Classifications

• • G—PHYSICS
  • G06—COMPUTING; CALCULATING OR COUNTING
  • G06Q—INFORMATION AND COMMUNICATION TECHNOLOGY [ICT] SPECIALLY ADAPTED FOR ADMINISTRATIVE, COMMERCIAL, FINANCIAL, MANAGERIAL OR SUPERVISORY PURPOSES; SYSTEMS OR METHODS SPECIALLY ADAPTED FOR ADMINISTRATIVE, COMMERCIAL, FINANCIAL, MANAGERIAL OR SUPERVISORY PURPOSES, NOT OTHERWISE PROVIDED FOR
  • G06Q40/00—Finance; Insurance; Tax strategies; Processing of corporate or income taxes
  • G06Q40/04—Trading; Exchange, e.g. stocks, commodities, derivatives or currency exchange

Definitions

• This invention relates to a set of linked methods, system upgrades, computer program products and financial product designs for enabling trading and settling of new product types on what where hitherto only futures exchanges and their clearing houses.
• the present invention relates to a method, a system, and a computer program product for trading and settling:- exchange traded credit derivatives, exchange traded interest rate swaps, exchange traded money market derivatives plus other exchange traded structured derivative contracts and also equivalents of more traditional non-derivative debt products e.g. deposits etc BACKGROUND TO THE INVENTION
• the current invention is mostly concerned with derivatives of the debt markets only. Raising debt (i.e. getting new money) is important. Having money is an advantage as it can be used to buy goods and services. Alternatively consumption can be deferred and the money invested in a business either by buying shares or more directly. In either case investing in a business always carries some considerable risk but with the hope of receiving a risk proportionate positive return on the investment. Taken as an average over the whole economy but depending on prevailing conditions such equity investments will tend to grow.
• a credit rating agency is a firm that provides its opinion on the creditworthiness of an entity and the debt securities issued by an entity.
• the rating scales are different for short term and longer term debt and different ratings may apply depending on who the legal borrower is e.g. parent or subsidiary.
• the distinction is partly due to the different purposes for which loans are typically required.
• the money markets are a major source (and sink) of funds for cashflow management i.e. corporate treasury operations.
• the primary capital markets are usually used for raising money required for investment in a company's business plans and include equities as well as debt.
• a debt security issued into the money markets is generally known as a "bill” whilst a debt security issued into the capital markets is often referred to as a "note” or "bond”.
• An additional distinction between money markets and capital markets is the role of the central banks. Central banks actively manage and seek to dominate supply and demand in the short term rate environment of their respective currencies. They do so in an attempt to control economic activity.
• the bond markets on the other hand are freer to find their own level occasionally frustrating central bank short rate moves by shifting in the opposite direction.
• interbank liquidity resides at certain predetermined points on the maturity curve.
• "Tomorrow-next" or “tom-next” (TfN) is simply the next business day's overnight but traded today.
• spot date which is simply trade date plus two business days (T+2).
• money market convention for these so called on-the-run points, which depend on the currency traded (because of national holidays) :-
• N-month/years date Is the same calendar day in the month or the nearest to it as the spot date but N months or years afterwards (e.g. If spot is 31st March then 1-month later is 30th April). If this is not a business day the next business day after that applies unless this takes us into the wrong (i.e. next) month in which case it's the previous business day that applies
• yield is non-trivial to calculate it is nonetheless a straightforward indicator of value for money. Better value in the context of the secondary market will of course mean cheaper so it is hardly surprising that a price against yield graph for a single bond will show its price dropping as yield goes up. However since holding the bond represents rights to positive cashflows on future coupon payment dates and at maturity, the bond's price can never go negative however high its yield goes. This means that the bond price will drop off more and more slowly as yield goes up and this effect is referred to as "positive convexity".
• Yield is such a useful concept that traders will often appear more interested in it than price especially when switching from one bond into another i.e. selling a previous holding to buy a new one. However traders will never lose sight of price because that is what their profits and losses are measured in. Clean price and accrued interest
• Dealers in the market place do not quote the full price when trading in price terms but instead quote a so-called “clean price”.
• the full price is known as the "dirty price” and the clean price is the dirty price less “accrued interest” which is defined below.
• Issuer type is important as credit ratings give the risk of default but not the expected recovery rates which are part of the overall risk and hence credit spread.
• the yield curve is important to traders because money can be made from predicting the shape changes it undergoes and indeed by borrowing and lending at different maturities. It is important to note that rates may move but with no change in shape of the yield curve. This parallel shift up or down in the curve is a neutral assumption that is often applied by traders when setting up their curve related strategies.
• CDOs Collateralised Debt Obligations
• SPVs Special Purpose Vehicles
• entities set up to allow for the transfer of risk from the originator to an entity that is generally thinly capitalised, bankruptcy-remote and isolated from any credit risk associated with the originator.
• SPVs Special Purpose Vehicles
• the SPVs business purpose and activities are limited to only those necessary to effect the particular transaction for which the SPV has been established (for example, issuing its securities and purchasing and holding its assets), thereby reducing the likelihood of the SPV incurring post-closing liabilities that are in addition or unrelated to those anticipated by rating agencies and investors.
• CDOs are designed so that investors can directly benefit from the diversification inherent in the underlying portfolio. This underlying collateral pool is repackaged so that they have the choice of buying junior, mezzanine, senior and super senior segments etc.
• the exact tiering depends on the deal but typically tranches are defined by two percentage face value numbers - The lower number known as the attachment point defines the minimum losses to which the investor is exposed while the higher number known as the detachment point defines the maximum losses.
• An alternative method of tranching is achieved by defining tranches in terms of the defaulting entity i.e. the first to default, second to default tranches etc.
• CDO tranches are invariably rated in order to make them saleable to funds whose rules demand only credit rated assets of certain quality are purchased i.e. the majority of traditional funds. As tranches are exposed to portfolio losses above and below certain thresholds, each tranche must carry an attractive coupon relative to its credit ratings or investors will not buy it. Issuers therefore work closely with credit rating agencies to "ramp-up" the value of each tranche relative to the risk it carries i.e. to package the diversification benefits as attractively as possible. [0061] In summary buying into a CDO can give investors exposure to a well- diversified range of credits, industries, geographical regions or structures that they may have been unable to access independently.
• a derivatives contract can be defined as an agreement between two counterparties in which rights and obligations are set up whose economic value, either by direct reference to a benchmark price quote or by operation of the contract in its delivery phase, can be derived from one or more underlying (often called 'cash') products.
• 'cash' underlying
• Open outcry was made even more efficient by participants wearing jackets colour coded to their job role or brokerage firm. Pit dealers would also sport large badges etched with their individual trader mnemonic (a three or four letter code) and exchange member ID. In most commodity types there was never more than one contract expiry available to trade per calendar month, thus each month could be allocated a unique single letter code. [0072] In open outcry after a trade was agreed and checked each counterparty in the pit would fill in an order ticket with their own half of the trade details i.e. bought or sold, price, number of lots, futures expiry month code and counterparty trader mnemonic. These so called filled orders would be handed from the pit to so called runners who would process the paperwork in order that matched trades could be efficiently registered with the exchange.
• ISDA International Swaps and Derivatives Association
• FIG. 1 A schematic representation of the legal structure of a single ISDA based derivatives trading relationship is shown in Figure 1. Since OTC derivatives are leveraged any legal or other operational failings can result in substantial losses. Therefore among ISDA' s most notable accomplishments was the development of its Master Agreement (see item 106 of Figure 1) and the publishing of a wide range of related documentation materials and instruments covering a variety of transaction types (see item 108 of Figure 1). Note however the clumsy way that each new trade has to be confirmed by appending a trade confirmation contract to the ISDA master agreement (see items 110, 112 and 114 of Figure 1). Note also that there must be at least one master agreement between any pair of counterparties (see items 100 and 102 of Figure 1). ISDA therefore failed to address in a meaningful way the scalability of trade confirmation and new counterparty workload even as it addressed the legal robustness of each instance of the contracts concerned.
• Figure 2 shows a schematic representation of the legal structure of exchange based derivatives trading. It is clearly more intricate than Figure 1 but crucially is far more scalable especially for smaller clients.
• Brokerage agreements give customers (see items 202 and 204 of Figure 2) access to exchange (see item 200 of Figure 2) via members (see items 220 and 222 of Figure 2) acting as their main futures broker and executing trades on their behalf (see item 218 of Figure 2).
• Such 'clearing' members must therefore be members of both the futures exchange and its clearing house (see item 230 of Figure 2).
• This is achieved via exchange membership agreements (see items 214 and 216 of Figure 2) and clearing membership agreements (see items 224 and 226 of Figure 2) respectively.
• Members acting as brokers are required to collect margins calls from customers and to enforce the rules of the clearing house as regards maintenance of sufficient margins in customer accounts.
• Non clearing exchange members because to access the market such members need a relationship with a clearing member in any case. They thus appear similar to clients. Shown separately in Figure 3 is the process permitted by exchange rules and systems that allows a customer (see item 300 of Figure 3) to use several different brokers. One broker may be used for execution of trades (see item 304 of Figure 3) but another broker may be used for clearing (see item 306 of Figure 3).
• the assigned filled orders are transferred from the responsibility of the executing member to the clearing member within the clearing house (see item 310 of Figure 3) via a process called a "give up" (see item 308 of Figure 3), governed by a so called give up agreement (see item 302 of Figure 3).
• Such give up instructions are usually handled by post-trade exchange or clearing house software.
• the give up process for short positions is not shown in Figure 3 but is identical.
• Figure 4 shows a logical representation of operational information flow in existing exchange based derivatives.
• Item 400 of Figure 4 represents just one of the many dealers trading on the exchange.
• the dealers decisions will be informed by general activity observable across various markets and news as published by quote vendors (see item 402 of Figure 4) such as Reuters, Bloomberg etc.
• the dealer shown also has direct access to the market place and via their own front office trading system (see item 404 of Figure 4) they are therefore likely to be a broker or a high volume trader. Low volume traders will tend to place orders by telephone via a broker (not shown).
• the front office trading system typically connects to the exchange via a so called exchange gateway (see item 408 of Figure 4) which forms the physical and logical boundary to the exchange maintained systems.
• the matching technology also calculates market status information (see item 412 of Figure 4) such as the lowest unmatched sell orders known as the best ask or offer and the highest unmatched buy orders known as the best bid. These are published via quote vendors (see item 402 of Figure 4) and of course to the trading screens themselves (see item 404 of Figure 4). The volumes of unfilled bids and asks at each permissible price respectively below and above the best bid and ask are known as the orderbook and are often also publish.
• the market supervision function (see item 410 of Figure 4) is one of the most important in the exchange.
• Daily settlement prices are used by the clearing house (see item 422 of Figure 4) to calculate variation margin calls to or from members (see item 416 of Figure 4) and because of their importance are also published by quote vendors (see item 402 of Figure 4). Another important set of published information is related to total outstanding contracts on which initial margin is collected and is known as open interest (see item 424 of Figure 4).
• STP straight through processing
• the back office trading reports (see item 406 of Figure 4) are these days likely to be in electronic format and both these and the front office trading systems can therefore' be linked into front office position keeping, risk management and reconciliation systems if deemed necessary (not shown).
• Much of the infrastructure for STP is nonetheless provided by the exchange and its clearing house for relatively modest and totally transparent fees per lot charges.
• the modern electronic futures exchange model therefore not only provides good cost effective STP infrastructure but upgrades are automatically enforced across the user base as they are centrally managed by the exchange and its clearing house.
• Margining and anonymity is the deposit of cash or collateral placed with the clearing house when you create a futures or options position. Unlike ISDA' s collateral management and other independent initiatives within the OTC based market the use of clearing and central counterparty services provided by the clearing house is mandatory at a futures exchange. In a process known as novation the web of bilateral counterparty credit exposures is first replaced by all members' contracts becoming with the clearing house. In a process known as margining collateral is then deposited at the clearing house and topped up on an as needed basis to guarantee performance of the contract and thus eliminate counterparty credit risk.
• the exchange's margining system provides important protection to the market. This protection is arranged by the clearing house which guarantees performance of contracts registered with it by its members. Any exchange member who is not a member of the clearing house must therefore have a clearing agreement with a clearing member in order to transact business on the exchange. To become a clearing member certain minimum financial requirements laid down by the exchange and clearing house must be met. Members are monitored to ensure that they continue to meet specified criteria. There are usually different categories of clearing membership depending on whether the member clears only its own business or can act as a broker etc.
• Variation margin and daily settlement prices [0104] At a fixed time of the trading day, usually after the close of trading of in a contract series, the exchange determines and then publishes so called daily settlement prices for each expiry (and where applicable strike) within the series. Daily settlement prices are simply a set of reference prices consistent with market activity at settlement time. The key to the variation margin process is the exchange's determination of an accurate daily settlement price for each and every futures and options contract. If at settlement time there is insufficient trading activity to observe a settlement price directly, market supervision can use prices generated by a relevant pricing model based on prices from a related market. Settlement prices are automatically transmitted to member back offices.
• New York Stock Exchange (NYSE), The National Association of Securities Dealers (NASD), The International Securities Exchange (ISE) and The Boston Stock Exchange are all OCC participant exchanges. Where contracts are dual listed a position initiated on one exchange can be closed on another.
• Initial margin thus guarantees in advance that all those due to receive gains will continue to get them even on a day when someone defaults. In this way the initial margin acts as a deposit which may be used by the members and the clearing house to satisfy the customer's or clearing member's obligations if the customer or clearing member fails to do so.
• the amount of this initial margin is set by the clearing house based on historical trends in terms of market price volatility as well as forthcoming events which may further affect volatility.
• An account's initial margin requirement is calculated as the largest possible loss (including all futures and options positions) that a trading account would face in the worst case scenario of market events. The details of these calculations vary from clearing house to clearing house but often recognise that customers' portfolios may hold offsetting positions. However clearing houses must remain conservative as excessively low levels of initial margin risk the integrity of the exchange. If on the other hand offsetting positions are not recognised appropriately, traders may not be able to make the most efficient use of their resources, which may lead to their exiting the market in favour of OTC or another exchange venue. Good quality margining is thus essential to maintaining liquidity.
• the invention aims to reengineer the existing electronic futures exchange model in order to establish convenient on exchange access to spot and forward derivatives normally only available on the ISDA based OTC market.
• electronic futures and options exchanges can become truly worthy of the title 'derivatives exchanges' by fully meeting the exact needs of hedgers and speculators for the first time as ISDA has now been doing for the past twenty years.
• the ability of office based independent traders to participate in the invention's new ISDA-like derivatives products plus the release of existing OTC participants from ISDA's scalability problems (particularly in credit derivatives) can be expected to lead to an explosion in liquidity.
• the invention aims to deliver a far better way of trading.
• the problems of exchange traded equity options will come to be seen as a temporary aberration and an artefact of a mispricing of infrastructural services.
• Interest rate financial futures and options There are two established types plus one less established type:- ⁇ Short Term Interest Rate (STIR) futures such as CME three month Eurodollar, LIFFE three month EURIBOR etc; and
• step 500 of Figure 5 the exchange determines whether the last trading day has arrived. If the last trading day has not arrived then normally daily settlement occurs and the position remains as a futures or options one as indicated at endpoint 502 of Figure 5. However if the last trading day has arrived then the final daily settlement price known as the Expiry Day Settlement Price (EDSP) is set at step 504 of Figure 5 via a predefined formula (see 506 of Figure 5) linked to external data related to the underlying market. As a result of this at the endpoint 508 of Figure 5 the final variation margin is called, the position is deleted from the clearing house register and initial margin is returned.
• EDSP Expiry Day Settlement Price
• the external underlying market data for cash settlement is an appropriate fixing taken from the deposit market.
• LIBOR London Inter- Bank Offer Rate
• the formula linked to this external underlying is simply: -
• step 600 of Figure 6 the exchange determines whether the last trading day has arrived. If the last trading day has not arrived and there is no option to make early delivery as indicated at step 602 of Figure 6, or indeed the option exists but is not exercised then position remains as a bond future (see 604 of Figure 6).
• the specified criteria for the bonds deliverable into a futures contract listed on an exchange can be found in its contract specifications.
• the exchange will publish an initial list of the bonds, as shown at step 612 of Figure 6, which it believes form the complete list of deliverables in time for market feedback. Such a list is commonly known as the basket.
• the basket contains different bonds which vary in their characteristics but match a set of criteria specified by the exchange for each different type of bond future.
• Each bond is assigned a conversion factor which is applied to the final invoice price calculation should it be delivered and is also published in the lists of deliverables together with accrued interest information (see 608 and 612 of Figure 6).
• This conversion factor is the mechanism which brings the maturity and coupon differences of the deliverable bonds onto a common base and is intended to make all of the bonds almost equally attractive for delivery. In practice however difference remain and a particular bond known as the cheapest to deliver is the most attractive. [0135] If the last trading day has arrived or an early delivery option has been exercised then the short futures holder must notify the clearing house which deliverable from the list they have elected to deliver (see 606 of Figure 6).
• the clearing house can then assign a long futures holder (see 614 of Figure 6) either at random or according to some other rule to take delivery.
• the daily settlement price is known as the Exchange Delivery Settlement Price (EDSP) but is set by the market supervisor according to prevailing conditions in the futures market as normal (see 616 of Figure 6).
• EDSP Exchange Delivery Settlement Price
• the bond seller delivers the same face value of bond as the notional size of the futures contract (e.g. $100,000 for CBoT ten year T-note future) in return for the proceeds of the sale as calculated by the clearing house (see 618 of Figure 6).
• the proceeds of the sale resulting from a single delivery are determined by the EDSP multiplied by the delivered bond's conversion factor and adjusted for accumulated accrued interest at delivery. This is called the invoice amount: -
• Invoice amount . Nominal Size * (EDSP% * Conversion factor + accrued interest%) [0137]
• the long futures holder pays this invoicing amount to short futures holder in exchange for elected bonds, relevant futures positions are closed and initial margin is returned. This transaction in the cash bond market prompted by the choice of bond to deliver by the short futures holder is called making delivery.
• Swap related futures give cash settled exposure akin to what would be achieved by a bond future whose underlying CTD carried the credit quality of the
• OTC Interest Rate Swap market and also had a perfect maturity match i.e. CBoT ten year Swap future is linked to an exact 10 year term of the swap market.
• S represents the ISDA Benchmark Rate for the M-year U.S. dollar interest rate swap on the last day of trading, expressed in percent terms
• CaIl EDSP Max(0 Reference Price - Strike Price)
• PutEDSP Max(0, Strike Price - Reference Price)
• step 702 of Figure 7 the exchange determines whether the option is in the money at expiry using a reference price (see 700 of Figure 7). This check is simply the same as checking if the option EDSP would be greater than zero were it a cash settled one. If not the option reaches endpoint 704 of Figure 7, remains as an option and expires worthless.
• the option holder has the additional right to manually exercise at any time prior to expiry (see 706 of Figure 7) but if the option is not exercised in this way either we are again at endpoint 704 of Figure 7.
• a final constraint that is certainly counterproductive and again merely conventional is the fact that all term futures products are listed as so called forward- forward products.
• forward-forward curves are filled in to include all possible expiry dates you will have a single contract going to final completion each day.
• spot market curves will contain different maturity terms but all for 'immediate' delivery whilst true forward market curves will also contain different maturity terms but all for deferred delivery on the same forward date.
• FSAs Forward Rate Agreements
• Overnight Indexed Swap [0157]
• OIS Overnight Indexed Swap
• one side pays a money market term deposit interest at a level negotiated at time of trading and the other side the relevant overnight index (e.g. the Fed funds rate) compounded over the same term.
• An OIS thus replicates off-balance sheet a mismatched deposit position of 1) a short term loan funded by an overnight deposit; or 2) an overnight loan funded by a short term deposit, depending on whether you are receiving or paying the term rate. Both rates are calculated on an agreed notional principal which does not however change hands.
• a FRA In a FRA one side pays a term deposit interest at a level negotiated at time of trading and the other side a market rate for the deposit at contract maturity. On the day the FRA is priced the market rate is defined by the relevant interest rate fixing (e.g. the BBA 1-month $ LIBOR rate). Crucially both payments are discounted using this same interest rate fixing. Because of this a FRA, as the name implies, truly allows traders to lock in a forward rate as they can simply use the deposit market to complete their hedge. Both rates are calculated on an agreed notional principal which does not however change hands. Three month and six month FRAs are the most common.
• relevant interest rate fixing e.g. the BBA 1-month $ LIBOR rate
• IRS Interest Rate Swap
• a floating interest rate e.g. the BBA 3-month $ LIBOR rate
• the fixed interest rate is struck at a level negotiated at time of trading and depends on the term of the contract. Both rates are calculated on an agreed notional principal which does not however change hands at final maturity.
• An interest rate swap is thus very similar to a sequence or strip of FRAs all struck at the same fixed rate.
• OTC credit derivatives [0163] In the traditional debt markets poorer credit (higher risk) borrowers must pay higher rates than lower risk borrowers. Conversely investors may generally assess the risk of a particular borrower in terms of the higher or lower market rates prevailing for their debt. However prevailing rates have to be seen in the context of the general supply and demand conditions that affect all debt. In particular the general level of riskless government or IRS yields will underlay movements in market rates for all other borrowers' debt. For this reason liquidity has tended to concentrate in these two markets at the expense of corporate debt.
• a CDS Index is just a set of single name CDSs traded as a group.
• the index tranche market is also very interesting.
• the concept is the same as for cash CDOs i.e. tranches are defined by two percentage face value numbers with the attachment point defining the minimum losses to which the protection seller is exposed and the detachment point defining the maximum losses.
• the attachment and detachment points are standard (i.e. 0%-3%, 3%- 6%, 6%-9% etc in Europe, 0%-3%, 3%-7%, 7%-10% etc in North America) a liquid market for correlation has developed.
• the fair spread premium for an index depends on the overall risk which is a function of the individual names in the underlying portfolio and how diversified the it is. In other words the default correlation must be known in order to fair value an index CDS. Interestingly index tranches have different exposures to correlation. For example higher correlations makes the risk within different tranches more equal which benefits investors in the most junior tranche whilst hurting investors in the higher seniority tranches.
• the invention is based on the modification of the components that make up a modern electronic futures exchange in order to vastly extend the range of products and services supported. Although some of the new products described are designed to mimic existing products the modified electronic futures exchange has significant structural advantages in any case over rival methods of delivering similar exposures.
• Figure 1 is a schematic representation of the legal structure of ISDA based derivatives trading
• Figure 2 is a schematic representation of the legal structure of exchange based derivatives trading
• Figure 3 is a schematic representation of the give up/in process of exchange based derivatives trading
• Figure 4 is a logical representation of information flow in existing exchange based derivatives
• Figure 5 is a flow diagram representing existing cash settled exchange traded futures and options
• Figure 6 is a flow diagram representing the physical delivery process for exchange traded futures as used for existing bond futures;
• Figure 7 is a flow diagram representing existing physical delivery into futures of exchange traded American options;
• Figure 8 shows the transformation of information flow in the invention based derivatives exchange
• Figure 9 shows how a front office screen for an exchange traded credit derivative might appear on 3rd October 2005;
• Figure 10 shows the Adapted For Exchange New Credit Derivative invention mapping of Traded Spread Product orders onto Internal Matching Product orders
• Figure 11 shows the Adapted For Exchange New Credit Derivative invention mapping of Internal Matching Product orderbook for display as Traded
• Figure 12 shows the Adapted For Exchange New Credit Derivative invention mapping of Internal Matching Product fills into front office Traded Spread
• Figure 13 shows the Adapted For Exchange New Credit Derivative invention flow diagram for pro rata Credit Coupon Product pricing breakdown
• Figure 14 shows the Adapted For Exchange New Credit Derivative invention flow diagram for Credit Coupon Product pricing breakdown from market prices
• Figure 15 shows the Adapted For Exchange New Credit Derivative invention flow diagram for Credit Coupon Product daily settlement calculation
• Figure 16 shows a schematic overview of the event protection products and processes which generate credit protection within the Adapted For Exchange New
• Figure 17 shows the Adapted For Exchange New Interest Rate Swap invention flow diagram for Floating and Fixed Coupon Product position breakdown
• Figure 18 shows the Adapted For Exchange New Interest Rate Swap invention flow diagram for Floating and Fixed Coupon Product daily settlement calculation
• Figure 19 shows the Adapted For Exchange New Money Market
• Figure 20 shows the Adapted For Exchange New Money Market
• Figure 21 shows the Exchange Traded Pooled Deposit Market Invention flow diagram for mapping and reverse mapping
• Figure 22 shows a schematic Representation of the trading of Clearing
• the invention consists of a number of linked innovations in product design, product management processes, pre and post trade systems design, product settlement processes and the role of the clearing house that when applied to an existing electronic futures exchange lead to the establishment of convenient on exchange access to spot and forward derivatives normally only available on the ISDA based OTC market. Not all products will rely on all the innovations.
• an innovation which involves the role and business processes of the exchange's clearing house can also be extended to a number of further inventive applications distinct from the trading of ISDA-like products on exchange yet potentially extremely useful to the financial markets.
• the invention can be clearly distinguished from all others which merely try to create exchange-like electronic central market trading systems and/or post trade clearing systems that remain within the ISDA based OTC markets' legal structure or analogues to it.
• Existing inventions of this first type typically show no recognition of the advantages of the traditional futures exchange model.
• There are numerous examples such as those dealing with central markets for ISDA based products (e.g. the patent application USPA 20040143535, July-22-2004) or those dealing with counterparty credit arising from the ISDA market structure (e.g. the patent US 5,802,499, September-1-1998) or those dealing with the post-trade confirmation process so unnecessary in a futures market model (e.g. the patent US 6,274,000, June- 21-2001).
• the invention can also be clearly distinguished from all others which merely try to create genuine exchange traded futures that indirectly reference the ISDA based OTC markets either via a cash fixing on those markets or indeed via structured negotiable securities with ISDA based products embedded in them e.g. via credit linked notes.
• Inventions of this type have typically shown complex innovations in product design and product settlement processes whilst retaining the historically straightforward link between pre and post trade of traditional futures markets.
• a leading example of this approach is "Swapnote” (see the patent US 6,304,858 Bl, Oct-16-2001 ) which although it is traded under license on the fully electronic futures exchanges of LIFFE and TIFFE would have been perfectly capable of being traded in the old open-outcry markets.
• the invention can also be distinguished from certain already existing exchange traded futures which merely introduce convexity into the standard futures environment in a non-parametrical and non time-valued way e.g. interest rate futures and options as currently traded on the Sydney Futures Exchange.
• Exchanges include designated contract markets and derivatives transaction execution facilities.
• Futures Contract An agreement [on exchange] to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) that obligates each party to the contract to fulfil the contract at the specified price; (3) that is used to assume or shift price risk; and (4) that may be satisfied by delivery or offset.”
• the object of this part of the invention is to give access to genuinely
• ISDA-like derivative exposures within a purely electronic futures exchange-like environment Two key points to notice about this invention are:- ⁇ Spot market - That it gives daily spot not forward exposure for the first time on a futures exchange-like environment.
• Most ISDA based credit, interest rate swaps and money market products are spot derivatives not forwards. This means that they give exposure to the relevant term structure from the very beginning of the curve. This contrasts with futures which are analogous to ISDA based forwards.
• ⁇ Quasi-negotiable securities By moving away from the current ISDA based bilateral model onto a futures exchange-like environment the products behave similarly to negotiable securities when viewed from within the exchange's membership and clearing structure. However a 'transfer' of title when it happens is in fact achieved by one client closing their position with the clearing house while their counterparty opens an identical new position.
• ⁇ Robustly fair marketplace The supervisory environment of a genuine exchange is such that a customer is protected by the exchange's trading rules and members are appropriately punished for breaches of best practice conduct. Both the central marketplace at the exchange and also the central depository at the exchange's clearing house provide easy access to the audit trails required whenever an investigation is commenced.
• ⁇ Risk management via daily settlements A key concern of regulators is that derivatives positions may be mispriced by uninformed or indeed fraudulent dealers within less sophisticated or indeed careless financial institutions.
• the exchange's mark to market procedures via daily settlements should greatly reduce this problem for internal compliance officers of smaller or less sophisticated financial institutions.
• o Efficient counterparty structure The legal structure of a genuine exchange is such that access to all the exchanges products can be achieved via any member that is allowed to offer such a service under the exchange and clearing house rules and any other relevant regulatory constraints.
• the prospective customer must simply sign a single brokerage agreement with that member to access all products.
• ⁇ Access via brokers As many brokers are members of several different exchanges a single brokerage agreement can give a customer access to the entirety of exchange traded derivative products regardless of exchange.
• Figure 8 is essentially a modified version of Figure 4. It therefore shows a logical representation of operational information flow in trading the adapted exchange based derivatives.
• Item 800 of Figure 8 represents just one of the many dealers trading on the adapted exchange. The dealers decisions will be informed by general activity observable across various markets and news as published by quote vendors (see item 802 of Figure 8). The dealer shown also has direct access to the market place and via their own front office trading system (see item 804 of Figure 8). The front office trading system connects to the adapted exchange via a so called exchange gateway (see item 808 of Figure 8) which forms the physical and logical boundary to the exchange maintained systems.
• Orders can be placed in the matching engine (see item 814 of Figure 8) in the hope that a counterparty can be found and valid half trades are entered into the trade registrations system (see item 818 of Figure 8) and are passed to the appropriate accounts within the clearing house (see item 822 of Figure 8).
• Market status information is calculated and published (see item 812 of Figure 8) and monitored by the market supervision function (see item 810 of Figure 8) who also set the daily settlement prices (see item 820 of Figure 8) used by the clearing house (see item 822 of Figure 8) which calculates variation margin calls to or from members (see item 816 of Figure 8) and open interest (see item 824 of Figure 8).
• trading reports (see item 806 of Figure 8) are produced by the member back office.
• the quotation convention here is the one most suitable for the dealers in the product.
• An internal matching product that exists only within the infrastructure of the electronic exchange.
• the representation here is the one most suitable for the matching engine when combining strategy and outright orders.
• One or more back office products that exists only within the clearing infrastructure of the clearing house, it's members and the dealer's back office.
• Mapping 1 (see circle point 1 in Figure 8) is a two way mapping that converts the dealer's front office quotation orders into the internal matching representation, and the dealer's fills back from this representation into the front office product.
• mapping 2 (see circle point 2 in Figure 8) is similar to the dealer's fills mapping but converts the whole order book from the internal matching representation back into the front office product.
• Mapping 3 (see circle point 3 in Figure 8) is the conversion from the internal matching representation into the back office product.
• Mapping 4 (see circle point 4 in Figure 8) is similar to the dealer's orders mapping but converts wholesale trades agreed over the telephone into the back office product representation directly.
• mapping 5 is the conversion of front office product settlement reference prices into actual back office product daily settlement prices. The former are set by the market supervisor each day from front office market activity on the close but the latter are what are actually needed for variation margin calls. [0227] The details of the mappings will vary with the particular ISDA-like invention i.e. Adapted For Exchange New Credit Derivative or Adapted For Exchange New Interest Rate Swap or Adapted For Exchange New Money Market Derivatives. Indeed not all the inventions require all the mappings. The mappings may also vary with the particular money market product. We now go on to describe the details of these mappings and the associated products for each ISDA-like invention subset.
• front office product fill reports on a dealer's trading system are accompanied by the relevant back office product breakdowns to help with front office versus back office reconciliation.
• front office product matched trades will be passed through to the clearing house (see item 822 of Figure 8). These matched front office trades will appear on the clearing house's trade register as normal contracts simply for convenience. However the economic significance of these trades is carried by the associated back office products and not by these front office position markers themselves e.g. matched front office trades will not be charged margin.
• Front office position markers held at the clearing house can be used to assist with front office versus back office reconciliation.
• the preferred embodiment of the invention will allow back office managers (see item 816 of Figure 8) to give up and take in products by reference to the front office position markers held in the clearing house's trade registration systems (see item 818 of Figure 8) alone i.e. the associated back office products referenced to a particular front office trade would be transferred as a group simply by transferring their front office position marker.
• the front office product is called the Traded Spread Product (TSP) that appears on trading and information systems is expressed in annualised basis points according to market convention.
• the quotation convention here is the one most suitable for showing this product's relationship to the spread between risky and riskless (i.e. government) debt.
• the Traded Spread Product can be traded as spot or forwards along the credit term structure.
• the Internal Matching Product is basically the full de-annualised premium expressed in price percentage points and allows the simply creation of front office forwards using existing exchange implied book matching technology.
• the back office product is the splitting of the Internal Matching Product into so called Credit Coupon Products (CCPs) for the clearing house etc.
• Credit Coupon Products are particularly suitable for making sure forward trades are margined efficiently.
• Item 900 of Figure 9 shows how a traded credit product might appear in the front office as a Traded Spread Product. Contract volume available on the bid and offer are not shown in the Figure but as with other exchange traded contracts the Traded Spread Product will have a standard notional unit of trading (e.g. $lmln, €lmln etc).
• the Traded Spread Products also obey a standard listing and expiry cycle. As the ISDA based market has already standardised to a large extent the appropriate listing cycle will mirror this i.e. ten years of products available for trading via March and September expiries plus one additional quarterly month so the nearest three expiry months are consecutive quarterly expiries. The market convention is that default protection expires on the twentieth calendar day of the expiry month or if such a day is not a business day on the next following business day. [0245] Both the Internal Matching Products and Credit Coupon Products follow the same expiry cycle as the Traded Spread Products obey but include all consecutive quarterly expiries i.e. March, June, September and December and not just March and September plus one additional quarterly month expiry at the front of the curve.
• One of the stated advantages of the Adapted For Exchange New Credit Derivatives invention is that the product and trade systems designs will generate forwards automatically and hence help create a full credit term structure. This is achieved by harnessing in a novel way the implied order book technology already available for certain existing electronic futures exchanges via the mappings that will shortly be described below. Thus the dealer could have simply placed an order to hit the 26.50 bid also shown in Figure 9 25 times to sell the same Mar-06 / Sep-06 forward directly.
• mappings that are part of the Traded Credit Product link the front office Traded Spread Product with the back office Credit Coupon Product via the Internal Matching Product as already described in general terms above. We now turn to specifics and describe these with reference to Figure 8 where each mapping exists between the boundary of the three sub-products at points indicated by circles numbered 1-5. Mapping 1 - Inbound
• mapping 1 occurs at the numbered circle point 1 in Figure 8.
• Figure 10 shows the details of the inbound mapping process as applied to the dealer's front office Traded Spread Product Orders (see 1000 of Figure 10) which turns them into Internal Matching Product Orders (either 1008 or 1010 of Figure 10).
• the first step consists of an initial check that the Traded Spread Product Order obeys the orderbook tick size as shown in branch point 1002 of Figure 10 and if not the order is rejected as shown in endpoint 1004 of Figure 10. If the orderbook tick size is legitimate there is next a branch point depending on whether the order is for the spot or a forward market (see 1006 of Figure 10).
• TSOs Traded Spread Product Orders
• IMOs outright Internal Matching Product Orders
• TSOs Traded Spread Product Orders
• IMOs Internal Matching Product Orders
• mappings have to be parameterised by the expiry dates of the products, the trade date and the Surviving Notional Principal (SNP) as stored in dynamic databases shown as 1012 and 1014 of Figure 10 respectively.
• SNP Surviving Notional Principal
• the SNP starts at 100% and drops after each notional credit event in the underlying basket or index. It is described in more detail later when we describe notional credit events. It is also not really relevant for the single name version of the Traded Credit Product where it can be taken to be 100% prior to a credit event having occurred and 0% after.
• FIG. 11 shows the details of the outbound orderbook mapping which converts each Internal Matching Product Orderbook Element (see 1100 of Figure 11) into a Traded Spread Product Orderbook Element (either 1112 or 1114 of Figure 11) for display purposes.
• the first step is a branch point depending on whether the orderbook element is an outright or a calendar spread strategy order (see 1102 of Figure 11). This is because there is a different mapping depending on whether, an outright Internal Matching Product Orderbook Element (IMOE) is being converted into the relevant spot Traded Spread Product Orderbook Element (TSOE), see 1104 of Figure 11:
• MIMOE outright Internal Matching Product Orderbook Element
• TSOE spot Traded Spread Product Orderbook Element
• TSOE Price (100*IMOE Price%)*360/(Relevant Days)/(SNP%) or whether a calendar spread Internal Matching Product Orderbook Element (IMOE) is being converted into the relevant forward Traded Spread Product Orderbook Element (TSOE), see 1106 of Figure 11:-
• the outbound filled orders mapping converts order fills in the Internal Matching Product into front office fill reports in the Traded Spread Product.
• Figure 12 shows the details of the outbound filled order mapping which converts each Internal Matching Filled Element (see 1200 of Figure 12) into a Traded Spread Product fill (see 1210 of Figure 12) for display purposes. It is essentially the same mapping as the outbound orderbook one minus the final rounding and aggregation step, but carrying additional information to help with front office versus back office reconciliation where relevant.
• the first step is a branch point depending on whether the filled element is an outright or a calendar spread strategy order (see 1202 of Figure 12). This is because there is a different mapping depending on whether, an outright Internal Matching Filled Element is being converted into the relevant spot Traded Spread Product Filled Element (see 1204 of Figure 12), or whether a calendar spread Internal Matching Filled Element is being converted into the relevant forward Traded Spread Product Filled Element (see 1206 of Figure 12). As for the other mapping already described both these mappings have to be parameterised by the expiry dates of the products, the trade date and the Surviving Notional Principal (SNP) as stored in dynamic databases shown as 1208 and 1210 of Figure 12 respectively.
• SNP Surviving Notional Principal
• Mapping 2 occurs at the numbered circle point 2 in Figure 8.
• Figure 13 shows for example the pro rata Credit Coupon Product pricing breakdown converting the Internal Matching Filled Element shown as item 1300 in Figure 13, into the relevant Credit Coupon Products shown as a set spanned by 1306 and 1308 in Figure 13.
• the mapping itself is detailed in module 1304 in Figure 13 which is parameterised as usual by the expiry dates of the products and the trade date as stored in database shown as 1302 in Figure 13, the Surviving Notional Principal (SNP) having been already incorporated indirectly at time of matching.
• SNP Surviving Notional Principal
• mapping itself is detailed in module 1404 in Figure 14 and is parameterised by the sequence of realtime reference prices shown as 1402 in Figure 14, which already incorporated indirectly the expiry dates of the products, the trade date and the Surviving Notional Principal as they are related to the current Traded Spread Product market in the same way that daily settlement prices are related to the Traded Spread Product market on the close, see Mapping 5 below.
• the advantage of this technique is that traded leg prices for Credit Coupon Products will show less scatter and hence contain information suitable for front office predictive and historical analysis.
• mapping 4 occurs at the numbered circle point 4 in Figure 8. [0272] This is identical to the inbound mapping at numbered circle point 1 followed immediately by the mapping at numbered circle point 3 in Figure 8. It is used to convert wholesale trades agreed over the telephone into the back office representation directly.
• Mapping 5 occurs at the numbered circle point 5 in Figure 8.
• Figure 15 shows the details of the mapping which converts of the set of front office Traded Spread Product Daily Reference prices (TSDRPj) as set by the market supervisor (see 1500 in Figure 15) into the actual back office Credit Coupon Product daily settlement prices (CCPDSP;) needed for variation margin calls (shown as spanned by 1510 through to 1512 in Figure 15).
• TDRPj Traded Spread Product Daily Reference prices
• CCPDSP Credit Coupon Product daily settlement prices
• the Traded Spread Product daily reference prices do not need to respect the orderbook tick size.
• the conversion mapping is of course once again parameterised by the expiry dates of the products, the trade date and the Surviving Notional Principal (SNP) as stored in dynamic databases shown as 1502 and 1504 of Figure 15 respectively.
• SNP Surviving Notional Principal
• the first step is to interpolate any missing TSDRPi's so the expiry sequence matches Credit Coupon Product sequence (see 1506 in Figure 15). This is needed as most June or Dec expiries are not listed for front office or matching purposes in the preferred embodiments of the invention.
• the mapping is essentially a bootstrapping combination of the inbound mapping at numbered circle point 1 and the Figure 14 version of the mapping at numbered circle point 4 in Figure 8 including an initial interpolation step to ensure a full sequence of Traded Spread Product settlement prices is available.
• Each Credit Coupon Product is a cash settled product (see Figure 5 ) but with the unique feature that its Expiry Day Settlement Price (see 506 of Figure 5) is predefined to be exactly zero and not linked by a formula to any external underlying market fixing.
• the Credit Coupon Product's value arises from the fact that it confers ownership rights of Event Protection Products that are created in order to generate efficient credit protection if there is a credit event. We discuss these Event Protection Products and Processes in the next section.
• the second part of the Adapted For Exchange New Credit Derivatives invention is formed from the event protection products and processes which generate credit protection far more efficiently than the existing ISDA based market. These are shown schematically in overview in Figure 16.
• the Credit Event Committee is a body established by the Exchange in cooperation with significant market participants in a) the existing ISDA based market such as the shareholder banks of the HC and CDS IndexCo; and b) the Adapted For
• the Credit Event Committee will generate and from time to time revise its own definitions, rules and principles concerning credit events that are nonetheless analogous to those existing in the current ISDA Credit Derivatives Definitions document (see 1602 of Figure 16).
• the Credit Event Committee in cooperation with open interest holders continuously monitor the entities referenced by Traded Credit Products listed on the Exchange and its Clearing House. By use of its own definitions, rules and principles concerning credit events but in any case entirely at its own discretion the Credit Event Committee will decide if and when a Notional Credit Event has been triggered (see 1604 of Figure 16).
• the Notional Credit Event decision is defined as final in the contract specification and cannot be changed. Dealers are generally aware of the fact, but in any case are obliged by the contract specification to accept the risk, that Notional Credit Events and "real" (or ISDA defined) credit events are technically distinct. [0288] Since by the act of trading on Exchange dealers accept the risk that a Notional Credit Event may be called by the Credit Event Committee "inappropriately" the Adapted For Exchange New Credit Derivatives invention does not allow for legal challenges arising from the details of such credit events. This is a highly significant advantage over the existing ISDA based market but does put a heavy onus on the Credit Event Committee to develop a strong reputation as a trusted "calculating agent" of whether a credit event has occurred.
• Event Protection Futures are cash settled products (see Figure 5 ) with the unique feature that Expiry Day Settlement Price (see 506 of Figure 5) is defined with reference to another physically delivered exchange traded product namely the Recovery Auction or Rate Product (see 1606 of Figure 16).
• Event Protection Futures positions are only ever assigned to the 'effective' Credit Coupon Product i.e. to the front expiry on the day the Notional Credit Event is called. Holders of long positions in the effective Credit Coupon Product receive long positions in Event Protection Futures from the holders of short positions in the effective Credit Coupon Product who take the corresponding short positions in Event Protection Futures. The Event Protection Futures are assigned at zero price on the day after the Notional Credit Event is called.
• Notional CCP lot size / Notional EPF size [0296] In the case of an equally weighted 125 name index, the reference entity weight would be 0.8% of original notional for each name within the index. Assuming a standard notional unit of $lmln for the Credit Coupon Product and $1,000 for the Event Protection Futures, we can see that 8 lots of Event Protection Futures will be assigned to every 1 lot of Credit Coupon Product on the day after the Notional Credit Event occurs.
• a Recovery Auction Product is a bond-like physically delivered exchange traded product (see Figure 6 ). Unusual features include the fact that the Recovery Auction Product a) is listed only as a result of a Notional Credit Event; and b) is listed for only a short single trading day a fixed number of business days after the Notional Credit Event; and c) can in principle contain loans in its list of deliverables as well as bonds; and d) has all the conversion factors in its list of deliverables set to exactly 1.
• the initial list of deliverables with accrued interest (see 612 of Figure 6) is published as soon as possible after the Notional Credit Event (see 1604 of Figure 16) is announced and the final list of deliverables with accrued interest (see 608 of Figure 6) is published the day before the Recovery Auction Product is listed for trading. Indeed the fixed number of business days after the Notional Credit Event defining when a Recovery Auction Product is listed for trading will have been set in cooperation with the market by the Credit Event Committee in its definitions, rules and principles (see 1602 of Figure 16) concerning credit events so as to allow sufficient time for market feedback (see 610 of Figure 6).
• the Exchange Delivery Settlement Price for a Recovery Auction Product may be used to cash settle Event Protection Futures (the products assigned at 1614,
• the Recovery Rate Product is a variant of the Recovery Auction Product that is listed for trading even before a Notional Credit Event and has no pre-set expiry date.
• the Recovery Rate Product's expiry date only becomes set after a Notional Credit Event happens according to the definitions, rules and principles concerning credit events as laid down by the Credit Event Committee from time to time.
• As with Recovery Auction Products the initial and then the final list of deliverables for The Recovery Rate Product are only announced after the Notional Credit Event but always so as to allow sufficient time for market feedback.
• an pre-existing Recovery Rate Product is already listed The Exchange Delivery Settlement Price needed to provide fair cash settlement Event Protection Futures will be set by reference to that existing product and no Recovery Auction Product need be listed.
• SEPF Standard Event Protection Futures
• SEPF EDSP Max(100 - EDSP of Recovery Product, 0) in which the Max function serves to prevent the Event Protection Futures ever giving negative protection.
• an Attached Event Protection Future is designed to give protection only after a certain threshold of principal has been exposed to loss for the underlying basket, index, sector index or synthetic CDO. Because of these thresholds we will now need to define a Total Event Loss Index (TELI) number for each index or basket etc for which thresholds will be relevant.
• TELI Total Event Loss Index
• TELI starts at 0% and is just the sum of the Max(100 - EDSP of Recovery Product, 0) terms already described above multiplied by the weight of the relevant reference entity in the basket for all the Recovery Auction or Rate Products that have occurred since the basket's launch i.e.
• TELI for basket Sum ⁇ Max(100 - EDSP of Recovery Product, 0) * weight of entity ⁇
• TELI is used as described in detail below.
• AEPF EDSP for basket Max(new TELI - Max(Attachment Point, old TELI), O)/ weight of reference entity in the basket in which The old TELI is just the Total Event Loss Index as it stood before the latest Recovery Auction or Rate Product EDSP whilst the new TELI includes the latest
• Derivatives invention would be the listing of indices such as the Dow Jones CDX North America and iTraxx Europe.
• a probable next step would be to list sub-sectors of these indices i.e. Autos, Consumer cyclicals, Consumer non-cyclicals, Energy, Industrials, Financials, Non-Financials and TMT.
• sector Traded Credit Products would have notional contract sizes commensurate with the main index of which they form a part in order to facilitate spread trading.
• a 1 lot short main index position versus a full set of 1 lot long sub-sector indices would carry zero event risk by design and would attract minimal or zero initial margin.
• Index and sub-index Traded Credit Products will have their Surviving Notional Principal number reduced appropriately after a Notional Credit Event in a relevant reference entity and Standard Event Protection Futures will be delivered against the relevant effective Credit Coupon Product positions. After the fixed number of business days defined in the Credit Event Committee's definitions, rules and principles the Recovery Auction or Rate Product will expire and the required EDSP will be set.
• the different N th to default Traded Credit Products will have predefined Surviving Notional Principal numbers from when they were first listed. For example for N th to default Traded Credit Products on an equally weighted 125 name index the 1 st to default Traded Credit Products will have an SNP of 100%, the 2 nd to default Traded Credit Products will have an SNP of 99.2%, the 3 rd to default Traded Credit Products will have an SNP of 98.4%, etc.
• the index or sub-index on which Attached Traded Credit Products are listed will have its Surviving Notional Principal number reduced appropriately after a Notional Credit Event in a relevant reference entity. Also Attached Event Protection Futures appropriate to the defined attachment point will be delivered against the relevant effective Attached Credit Coupon Product positions. After the fixed number of business days defined in the Credit Event Committee's definitions, rules and principles the Recovery Auction or Rate Product will expire and the required EDSP will be set. This will be used to update the index or sub-index Total Event Loss Index number allowing the Attached Event Protection Futures to cash settle to their EDSP.
• One embodiment of the invention is called the Resetting Index Traded Credit Product and solves the problem of stale off-the-run series by defining an index's current constituent names plus substitutes in the event of names dropping out after Notional Credit Events. As the old effective Resetting Index Credit Coupon Product expires the next effective Resetting Index Credit Coupon Product will reference the index's composition as it existed on at this date. Thus underlying index remains undefined until the effective date and is not set in advance on the date that the index was first created.
• This Resetting Index Traded Credit Product will thus automatically keep track of changes in the index composition and will not need to be rolled.
• the design means that the Surviving Notional Principal number will only apply to mappings involving the effective Credit Coupon Product with all other Resetting Index Credit Coupon Products using 100% instead of the Surviving Notional Principal number. Also the Surviving Notional Principal number will be reset to 100% as each new effective Credit Coupon Product is finally referenced to the index's composition on its effective date. Otherwise this type of index product and its sub-sectors behave just like standard indices.
• Options on the Traded Spread Product are another possible extension of the listing of Traded Credit Products.
• cash settled and deliverable European style options on forward Resetting Index Traded Spreads are likely to be attractive to the market as they neither suffer from adverse premium loss after or excess volatility just before a Notional Credit Event in a relevant reference entity is announced.
• Traded Credit Products should be popular because of the premium return feature. As with normal options the time value component of the premium will decay as expiry approach whilst the intrinsic value will be a function of the prevailing spread. These products are designed to cope with the complication that after a credit event a single name Traded Spread Product effectively ceases to exist and is replaced by its corresponding Event Protection Future. There is therefore a 'knock out' if a credit event occurs in the referenced entity but as the name implies for Premium Protected Options no premium is lost at this point as a result of the knock out. This can be achieved in the exchange listed environment because Premium Protected Options can be traded in margined premium and not premium paid format there. Specifically the Premium Protected Knock Out Options simply expires early with no further variation margin calls being imposed, rather than the final variation margin call to zero that would be expected in a more traditional knock out variety.
• Recovery Rate Premium Return Options solve this problem in a simple yet creative way by having as their name implies a premium return feature should no credit event occur by expiry time.
• a premium return feature should no credit event occur by expiry time.
• Credit event protection products can be viewed as just a another form of insurance.
• Other insurance products such as those that payout in the event of loss of life, accident etc rather than in the event of a default can therefore be generated using similar design principles.
• Post Event Contract to be any contract that is assigned to holders of another contract according to an objective triggering event.
• Premium Return Knock Out Options as the generalized form of Recovery Rate Premium Return Options.
• the Adapted For Exchange New Interest Rate Swaps invention does not require any Event Protection Products and Processes and so is fundamentally less complex than the Adapted For Exchange New Credit Derivatives invention. It does however involve two distinct back office product types and in this sense is more complex.
• the ISDA based interest rate swap markets have been established far longer than the ISDA based credit derivative market. The former are thus correspondingly far more efficient than the latter.
• the invention nonetheless brings the significant benefits in the fields of:- ⁇ Counterparty credit risk -
• the invention will effectively remove the need for counterparty credit lines via central clearing of the ISDA-like exchange traded products. It will therefore eliminate a costly and complicated part of the trading and risk management process and broaden access to these markets still further. This will find particular applicability in emerging market economies where counterparty credit issues are generally speaking far more significant than in the developed world. Indeed the invention will make the creation of benchmark rates for burgeoning corporate debt markets in such countries possible without the need for significant and costly government bond issuance.
• ⁇ Netting - The invention is particularly efficient iri netting exposures. This is because of both the breakdown into coupons and more significantly the separation of the fixed and floating exposures into separate products.
• the front office product is called the Traded Swap Rate (TSR) that appears on trading and information systems is expressed in annualised percentage points according to market convention.
• the quotation convention here is the one most suitable for showing this product's relationship to the yields in the long term debt markets.
• ⁇ There are two distinct back office product types formed by the splitting of the front office Traded Swap Rate into so called Fixed Coupon Products (XCPs) and Floating Coupon Products (FCPs) for booking at the clearing house etc.
• XCPs Fixed Coupon Products
• FCPs Floating Coupon Products
• the combination of Fixed and Floating Coupon Products are particularly suitable for making sure trades within a large client portfolio are netted and margined efficiently.
• IRS rates vary with the term of the obligation and are simply the market price for a zero cost exchange of interest rate exposure from fixed to floating or vice versa. More specifically IRS deals commit traders to enter into a) a periodic obligation to receive (or pay) a fixed interest rate in exchange; in exchange for b) a periodic obligation to pay (or receive) amounts based on a floating interest rate index (e.g. 3 month BBA LIBOR), where all the interest rate amounts payable are calculated based on the notional size of the deal.
• a floating interest rate index e.g. 3 month BBA LIBOR
• the Standard Par IRS Product expiries will be x business days prior to the effective date which is defined as the twentieth calendar day of the expiry month or if such a day is not a business day on the next following business day.
• the x business days depends in principle on the currency in question but is typically 2 days (e.g. in $, €, ⁇ etc).
• Both the Fixed and Floating Coupon Products follow the same expiry cycle as the Traded Swap Rates obey but include all consecutive quarterly expiries i.e. March, June, September and December and not just March and September plus one additional quarterly month expiry at the front of the curve.
• Each Coupon Product has a notional maturity that is the effective date of the following Coupon Product expiry.
• the standard notional unit size of the Floating Coupon Products will be the same as the notional unit of trading for Traded Swap Rates (e.g. $lmln, €lmln, ⁇ 100mln etc).
• the standard notional unit size of the Fixed Coupon Products will be the smallest unit size of the currency i.e. only $0.01, €0.01, ⁇ 1 etc.
• Figure 17 shows the details of the one to many mapping which converts from the Traded Swap Rate Fill Element (TSRFE m ) (see 1700 of Figure 17) into the relevant back office Floating Coupon Products (FCPi) (shown as a set spanned by 1708 and 1710 in Figure 17) on the one hand and the offsetting positions in back office Fixed Coupon Products (XCPi) (shown as a set spanned by 1712 and 1714 in Figure 17) on the other.
• TSRFE m Traded Swap Rate Fill Element
• FCPi Floating Coupon Products
• XCPi Fixed Coupon Products
• the accrual factor, Aj are simply the fraction of a year that the number of days between the i th effective date and the i th notional maturity date represent.
• the accrual factor calculation method will vary with currency and will probably be specified in the particular Par IRS Product design. The calculation will often be made consistent with the conventional quotation method in any existing ISDA based swap markets in that currency. Thus for a $ or € product for example the A's would be defined in day fractions of a 30/360 day count basis.
• the mappings therefore have to be parameterised by the expiry calendar for product so that a full strip of both types of Coupon Product are assigned (see 1706 of Figure 17).
• mapping 4 occurs at the numbered circle point 4 in Figure 8. This is identical to the mapping at numbered circle point 3 as described above and in Figure 17. It is used to convert wholesale trades agreed over the telephone into the back office representation directly.
• Mapping 5 occurs at the numbered circle point 5 in Figure 8.
• Figure 18 shows the details of the conversion of the front office Traded Swap Rate Reference prices (see 1800 of Figure 18) as set by the market supervisor into the actual back office back office Floating Coupon Product (shown as a set spanned by 1814 and 1816 in Figure 18) and Fixed Coupon Product daily settlement prices (shown as a set spanned by 1818 and 1820 in Figure 18) needed for variation margin calls.
• This is a relatively complex process which also requires a daily stub rate reference price (see 1804 of Figure 18) and is key to the product design as a Par IRS Product.
• Module 1804 of Figure 18 illustrates the bootstrapping process used to calculate the required discount factors.
• the first step in module 1804 of Figure 18 is to use interpolation to determine Traded Swap Rate settlements in time periods for which an express rate does not exist i.e. at the June and December points. Linear interpolation, exponential interpolation, cubic spline interpolation, exponential spline interpolation, or any other desired type of interpolation may be used.
• ⁇ W, 1+A 1 C 1
• stub discount factor Do is the zero coupon discount factor calculated from the money market stub reference rate applicable for the period between trade date plus x business days (typically 2 days) and the first effective date (see 1806 of Figure 18):
• ao and So are the money market accrual factor and the stub rate, respectively, for the period from spot to the first effective date.
• the stub rate source is a identical to the floating rate used in the swap market (e.g. the BBA $ LIBOR panel for $ Traded Swap Rates).
• the accrual factor ao is calculated using the daycount basis conventional in the relevant money market e.g. Actual/360 for a $ or € product.
• the mappings therefore have to be parameterised by the expiry calendar for product so that a full strip of both types of Coupon Product are assigned (see 1808 of Figure 18).
• the settlement uses a standard floating rate benchmark, L, that varies according to currency e.g. the $ Traded Swap Rates will use 3 month BBA $ LIBOR.
• L a standard floating rate benchmark
• the Floating Coupon Product is cash settled using the formula (see 506 of Figure 5):
• FCP EDSP a * L l+a * L where a is the relevant money market convention accrual factor.
• XCP EDSP l+ a * L where a is the relevant money market basis accrual factor.
• Adapted For Exchange New Credit Derivatives invention can be used to create deliverable bond-like futures. These would therefore be second generation products very much in the mould of traditional bond futures but that give robust exposure to the two aforementioned inventive products in a convenient form.
• This second generation deliverable bond-like futures invention brings significant practical benefits :- ⁇ Convenience of trading - As already explained in the event that the market prefers the current ISDA market spot plus one year, spot plus two years, etc format for listings it would be necessary to list a new spot IRS product curve every trading day every day. Rather than in addition to this listing the standardised Par IRS Product on a March, June, September, December expiry cycle as described previously, it may be more convenient to list 2-year, 5-year and 10-year deliverable swap future as described below.
• S represents the ISDA Benchmark Rate for the M-year U.S. dollar interest rate swap on the last day of trading, expressed in percent terms
• the Adapted For Exchange New Money Market Derivatives invention as both OIS and/or FRA Product are similar in complexity to the Adapted For Exchange New Interest Rate Swaps invention. On the one hand these products have a single expiry and do not need the breakdown into coupon type products. On the other hand the introduction of the money market convention and non-standard notional units of trading add considerable complexity.
• the invention is particularly effective in meeting end user needs. Whereas the existing standardised Short Term Interest Rate futures markets are professional forward-forward markets with esoteric expiry dates unrelated to business needs, the invention makes forward and spot money market derivatives available within a genuine exchange for the first time.
• Money Market Derivatives invention use the money market convention that has already been described in the "Background to the invention" section. Thus each trading day a restricted subset of on-the-run points will be made available for trading on the matching engine even though the full set will remain available for trading via OTC-style wholesale trading facilities. This will require:- ⁇ daily listing and delisting of product for matching engine trading; and ⁇ daily adjustments to block trade thresholds for listed and delisted product. [0387] The latter point is required so that traders can if they wish trade where no matching engine listing exists i.e. the block trade threshold must be zero for off-the- run points.
• the OIS Product is one embodiment of the Adapted For Exchange New
• the front office product is called the Traded OIS Rate (TOR) that appears on trading and information systems is expressed in annualised percentage points according to market convention.
• the quotation convention here is the one most suitable for showing this product's relationship to rates in the cash money markets.
• the Traded OIS Rate is also important for audit trail purposes.
• Mapping 3 occurs at the numbered circle point 3 in Figure 8.
• Figure 19 shows the details of this one goes to two mapping that converts from the Traded OIS Rate Fill Element (TORFE) (see 1900 of Figure 19) into the relevant back office Overnight Indexed Product (OIP) (see 1902 of Figure 19) and offsetting back office Fixed Rate OIS Product (FROP) (see 1904 of Figure 19).
• TORFE Traded OIS Rate Fill Element
• OIP Overnight Indexed Product
• FROP Fixed Rate OIS Product
• the accrual factor, a is simply the fraction of a year that the number of days between the spot date (T+x, where x is most typically 2 business days) and the expiry date represent.
• Mapping 4 occurs at the numbered circle point 4 in Figure 8. This is identical to the mapping at numbered circle point 3 as described above and in Figure 19. It is used to convert wholesale trades agreed over the telephone into the back office representation directly.
• Mapping 5 occurs at the numbered circle point 5 in Figure 8.
• Figure 20 shows amongst other things the details of the mapping that converts the front office Traded OIS Rate Reference prices (see 2002 of Figure 20) as set by the market supervisor into the actual back office back office Fixed Rate OIS Product (see 2010 of Figure 20)and Overnight Indexed Product (see 2008 of Figure 20) daily settlement prices needed for variation margin calls.
• the Traded OIS Rate Reference prices do not in principle need to respect the Traded OIS Rate tick and may be calculated from some objective averaging function of trading conditions just prior to the daily settlement time.
• Module see 2006 of Figure 20 illustrates the two steps needed to calculate the discount factors required to settle the Fixed Rate OIS Product.
• the first step is to use interpolation to determine Traded OIS Rate settlements in time periods for which an express rate does not exist i.e. at off-the-run points. Exponential interpolation, cubic spline interpolation, exponential spline interpolation, or any other desired type of interpolation may be used. The result is that a Traded OIS Rate Reference Price, Oi, is available for every possible expiry date i.
• Module 2008 of Figure 20 also shows the process required for indexation to a daily overnight index rate, X, such as the Fed Funds rate. It is key to the product design as a true OIS Product. Although the daily settlement prices of the Overnight Indexed Products, OIP ⁇ , remain 100% for the entire life of a position, each evening the position size is augmented as follows :-
• a O /N is the accrual factor applied to the overnight index rate, X, is (in $'s usually a 1/360 or a 3/360 for a Friday etc).
• the FRA Product is extremely closely related to the Par IRS Product (see page 75). In fact the FRA product is identical to the front quarterly Par IRS Product which breaks down into a single pair of back-office products (i.e. no strip) except that:-
• the Enhanced Clearing House invention takes the standard futures exchange's clearing house and with a few minor changes transforms it into something far broader i.e. a) a central cash money market; or b) a securitisation of loans venue; or indeed c) a rival to existing securities depositories; and in particular d) a rival issuance venue for securities normally issued by special purpose vehicles.
• Front office position markers held at the clearing house can be used to assist with front office versus back office reconciliation. They will also be used for calculating open interest reports for front office systems.
• Front office position markers held at the clearing house will also be used for efficient give ups.
• the preferred embodiment of the invention will allow back office managers to give up and take in products by reference to the front office position markers held in the clearing house's trade registration systems alone.
• the associated back office products referenced to a particular front office trade would be transferred as a group that moves wherever their front office position marker goes.
• a modern futures and options exchange is a highly efficient primary market in a certain subset of derivatives contracts. However even these modern electronic exchanges must have predefined trading hours and times when the market is closed. This contrasts with the flexibility of the OTC ISDA based market which trades on demand at any time globally.
• This part of the invention introduces three or more different daily settlement times for each near 24-hour a day market which has the advantage of:-
• This part of the Enhanced Clearing House invention requires simple but significant changes that introduce :- a) Three or more different daily settlement times within the same clearing house for each near 24-hour a day market e.g. an Asian close, a European close and an Americas close; and b) Hence three or more different daily variation margin collection cycles; and c) A clearing membership qualification by region. Any clearing member would have to demonstrate the capacity to staff it's back office for the relevant daily settlement and clearing cycle before being qualified. Thus ABC Corp might be a clearing member only for the European close for example. However XYZ bank might be a clearing member for all time zones. d) Each individual clearing house account reference will also carry a time zone designation and all trades within that individual clearing house account will settle in the same time zone.
• the present invention recognises that these two streams of effort should be overhauled, modernised and replaced by a single fully robust system springing from an adapted futures exchange type environment.
• a modern futures and options exchange is a highly efficient primary market in a certain subset of derivatives contracts. Because of the central counterparty services created by the exchange's clearing house these derivatives contracts behave almost like securities. By introducing immediate cash currency payments plus an alternative method of handling default risk as compared to the current margin based system a highly operationally efficient central money deposit market can be created.
• the object of this part of the invention is to:
• the front office product is called the Traded Rate Product (TRP) that appears on trading and information systems its price is expressed in annualised percentage points according to the money market day count convention.
• the Traded Rate Product volume is basically the amount of money being borrowed or lent and so its notional lot size has to be the smallest unit size of the currency i.e. only $0.01, €0.01, ⁇ 1 etc.
• the internal matching product is called the Forward Value Product (FVP) and remixes the price and volume information of the Traded Rate Product into the most appropriate form for use of existing exchange implied book matching technology.
• the Forward Value Product price is the same as the discount factor associated with the Traded Rate Product price and term expressed to high accuracy.
• the Forward Value Product volume is basically the amount of money being repaid at the forward date given the Traded Rate Product price, term and volume.
• the notional lot size must also be the smallest unit size of the currency i.e. only $0.01, €0.01, ⁇ 1 etc. [0433] All expiries going out to two years will be listed for back office purposes.
• mappings that are part of the Pooled Deposit Product link the front office Traded Rate Product with the internal matching and back office Forward Value Product as already described in general terms above.
• circle 3 can be ignored as no mapping takes place there for the Pooled Deposit Product invention.
• FIG. 21 shows the details of the one to one inbound mapping that converts a dealer's front office Traded Rate Product Orders (see 2100 of
• the mapping has to be parameterised by the expiry dates of the products and the trade date (see 2104 of Figure 21).
• the accrual factor, a is simply the fraction of a year that the number of days between the spot date (T + x) and the expiry date represent (x is usually 2 days).
• the accrual factor calculation method will vary with currency consistent with the conventional quotation method in the existing markets. Thus for a $ or € product for example the a's would be defined in day fractions of an Actual/360 day count basis.
• TRO Lot volume FVO Lot volume / (100% + a *TRO Price %)
• mapping has to be parameterised by the expiry dates of the products and the trade date (see 2104 of Figure 21), with 'a' being the relevant accrual factor. It may be simpler computationally to simply store the front office product details with the Forward Value Product orderbook or fill as used for internal matching rather than calculate the reverse mapping.
• Mapping 2 occurs at the numbered circle point 2 in Figure 8.
• Mapping 5 occurs at the numbered circle point 5 in Figure 8.
• this Pooled Deposit Product market will have rules only allowing top quality banks of highest creditworthiness to participate. For each exchange member all payments due would be made net to the clearing house. Should a default occur and a cash currency payment not be made available by an exchange member to the clearing house the shortfall in funds to pay-out to other members would be distributed pro rata after netting. This is the essence of credit pooling and any trade in this Pooled Deposit Product market would therefore carry the same credit rating. [0452] If the market' s rules allow a short grace period after a default then the defaulting member might be able to make good the shortfall of funds plus interest.
• One variant of this invention would reintroduce the concept of initial margin to cover borrowing (i.e. short Forward Value Product) positions. This would then be used as a cushion against default.
• One advantage the Pooled Deposit Product market approach is that it allows the central bank to efficiently monitor the market at normal times and intervene quickly at times of a member bank failure. Thus for example as a defaulting bank is expelled from the system instead of the clearing house unwinding or transferring positions to other normal members it could in principle transfer the entire defaulting bank's position to the central bank.
• Pooled Deposit Product invention uses the money market convention that has already been described in the "Background to the invention" section. Thus each trading day a restricted subset of on-the-run points will be made available for trading on the matching engine even though the full set will remain available for trading via OTC-style wholesale trading facilities. This will require:-
• Ratio calendar spreads constructed so that there is zero immediate delivery of funds are basically the same as deliverable forward trades. No doubt an implied orderbook of these forwards could be constructed from the Forward Value Product internal matching spot market orderbook. These would then compete with FRAs to some considerable extent, at least for Pooled Deposit Product market members.
• the thrust of all the inventions presented so far have been to broaden the role of the traditional futures and options exchange trading and clearing venue in order to streamline the operations of the financial industry.
• the first part of the invention sought to replace ISDA' s coordinating role with a truly central market in the main derivative products traded by the market.
• the second part concerned supporting innovations in the clearing house itself in order to achieve a more efficient global coverage and greater accuracy in the product margining and settlement.
• the third part of the invention concerned overhauling and replacing the centuries old architecture of the interbank deposit market.
• a modern futures and options exchange is a highly efficient primary market in a certain subset of derivatives contracts. Because of the central counterparty services created by the exchange's clearing house these derivatives contracts behave almost like securities. However during a give up there is genuine transfer of title and if payment versus delivery methodology was introduced into this process a secondary market in 'Clearing House Securities' could be created. A genuine secondary market would of course require a new trading platform to be linked into this modified give up process of a normal futures clearing house. The resulting central securities marketplace will be highly operationally efficient as it will already be deeply linked to the derivatives markets.
• this Clearing House Securities invention allows for the securitisation of loans and hence their efficient delivery into the Adapted For Exchange New Credit Derivatives Recovery Auction or Rate Product.
• Other applications include the entire range of existing securities and in particular a rival issuance venue for securities normally issued by special purpose vehicles such as credit-linked notes and synthetic CDOs.
• Figure 22 shows this part of the invention schematically.
• the issuing member see 2202 of Figure 22
• the issuing client see 2200 of Figure 22
• This securities generation market is just what was the normal market of the futures and options exchange (see 2202 of Figure 22).
• the open interest (see 2206 of Figure 22) in the Clearing House Security is created by one or more cross-transactions in the primary market (see 2202 of Figure 22).
• the receiving long makes the cash payment to the clearing house but receives not the loan but a series of cashflow clearing house securities at zero price and of notional size and payment dates corresponding to the loan repayment dates;
• the example of securities loans can be generalised to include other assets held at the clearing house. In particular this could include the entire range of existing securities and hence generating a rival issuance venue for products normally issued by special purpose vehicles such as credit-linked notes and synthetic CDOs.
• Collateralised issuance can simply be performed by delivering the appropriate collateral to the clearing house which in return issues the float at zero price in order that it may be resold as a primary issuance.
• This collateral could include cash; or treasury bills, notes or bonds; or even derivatives and clearing house securities contracts from the same exchange.
• the clearing house can act as a special purpose vehicle and generate credit-linked notes, synthetic CDOs, etc., etc.
• the exchange and its clearing house could also perform those supervisory activities normally undertaken by the trustees of SPVs.

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• 2006
  • 2006-04-03 WO PCT/GB2006/001223 patent/WO2006103474A2/fr not_active Application Discontinuation

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