WO2012047988A2 - Derivative fixing matching system and method with greater liquidity - Google Patents

Abstract

An improved computerized method and system for matching of derivative positions with greater liquidity than in existing matching systems is disclosed. Positions to be matched are received in a computer. Those positions are matched, including against synthetic orders on the IMM FRA dates, and the matched trades are simultaneously hedged with IMM FRAs to provide a yield curve neutral result. The disclosed invention finds particularly applicability to forward rate agreement matching systems, but can be applied to a broad range of financial derivatives.

Description

DERIVATIVE FIXING MATCHING SYSTEM AND METHOD

WITH GREATER LIQUIDITY

CROSS-REFERENCE TO RELATED APPLICATIONS:

The present application claims the benefit of priority under 35 U.S.C. § 119(e) to U.S. Provisional Application No. 61/389,840 filed on October 5, 2010, the disclosure of which is incorporated herein by reference in its entirety.

BACKGROUND TO THE INVENTION:

Field of the Invention

The present invention relates to a method and system for creating greater liquidity in matching systems for reducing risks in derivative trades. More particularly the invention finds applicability to interest rate swap contracts, although it also has applicability to risk reduction for other financial products portfolios.

Related Art

Traders and other holders of interest rate swaps have a need to hedge their portfolios to reduce, among other risks, the fixing risk arising from floating rate mismatches. Matching systems that buy and sell forward rate agreements (FRAs) are commonly known in the art. Matching systems can be either bilateral, in which every buy is matched by a corresponding sell, or unilateral such as is disclosed in U.S. patent application no. 11/744,403, published November 6, 2008 as U.S. Patent Application Publication No. 2008/0275807. Known matching systems all involve at least a two step process in which buy and sell orders are matched, and these resulting trades are then hedged to provide a yield curve neutral result.

These known matching systems provide some measure of risk management, but do not necessarily provide that the maximum number of buy and sell orders entered into the system can be matched. Combining the matching and hedging in a single step, and employing synthetic buy and sell orders in the present invention increase the number of orders that can be matched in any given run.

SUMMARY OF THE INVENTION:

An exemplary embodiment of the present invention is an improved computerized method for matching of FRAs with greater liquidity than in existing matching systems. Derivative positions to be matched are received in the computer from at least a first and second trader. Actual buy and sell orders received are then matched, and buy and sell orders on the International Monetary Market ("IMM") settlement dates of the Chicago Mercantile Exchange dates are synthetically generated as necessary to increase the liquidity in the matching system and maximize the positions that can be matched. The matched positions are simultaneously hedged to provide a yield curve neutral result according to well known methods for such hedging. The disclosed invention allows more of the positions originally received in the computer to be matched than matching systems without the synthetic order generation and simultaneous hedging feature. In addition to enabling more liquidity and execution, this method allows traders to minimize outstanding notional IMM contracts.

A further exemplary embodiment of the present invention is a computerized system for matching of FRAs with greater liquidity than in existing matching systems, the system comprising computerized means for performing each of the method steps describe above.

DETAILED DESCRIPTION OF THE INVENTION:

There is an existing and very active market for what are called interest rate swaps. In its simplest form two parties enter into a contract in which one agrees to pay a fixed rate of interest for a period of time to the other party and the counterparty agrees to pay interest based upon a rolling or floating rate of interest, generally based upon the LIBOR rate that is set on each 3- month anniversary following the transaction. For example, Party A may agree to pay to Party B a fixed rate of interest of 2% for 5 years based upon the assumption of a particular "notional" amount of the principal to which the interest payment is applied. The principal amount upon which the interest is calculated is referred to as the "notional" amount because the amount is used only as a reference rate and does not actually change hands between the parties to the transaction. The risk being traded under the contract is only the difference in the interest rates.

Thus for purposes of the example, the notional principal for the contract is $1 billion dollars. Party A agrees to pay Party B a fixed interest rate on the notional amount, for example 2%, for the five year life of the swap. Party B agrees to pay Party A an amount equal to what the interest would be on the notional $1 billion dollars based upon a rolling 3-month LIBOR rate. Therefore, every three months from the date of the agreement, the then applicable LIBOR rate will be calculated. At that time, Party A owes Party B 2% interest based on the notional $1 billion dollars. At the same time, Party B owes to Party A the then applicable LIBOR rate on the notional $1 billion dollars. In practice, the parties merely determine who is ahead or behind and a payment is made on the net difference. If the applicable LIBOR rate exceeds the fixed 2% rate, then Party B must make a payment to Party A of the difference between the 2% rate and the applicable LIBOR rate applied to the notional amount over the applicable period. As may be appreciated from the foregoing, Party B has agreed to pay on the basis of a 3- month rolling LIBOR rate and therefore is only aware of the LIBOR rate as it existed at the time of the agreement. The LIBOR rate is likely to be different in three months. As well, because the contract is a 5-year commitment with a reconciliation between the fixed and variable interest rates each 3-months, the 5-year obligation will have 19 fixing periods. Party B has an unknown exposure. In the circumstances, it is often desirable for Party B to limit its exposure prior to the termination of the 5-years.

There are a number of ways to address this issue. For example, Party A can call Party B and suggest that they reconcile the accounts between them as of a particular date - do various present value analyses - and agree to unwind or "tear up" the contract.

Another alternative is to enter into a novation, that is have another party agree to be a substitute for Party A or Party B and release the party substituted for from the contract. In the marketplace this is generally referred to as a "novate." Thus, based upon the terms of the contract with respect to the right of assignment, Party B can transfer its rights and obligations to Party C, creating a new agreement between parties A and C and releasing Party B from his obligation.

However, there are also strategies in which each of the parties keep the contracts in place, but protect themselves from interest rate fluctuations and the present invention relates to situations where the contract is kept but the interest rate fluctuation risks are hedged. For example, again assume the same transaction between Party A and Party B. Party A has agreed to pay to Party B 2% interest for 5-years based upon a nominal $1 billion dollar principal, and Party B has agreed to pay Party A based upon the LBOR rate. Over the 5-year term of the contract the LIBOR rate will be changing 19 times at 3-month intervals. In all likelihood, Party B has made a small profit on the initial trade (because of pricing differentials that slightly favor those who are willing to risk LIBOR rates). Having obtained a profit, Party B may now wish to hedge the risk that he will encounter over the next 2, 3, 4, 5 or greater 3-month LIBOR fixing dates. Hedging is generally performed by use of FRAs under which it is possible to purchase a contract which entitles the holder to a guaranteed interest rate at some future date.

Dealers in interest rate swaps generally have entered into literally thousands of them - often having agreements under which they agree to pay a fixed rate and agreements under which they have agreed to pay a changing rate. For example, Party A may have entered the contract in which Party A agreed to pay a fixed rate at 2% for 5 years on a nominal $1 billion dollars to Party B in exchange for a floating rate 3-month LIBOR commitment from Party B. Three (3) days later Party A may enter into a nearly identical agreement, except under that agreement it is Party A that has agreed to pay the LIBOR rate on a 3-month LIBOR basis for 5 years on a nominal $1 billion dollars. There is now a 3-day difference between the two agreements. This 3-day difference could be significant in the future and Party A may wish to hedge what is often referred to as the "fixing risk," that is the gaps between the interest rate risk held by a party who has swaps with positions on both sides in a transaction between two different fixing dates.

An interest rate swap portfolio maintained by a dealer contains both financial market risk and non-market risk. The non-market risk typically comprises model risk, counterparty credit risk and operational risk. The market risk in an interest rate swap portfolio is generally considered to comprise: (1) delta risk, which is the exposure to directional changes in market interest rates; (2) spread risk, which is the exposure to change in swap spreads; (3) vega risk, which is the exposure to changes in interest rate volatility; (4) basis risk, which is the exposure to mismatched swap indices within the trading portfolio; and (5) fixing risk, which is the exposure to mismatches in swap rate fixing dates within the portfolio. Both market and non-market risks are normal incidents of derivative market making activities, and both types of risk need to be managed. Those skilled in the art will be familiar with various strategies for managing these risks. The disclosed invention concerns a new and improved method and system for managing fixing risk.

Fixing risk is created by daily fluctuations in a specific reference index. Daily changes in LIBOR rates are a good example. Because transactions are customized to precisely suit client requirements, date mismatches build up over time between the floating legs of customer transactions. Fixing mismatches in the portfolio are offset in the professional market with FRA switches (where dealers match off reset exposure by simultaneously buying and selling FRAs against exposed dates). The FRA switch market allows for fixing mismatches to be mitigated several months in advance of the actual fixing.

The market risk changes with each new swap. Swap dealers typically do not match each new swap entered into with an offsetting position, but instead add the new transactions to the existing "book" of swaps, and periodically hedge the portfolio. Dealers seek to manage their swaps books as "delta neutral" so that they have no interest rate risk remaining after offsetting hedge positions have been entered into.

Therefore, there is an active marketplace seeking the purchase or sale of FRAs. As is generally the case where parties are seeking counterparties for a transaction and literally thousands of transactions are being sought, a broker is used. For decades transactions such as those described above have been conducted with the assistance of what is now called "voice brokers." As the name implies, brokers call other brokers to seek out counterparties to complete transactions with the brokers speaking to each other. Computerization has both assisted voice brokerage and in some instances replaced it for many types of transactions. Particularly given the nature of the transactions and the fact that FRAs are not listed on exchanges, computerization has permitted parties who deal in these types of contracts to identify possible traders.

Brokers have developed strategies to have traders list positions that they wish hedged thus creating a marketplace where hedging strategies can be executed. One method is to publish on a regular basis (for example, weekly) a listing of projected LIBOR interest rates the broker believes fairly reflects the LIBOR interest rates that will likely be applicable in the future for purposes of establishing FRA contracts.

Specifically, the broker publishes what is referred to as its yield curve. Although there is uncertainty about what a LIBOR rate might be over the short term or within 3-month intervals, there are generally known benchmarks which establish what the interest rate is going to be at a specific time. For example, there is a 5-year U.S. treasury note rate and a 10-year U.S. treasury note rate. Thus, on a given day the interest rate that would be applicable on the 5-year and 10- year note is known. However, the rate that will exist on any particular day between those dates will fluctuate. It is not necessarily a straight line between the two benchmarks. The curved line between them is the "yield curve" published by the broker which expresses the broker's opinion about what the interest rate is likely to be along various points (i.e., days) along the curve. Different traders may have different opinions as to where interest rates might be along that yield curve at any given date. Based upon that trader's analysis, he or she can determine the perceived theoretical interest rate risk for the interest rate obligations it owns. Indeed, large dealers in interest rate contracts, such as the large, well-known investment banks, create their own internal yield curves for assessing interest rate risk. Since the input at financial institution may be different than that of another financial institution, the projected interest rate out into the future on the curve may differ.

In any event, the broker' s published yield curve is available to all traders and if any trader wants to hedge its portfolio using that published yield curve, the trader provides a list to the broker of FRA buy and sell orders to be matched. By listing, the traders are agreeing that the broker can execute a trade if it finds a counterparty.

To further understand the present invention in context, it is important to understand why the FRAs are being traded and certain practical restrictions that have in the past limited the amount of "matches" or transactions that can be found and once found, executed.

A forward rate agreement, or FRA, is an agreement to exchange the difference between the rate of the original agreement and the rate set two business days before the agreed upon contract period. As with an interest rate swap, the buyer of the FRA agrees to pay a fixed interest rate for the period of the FRA, and the seller agrees to pay a floating reference rate determined on the fixing date. The reference rate is an independent interest rate that the counterparties cannot influence or manipulate, and as heretofore indicated, a commonly used reference rate is the inter-bank rates charged on short term loans between banks, e.g., LIBOR. On the settlement date, only the interest applicable on the notional amount between the rate agreed to when the FRA is established and the floating rate prevailing on the fixing date changes hands. An FRA is therefore in essence a forward dated loan, but with no exchange of principal, and the cash exchange between the counterparties depends only on the difference in interest rates. There has been a convention established under which the FRA is typically quoted with reference to (i) the fixed rate, (ii) the notional principal amount, (iii) the time until the start of the FRA, and (iv) the time until its expiration. As previously set forth, he seller of the FRA will receive cash from the buyer when the interest rate at settlement is less than the fixed rate agreed to at the settlement of the FRA, and the seller will pay cash to the buyer when the interest rate at settlement is greater than the agreed fixed rate. An interest rate swap is basically a package or series of FRAs.

As can be appreciated, the trading of interest rate swaps and other interest rate derivatives introduces mismatch exposure arising from the timing differences in the buying and selling of the derivatives. This mismatch risk can be offset or hedged through a series of FRA trades. Typical FRA hedging of mismatch risk requires bilateral FRA trading - i.e., in a given customer's portfolio, the total of all buy trades must equal the total of all sell trades. Without the requirement of bilateral hedging - i.e., that the sum of a customer's trades be delta neutral - the hedging process could increase, rather than decrease, the risk in the hedged portfolio.

This need for bilateral trading makes it difficult for a customer desiring to offset mismatch exposure to effect all of the hedging trades that he may want to conduct. For example, if the customer wants to hedge by buying $10 million FRAs and selling $5 million FRAs, standard bilateral trading practice will limit the customer to effecting only $5 million in buy and sell trades, leaving the customer with a $5 million FRA buy order that it cannot fulfill because of the bilateral trading requirement. After the bilateral matching, there is then further hedging, as is well known in the art, to provide a yield curve neutral result.

The present invention expands the likelihood that bilateral matches can be found between traders, and involves the use of what are referred to as IMM FRAs. The IMM matching method and system of the present invention allows for positions to be matched against IMM FRAs through the generation of synthetic buy and sell IMM FRA orders. The disclosed matching method and system use the IMM FRA dates, the same dates used in the hedging process, as pivot points on which to facilitate switching. The present invention takes advantage of the fact that customers will often try to switch a number of dates against the IMM FRA, knowing that the IMM FRA is a point of consistent liquidity. When a customer does not provide firm IMM FRA orders in the position it submits for matching, then in accordance with the present invention, the system creates synthetic IMM FRA orders. By using synthetic orders, the claimed invention increases the client' s ability to match, since the method and system pivots the switch on a known liquidity point, the IMM FRA. This method and system permits the combining of the switching process and the hedge process into one simultaneous procedure.

In known matching systems, there are two separate steps to provide a delta and curve neutral result. First, buy and sell orders are matched against opposing buy and sell orders. Second, the resulting delta ladder is then hedged according to well known methods using FRAs out of the IMM dates (March, June, September, and December). An example of this is as follows:

DATE SWITCH HEDGE TOTAL

3/21/2012 IMM FRA 340 340 3/29/2012 FRA -1000 -1000 4/29/2012 FRA 1000 1000 6/20/2012 IMM FRA -340 -340

The same example showing the counterparties involved in the trade is as follows:

SWITCH HEDGE

DATE Bank A Bank B Bank A Bank B

3/21/2012 IMM FRA 340 -340 3/29/2012 FRA -1000 1000 4/29/2012 FRA 1000 -1000

6/20/2012 IMM FRA -340 340 The individual trades in this example are as follows:

Buyer Qty Issue Seller

Bank A 1000 4/29/2012 FRA Bank B

Bank B 1000 3/29/2012 FRA Bank A

Bank A 340 3/21/2012 IMM FRA Bank B

Bank B 340 6/20/2012 IMM FRA Bank A

The feature of the claimed invention is to simultaneously match buy and sell orders using the disclosed synthetic IMM matching while hedging to provide the yield curve neutral result.

An example of the present invention with IMM switching and simultaneous hedging is shown below. The following is, for example, a set of positions received from three different counterparties.

DATE Bank A Bank B Bank C

3/21/2012 IMM FRA -1000

3/29/2012 FRA -1000 1000

4/29/2012 FRA 1000 -1000

6/20/2012 IMM FRA 1000

In this scenario, no trades will be executed without synthetic IMM orders, as there is no offsetting buy order for Bank B on 03/21 IMM FRA, and no offsetting sell order for Bank C on

06/20 IMM FRA. Considering the same example, but with synthetic orders employed for counterparty A highlighted and shown as follows:

DATE Bank A Bank B Bank C

3/21/2012 IMM FRA 1000 -1000

3/29/2012 FRA -1000 1000

4/29/2012 FRA 1000 -1000

6/20/2012 IMM FRA - 1 00 1000 Using the synthetic trades as disclosed in the invention, it is possible to effect four matching trades.

Buyer Otv Issue Seller

Bank A 1000 4/29/2012 FRA Bank C

Bank B 1000 3/29/2012 FRA Bank A

Bank A 1000 3/21/2012 IMM FRA Bank B

Bank C 1000 6/20/2012 IMM FRA Bank A

Combining the IMM matching and the yield curve hedging as part of the disclosed invention is as follows:

SWITCH HEDGE Total

Bank Bank Bank

DATE Bank A B C Bank A Bank B Bank C Bank A Bank B C

3/21/2012 IMM

FRA 1000 -1000 -660 90 570 340 -910 570

3/29/2012 FRA -1000 1000 -1000 1000

4/29/2012 FRA 1000 -1000 1000 -1000

6/20/2012 IMM

FRA -1000 1000 660 -90 -570 -340 -90 430

The individual trades when using synthetics and integrating IMM FRA hedging are as follows:

Buyer Otv Issue Seller

Bank A 1000 4/29/2012 FRA Bank C

Bank B 1000 3/29/2012 FRA Bank A

Bank A 340 3/21/2012 IMM FRA Bank B

Bank C 560 3/21/2012 IMM FRA Bank B

Bank C 350 6/20/2012 IMM FRA Bank A

Bank C 90 6/20/2012 IMM FRA Bank B The following shows the trades from the perspective of Bank A, with the synthetic orders being highlighted:

DATE SWrrCH HEDGE SWrrCH HEDGE FINAL

3/21/2012 IMM FRA 1000 -100 -560 340

3/29/2012 FRA -1000 -1000

4/29/2012 FRA 1000 1000

6/20/2012 IMM FRA 100 - 1000 560 -340

If one sums the synthetic switch and resulting hedges for the 03/21/12 IMM FRA (Bank A), the total of 340 is the same as when the original switch is completed with no synthetic orders. The customer would receive a net buy of 340, not a buy of 1000 and sells of -100 and -560 to arrive at 340, as in other known matching systems. This reduces outstanding notional on the customer books, and reduces necessary confirmations, documents and payments, and facilitates the ability to use the IMM dates as pivot points to provide liquidity.

The embodiments described may be modified in many ways without departing from the invention which is defined in the following claims. The foregoing description of the disclosed method and system has been made with reference to interest derivatives, but it will be understood by one skilled in the art that the disclosed method and system can be applied to a wide range of derivative instruments, and are suitable for use with any instrument for which fixing is used.

Claims

CLAIMS: What is claimed is:

1. A method for electronically matching derivative trades using a computer system comprising at least one computer, comprising the steps of:

a. receiving in the computer derivative positions to be matched from at least a first and second trader;

b. matching actual buy and sell orders received from the at least first and second traders and synthetically generating buy and sell orders on the IMM dates as necessary to increase the liquidity in the matching system and maximize the positions that can be matched;

c. simultaneously hedging with IMM trades the matched positions to provide a yield curve neutral result.

2. A method according to claim 1 in which the derivative positions to be matched are forward rate agreements.

3. A computer readable storage medium having instructions stored thereon which, when run on a computer, cause the computer to perform the steps of the method or system claimed in Claim 1.

4. A system for electronically matching derivative trades using a computer system comprising at least one computer, comprising:

a. means for receiving in the computer derivative positions to be matched from at least a first and second trader;

b. means for matching actual buy and sell orders received from the at least first and second traders and synthetically generating buy and sell orders on the IMM dates as necessary to increase the liquidity in the matching system and maximize the positions that can be matched;

c. means for simultaneously hedging with IMM trades the matched positions to provide a yield curve neutral result.

5. A system according to claim 4 in which the derivative positions to be matched are forward rate agreements.