, Credit Suisse, Deutsche multiple brokers in India and MIFID
Bank, Goldman Sachs, JPMorgan Chase, Merrill Lynch, compliance reporting for Equity
Morgan Stanley, and UBS. Recently, The Royal Bank of Business. He is based in London,
Scotland plc (RBS) and then HSBC Bank USA have been United Kingdom.
added to the list of clearing participants. Email: hasim.noohu@wipro.com

5 NSIGHTS
Product scope
THE ICE Trust CDS Clearing house based on a resilient system architecture
and support along with strong risk management capabilities houses all the
products that are supported by the DTCC Trade Information Warehouse
and include CDS indexes, single names and tranches. ICE Trust is clearing
Series 8, 9, 10 and 11 and 12 of those indices. Even though, it is robust
enough to support the clearing of all North American CDS indices, it is
currently attempting it on a phased manner and thus presently hosts the
most active indices, including:
Index Name Index Description Index Term
CDX.NA.IG North American, Investment Grade (Series 11, 10) 5 Year, 10 Year
CDX.NA.IG.HVOL North American, Investment Grade, High Volatility 5 Year
(Series 11, 10)
CDX.NA.HY North American, High Yield 5 Year
(Series 11, 10)
Clearing & Settlement Cycle
Currently the CDS Clearing House is in the process of clearing all the
historical trades which are uploaded in the system through the process of
backloading. This ensures clearing of large positions in a quicker and
efficient way but on the other hand requires it to operate on a weekly
clearing cycle on Friday. Margin collections are performed daily using a
direct settlement model which allows settlement of transactions directly in
another settlement bank or the Fed Account. Currencies of the G7 countries
like USA, UK, Japan are acceptable as initial margin deposit but for posting
Mark-to-market margin, only the currency of the underlying traded
product is permitted. The linkage with CLS Bank via DTCC route aids in
processing the coupons and final cash settlements through its net
settlement system and in the currency of the underlying traded product. It
uses the multi-lateral netting methodology
Linkages With Service Providers
ICE Trust structure has a completely integrated but still flexible model
commanding strong interoperability with DTCC's Trade Information
Warehouse via DTCC's trade matching and confirmation service
CAPITAL MARKETS
A Domain Consulting Publication
Deriv/SERV, the leading price distribution service provider Markit, CLS
Bank via DTCC and the buy side firms through T-Zero.
The diagram below illustrates the linkages between ICE Trust and
various service providers and participants in the CDS Clearing process
ICE Trust CDS Clearing Process
TRADES CLEARED
• DTCC provides positions to ICE Trust after matching
and confirmed the trades. DTCC
• ICE Trust becomes CCP between the buyer and seller
of CDS protection.
SETTLEMENT PRICES FOR MARK TO MARKET
• Markit provides intra day and End of Day settlement
Prices to ICE Trust
• ICE Trust validates the settlement prices MARKIT
• Markit provides the End of Day settlement prices to
clearing members
• ICE Trust uses settlement prices for daily mark -to-
market calculations.
RISK MANAGEMENT
• Initial Margins based on portfolio methodology that
comprises of Portfolio Risk Margin, Physical Settlement
Margin and Special Margin
• Variation Margin or Mark -to-Market calculations
• Clearing participants maintain Collateral deposit in the
General Guarantee Fund
End of Day Processing
• Reports to Clearing Participants – Initial Margin Clearing Participants
requirements, Mark -to-Market requirements
• Payment instructions to settlement banks include
coupon payments, mark -to-market credits and debits,
final settlement payments and guarantee fund
Settlement Banks
adjustments
Markit & Ice Trust
Markit provides settlement prices to ICE Trust for calculating daily mark-
to-market which will be settled with clearing members. It also provides
settlement prices to clearing members in order to calculate margin for their
clients. ICE Trust validates the settlement prices provided by Markit.
Dtcc & Ice Trust
DTCC's Deriv\SERV, the trade matching and confirmation service and
Trade Information Warehouse which holds the “Golden copy” of the trade
are the leading service providers in the clearing and post trade processing of
OTC Credit derivatives especially CDS. ICE Trust through its linkages with
them leverages these capabilities for its clearing solution.
 CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
6

?
Transactions stored in the Trade Information Warehouse confirmed Clearing Volume By Ice Trust
via Deriv\SERV are cleared through CDS clearing house. The
8000
novation and netting of these transactions creates new positions 7478

created between Clearing House and the clearing members. These 7000
are then passed back to Trade Information Warehouse which replace
6000
the old ones. .
?
DTCC-CLS Bank centralized settlement platform is the only 5000
centralized multicurrency CDS settlement service. Settlement of the T ill 22nd M ay 2009

trades cleared through ICE Trust CDS Clearing house is managed 4000 End of April 2009
End of M arch 2009
through this platform. 3000
2493

Ice Trust Risk Management Framework 2000

ICE Trust has built a robust risk management framework for tackling CDS,
1000 613 646
undoubtedly a very risky product. ICE Trust uses portfolio margining 257
71 106 30 12.7
approach, where it calculates initial margin based on clearing member net 0
positions. Clearing member must deposit collateral with ICE Trust to cover N o O f Transactions N otional Value O pen Interest
(U SD in billion) Value (U SD in billion)
the initial margin. Apart from initial margin, ICE Trust calculates
mark-to-market margin in End of Day which must be settled by clearing Source: www.theice.com
members on day-to-day basis. ICE Trust has created a guarantee fund Conclusion
structured on the basis of losses expected under severe but reasonable With first month of operations resulting in clearing of trades worth notional
market conditions and requires its members to contribute in proportion to more than USD 70 billion. ICE Trust CDS Clearing House has started on a
the risk of their cleared positions. positive note. With the increase in volumes and further addition of
products, it will become a force to reckon with in the CDS trade processing
VARIATION MARGIN (MTM) INITIAL MARGIN
space. Considering the strong membership base, resilient infrastructure
Initial Margin includes
•
Mark-to-market valuations are based on the and compliance with regulatory agencies and standards, ICE Trust CDS
official EOD settlement price, arrived through •
Portfolio Risk margin – related to the size and risk of
ICE Trust’s proprietary process. open positions
Clearing House will provide positive impetus in creating the necessary
•
Physical Settlement margin – covering the physical
trust in the current situation.
•
The mode of payment of MTM margin is either
settlement of the contract
cash or credit to clearing member’s settlement
account on a daily basis •
Super or Special Margin – additional margin by ICE References
Trust based on market conditions. - https://www.theice.com/ice_trust.jhtml
•
Cash and debt securities issued by Governments of - www.dtcc.com
G7 countries are acceptable as collateral
- www.fincad.com
•
End-of-Day margin deficit after adjusting against the
collateral deposited by clearing members will be
- www.shearman.com
covered by cash the following morning. - www.treasurydirect.gov
 CAPITAL MARKETS

7 NSIGHTS
A Domain Consulting Publication

The London Stock

Exchange (LSE), on
30th March, announced
Clearing and Settlement of Depository Receipts at the introduction of
the London Stock Exchange Central Counterparty
would sell securities in the local market. This act would (CCP) Clearing service
Vishakarajan Rajendran bring the prices on par. When selling of securities for 50 most heavily
happens, the DR is cancelled and the equivalent number traded securities on its
Background: The article explains the mechanics of of securities is released into the local market. The
Depository Receipts and their Clearing & Settlement at LSE. clearing and settlement process would be the same as it
International Order
A Depository Receipt (DR) is created when a company is for the local securities traded in the foreign market. Book (IOB) – LSE's
wants to list its already publicly traded securities in a foreign platform for trading of
exchange. This can be done only when the company meets Trading at LSE: The London Stock Exchange (LSE) Depository Receipts.
the DR listing requirements. The diagram depicts the provides trading services through two major platforms:
interactions between different participants involved in SETS and IOB. SETS is LSE's order book facilitating
creation and trading of DRs. trades in UK and Irish securities. It is a powerful
platform through which LSE provides automatic,
Buy Sell transparent and flexible order driven trading system for
Broker DR Market Broker constituents of the FTSE Index, Exchange Traded
Funds, Exchange Traded Commodities, along with UK
Issue Cancel and Irish securities. LSE provides competitive clearing
DR Depository of these trades through LCH Clearnet and X-Clear.
Another platform, the International Order Book (IOB) is
Deposit Shares Release Shares
Buy Sell LSE's electronic order book that provides cost efficient Vishakarajan
Shares Local Custodian Shares access for traders to invest in fast growing markets like Rajendran
Deposit Shares
Asia, Middle East, and Eastern Europe via depository is a Business Analyst
Release Shares
receipts. Trading on the IOB started in 2001 and since in the Clearing and
Buy Sell
Local Broker Local Market Local Broker then the volumes have grown rapidly. The impressive Settlement - Domain
increase in volume needs to be supplemented with Focus Group within the Securities &
increase in efficiency and mitigation of risks. To address Capital Markets Domain
When any DR is traded, the broker has to determine this need, LSE has introduced CCP service initially to 50 Consulting Group. He has been part
the price of the DR. To determine the price, the broker most liquid securities by value traded on IOB. of engagements on Equities Clearing
compares the price of the DR and the price (foreign and Settlement Application
currency equivalent) of the securities in the local market. Post-Trade Processing: Development and Operational areas.
If the DR is trading at a higher price, the broker would ? On execution, LSE sends the trades to its post He is based in Bengaluru, India.
buy more securities from the local market and issue trade router X-TRM Email:
additional DRs. If it is other way around, the broker ? X-TRM registers the trade and routes it to the CCP vishakarajan.rajendran@wipro.com
 CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
8

– LCH Clearnet. It provides trade information to the trading LSE for TDN are netted and the
participants and clearing members IOB
Trade
Execution instructions are sent to
?
LCH Clearnet registers trades for clearing and sends confirmations XTRM Trade Trade Euroclear.
registration routing
to the members
Trades
?
LCH Clearnet performs risk management & optional netting and Settlement: LCH instructs
MT 518 or Access
via LCH website
Member Member
instructs Euroclear EOD Netting
gross settlement to
Report

LCH
?
LCH Account
Settlement will be at Euroclear and will be as per the process between Euroclear throughout the
Margin Calls
Margining Margin
LCH Clearnet & Euroclear day and net settlement at Movement

?
All trades will be settled against LCH Clearnet. Gross/Net Instructions
end of the day at 17.45 to
Member Bank Account

Clearing: Members, which have direct or indirect relationship with LCH,
willing to trade these 50 CCP eligible securities should continue the same
relationship and need to register by submitting the prescribed static data
form. Any other members willing to utilize this service should establish a
direct or indirect relationship and submit the prescribed static data form.
However, these members will still be able to trade on the non-CCP eligible
securities without the direct/indirect relationship.
LCH, as a CCP, provides robust risk management so that in the event of
member's default, the non-defaulter's positions are not affected. This is
done by collecting initial and variation margins. LCH calculates intra-day
and end-of-day margins using the Equity Risk Analysis (ERA) algorithm.
This is done in the same way as the other securities, part of the Equity Clear
business of LCH. If any member is uncovered of an intra-day margin, LCH
will contact the member over phone and will advise the member to pay the
required amount. Before 02.30pm UK time, members can pay the margin
calls in EUR, GBP or USD. Post 02.30pm, only USD payments are accepted.
Debit instructions are sent to the member's bank and the same must be
confirmed by the bank within 1 hour. Overnight margin calls sent to the
member's bank must be confirmed by the bank before 09.00 am.
LCH provides an optional trade confirmation service where the
members would receive confirmations in the form of MT518 messages on a
gross trade basis. LCH also provides an optional netting service. For
members willing to settle on net basis, Trade Date Netting (TDN) is offered.
Every end of day, post gross trade reconciliation by LSE the trades flagged
Euroclear
Ownership
transfer
18.00. Members need to sign
Buy-Ins
Power of Attorney
agreements with LCH to
allow LCH to deliver on
their behalf in Euroclear Bank. In case of settlement failures resulting in buy-
ins, LCH will input a new transaction against the liable party to include the
relevant securities, costs, etc. This will be used to settle against the original
transaction.
Conclusion: By introducing CCP services to 50 most heavily traded
securities on IOB, LSE brings in post-trade anonymity, robust risk
management and settlement netting to the trades done on its IOB trading
platform. The participants gain complete counterparty risk protection. This
announcement is in line with the European Code of Conduct for Clearing
and Settlement. Also LSE is utilizing X-TRM, the trade routing service, so
that at a later point in time multiple CCPs can be brought in to provide
clearing services. This is considered to be a move towards increasing
participants' interoperability, reducing costs and paving a way for
emergence of efficient providers.
References
- http://www.finextra.com/fullstory.asp?id=19847
- http://www.londonstockexchange.com/traders-and-brokers/products-
services/trading-services/international-order-book/order-book.htm
- http://www.lchclearnet.com/cash_equities/lse/how_it_works.asp

9 NSIGHTS
Continuous Linked Settlement (CLS) for Clearing and
Settlement of Non Deliverable Forwards (NDF)
Vaibhav Khare
Introduction
Non-Deliverable Forward (NDF) is a class of short term
Foreign Exchange (FX) derivative product traded Over
the Counter (OTC). It is popularly used to hedge
exposures by portfolio investors, hedge funds and
multinational corporations in emerging market
currencies, which are subject to convertibility
restrictions or in currencies wherein a conventional
forward market does not exist. Examples of such
currencies are Korean Won (KRW), Taiwan Dollars
(TWD), Philippine Peso (PHP), and Indian Rupee (INR).
Besides hedging purposes, NDF are also majorly used
for taking speculative positions in the local currency.
Although they are similar to FX Forwards in that
they allow hedging currency exposure, one notable
difference is that a NDF is always cash settled (usually
in U.S. dollars) and there is no physical exchange of
principal sums of the foreign currencies, hence the
name, 'Non Deliverable Forwards'.
The difference between the contracted forward rate
(decided at the start of the deal) and the spot reference
rate at maturity (referred to as 'NDF Fixing rate') is the
amount of profit or loss for the counterparty which
constitutes the net cash settlement in US dollars, on the
'Settlement date'.
Understanding Hedging using NDF
Consider an example of an investor who has taken long
position of USD $2 million in the Taiwanese stock
CAPITAL MARKETS
A Domain Consulting Publication
Non Deliverable
Forwards (NDF) as a
hedging and speculation
tool in Foreign
Exchange (FX) markets,
has long been the fancy
market for a year. His position is implicitly 'long' in the of Investors. Clearing
Taiwanese Dollar (TWD). In the absence of a forward and Settlement (C&S)
market where he would have 'locked' his USD/TWD
in these instruments
position rate with a 1 year forward position; he hedges
his exposure using a NDF instead. A NDF rate of was plagued by ills like
USD/TWD of 31.65 is agreed (short TWD position) manual processing,
between the investor and the counterparty, wherein verbose documentation
positions would be cash settled between this rate and
and absence of common
the prevailing USD/TWD fixing rate (i.e. spot rate at
the fixing date) after 1 year. messaging standards.
Assuming a scenario after a duration of a year, CLS Bank via its CLS
wherein fixing rate turns 32 (i.e. TWD depreciates), the services has managed to
Customer's stock market position loss due to TWD
streamline these C&S
depreciation is offset by the NDF proceeds [(since he
receives $21,875 (i.e. $2,000,000-$1,978,125)]. In another processes.
scenario wherein the fixing rate turns 31.25, the
customer benefits in his stock market position exposure
due to TWD appreciation, although he loses on the
NDF position [since he would have to pay the bank
$25,600 (2,00,0000-2,025,600)].
Speculation Purposes of NDF
Besides hedging NDF are also used for speculation by
market players. Operators, regardless of actual Vaibhav Khare is a
exposure, may take long/short positions in a local Senior Business
currency depending on their perceived future outlook Analyst in the Clearing
for the currency. and Settlement DFG
within the Securities and Capital
Limitations of Traditional Post Trade Processing of NDF Markets Domain Consulting
The conventional settlement of NDF involves the Group. He is based in Boston, USA.
bilateral settlement between the counterparties like E-mail: vaibhav.khare@wipro.com
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any other OTC Derivative contract involving Master Agreement, with the Clearing and Settlement of NDF by CLS
net settlement in US Dollars being exchanged on the settlement date using
Nostro and Vostro accounts. This traditional Post Trade processing of NDF Counter part 1 (May use CLS Service as Settlement Member, User Member or Third Party)
has many limitations and shortcomings as seen below:
? Intensive post-trade manual processes like documentation in the
form of 'ISDA Long Form confirmations' for NDF, which are time
2) Matched by 3) Valued/Fixed 4) Settled

NDF Settlement Date

consuming and costly. CLS

NDF Fixing Date

1) NDF Trade
? Low STP rates and thereby scope for error. The subsequent error CLS CLS CLS
Sent to CLS Fixing Cash flows
rectification itself is cost prohibitive. Instructions settled
Sent to CLS
? Lack of standardization across industry participants.

These factors led to increase in post trade processing costs of NDF. With
rising volumes of NDF trades and increasing popularity, Industry
standardization to streamline post trade NDF processes was clearly the Counter part 2 (May use CLS Service as Settlement Member
, User Member or Third Party)

need of the hour. CLS seized this opportunity and added NDF Settlement to
its growing product clientele (FX, OTC products).
CLS Bank is a private sector special purpose bank that offers the
Continuous Linked System (CLS), the world's first simultaneous and
irrevocable global multi-currency settlement system to settle payments
associated with a foreign exchange (FX) transaction. CLS Bank provides
settlement services by maintaining a central bank account with each of the
eligible currencies.
CLS resolves the problem of counterparty default risk in FX transactions by
acting as an intermediary and releasing the payments on the principle of
payment-versus-payment (PvP). This differs from the more traditional
Delivery versus Payment (DvP) process where the two sides to a foreign
exchange transaction (Buy & Sell) are settled separately. Due to time zone
differences, transactions using the DVP process are vulnerable to the risk of
one party defaulting before both sides of the trade are settled. PvP
eliminates time zone risk because CLS settles both sides of a transaction
simultaneously and not separately i.e. a final transfer in one currency occurs
when, and only when, a final transfer of the other currency also takes place.
Settlement via CLS removes the settlement risk on all transactions settled
via the service.
(Source: www.cls-group.com)
1. On the Trade date, the NDF Trade details like currency involved,
Fixing/Valuation date, Settlement date exchanged between
counterparties are sent to CLS
2. Matching/Confirmation done by CLS
3. On NDF Fixing/Valuation date the cash flows to be settled on
settlement date are computed.
4. On Settlement date the cash flows are settled via CLS
CLS in its quest to increase its coverage of OTC products has extended its
settlement service to NDF transactions in order to streamline, automate and
standardize post-trade processes for this instrument. Existing users of CLS
Settlement can leverage CLS Bank's existing infrastructure for NDF
settlement thereby minimizing implementation costs. CLS Settlement
offers STP service from NDF confirmation to NDF settlement.
Advantages of CLS for NDF Settlement
? CLS has established a NDF Protocol incorporating the 'Multilateral
Master Confirmation Agreement' for NDF. This Protocol does away
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with the need for members to exchange 'long-form confirmations'. enticing for vendors to jump in the Clearing and Settlement space.
The guidelines for the 'long-form confirmations' documentation are
prescribed by ISDA generally for new OTC products like NDF. Long References
form confirmations necessitate reconciliation and have a longer, time - http://www.cls-group.com/Publications/NDF.pdf
consuming and extensive documentation process involving - www.isda.org
confirmation of economic terms like the transaction date, notional - http://www.newyorkfed.org/fxc/annualreports/ar2004/fxcar04.html
amount of currency, spot exchange rate and non economic
information like NDF Fixing source and date.
?
Automation introduced by CLS has scored, in that it has done away
with netting agreements which were drafted using legal help and
made after to and fro exchange of information between
counterparties. CLS Settlement for NDF has eliminated this manual
intensive process, allowed to free up these resources and reduce
costs in this area.
?
CLS in collaboration with SWIFT has brought about standardization
in message standards in the form of SWIFT Net Fin and ISO 20022
XML
?
Provision of existing time tested CLS infrastructure to NDF
settlement thereby contributing to Cost savings, Operational risk
reduction and settlement efficiencies.

Future Trends and Challenges

Besides speculative trading, the tremendous interest and increase in
volumes of NDF is the direct result of non-availability of a hedging platform
for investors in these currencies. The trend in restrictions in international
trading in these currencies or transition to full convertibility of currencies
such as INR would determine the future growth and sustenance of NDF
markets. With increasing popularity and volume growth, it's a matter of
time before more players jump in to the space of automation in NDF
clearing and settlement. Already CLS with its initiatives in this space has
succeeded in streamlining a lot of processes and bringing in
standardization in settlement, besides reducing operational and settlement
risks and lowering processing costs. The boom in these instruments
coupled with upswing in the emerging markets economies should prove
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Strange Nets are those
peculiar net positions
where stock and cash
Strange Nets (Settlement) move in the same
Girish Nayyar direction or one of them
i.e. 140 quantity of stock and $1900 in cash. The second does not move at all. We
1. What is a Strange Net?
option is to settle a single net position – pay $400 and will discuss here the
receive 20 units of stock. reasons why trades can
Strange Net is an argot used exclusively in clearing and
settlement (C&S) back office. It is a slightly obscure
1.1 Strange Net Scenario #1 – Cash only settlement
result into such strange
term; googling it will fetch no meaningful results. It has nets and subsequently
The stock price starts to move up and Tom decides to
no definition in Investopedia, and any use outside the
group will yield a questioning stare back, so much so
square off his position by selling his balance 20. how these are settled.
that even front office guys do not recognize it. Equally Trade # Time Action Quantity Amount ($)
elusive is its synonym – odd net. Sounds odd, isn't it? T4 11:30 Sell -20 +250
Read on to get some understanding of this peculiar
What will be the Net position now? Tom has made a
shenanigan.
loss of $150 and he has to pay this amount without
Let's take a step back and introduce its hypernym
receiving any stock in return.
first – Net position. Sounding familiar already? Net
On the face of it, this net transaction can be easily
position is the difference between total open long and
settled by making the cash payment of $150. But, will
open short positions in a given security. This is best
this transaction settle normally at the CSD? The answer
illustrated with an example. Below are some trades
is no in most of the cases. Why? Because there is no
done by Tom on a single day in one stock.
exchange of securities involved. A CSD is a repository
Time Action Quantity for securities and normally effects settlements that
Trade # Amount ($)
involve exchange of securities. For making pure cash Girish Nayyar is a
T1 10:00 Buy +100 -1200 not
payment, you need to go to a bank. Business Analyst in
T2 10:30 Buy +60 -700 found the Clearing and
T3 11:00 Sell -140 +1500 1.2 Strange Net Scenario #2 – Stock only settlement Settlements Domain
Stock price moves up significantly in the next half an Focus Group within
The Net position for all the above trades could be
hour and Tom decides to go short on the market. the Securities & Capital Markets
worked out at the end of day as Buy 20 @ $400
Domain Consulting Group.
(difference between buys of 160 @ $1900 and sell of 140 Trade # Time Action Quantity Amount ($)
He has worked on a number of
@ $1500). T5 11:30 Sell -10 +150 projects in the domains of corporate
Tom has a couple of options to settle these trades. He banking and investment banking.
Tom has covered his cash loss, but he has to now
can settle them individually as 3 independent trades, in He is based in London, United
deliver 10 quantity of the stock without receiving
which case he will need to have adequate quantity of Kingdom.
anything in return. He has to deliver the securities Free
stock and cash in his account to support the settlement Email: girish.nayyar@wipro.com
of Payment (FOP).
 CAPITAL MARKETS

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This net transaction too has a problem in its settlement. Some of the 2. Settlement of a Strange Net
CSDs do not support FOP settlements. 2.1 Settlement Option A - Aggregate Buys and Sells
Perhaps, the simplest way of settling a strange net is by aggregating buys
1.3 Strange Net Scenario #3 – Same side stock and cash and sells. Both the shapes can then settle as normal DvP transactions.
The stock price keeps moving higher and Tom shorts a further 15 quantity. Though the solution is simple, it has one problem. It requires a larger
There is flashing news at 12:15 about profit warning by the management of amount of stock and cash to successfully settle the two transactions
the company and its share price takes a nosedive. Tom quickly covers up independently.
his shorts and in fact goes long by a small quantity.
Scenario Settlement
Trade # Time Action Quantity Amount ($)
T6 12:15 Sell -15 +300 #1 – Cash only Buy 160 @ $1900
T7 12:30 Buy +30 +200 Sell 160 @ $1750
#2 – Stock only Buy 160 @ $1900
Tom's net position stands at a surplus of 5 quantity and he does not even
Sell 170 @ $1900
has to pay for it. To top it, the big surprise is that he will be paid a cool $100
#3 – Same direction stock and cash Buy 190 @ $2100
for his purchase!
Sell 18 5 @ $2200
Tom has done his job and made a profit, but the back office guys will
have some difficulty in settling this net transaction. Apparently, this All the CSDs support this model since these are effectively two normal settlements.
particular CSD does not allow instructing a settlement with same direction CCPs that settle strange nets using this model :
- European Multilateral Clearing Facility, CCPs for Chi-X, Nasdaq-OMX and
stock and cash.
BATS
In summary, below is a matrix of net positions that will result in either - Eurex, CCP for Xetra
normal Delivery versus Payment (DvP) settlement or Strange Net
settlement. Out of 9 possible combinations of stock and cash, only 2 are fit to 2.3. Settlement Option C – Settle Stock FOP and Cash DvP
be termed as normal DvP nets, remaining all are strange nets. An innovative solution to work around the problems in Option B is to settle
the cash as a normal DvP transaction in exchange of a nominal 1 quantity of
stock. Remaining quantity of stock is then settled as a FOP transaction.
Stock

Receive Deliver Zero Scenario Settlement

#1 – Cash only Receive Stock 1, Deliver Cash $150

Receive Strange Normal Strange Deliver Stock 1, Receive Cash $0
#2 – Stock only Deliver Stock 10, Receive Cash $0
Cash

Deliver Normal Strange Strange

#3 – Same direction stock and cash Receive Stock 6, Deliver Cash $0
Zero Strange Strange Strange
Deliver Stock 1, Receive Cash $100
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Almost all CSDs support FOP settlements. So, this model will work in most of the markets.
CCPs that calculate strange nets in this model :
- SIS X-Clear, for trades on NYFX

2.4. Settlement Option D – Settle as is

Wouldn't it be so much better if the CSDs just support the settlement of the
net in its arithmetically accurate form in the single shape? CREST and
Euroclear Bank are two such CSDs which support strange net settlements in
1 shape.

3. Conclusion
Strange Net is a net position where either stock or cash is zero or both stock
and cash are moving in the same direction. There are practical problems in
settlement of such strange nets owing to CSDs not supporting FOP, or cash
only or same direction stock and cash transactions. To work around these
issues, each CCP has designed its own way of settling strange nets.
Splitting the net into aggregated buys and sells is the simplest and most
popular strange net settlement method, but it may require exchange of large
quantities of stock and cash and if any of the counterparties does not have
the adequate quantity in his account, the settlement will fail. To avoid this,
some CCPs split the strange net into stock only and cash only components
and then settle the two shapes independent of each other. In this case, the
two transactions are reflected in two separate statements and so, can be
difficult to reconcile. Recently, the most innovative solution that has
evolved is to settle cash in exchange for a nominal quantity of stock so that it
goes through as a DvP transaction and settle the balance quantity of stock as
a FOP settlement.

15
Continuous Net Settlement -
The NSCC Way to deal with Fail-To-Deliver Trades
Sanjay Mittal
Introduction: According to the recent report published
by US Government Accountability Office, the
aggregated fail-to-deliver (FTD) value stood at $7.5
billion at December 31st 2007 1. According to DTCC,
99.9% of daily dollar value of trades settles within the
US standard settlement period of three days and the
remaining accounts for the FTD. Although it is believed
that many FTDs are caused by processing delays or
mechanical errors, naked short selling for manipulating
the markets is also considered an important factor, and
is thus closely monitored by the regulating agencies.
NSCC is required (by SEC) to report all FTDs for each
clearing participant in each security to SEC and SROs on
a daily basis. The CNS system helps the NSCC to meet
its obligation (as a central counter party) to deliver
securities to those participants with long positions by
debiting the participant's account at DTC. This is an
automated process through NSCC's Stock Borrow
Program.
Continuous Net Settlement (CNS) is a service
offering by the NSCC that centralizes the calculation of
the net position of the participant at firm level for all
traded securities at the settlement date. On the other
hand, the Stock Borrow Program (SBP) that is an
ancillary service offering by NSCC through CNS
System, allows the DTC to automatically borrow stock
and fixed income securities from the participants'
account and lend the same to NSCC to clear the open
position. (Note: All participants express their
CAPITAL MARKETS
NSIGHTS
A Domain Consulting Publication
CNS is a service
offering by the NSCC
that centralizes the
calculation of the net
position of the
participant at firm
level and allows it to
borrow securities from
willingness to loan securities, in the event of any
other participants who
shortfall being faced by NSCC, to DTC by participating
in the SBP. The participant's money settlement account are willing to loan and
is credited with the full market value of the borrowed deliver the same to the
securities. In the event of the availability of more than buyers, thereby
one lender, an algorithm which is a function of random
number, participant's average loans and clearing fees,
meeting its obligation
is used to select the lender.) The participant is then of being the CCP.
required to cover the loaned securities by buying from
the market during the early trading hours on the day
following the settlement date or by borrowing.
Borrowing, however, does not discharge the FTD
participant from its obligation to deliver.
Sanjay Mittal is a
How it works: Business Analyst in
1. Broker B sells 100 shares of XYZ to the Broker A the Clearing &
and FTD on the Settlement Date. Furthermore, Settlement - Domain
Broker B has a flat account at DTC (implying Focus Group within the Securities
thereby that there are no XYZ securities & Capital Markets Domain
available to lend to cover the short position). Consulting Group.
2. Broker C has 100 long position for XYZ at DTC His significant achievements in
and is willing to loan. career include successful
3. NSCC borrows 100 shares of XYZ from Broker C implementation of a C&S system
and delivers to Broker A, and thereby meets its and an options client exercises
obligation as CCP. and assignments notification
4. Broker B continues to have short position unless system for a large broker dealer in
it buys or loans. Moreover, it shall not be allowed the US. He is based in New
to go further short in that security without Jersey, USA.
buying or borrowing. Email: Sanjay.Mittal1@Wipro.com
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16

Position Movements on Settlement Date within participants account's at also required to be reported through the CNS system. Similarly, if the writer
NSCC & DTC1 of a call affects a short sale (if the buyer exercises its option), this needs to be
As visible from the below table, the long 100 position of lender is moved reported as well. Options and other instruments like single stock future are
to buyer's account at DTC which makes the NSCC position as net flat for the also being considered by the regulating agencies to extend the short sale
buyer. But, simultaneously, it also creates a long position for lender at disclosure rules.
NSCC. Hence, the seller continues to have a short position until it delivers According to DTCC, in the normal course of business, 15-20% of FTD are
its obligation to NSCC. filled through the SBP automatically. The NSCC allocates the long position
(those available for loans) to cover the short positions. Allocation priority is
Participant at the discretion of NSCC although it considers the age of fails, security and
TD/SD NSCC/DTCC Broker A Broker B Broker C quantity. Participants with remaining open long position not filled through
Buyer: FTR Seller: FTD Lender the Stock Borrow Program have option to request for priority in CNS
TD NSCC Position Long 100 Short 100 Flat allocation by NSCC. Alternatively, it can file papers with NSCC requesting
TD DTC Position Flat Flat Long 100 the net short member to deliver those securities to net long member2.
SD NSCC Position Flat Short 100 Long 100 In the coming years, the market environment is expected to be even
SD DTC Position Long 100 Flat Flat
tougher as newer stringent rules are imposed by the regulatory agencies in
order to improve the market efficiencies and safeguard investor interests.
According to SEC's Regulation SHO (Aug 2004), Emergency orders
(Sept 2009) and Interim Final Temporary Rule (Oct 2008), SEC requires References
participants with FTD on the third settlement day after trade date, in any - http://www.gao.gov/htext/d09318r.html (Site accessed June 9, 2009)
equity security, to take action on the next morning to close out their - http://www.dtcc.com/products/cs/equities_clearance/cns.php (Site accessed
position, with limited exceptions3. June 9, 2009)
NSCC submits all fails data to SEC on the Settlement Date. SEC closely - http://www.sec.gov/rules/final/2008/34-58785.pdf (Site accessed June 9,
monitors all short positions that failed to settle at T+3. Any 2009).
broker/participant carrying short position in any security shall not be
allowed to go further short until it covers the short position either by
buying-in or by borrowing. This not only adversely impacts the business of
the participant with the short position, but also the image of the participant
firm goes down in the eyes of its clients. The reason is that the participant
being short in one client account will not be allowed to trade (short-sell) for
rest of the clients as well even though the other clients would be holding
long positions in the same security.
The listed equity options, where the participant exercises a put option
and is net short, can have a similar tendency of not being able to meet its
obligation to deliver the underlying assets (equity security in this case), are
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Recently issued Market

Repo Settlement and Market Practice
Anuj Gupta
In first half of 2009, ISITC (International Securities
Association for Institutional Trade Communication),
the industry trade group for standards in trade
processing, released three new settlement Market
Practices. One of these market practices was for 'Repo
and Reverse Repo agreements'.
This market practice would facilitate in resolving
some of the vital issues that participants come across
during the settlement of a Repo trade in U.S. securities
market. In the words of ISITC Settlements Working
Group, "by utilizing these market practices, industry
participants will be able to produce consistently
formatted messages for instruction and confirmation of
settlement. Specifically, this will create improved
operational efficiencies and reduce error-related risks."
Repo is among the highest traded financial products
in US securities market. As it is mainly an OTC product,
there are no official figures released. However, the
survey statistics released by latest SIFMA Research
Quarterly says, “the average daily volume of total
outstanding repurchase and reverse repurchase
agreement contracts totaled $ 7.06 trillion in the first
quarter of 2008, a 21.5 percent increased over the $ 5.81
trillion during the same period in 2007.”
What is addressed in this Market Practice?
Let's start with at a real life incident from a buy-side firm
(an Investment Management firm), where a team was
formed to define a process for the Repo trading. The
objective was to create a process, so that the firm can
Practice for Repo
settlement will provide
the much needed clarity
on Repo terminology,
clearing process and the
leverage on the existing IT infrastructure for over-night
settlement instructions.
Repo trading. (The initial scope was to consider only Due to absence of this
Repo not the Reverse Repo). market practice, the
After many rounds of discussions which spanned a Repo industry was
couple of weeks, the team was stuck on a very
fundamental question. “Are we talking about Repo or
devoid of a suitable
Reverse Repo?” technology
Repo has a fine peculiarity the way it is christened. infrastructure, which is
Let us try to appreciate this peculiarity. essential for a seamless
Let's assume that there is a regular bond trade
between two parties. In this case, one party will buy the trade processing.
bond and another will sell the bond. However, for a
parallel Repo transaction; instead of buy or sell, one
party trades in Repo and another party trades in
Reverse Repo.
So, the peculiarity of the terminology is that
industry identifies them as two different asset
categories i.e. Repo and Reverse Repo. However, they
Anuj Gupta is a
are nothing but two different facets of a same financial
business analyst in
security. It was intriguing to know that in this kind of
the clearing and
high volume market there is still a fundamental
settlement - domain
question that remains to be answered.
focus group within the securities
After rounds of discussions, the team realized that & capital markets domain
the business requirement is to start trading in Reverse consulting group. He has worked
Repo and not in Repo. The existing industry definition, in projects spanning across fixed
that the team was referring to, was written from a sell- income trade processing, portfolio
side (Dealer/Broker)'s stand point. analytics and fund valuation
To resolve these subtle operational gaps, ISITC domain. He is based in Los
brought all market players to a round table and tried to Angeles, USA.
reach a common understanding. The outcome of that Email: anuj.agupta@wipro.com
 CAPITAL MARKETS

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18

activity is the emergence of best practice (market practice) documents that

will be used across the market for Repo trade settlement. Some of the points
revolve around how to use MT541 and 543 for Repo and Reverse Repo
transactions? What is the precise definition of Repo and Reverse Repo? etc.
Discussions during the Repo working group were an eye opener to the
fact that despite being a trillion dollar market, there is such a poor
technology infrastructure in place. Some of the statements made by the
coordinators who were part of the working group point in this direction:
“There is a very less automation in Repo settlement area”, “Custodians'
systems are not built to handle the Repo trade settlement”, “and they are
still using ancient ways of settling the Repo trades via Fax and FTP.”
One of the main reasons behind the technology backwardness in the
Repo market was that there was no consistent understanding of the
terminology and the process among the market participants before this
market practice. The release of this market practice will bring the much
needed understanding and Repo market would see more automation in
coming future.

References
- http://www.isitc.org/
- http://www.bobsguide.com/guide/news/2009/Apr/7/Key_Settlements_Market
_Practices_Finalized_at_ISITC%27s_15th_Annual_Industry_Forum.html
- http://www.sifma.org/research/pdf/RRVol3-6.pdf
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The payment systems

Risks in Wholesale Payment Systems
Joydeep Dutta
Introduction
Wholesale payment systems can broadly be classified as:
net periodic settlement systems (NPSS) and real-time gross
settlement (RTGS) systems. Both the NPSS and RTGS
systems are coupled with a set of risks. The magnitude of
exposure a bank has and the delay in the final settlement
from the time settlement instruction has come in determine
the settlement risk a bank faces. A customer of the sending
bank (read “sender”) makes a payment to the customer of a
receiving bank (read “receiver”) using the Wholesale
Electronic Funds Transfer system.
Net Periodic Settlement Systems (NPSS) - Here the
payments between the banks are netted for a particular
organization and final settlement is made either through
receipt or payment with respect to that organization at
certain point of time. For e.g. end of the day
Real Time Gross Settlement (RTGS) systems – Here
the payment occurs on an immediate basis in the form of
a bilateral transfer i.e. An instantaneous credit for a debit
Both these systems have their own pros and cons,
whereas the NPSS reduces the transaction costs and
even numbers by combining them and creates
economies; RTGS systems provide instantaneous credit
thus reducing settlement risks. But at the same time, it
leads to increase in costs due to high volume of
transactions. Though NPSS solve this issue, they don't
are associated with
various levels of risks
like credit risk, systemic
risk, liquidity risk, et al.
is no credit in the account to cover the transaction. In other The major controversy
words, at least one of the institutions involved extends free concerns the risk
credit that will be repaid before the end of the day. The exposure of the
nature of daylight overdrafts on gross settlement networks
and net settlement networks are different.
payments system due to
In case of Net Settlement Systems, the settlement occurs the existence of daylight
only after a particular time period generally at the end of overdrafts.
the day. Here the overdraft occurs in following ways –
1. Transfer effected by the sending bank even though
no funds have been provided by the sender.
2. Allowing usage of funds to the receiver even
though funds are yet to be received.
In the gross settlement network, a daylight overdraft
refers to a final and irrevocable transfer of funds in the
absence of adequate balance in the sending bank's account.
Irrespective of whether the settlement is gross or net, if
in case daylight overdrafts are allowed, they need to be
supported by some assurance of settlement in case of Joydeep Dutta is a
default. This can be emphasized by the fact that a financial Business Analyst in
system which is permitting daylight overdraft but not the Clearance and
guaranteeing settlement will give rise to risks associated Settlement - Domain
with uncertainty of settlement. The adverse impact of this Focus Group within
will be that the end users of the system will have to bear the the Securities & Capital Markets
costs arising out of these risks. Domain Consulting Group. His
significant achievements in career
Overdraft 1 Sending bank’s reserve account
includes successful
Promises payment balance has gone negative

make the funds immediately available. Customer A (Sender)

Against an Overdraft
A’s Bank (Sending Bank) implementation of a FIX enabled
Central Bank
Sell Side FO application at a
Daylight Overdrafts Overdraft 2
Allows fund usage,
leading Investment Bank.
A daylight overdraft as the name suggests refers to payment Customer B (Receiver)
without receiving good funds
B’s Bank (Receiving Bank)
Bank’s net debit position exceeds its He is based in Singapore.
reserve account balance with Central Bank

made during the course of a business day even though there Any of these risks may lead to failure of the payment system if the overdrafts are not
covered with good funds by the End of Day
Email: joydeep.dutta1@wipro.com
 CAPITAL MARKETS
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Risks In Wholesale Payment Systems And Connected Costs
Credit risk is the risk of non-receipt of the funds which are expected to be
credited and has two sides – sender risk and receiver risk. Sender risk occurs
when the sender of the funds is not able to cover funds for which the
overdraft has been provided. Receiver risk is referred to as the risk faced by
the receiving bank in the event of non-settlement by the sending bank. The
third sub-set of the credit risk is the cost to the receiver, in case the receiving
bank revokes the funds made available to him based on expected credit.
Systemic risk as the name suggests is the risk of failing of partial or entire
banking system due to settlement failure of one bank. This is even bigger
risk because it might lead to the collapse of the entire system. This situation
may occur if the payments have a dependency on the receipts. If the
particular receipt is huge, it might lead to non-settlement with other banks
and in turn these banks will face similar problem. The aftermath of such a
crisis will be that the entire payment network might have to bear the costs
associated with such settlement failure.
Liquidity risk is a settlement failure occurring due to non-settlement on
time. This type of risk has a possibility of mitigation in case the sender
honors the payment at a later date \time. But even then it would have
related costs associated with it as there has been a breach of contract on time
basis. Also this will have impact on any future transactions with the same
bank. The receiving bank may not consider transacting with the sending
bank due to such bad previous experience.
Private V/s External Costs
The connected costs associated with the risks as discussed above can be
separated as private and external. It is worth noting the dissimilarity between
private and external costs.
Private costs – These are internal to the bank and can be managed in a way
specific to the banks through its internal controls. Also the bank would have its
own benefits for controlling these costs. E.g. Costs associated with receiver risk.
External Costs – These are due to a settlement failure with other banks
and cannot be controlled by a particular bank. Also the bank may not be
incentivised to put in place appropriate controls on its part for managing
these costs as these are not entirely borne by them.
20
Possible Alternatives For Risk Mitigation
Pricing: Probably the best alternative to ensure settlement finality would be
to have insurance or guarantee fund supported by participants of the
payment network. It needs to be made certain that consensus of all
participants be bought in for setting up such a fund or buying insurance for
protection in the event of default.
Net bilateral credit: In this alternative, exposure of receiving bank to a
sending is limited based on the already established credibility of the
sending. This alternative is plausible in case where the transactions are not
expected to go beyond a particular limit but will become a hassle for a user
who needs to send more funds to a receiver via these banks.
Finality of Payment: The receiving bank will be responsible for all the
payments accepted. This is based on the premise that receiving bank is in the
best position to monitor and avoid such costs.
Conclusion
Based on the discussion above, it can be easily understood that all payment
networks with allowance for daylight overdrafts settling via gross or net
mechanism will have inherent risks and costs associated with such risks. To
manage these risks, wholesale payment systems risk management
framework should include rules and processes for identification,
measurement, mitigation, and management of such risks. Appropriate
controls and sound economic policy will ensure proper mitigation of risks
that arise out of settlement failures due to daylight overdrafts.
References
- Wholesale Payment Systems Handbook – Federal Financial Institutions
Examination Council
- Federal Register / Vol. 73, No. 248 / Wednesday, December 24, 2008 / Notices -
Docket No. OP–1345
- http://www.theclearinghouse.org/reference/comment_letters
/2008cl/034784.pdf
- http://www.richmondfed.org/publications/research/economic
_review/1985/pdf/er710302.pdf
 CAPITAL MARKETS

21 NSIGHTS
A Domain Consulting Publication

How would the back

office of brokerage firms
look in the future? The
The Brokerage Back Office of the Future article highlights three
Kanishka Dasgupta key areas that would
geography. Such a structure leads to multiple points of define post trade
contact within the firm for a client dealing in different processing.
The rapid advances in market structure including new products and in turn means that the brokerage firm has
trading venues, introduction of new products, separate relationship threads with the same client
globalization and regulatory pressures are some of the across various product classes.
changes that have been buffeting brokerage firm's back

Fixed Income

Fixed Income
offices in the recent times. Front office developments

Derivatives

Derivatives
FX/MM

FX/MM
like Direct Market Access and Algorithmic Trading are

Equity

Equity
having an impact on trading volumes while a focus on
cost means that the back offices have to manage more
Front Office Front Office
with fewer resources at disposal.
The current structure of the back offices of most
brokerage firms does not always adequately represent Middle Office Middle Office

the significant changes that are taking place in the

surrounding environment. The reasons behind this Product Based Back Office Unified Back Office
range from a lower priority focus on back office
operations and systems to historical factors as a result of
mergers and acquisitions. All of these point towards the Current Structure Future Structure

need for a fundamental relook at the back office
structure so that it is both nimble and robust enough to
efficiently discharge its responsibilities in the days to
come.
1. From Product Silos towards a Unified Back Office: The
back office structure of the future would be centralized, with
focus on a product agnostic and round the clock processing
capabilities.
Currently the back office functions of most
brokerage firms are normally modeled to mirror the
front office structure which is typically by product
class/business lines and geography. These result in
distinct vertical silos, with each silo handling post trade
processing for a different product class within a
In the future, brokerage firms would implement a Kanishka Dasgupta
unified back office structure for the back office centered is a Business Analyst
around the adoption of cross product strategy where in the Clearing &
each person needs to have knowledge of multiple Settlement Domain
products. The back office would be a centralized Focus Group within
processing hub providing a 24 by 5 seamless service to the Securities & Capital Markets
clients and traders across the globe. Brokerage firms Domain Consulting Group. His
would also look to explore leveraging third party significant achievements in career
vendors providing such services out of offshore include setting up one of the largest
locations especially for their more standardized back office processing centers in
functions. Such a structure is also expected to bring India for a leading investment bank.
significant benefits around process standardization He is currently based in Hong Kong.
besides providing a holistic view of the client and firm Email:
wide risk. kanishka.dasgupta@wipro.com
 CAPITAL MARKETS
NSIGHTS
A Domain Consulting Publication
2. From System Fragmentation towards Integration: The back office of the
future would center around a few core enterprise wide systems supported by
componentized local market processing capabilities and interfaces.
The current application landscape of most brokerage firms consist of
systems dedicated to specific asset classes. This is often a direct outcome of
the time to market demands placed by the front office to remain competitive
by trading in new products and the inability of existing systems to
accommodate these new instruments. Furthermore most of these systems
are legacy applications that had not been built to take care of the evolving
market infrastructure. They normally would require significant
development costs to improve STP and ensure that customer service
remains at consistently high levels. The fragmentation of systems also
means that commonality of processes cannot be leveraged across the
organization.
While a single application handling all asset classes and processes might
look attractive, no such system exists today. Furthermore such a solitary
colossal system, even if it had the required features to support front to back
flow for different instruments would in all probability be unable to
accommodate the time to market requirements of new flows.
Instead the brokerage back office of the future would consist of a limited
number of specific enterprise wide solutions providing coverage across
different business lines and product classes. Such applications would
consolidate and handle similar processes across the enterprise – for
example a cash settlement function which involves comparable steps
irrespective of the instrument being traded or MIS.
The architecture of such systems would be componentized with the core
solution separate from local processing modules which would handle
market specific requirements. The solution needs to be dynamic and
configurable to cope with changes in market infrastructure along with the
ability to handle large volumes across the organization.
3. From Partial Automation towards STP: The back office of the future would
function with a high degree of operational efficiency involving real time controls
and automated exception management.
22
While the concept of STP has been around for quite some time, the
progress in increasing STP rates in brokerage firms has not always been
significant. The reasons are often due to the substantial effort, cost and
complications involved in transforming processes. But the recent market
turbulence has brought the spotlight and focus back on STP projects. Firms
are viewing investment in STP projects as obligatory and crucial towards
building more efficient processes, effective risk management and above all
providing differentiated customer service.
Back offices of the future would have minimum manual intervention in
their front to back process. To achieve this state the firm would integrate
people, process and technology, make use of business process management
tools and display an obsessive focus towards data quality. They would use
and insist on common protocols in their interactions with clients and
market participants and be first movers to align themselves with industry
trends that focus on STP among other things.
Exceptions when raised in such a process would be handled in an
automated fashion wherever possible. In the case of reference data issues
for example, this could involve automatic triggering of alerts to the Data
division and to the concerned back office department responsible for
monitoring the exception. The system would have in built rules to attempt
and restart processing on its own from the point where it stopped by
looking up the reference data system after a pre determined time. In case of
exceptions where manual intervention is required the system would
automatically allocate and prioritize exceptions to ensure relevant action
can be taken as quickly as possible to resolve the issue.
Conclusion
The processes and systems of back offices of brokerage firms are currently
not always aligned or equipped to optimally meet the wants of a constantly
evolving market place and demanding customers. Brokerage firms would
need to put in place a strategy and structure for their back office focused
around the ability to provide continuously differentiated customer service
at the lowest cost.

23
Cloud computing in the Asset Management World –
A soothing remedy products, newer trading techniques and newer pricing
Shishir Gupta
It is believed that “Every cloud has a silver lining”. After every
financial crisis, like a sphinx from the ashes, have arisen
newer business strategies, operational technologies, financial
products and pricing techniques. This time around too, in the
aftermath of the financial destruction that has left America
and the world in shambles, there is a ray of hope for the asset
management industry. The hope lies in the usage of the
power of cloud computing and its collaboration with services
like Software as a Service (SaaS), Infrastructure as a Service
(IaaS) and Platform as a Service (PaaS). This article intends to
throw light on the opportunities that are available on the
horizon for the asset management industry players through
the use of the untapped potential of cloud computing.
The Asset Management world today: The global financial
services industry spent $558.4 billion in 2008 on IT
(hardware, software, IT services, internal services and
telecommunications) (Roster, 2009). A major component of
the $558.4 Billion was spent on infrastructure maintenance,
payroll costs, capital expenditure on acquisition on new
hardware and software licensing costs. This implies that
financial institutions are trying to spend much money in the
delivery and servicing systems rather than investing in their
core business. High spends in delivery and servicing
applications are because these applications comprise mainly
of products, both purchased and in-house developed. These
products have high maintenance costs, licensing cost and
are perilously dangling on becoming outdated.
In the front office world, portfolio management systems
(PMS) are a classic case. With the introduction of newer
CAPITAL MARKETS
NSIGHTS
A Domain Consulting Publication
In the aftermath of the
financial meltdown,
revival in the Asset
Management industry
lies in the usage of the
methods in the market, the PMS application needs to power of cloud
undergo a change not only in functionality but also in the computing and its
overall look and feel of the application. It should have the collaboration with
ability to assist the fund manager to create winning portfolios
services like Software as
with timely identification of risks and portfolio re-balancing.
Take the case of data management function in the middle a Service (SaaS),
office – this involves maintenance and storage of reference, Infrastructure as a
pricing and market data along with ability to leverage data to Service (IaaS) and
support trade execution, performance, compliance, and
Platform as a Service
reporting. This means that the fund needs to ensure that the
data is scrubbed regularly, checksum is maintained and data (PaaS).
remains secure and reliable. In the back office world, fund
accounting is an important function – this involves
calculation of the Net Asset Value (NAV) including the
calculation of the funds' income and expense accruals,
Maintenance of the fund's financial books and records,
reconciliation of daily and Monthly Broker Statement etc. It is
a critical function and any lapse in this area affects the
valuation of the assets and the mark-to-market calculation for
not only the fund itself but also for all the investors.
The above functions are just a few examples where we
Shishir Gupta is a
find that the AM world is trying to come to terms with
Business Analyst in
newer needs and changing critical requirements.
the Asset Management
Intricacies in the AM world: To comply with the need of the Practice group within
AM industry to be innovative and profitable, high capital the Securities &
expenditure is required in acquiring new applications along Capital Markets Domain
with the intricate process of hiring of scarce, right skilled and Consulting Group. He has
high wage employees to operate those applications. There are experience in SWIFT and Asset
other operational issues in relation to management of device Management functions. He is based
and location dependencies, under utilization of resources and in Bangalore, India. E-mail:
thorny aspects of reliability, security, scalability and shishir.gupta1@wipro.com
 CAPITAL MARKETS

NSIGHTS
A Domain Consulting Publication
24

sustainability. The integration of newer applications, enhancement of current
applications, introduction of newer devices, newer platforms, compliance to new
regulations etc leads to issues such as high application down time, longer integration
cycles, high maintenance cost, large regression errors etc, which might impact damage
a financial institution's reputation and image as well as land it into legal troubles. So
what can help AM industry in this situation and time?
Cloud computing to the rescue: A recent Gartner report states that the current
SaaS market is a paltry $6.4 Billion; this pales in comparison to the $558.4 Billion
spent on IT. (Roster, 2009). This piece of information should whet the appetite of
any investment fund manager. In the case of data management function, cloud
computing provides the ability to the fund manager to store his data at a remote
place accessible through the cloud network. The database would be acquired and
maintained by a service provider and licensed to the fund manager for a fee. The
fund manager would be able to use the database without incurring the cost of
maintaining it. He would not be required to acquire the hardware, upgrade it
periodically or hire a large employee base. Any additional requirement of
additional space would be fulfilled by the service provider for a fee.
Applications providing services like fund management or corporate action or
transfer agency functions can be acquired by a service provider and then
provided to different funds for a fee. This would resolve the issue of under
utilization of resources and help save costs. 1If we consider regulatory
compliance, it is a need common across players. If compliance monitoring and
reporting can be hosted by a common service provider, then the cost of frequent
upgrades and patches to the applications can be eliminated altogether.
Most of the applications under cloud computing would be device and
location independent as the software would be available through the web. Even a
handheld phone or laptop can easily be used to execute the applications. The
service providers would also offer the option of customization to the service and
infrastructure provided to each fund. Funds would have the option to terminate
the services of a provider anytime and switch to the next provider.
Concerns in Implementation: This disdain for cloud computing may not be due
to lassitude but is attributable to a number of concerns, especially from the asset
management point of view:
a. Security concerns: Data in the asset management industry typically consists of
security positions, cash positions, trade positions etc, which is highly confidential and
as the data under cloud computing is in the hands of a third party, it stands exposed
and is prone to fraud or breach. The fund would require the service provider to
provide proper data security, periodic consistency checks, proper business continuity
plan in the advent of disaster and has a proper business day support.
b. Availability concerns: In case the applications at the service provider's
location go down at the prime time, it can lead to probable losses and penalty for
the fund. Say, at EOD, the NAVs need to be calculated and at that point of time,
the fund accounting application goes down for a long period. The NAV
calculations would not be completed and fed to the markets in time; this could
lead to dissemination of wrong information in the market. Some of other pain
areas could be non-compliance to laws like AML (anti-money laundering)
monitoring and improper reporting.
c. Portability concerns: Today, most of the big IT firms like Microsoft, Google,
Amazon, Yahoo etc. are engaged in developing platforms and applications for
cloud computing. The worst bit is that all of them are trying to sell their own
proprietary code and network, so in case a fund engaged with one provider
decides to shift its services from one network to another, there could be a problem
in portability. The change in platform or application may affect the data
consistency and reliability or even loss of data.
Conclusion: Cloud computing would be a boon to the Asset Management world
in these financially difficult times, provided the concerns in implementation are
met. A concerted effort by both the investment fund and providers (initiatives
like open source development) is required to bring about a successful cloud
computing revolution to the Asset Management world.
References:
- Roster, Jeff, “IT Spend by Industry Worldwide”, Gartner, 2009,
- Wikipedia, http://en.wikipedia.org/wiki/Cloud_computing, 2009
1. Depends on the kind of charging methodology utilized – time based (subscription model) or
amount of resource based (Utility model). There are different charging methodologies that can be
used in cloud computing. Further reading recommended.
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Securities & Capital Markets Vertical, Wipro Technologies, No 70, 1,2,3,4 & 84 Keonics Electronics City,
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