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OTC Derivatives Trade Lifecycle



A trade lifecycle explains the journey of a trade from its inception till its end. Though it seems easy, it is in fact complicated by the following two facts.

Types of trades

Apart from the above, different types of asset classes can go through different types of processes, further complicating the task of generalizing the trade lifecycle.

In this article, I have tried to generalize these processes for common derivative trades that are processed by a broker-dealer.


Stages in the Trade Lifecycle
The industry norm is to classify the various processes into the following stages.
  1. Client onboarding
  2. Pre trade
  3. Trade
  4. Post trade pre settlement
  5. Settlement
  6. Post settlement
The following diagram describes the various steps/processes involved in each of these categories.

OTC Derivatives Trade Lifecycle

Client Onboarding

It is the first step in the trade lifecycle where a client is first onboarded. Onboarding here refers to establishing a formal and legal relationship with the client.

In OTC derivatives, the clients can be any of the following. For retail clients, the onboarding can be done in a matter of days, if not weeks. For the clients mentioned above, the onboarding procedure can take a few months, if not years.

Buyer and Seller are the two ultimate parties to the trade. However, there are many others involved; and for institutional trades, the buyer-seller due may not be directly involved but deal through their agents. The following is the list of entitles involved in the trade lifecycle.


Parties in an OTC Trade Lifecycle

Buy-side Firm or Institutional Investors
Buy side does not mean that they only buy. They do sell. The name is with reference to their trading strategy which involves buying securities for long term holding, though it may not be the case always in practice. Mutual funds, Pension funds, Endowments, Trusts, Insurance companies, Investment companies, Hege funds, etc. are some examples of Buy side firms. In most cases, they do not operate directly in the market but operate through their agents appointed for different functions (e.g. trade execution, settlement, etc.)

Sell-side Firm or Broker-Dealers
Sell-side does not mean they only sell. They do buy. The name sell-side is with reference to the opposite position that they usually take against buy-side firms. Usually, the name is with reference to brokers or broker-dealers. When the sell-side firm buys or sells on behalf of the buy-side firm and charges a commission for its service, it is called “broker” or “executing broker”; and when it buys or sells for its own account, it is called “dealer” or “market-maker”. The sell-side firms are usually big commercial banks such as JP Morgan, UBS, Bank of America Merrill Lynch, Citi Bank, HSBC, etc., or big investment banks such as Goldman Sachs, Morgan Stanley, etc.

Investment Manager (Asset Manager or Portfolio Manager)
Investment Manager (IM) is an entity to whom certain front office functions such as trade selection, trade execution or risk management are outsourced by the Buy-side firms (Institutional Investors). It should be noted that the Investment Manager is only the agent of the Buy-side firm but not the principal. It is the IM which interacts with the sell-side firm and executes the trades on behalf of the buy-side firm. The final parties to the trade are the buy-side firm and the sell-side firm. The association between buy-side firm and IM can be many-to-many: one IM may handle multiple buy-side firms, or one buy-side firm may operate through multiple IMs.

Interdealer Broker (or Voice Broker)
As the name suggests, they are the brokers who connect two dealers and charge a commission for their services. Interdealer Broker (IDB) is not a party to the trade; he is only an agent. The principals to the trade are the two dealers. They are also called as “Voice Brokers” because they communicate with the dealers mostly via telephone. With technological changes, they are now replaced by electronic trading platforms. Examples of IDB are ICAP, Tullet Prebon, GFI and BGC Partners.

Custodian
Custodian is an entity that provides the following functions.

Core functions:
Value-added services:


Custodian is an agent and not a party to a trade. They mostly provide back-office services. Custodians are usually commercial banks. In some jurisdictions, only banks can act as custodians. Custodians can be global custodians or local custodians. Global custodians may offer services in multiple locations either through direct presence or through a network of sub-custodians (i.e. agent banks) in other locations.

Most buy side firms appoint custodians as their agents to process their trades and to hold their securities and cash. The buy side firm may also be local or global in their presence. Accordingly, the following configurations exist between the two.

Buy-side firm Custodian Example of custodian
Local Local Maybank, Itau
Global Local Standard Chartered Bank, UniCredit
Local Global UBS, SEB, SGSS
Global Global Bank of New York Mellon, State Street, JP Morgan, Citi Bank, Northern Trust


Fund Administrator
It is an entity to which the buy-side firm, usually, outsources some of the middle office and back office functions of transfer, fund accounting, fund valuation, distribution support, compliance and tax reporting. Custodians may also provide these services as value added services apart from their core services.


Prime Broker
Prime broker need not be a broker at all. His services are more of a consultant. Usually, prime brokers provide the services of a custodian and fund administrator, along with some additional services. The following are some of the services provided by the prime broker.

The prime brokers offer the above services as a package to its clients. The fees charged is, usually, based on the assets under management of the clients.

Hedge funds prefer prime brokers, while pension funds, insurance companies and mutual funds prefer custodians. The main reason is because most hedge funds require some form of trade financing, which the prime brokers would be willing to provide. Custodians do not, generally, provide trade financing. Big commercial and investment banks such as JP Morgan Chase, Citi Bank, Goldman Sachs, Bank of America Merrill Lynch, Deutsche Bank, etc., act as prime brokers.


Trading Venues
For OTC trades, traditionally, there is no organized place (physical or virtual) for trading. Trade negotiation and executions are done through direct bilateral communications or through Inter-dealer brokers. In recent years, due to technological changes and regulations, electronic trading platforms (also known as Alternative Trading Systems (ATS) have emerged. They are registered entities which are less regulated than the exchanges. Currently, it is mandatory to execute OTC trades on these platforms both under Dodd-Frank Act of US and MiFID regulations of EU. We will discuss more about this later in this article.


Clearing Agency
Clearing Agency is an entity that conducts multi-lateral clearing among market participants. Traditionally, OTC trades are settled bilaterally between the parties and without any trade guarantee. Under Dodd-Frank Act of US and EMIR regulations of EU, it is mandatory to clear most trades via a clearing agency. We will discuss more about this later in this article.


Depository
Depository is to securities what banks are to cash. They hold various securities for electronic safe-keeping and settlement. They are regulated entities and act as central repositories of securities for a country or jurisdiction (hence they are also referred to as “Central Security Depository” or CSD, in short). The securities are maintained in electronic form which aids in fast transfers without any fraud. The transfer of securities is done through book entities, like credits and debits in a bank account.

Most depositories operate at a country level such as NSDL for India, DTC for US, Crest Co for UK and Ireland, etc. Most countries have just one central security depository. However, some countries may have two or more than two depositories, such as NSDL and CSDL in India.

Some depositories act at a global level. That means they can hold securities from multiple countries. These depositaries are called as “International Central Securities Depositories” or ICSD. Two such ICSDs operate currently; they are Euroclear and ClearStream.

The largest CSD is DTCC. It is not only the largest depository but also holds the largest non-US securities of USD 2 trillion as American Depository Receipts (ADR) from 100 countries.

CSDs also provide other value-added services like acting as CCP, processing corporate actions such as proxy voting and some tri-party agent services.


Tri-party Agents
Tri-party agents (TPA) provide services like administering security borrowing/lending, tri-party repo/reverse repos, collateral management, etc. Most custodians provide these services. However, separate third party firms can also provide these services.


Banks
Money moves through banks via their payment systems and hence they are involved in the trade lifecycle. Banks move cash from buyer to seller, while the CSDs move securities from the seller to the buyer. Both are connected to the clearing agencies and play an important role in the settlement of trades.


SWIFT
SWIFT is an acronym for Society for Worldwide Interbank Financial Telecommunication. It is an industry cooperative and maintains a closed user group of computer network for secured financial messaging between various parties. It is the global provider of secure messaging services covering more than 11,000 banking and securities organisations, market infrastructures and corporate customers in more than 200 countries and territories. SWIFT does not hold funds or manage accounts on behalf of customers. It only provides the standard messaging tools for secure financial communication between financial institutions.


Data Vendors
They disseminate prices, rates and news to the market participants in real-time. They also provide historical prices {called “time series”) of a particular security, rate or instrument. They also provide reference data, market data, independent valuation services, electronic communication services for trade negotiation and trade execution. The most notable data vendors are Bloomberg, Thomson Reuters, Telekurs (currently Six Financial Information) and Fact-Set.


IT Service Providers
Information Technology is involved in almost every facet of the financial services industry. Improvement of processes using automation and STP is a continuous process in the financial services industry. IT is also involved in various niche functions too such as documentation, trade confirmation, corporate actions, trade and position reconciliation, portfolio compression, etc. Some of the notable IT services providers are Omgeo, DTCC DerivSERV, IHS Markit and triOptima.

The above-mentioned parties are some of the important participants in the OTC Derivatives trade lifecycle. The following diagram shows the involvement of various participants in the trade lifecycle.


Parties to OTCD

Client Onboarding

In our discussion on client onboarding, we will not discuss the onboarding procedures/requirements of all the parties that we discussed above. Instead, we will focus on the onboarding requirements of a few parties and in general.

Client onboarding includes three essential steps, namely.
  1. Due Diligence
  2. Account setup; and
  3. SSI set-up

Due Diligence

Client due diligence is required to understand the client better and it is also a regulatory requirement. Under due diligence, the following requirements will need to be adhered to:
  1. Customer Identification Policy
  2. Customer Acceptance Policy
  3. Regulatory compliance

Customer Identification Policy (CIP):
A broker-dealer would first want to identify and understand the client that he is dealing with. One way, and a mandatory way, to understand the client is through documentation. This procedure is also known as “Know your Customer” or KYC. Under this procedure, all important documents of the client need to be collected and verified for authenticity and compliance. Depending on the client and its constitution, various documents may be required. It is not possible to highlight all the documents that could be required but the following is a general list of documents that may possibly be required.
The purpose of KYC is to identify the client, primarily through documentation but also through interaction and analysis. The document collection step in a KYC is not a one-time process. It needs to be done at regular intervals, usually once in 3 years or at other frequencies as determined by regulators or internal policies. The task of knowing the client through personal interactions is an ongoing activity. The KYC task also extends to sub-accounts and beneficiaries of accounts, where collective investment schemes are involved.

Once all these documents are collected, analysed, verified and found to be good, the client can be onboarded. However, that does not mean that he will be onboarded. There are some other steps that need to be followed before the onboarding can take place. The second of such steps is Client Acceptance Policy, discussed below.


Client Acceptance Policy (CAP):
A financial firm may not be willing to provide their services to everyone. It is quite possible that its business model targets only a section of the market such as Ultra High Net-worth individuals (UHNI) or Institutional clients or commercial clients, etc. In such as case, just because a client has passed the CIP step does not mean that he can be onboarded as that client may not be suitable to the business model of the firm. Hence, the second requirement for onboarding a client is “Client Acceptance Policy”. Under this step, the firm must assess whether it can provide the services to the client and whether it fits its business model.


Compliance:
Even if the client fits the Client Acceptance Policy (CAP), that does not mean that the client can be onboarded either. The client must then pass through the compliance test in order to be onboarded. For example, let’s say that the client has produced all the documents that are required under KYC. This allows him to pass the CIP test. The firm is targeting clients who are in HNI segment. Let’s assume that this client is an HNI and thus has passed the CAP test as well. However, the client is a criminal and/or a fraudster. In this case, the client cannot be onboarded as he fails to pass the compliance test.

Regulators, usually, provide names of persons or institutions with whom business should not be done. In US, one such regulation is under OFAC. OFAC stands for Office of Foreign Assets and Control. It provides a list called as SDN List (Specially Designated Nationals List). This list contains the names of persons and institutions who have criminal and other serious charges against them. If a person or institutions name appears in this list, then businesses should avoid dealing with such persons or institutions. Thus, financial firms should go through this list regularly to check whether the client names appear in such list.

Similarly, regulators in other jurisdictions, from time to time, provide a list or announce names of persons and firms with whom business is prohibited. It is the duty of financial firms to perform due diligence as per this lists or announcements.

Even if the client name appears in the list of another country’s jurisdiction, financial firms should avoid onboarding such clients as they may be banned from doing business in such country.

Once a client has passed through all the three tests above, then the client is good enough to be onboarded. The second step in client onboarding is Account Setup. The following paragraphs describe this activity.

Account Setup

When we go to a bank to open a savings or current (checking) account, the bank after verifying all the documents that we submit, provides us a unique account number, check book and online user id to help us transact with it. It also makes us to sign various legal document during this process. This entire process is referred to as “Account Set-up”. This is an example of opening a simple bank account.

In case of a trading account, an account has be opened with a broker-dealer. This, usually, involves the opening of a trading account and a Demat (Depo) account. The trading account establishes the relationship between the client and the broker-dealer. The Demat account is where the securities are held, and it establishes the relationship between the client and the depositories.

The above is an example of retail account set-up for a bank service, depository service and trading service. The account set-up process for OTC Derivatives is much more complex than this as it involves many more parties and a lot of legal documentation.

In an OTC Derivatives, the client account is setup after the master agreement is executed. The setup includes the following: In the following paragraphs we will discuss briefly on the above points.

Agreements:
The type, complexity and number of agreements in an OTC Derivatives transactions depend on the type of services sought or rendered, and the parties involved.

It is easy to understand the types of agreements if we were to look into the types of OTC derivatives involved. Generally, there are two types of OTC derivatives trades, namely.
  1. Bilateral (Uncleared) OTC; and
  2. Cleared OTC
Bilateral OTC: In this type of trades, the trade execution, clearing and settlement is conducted by the parties bilaterally. The risks involved in the clearing and settlement are handled by the parties themselves. This is how the traditional OTC market worked. For this kind of trades, the agreements are between the parties.

Cleared OTC: In this type of OTC trades, the trade negotiation and execution is done bilaterally by the parties, but the clearing and settlement activity is outsourced to a clearing agent or clearing house. Here, a set of agreements are between the clients and another set of agreements are between the clients and the clearing house.

The below diagram depicts this relationship.


OTC Documentation


A detail description of the agreements is beyond the scope of this article. I have discussed that in another article titled "Overview of ISDA Documentation".

However, a few important points are discussed in the following paragraphs.

Irrespective of whether it is a Cleared OTC or Bilateral OTC, the trade execution is always between the buyer and seller and is bilateral. The parties (buyer and seller) should have a formal documentation in place to govern all aspects related to their trades. Though the parties can create their own documentation, for practical reasons parties use the ISDA Documentaton. ISDA documentation is widely used and currently is the backbone of all OTC derivatives trades. There are other documentation standards available for a few products but in most cases, ISDA is used. For reference, the following are the documentation standards available currently.

Documentation Coverage
International Foreign Exchange and Currency Options (IFEXCO) Master Agreement FX Spot, FX Forward and FX Options
International Swaps and Derivatives Association (ISDA) Master Agreement All OTC Derivatives including FX options and FX non-deliverable forwards (NDFs)

The ISDA Documentation establishes the trading relationship between the clients. In Cleared OTC, the parties take the trade to a clearing house for clearing and settlement. The clearing house is represented by the clearing members. The relationship between the clearing house and the clearing members is governed by the bye-laws and rules set by the clearing house. The parties (buyer and seller) deal with the clearing members. The relationship between the clients and the clearing members are governed by the clearing agreements, collateral and security interest agreements.

There are two types of clearing, namely (1) Ring Clearing; and (2) Central Counterparty Clearing (CCP). If a clearing house only provides administrative support but does not provide trade or settlement guarantee then such type of a clearing is called as "Ring Clearing". On the other hand, if a clearing house provides trade or settlement guarantee along with administrative support then such type of a clearing is called as "Central Counterparty Clearing or CCP Clearing". In a CCP clearing, the clearing house becomes a legal counterparty to both the parties (buyer and seller) through a process called as "Novation", which is discussed later in this article.

Sometimes a prime broker may be involved in trade execution, which requires additional documentation. There are two types of prime brokerage services that are provided in the market place (1) Normal prime brokerage service; and (2) FX prime brokerage service.

In a normal prime brokerage service the client gives the orders to the prime broker who then executes them with an executing broker and rebooks them in a back-to-back trade with the client. Thus, there are two deals - one between the client and the prime broker and the other between the prime broker and the executing broker. The prime broker does not charge a margin in these transactions. Instead, the back-to-back trades are done on the same price without any effect on its profit or loss account.The prime broker gets his prime brokerage fees for this service.

In a FX prime brokerage, the client can directly do the deal with the executing broker. Once executed, the client orders the deal to be booked in the name of the prime broker. When informed about the trade, the prime broker accepts the trade and becomes the counterparty to the trade and settles it directly with the executing broker. At the same time, the prime broker enters into an offsetting contract with the client. The purpose of such arrangements is to provide liquidity to the client and a single counterparty for all its trades. It is a specialised service. Typically, the following are the clients of this service. The following are the major providers of FX Prime Brokerage services: When a prime broker is involved, additional documentation is required. The following diagram shows the agreements that need to be executed when a prime broker is involved.


Prime Broker Documentation


The Prime Broker Agreement is the detailed agreement which establishes a formal relationship between the client and the prime broker. The executing broker informs the prime broker about execution which is called "Give-up". The prime broker then matches it with the notification provided by the client and either accepts or rejects the give up, depending on the matching status. If the give-up matches the notification, the prime broker provides a confirmation to the executing broker and becomes its counterparty. Else, the prime broker rejects the trade and does not provide any confirmation to the executing broker. In such a case, the executing broker should have recourse to the client for compensation and thus there is a separate agreement to that effect between the client and the executing broker or dealer called as "Compensation Agreement".


Client Full Name and Code:
The client full name as per its official registration and its LEI (Legal Entity Identifier) should be registered in the internal databases. For trading purposes a short name and code are also generated. The short name is used to identify the client internally for quick access purposes. For example, Merrill Lynch International London Branch can be given a short name of "MLI London" for easy identification. The code acts as additional internal identifier so as to link various internal databases for down stream processing and reporting purposes.

List of permissible products
The type of products to be traded with a client depends on its type, consitution, risk involved and other considerations, including regulatory requirements. As discussed earlier, the clients in OTC derivatives are corporates, institutions or dealers.


END OF MY NOTES

Updation History
First updated on 15.06.2019