ISDA Common Domain Model (CDM)
ISDA Common Domain Model (ISDA CDM) is an effort by ISDA, with the help of the derivatives industry, to create a blueprint of how derivatives are traded and managed across the transaction lifecycle. It provides a common digital representation of products and events to enhance consistency and interoperability in the application of technologies in the derivatives market.
The above paragraph is loaded with jargons and is therefore difficult to understand for someone new to the derivative industry or is not abreast with its developments. To understand it better, let's look at the below extract on the concept of ISDA CDM provided by ISDA's CEO Scott O'Malia in one of its publications. I think the extract provdies a decent high-level description of the concept.
"The current derivatives infrastructure is hugely inefficient and costly, and there's virtually no way to implement scalable automated solutions because each firm and platform uses its own set of representations for events and processes.
The ISDA CDM will change all of that. By creating a standard representation for events and products, we will enable firms to develop automated solutions that canbe interoperable and scalable in a way that has never been done before.
There are always reasons to do nothing and maintain the status quo, but the challenges we face today will not get any easier, and we will never be able to full harness the potential new technologies across the industry.
This is once in a generation opportunity to restructure the foundations of the market, and we need to grasp this opportunity.""
To start with ISDA CDM is not a solution to a problem. It is a blueprint to workout solutions to problems. The solutions will have to be worked out by the industry itself for which ISDA's role is to act as a coordinator, provide guidance and create a platform on which the solutions can be implemented.
What is the problem?
Over time, each firm has established its own systems and its unique set of representations for events and processes that occur during the life of a derivatives trade. For example, firms might have developed unique trade identifiers (trade numbers, etc.), counterparty identifiers (counterparty ids, SSI Ids, etc.), event identifiers (dividend, mergers, bonus, etc.), product identifiers (one counterparty may record a particular swap as vanilla, while it may be captured as exotic by the other). There is no commercial advantage to organisations maintaining their own representations. It results in firms having to continually reconcile their trades to make sure they have the same information - a big drain on resources. It also curtails the potential for greater automation, and results in increased operational risk. New technologies offer the potential for greater automation and efficiency in reducing complexities and costs. But effective automation can only be built on standardisation.
Let's take an example to understand this problem better. Let's suppose that ABC Corp trades with XYZ Corp. Both the companies record the details of the trade in thier own trade capture systems. This data is then supplemented by other information such as static data, reference data and market data for further processing by other systems in the respective companies. It is possible that the data from one system flows to the other in different formats. This creates a risk at every step in the lifecycle, resulting in constant reconciliations between internal systems.
Even if all the internal systems are integrated and work on a single work-flow model, at various instances both the companies will need to share the information with each other for further processing of the trades, such as during confirmation, novation, collateral, settlement and reporting. If both the companies have different representations and formats then this reconciliation and the follow-up dispute resolution requires manual processing, which is easily avoidable and is expensive and time consuming.
What is the solution?
If both the parties record the events and representations in the same way and use the same or compatible formats in recording then they can avoid the needless reconciliations of data, as the data is the same for both the parties. It does not mean that matching or reconciliation is not required (as trade matching and/or affirmation is required for legal execution of the trade and hence cannot be avoided.) It only means that the entire reconciliation can be automated without the need for manual interference thereby saving resources (time and cost).
Just extend this example to the entire derivatives industry and see the benefits that it can provide. The below diagram provides an overview of the costs involved at various stages in the post trade lifecycle of derivatives trades. As you can see in the diagram, there is a potential to reduce more than 90% of the costs in functions such as trade and transaction management, regulatory reporting, settlement, payment and clearing.
While data inconsistency and different representations is one issue, the industry is currently facing other challenges. Some of them are the following.
- Increased margin requirements
- Revenue compression for traditional industry participants due to lack of proprietary trading
- Revenue compression for all participants due to more market transparency brought about by regulations (more the information dissymmetry, more the potential for profits)
- Rising cost pressures from manual processing and legacy technology infrastructure
- Higher capital buffer requirements
- Costs due to transaction and other reporting requirements
- Others, including technology infrastructure updates, etc.
Traditional cost-reducing methods, such as outsourcing, offsourcing and reducing headcount, will likely yield diminishing marginal returns. Large scale technology upgradations by a few industry participants may solve the issue temporarily for them but the same issues of legacy technologies and cost pressures will creep in when business models, strategies and the general industry shifts over time.
The better way to handle these challenges is by having industry wide technology adoption, which helps in sharing the technological development costs. Together with industry wide standardization, it will bring the maximum efficiencies while saving huge costs. The industry has already adopted some common technologies and standardisations over the last few years - standardisations such as Credit Support Annex, UTI and LEI; and technologies such as FpML and FIX protocol.
With increasing costs and decreasing revenues, the only way firms can operate profitably and sustain for long periods of time is by evolving their business models and the technology on which it is run.
How does ISDA CDM help?
ISDA CDM aims at standardising the events, representations and formats across the entire industry. For example, in a trade between ABC Corp and XYZ Corp above, let's suppose that the events, representations and formats are standardised under a common platform then there is no need for manual reconciliation at all. The entire reconciliation and confirmation process can be automated, which also means that there may not be any requirement for dispute resolutions, or even if required, the resources consumed (time and money) are very limited.
Already, ISDA Taxonomy (as was discussed in an separate article) laid the foundation for standardising product classification. ISDA CDM standardises events, representations and data formats. Put together, they are standardising quite a lot of things in the industry. Now the industry has to select the most suited technology or technologies that can use these standards to bring efficiencies and cost savings. Distributed Ledger Technology (DLT), Smart Contracts and Machine Learning are the emerging technologies that are currently being used. They have already been tested with ISDA CDM and the results are promising, as are indicated in various ISDA research papers.
What processes or functions will benefit the most under ISDA CDM?
While the entire lifecycle of the derivative trades will benefit under the model, the following functions will benefit the most.
- Trade affirmation and trade management
- Collateral management
- Regulatory reporting
- Exercises and settlements
- Portfolio compression
- Novation and transfers
The ISDA CDM is being actively embraced by the industry. It is currently under development and would reach its full potential in the next few years. It has the potential to bring drastic changes to the post-trade processing of derivatives trades. Therefore, it is important for people working in the derivatives industry to understand its significance and impact.
END OF MY NOTES