Credit Derivatives: Confirmation Backlogs Increased Dealers' Operational Risks, but Were Successfully Addressed after Joint Regulatory Action
Published: 2007-06-13T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Over-the-counter (OTC) credit derivatives are privately negotiated contracts that allow a party to transfer the risk of default on a bond or loan to another party without transferring ownership. After trading in these products grew dramatically in recent years, backlogs of thousands of trades developed for which dealers had yet to formally confirm the trade terms with end-users--such as hedge funds, pension funds, and insurance companies--and other dealers. Not confirming these trades raised the risk that losses could arise. GAO was asked to review (1) what caused the trade confirmation backlogs and how they were being addressed and (2) how U.S. financial regulators were overseeing dealers' credit derivative operations, including the security and resiliency of the information technology systems used for these products. GAO analyzed data on credit derivatives operations that dealers submitted to regulators, reviewed regulatory examination reports and work papers, and interviewed regulators, dealers, end-users, and industry organizations.
section_title: What GAO Found
paragraphs: After trading volumes grew exponentially between 2002 and 2005, the 14 largest credit derivatives dealers--including U.S. and foreign banks and securities broker-dealers--accumulated backlogs of unconfirmed trades totaling over 150,000 in September 2005. These backlogs resulted from reliance on inefficient manual confirmation processes that failed to keep up with the rapidly growing volume and because of difficulties in confirming information for trades that end-users transferred to other parties without notifying the original dealer. Although these trades were being entered into the systems that dealers used to manage the risk of loss arising from price changes (market risk) and counterparty defaults (credit risk), the credit derivatives backlogs increased dealers' operational risk by potentially allowing errors that could lead to losses or other problems to go undetected. In response, a joint regulatory initiative involving U.S. and foreign regulators directed the 14 major dealers to work together to reduce the backlogs and address the underlying causes. By increasing automation and requiring end-users to obtain counterparty consent before assigning trades, the 14 dealers reduced their total confirmations outstanding more than 30 days by 94 percent to 5,500 trades by October 2006. Through ongoing supervision and examinations, U.S. banking and securities regulators became aware of the credit derivatives backlogs as early as late 2003 and had been monitoring efforts taken by each dealer to reduce its backlog. Under the joint regulatory initiative, regulators obtained aggregate data from the dealers that allowed regulators to better monitor how backlogs were being resolved. Recognizing the potential for similar problems to arise in other OTC derivatives markets, regulators began obtaining similar data for other OTC derivative products in November 2006.

section_title: Letter
paragraphs: Until late 2005, the growth in trading volume of over-the-counter (OTC)  credit derivatives had greatly outpaced the processing capabilities of the  financial firms offering these products—heightening the operational risk  that such firms could incur losses from human errors or system failures.  OTC credit derivatives are privately negotiated contracts that allow a party  to transfer the risk of default on a bond or loan to another party without  transferring ownership. In a credit default swap, for example, a bond  investor agrees to pay a periodic premium to a financial firm in exchange  for the firm’s agreement to compensate the bond investor for any losses if  the bond issuer defaults on the bonds. Like other OTC derivatives, credit  derivatives are typically bought and sold through dealers, namely banks  and securities broker-dealers, that stand ready to buy or sell credit  derivatives to end-users, such as hedge funds, pension funds, and  insurance companies. Although OTC trading in credit derivatives is not  regulated in the United States, the dealers are subject to supervision by  their respective regulators, including U.S. banking and securities  regulators.
Introduced in the early 1990s, credit derivatives surpassed a total notional  amount of $34 trillion at year-end 2006. As trading volume grew  exponentially in recent years, major dealers developed backlogs of  thousands of trades for which the trade terms had not been formally  confirmed with their counterparties, which included end-users and other  dealers. Having unconfirmed trades could allow errors to go undetected at  dealers and later result in losses, a situation that an official from the  United Kingdom’s regulator of credit derivatives dealers characterized as  “an accident waiting to happen.”
Given the concerns about the inability of the credit derivatives market’s  infrastructure to keep up with the growth in trading volume, you asked us  to review the causes of the confirmation backlogs and the steps U.S.  financial regulators were taking to address the issue. This report discusses  (1) what caused the backlogs and the steps being taken to address them  and (2) U.S. financial regulators’ oversight of the operational risk that  dealers faced from the backlog in credit derivatives confirmations,  including the security and resiliency of related information technology  systems.
To determine the causes of the backlogs and the steps that are being taken  to address these issues, we analyzed the trading volume of credit  derivatives, confirmation backlogs, and other transactional data provided  by major dealers of credit derivatives to U.S. and foreign regulators  through Markit Group, a provider of independent data, portfolio  valuations, and trade processing for OTC derivatives. We examined the  procedures that this firm employs to collect and analyze the data and  determined that the data were sufficiently reliable for our purposes. We  also reviewed and analyzed reports on the credit derivatives market by  industry associations, international organizations, firms, and academics.  We interviewed eight dealers of credit derivatives, a hedge fund, and  various industry trade organizations, including organizations representing  OTC derivatives dealers and derivatives end-users, including the  International Swaps and Derivatives Association (ISDA). To determine  how dealers’ exposures to operational risks associated with credit  derivatives were being supervised, we interviewed staff from the Federal  Reserve, including its examiners for two banks; the Office of the  Comptroller of the Currency (OCC), including examiners for three banks;  the Securities and Exchange Commission (SEC); and the United  Kingdom’s Financial Services Authority (FSA). We also reviewed and  analyzed examinations conducted between 2004 and 2006 by the Federal  Reserve and the OCC on the activities in credit derivatives of five banks  and by the SEC covering the holding companies of five securities broker- dealers that engage in credit derivatives activities. We conducted our work  in Charlotte, North Carolina; Chicago; New York; and Washington, D.C.,  from August 2006 to March 2007 in accordance with generally accepted  government auditing standards. Appendix I provides a detailed description  of our scope and methodology.
subsections: section_title: Background
paragraphs: Introduced in the early 1990s, credit derivatives have been widely adopted  as a tool for allowing market participants to take on or reduce their  exposure to credit risk. First used primarily by banks to reduce credit  exposures stemming from loans made to clients, credit derivatives have  evolved to include an array of different products (table 1). According to  regulators and others, credit derivatives have the potential to improve the  overall efficiency and resiliency of the financial markets by spreading  credit risk more widely across a large and diverse pool of investors.  According to the British Bankers’ Association, single-name credit default  swaps remain the most common type of credit derivative, comprising  about 33 percent of the market in 2006, though their share of the market  has decreased since 2004. These swaps allow the buyer of protection to  transfer the credit risk associated with default on debt issued by a single  corporation or sovereign entity—called the reference entity. With a  standard credit default swap, the buyer of credit risk protection pays a  quarterly premium payment to the seller of credit risk protection over the  life of the contract, typically 5 or more years. Should a defined credit event  occur, such as a default by the specified corporation on the referenced  debt, the protection seller would assume the losses. As table 1 shows,  other commonly traded products include full index trades, synthetic  collateralized debt obligations, and tranched index trades.
In the credit derivatives market, banks and securities broker-dealers  generally serve as the product dealers, acting as the buyer or seller in  credit derivative trades with end-users or other dealers. The top five  dealers in 2005, ranked by total trading volumes as estimated by Fitch  Ratings, were Morgan Stanley, Deutsche Bank, Goldman Sachs, JP Morgan  Chase, and UBS. End-users of credit derivatives include hedge funds,  insurance companies, pension funds, and mutual funds.
According to ISDA, which conducts periodic surveys of market  participants, the credit derivatives market has grown dramatically in  recent years, increasing from an estimated total notional amount of nearly  $1 trillion outstanding at year-end 2001 to over $34 trillion at year-end 2006  (see fig. 1). Part of this rapid growth has been attributed to product  innovation and an increasing number of market participants, particularly  hedge funds. Despite its expansion, the credit derivative market is still  much smaller than the OTC interest rate derivatives market, which had a  total notional amount outstanding of around $286 trillion at year-end  2006.
subsections: section_title: Processing Credit Derivatives Trades
paragraphs: Traders and sales staff at dealers who interact with customers represent  the dealer’s “front office.” The staff in the front office generally use  electronic systems to capture the trade data and transmit it to the systems  used to manage market and credit risk. Dealers also have “back offices,”  which include staff that record, verify, and confirm trades executed by the  front office. As shown in figure 2, the steps for entering into and  processing an OTC trade for credit derivatives include negotiation,  capture, verification, and confirmation. These processes have been  increasingly automated over time, but some remain manual. For example,  a relatively small percentage of credit derivative products—generally  those with more customized and complex terms—cannot be confirmed  electronically. In addition, various post-trade processes occur during the  life of a credit derivatives contract, including making or receiving premium  payments, exchanging collateral, and settling contracts after a credit event  occurs, such as a bond default.
Segregating these various duties into front and back office responsibilities  serves to maintain operational integrity, such as by identifying data entry  errors and to minimize fraud and other violations. Management  responsibilities performed by the back office vary by institution, but they  may include evaluating transactional exposure against established market  and credit limits and risk management reporting. Some dealers have  combined a number of the functions performed by the back office, such as  risk management, into a middle office, and some use a separate risk  management group.
section_title: Regulation of OTC Credit Derivatives
paragraphs: Because OTC credit derivative transactions occur between private parties  and are not traded on regulated exchanges, they are not subject to  regulation in the United States, provided that the parties and other aspects  of the transaction satisfy requirements of the Commodity Exchange Act.  For credit derivatives that would otherwise be securities, the transactions  fall within the definition of “swap agreement” in the Gramm-Leach-Bliley  Act. The Commodity Exchange Act allows unregulated derivatives  trading in certain types of commodities by eligible parties under limited  circumstances. Similarly, the Commodity Exchange Act and the  Securities Act of 1933 allow unregulated derivatives trading by eligible  parties under limited circumstances. Although the OTC credit derivatives  products themselves are not regulated, certain market participants are. If  the dealer is a U.S. bank federally chartered as a national bank, it is  supervised by OCC. If a bank is owned by a bank holding company, its  holding company is regulated by the Federal Reserve. These bank  regulators oversee these entities to ensure the safety and soundness of the  banking system and the stability of the financial markets. If the credit  derivatives dealer is a securities broker-dealer, it is overseen by SEC.  According to U.S. regulators, some of the U.S. banks and securities broker- dealers also conduct credit derivatives trades in foreign affiliates subject  to foreign regulation. Similarly, other participants in the credit derivatives  market include foreign banks that are supervised by foreign regulators  and, in some cases, also by U.S. regulators if operating in the United  States.
section_title: Manual Processes and Trade Assignments Led to Backlogs of Unconfirmed Trades at Dealers, but Industry Efforts Have Significantly Reduced the Backlogs
paragraphs: As the credit derivatives market grew, lack of automation and other  factors led to large backlogs of unconfirmed trades at dealers. The eight  dealers we interviewed told us that they began to experience a significant  increase in their backlogs of unconfirmed trades ranging from the middle  of 2003 to the first half of 2005. According to ISDA’s survey data, trading  volume in credit derivatives more than doubled around this period, with  the average number of trades conducted at large firms increasing from 644  trades a week in 2004 to 1,450 trades a week in 2005. According to data  provided to regulators by 14 of the largest credit derivatives dealers— which include U.S. and foreign banks and securities broker-dealers—these  dealers collectively executed around 130,000 trades in September 2005,  and dealers’ backlogs of confirmations outstanding had risen to over  150,000 (table 2). Of these, 63 percent had been outstanding for more  than 30 days, and 41 percent had been outstanding for more than 90 days.
subsections: section_title: Two Factors Largely Caused the Confirmation Backlogs at Dealers
paragraphs: A major factor contributing to the backlogs was dealer and end-user  reliance on largely manual processes for confirming credit derivative  trades that could not keep up with the rapidly growing trade volume.  Unlike highly automated processes for confirming trades in corporate  stocks, the processes that dealers were generally using to confirm their  credit derivative trades relied on inefficient manual procedures. For  example, a dealer would manually prepare a confirmation and fax it to the  counterparty; in turn, the counterparty would manually compare its trade  record against the confirmation and, if the terms matched, fax the signed  confirmation to the dealer. Such manual processes were resource  intensive and generally lacked the scalability required to efficiently  confirm the rapidly growing volume of trades.
Recognizing the need to improve the efficiency of the confirmation  process for credit derivatives, dealers had been working with the  Depository Trust and Clearing Corporation (DTCC) to increase the use of  an automated confirmation system. DTCC staff said that they started to  work with several dealers in 2002 to create an automated system to  electronically compare, match, and confirm credit derivative trades. The  initial strategy was to have the system confirm only single-name credit  default swaps and then to expand the system’s capabilities to confirm  other credit derivative products and provide other services. DTCC  launched its automated system, Deriv/SERV, in late 2003, and 15 dealers  and 7 end-users had signed up to use the system by around mid-2004.  DTCC staff explained that obtaining wider use of Deriv/SERV took time, in  part because of the need to publicize the system and because users needed  to train their staff and revise their systems to use Deriv/SERV. According  to staff at one hedge fund, many end-users did not initially use Deriv/  SERV because they lacked the necessary technology. Consequently, up to  85 percent of the credit derivative trades were being confirmed manually  during 2004, according to market participants. However, DTCC has  expanded Deriv/SERV’s capabilities to confirm a broader range of credit  default swaps and as much as 46 percent of trades were being confirmed  electronically by September 2005, according to data provided to regulators  by 14 major dealers.
The second major factor contributing to the backlogs was the increasing  incidence of end-users transferring their positions to other counterparties.  Although the length of the contract for the most popular credit derivatives  typically spans 5 years, some end-users, particularly hedge funds, engaged  in frequent “in and out” trading of these products or had other incentives  to liquidate their positions earlier. To do so, the end-users assigned their  sides of trades to third parties. Although the agreements accompanying  the trades did not permit assignments without the dealer’s prior consent,  the dealers agreed to assignments after the fact because of competitive  pressures and because the new counterparties (the assignees) tended to  be other dealers. In effect, these assignments (also called novations)  ultimately resulted in a new contract between the original dealer and the  new counterparty, which would not be reflected on the dealer’s records  until the original dealer accepted the assignment. A hedge fund official  told us that when his firm wanted to terminate trades early, it initially  returned to the original dealers, but the dealers charged termination fees  that made this method more costly than assigning the trades.  Assignments have provided greater market liquidity and price discovery,  but according to dealers and regulators, they complicated the  confirmation process. Without prior knowledge of an assignment, the  original dealer could not readily confirm the details of the new trade until  the dealer became aware of the assignment. Some end-users said that they  obtained consent from the original dealers but that the dealers were not  communicating the information internally to the appropriate staff for the  purpose of confirming the trade.
Although assigned trades were a small share of total trading volumes, they  represented a disproportionately large share of unconfirmed trades  because of the time required to identify the correct counterparty.  According to data provided by the 14 major dealers to regulators, trade  assignments accounted for 13 percent of dealers’ trading volume in  September 2005 but 40 percent of their total confirmations outstanding for  more than 30 days at the end of September 2005. Dealers told us that they  typically detected unilateral assignments through payment errors. For  example, a dealer would receive a premium payment from a party other  than the party with which it had entered into the trade. Importantly,  market participants had agreed to settle premium payments due under  credit default swaps on a quarterly basis in order to provide greater  market liquidity. Bank examiners told us that because of this settlement  cycle, it could take a dealer as many as 90 days or more to detect a  unilateral assignment through a payment error.
Dealers we spoke with identified several other factors that hampered their  efforts to confirm trades in a timely manner. First, some dealers told us  that as the volume of trading in credit derivatives grew, they faced  challenges hiring experienced back-office staff and that training new staff  took months. Second, other dealers said that the lack of standardized  documentation, particularly for new products, led to disputes over the  trade terms or the need to negotiate them, further delaying confirmation.  Compounding matters, there was a shortage of derivatives attorneys  available for such negotiations, according to a bank examiner. Finally, two  dealers said that the industry lacked standardized reference data to  identify the specific entities referenced in credit derivative contracts. One  of the dealers told us that the lack of such data led to mistakes in  recording trades and hampered electronic confirmations. Mistakes in  documenting the correct reference entity prompted a group of dealers to  develop a database of reference entities and obligations in 2003 that has  become an industry standard.
section_title: Confirmation Backlogs and Unilateral Assignments Increased Dealers’ Operational Risks
paragraphs: Although dealers were capturing their credit derivatives trades in their risk  management systems to manage the associated market and credit risks,  the substantial backlog of unconfirmed trades heightened dealers’  operational risk, potentially hampering their ability to effectively manage  other risks. As with any trading activity, dealers engaging in credit  derivative trades are exposed to market, credit, and other risks that they  must adequately measure, monitor, and control. According to dealers and  their regulators, the major credit derivatives dealers generally were  entering their credit derivatives trades promptly into their trade capture  systems and, in turn, measuring, monitoring, and managing the credit and  market risks associated with those trades. Dealers, for example, measure  and manage market risk by estimating the potential losses that a portfolio  of positions may suffer and then impose limits that restrict the estimated  losses to an acceptable level. Similarly, dealers manage counterparty  credit risk—which can produce losses if the dealers fail to receive  payments owed to them—generally by measuring the total credit exposure  to, and creditworthiness of, individual counterparties, and not allowing  these exposures to exceed pre-established limits.
Although the credit and market risks were being managed, the large  backlogs of unconfirmed trades increased dealers’ operational risks.  Confirmations serve as an internal control to verify that both parties agree  to the trade terms and have accurately recorded the trade in their systems.  For this reason, trades should be confirmed as soon as possible. Having  unconfirmed trades could allow errors to go undetected that might  subsequently lead to losses and other problems. Errors could be made at  any time—for example, counterparties could miscommunicate when  making a trade or dealers could enter the wrong trade data into their  systems. If such errors go undetected, a dealer could make an incorrect  premium payment to a counterparty or inaccurately measure and manage  risk exposures, notably market and counterparty credit risks. Similarly,  errors could lead to legal disputes between a dealer and a counterparty if a  credit event triggered a contract settlement.
Further, these operational risks have the potential to contribute to broader  market problems. For example, in its July 2005 report on strengthening the  stability of the global financial system, the Counterparty Risk Management  Policy Group II, composed of representatives of dealers and end-users,  noted that as the number of outstanding credit derivatives trades  continues to grow, a credit event involving a popular reference entity  could materially strain the ability of market participants to settle  transactions in a timely and efficient manner. However, these operational  risks did not result in such broader market problems, in part because of  favorable market conditions when the confirmation backlog arose and  because only seven referenced entities in the United States have defaulted  since 2005—with market participants able to effectively settle trades  referencing these entities.
Although unconfirmed trade backlogs were growing, dealers had been  taking steps to reduce the operational risks associated with these trades.  To ensure that the trade data being captured and used to manage risks  were accurate, dealers were informally contacting their counterparties  before sending out confirmations to verify the key economic terms of the  trades, but this practice varied among the nine dealers reviewed.  Specifically, five dealers generally followed this practice for their credit  derivative trades, according to their staff or examiners. In contrast, two  dealers generally had been informally verifying trade terms for only those  trades considered higher risk, according to their staff or examiners.  Finally, staff at two other dealers said that they generally were not  verifying trade terms before confirmation because their counterparties  preferred not to do so. The dealers also were monitoring their  confirmation backlogs based on risk, such as by the number of days an  unconfirmed trade was outstanding. Moreover, two dealers curtailed  business with clients that had a large number of outstanding  confirmations. In addition, the dealers had reviewed their confirmation  processes and were improving them by, among other things, upgrading  technology, reorganizing operations, and hiring staff. While dealers found  some errors after confirming their trades, only two of the dealers  interviewed told us that they had suffered a $1-million-or-more loss as a  result of an error stemming from their confirmation backlog but  characterized the losses as immaterial.
Like unconfirmed trades, unilateral assignments increased operational,  credit, and legal risks. First, unilateral assignments led to operational risk  by creating new trades that were not being confirmed promptly to detect  errors. Second, to effectively manage credit risk, dealers must know, at a  minimum, the correct identities of the counterparties to their credit  derivative contracts. Unconfirmed trades arising from unilateral  assignments meant that dealers did not always know the exact  counterparty to which they were exposed. As a result, their ability to  accurately measure their credit exposure and enforce their pre-established  limits on it was hampered. Moreover, because dealers did not always  know the correct counterparties for each of their trades, they often made  premium payments to, or received payments from, the wrong entity. Third,  unconfirmed assigned trades also raised dealers’ legal risk because of the  potential for counterparties to later dispute the terms of the trade or the  enforceability of the contract. For example, a court may deem an assigned  trade as legally invalid if the original dealer did not provide its written  consent. As the Counterparty Risk Management Policy Group II reported  in 2005, some assignments occurred before the original trades were  confirmed, increasing the risk of potential disputes over the status and the  terms of the trade.
Several factors helped to mitigate the risks arising from unilateral  assignments. According to dealers and regulators, the assignments did not  increase market risk for dealers because dealers generally were capturing  the key economic terms of the trades in their risk management systems  accurately, and these terms remained the same when a trade was assigned.  Further, although unilaterally assigned trades impaired the ability of  dealers to measure and manage their counterparty credit risk, dealers and  examiners told us that hedge funds and other end-users assigned nearly all  of their trades to dealers, given their role as intermediaries to end-users.  Because dealers were typically more creditworthy than the end-users  assigning the trades, the original dealers ended up with more creditworthy  counterparties after an assignment, according to dealers and examiners.  Situations could arise, however, where this factor would not necessarily  mitigate the original dealer’s counterparty credit exposure. In addition,  dealers told us that they had collateral arrangements with their  counterparties to manage their credit risk. For example, dealers required  hedge funds to post a negotiated amount of initial collateral, such as cash  or securities, for each trade they entered into with dealers. As a risk  management practice, two dealers told us that they would not release  collateral to their counterparties until they verified that a trade was  assigned. In addition, a provision of the standard contract that  counterparties enter into as part of conducting derivatives transactions— known as the ISDA Master Agreement—required counterparties to obtain  the written consent of their counterparty before assigning a trade. Some  dealers told us that they could have relied on this provision, if needed, to  reject a unilateral assignment. Finally, none of the dealers said that their  counterparties tried to nullify an assigned trade.
section_title: Under the Direction of FRBNY as well as Other Regulators, Dealers and Others Have Worked Collaboratively to Considerably Reduce the Backlog and Address Its Causes
paragraphs: The unilateral assignments and the increasing backlogs raised regulatory  concerns that prompted U.S. and foreign regulators and the major credit  derivative dealers to seek a collective solution. FSA, which oversees  financial activities in the United Kingdom, took one of the first actions to  address the backlogs by sending dealers a letter in February 2005. The  letter expressed FSA’s concern about dealers’ level of unsigned  confirmations and asked them to consider the robustness of their  operational processes and risk management frameworks in the rapidly  evolving credit derivatives market. U.S. regulatory staff told us that they  had been aware of the backlogs since at least 2004 through their oversight  activities and discussions with other regulators. For example, in 2004, U.S.  bank examiners began to identify the growing backlogs of unconfirmed  trades at dealers, including how unilateral assignments were contributing  to such backlogs. Although they began monitoring dealers’ efforts to  resolve these issues, the regulators recognized in spring of 2005 that  individual dealer efforts to address the practice of unilateral assignments  were proving unsuccessful and that greater automation was needed.  Regulatory staff told us that these unilateral assignments posed a  “collective action” problem, in that dealers could not individually stop the  practice for fear of losing business to other dealers that did not require  counterparties to notify them prior to assigning a trade. According to  regulatory staff, the prevalence of unilateral assignments was especially  troubling because dealers did not always know the counterparties to their  trades, raising questions about dealers’ ability to accurately manage the  risks of these activities. In addition, regulatory staff said that the fact that  dealers did not always know their counterparty’s identity raised  operational concerns about the ability of market participants to settle  trades, should a large reference entity default. Finally, regulators noted  that resolving the causes of the backlogs required multilateral regulatory  involvement, because no single regulator oversaw all the dealers.
To address these problems with confirmation backlogs and unilateral  trade assignments, FRBNY convened a meeting in September 2005 with  the 14 major credit derivative dealers and their regulators—referred to as  the joint regulatory initiative. Regulatory representatives from around the  world—including OCC, SEC, FSA, the German Financial Supervisory  Authority, and the Swiss Federal Banking Commission—attended the  meeting as supervisors of at least one of the major dealers involved in the  initiative. At this meeting, the U.S. and foreign regulators discussed how  the dealers would improve assignment practices and resolve the  confirmation backlogs. In October, the dealers sent FRBNY a letter that  outlined the steps to be taken to improve the credit derivatives industry’s  practices and confirmation backlogs. The plan included    establishing target dates and levels by which to reduce the  increasing the use of electronic confirmations systems,   supporting the implementation of a protocol to end unilateral  assignments, improving the process for settling credit derivatives contracts after a  credit event, and   providing regulators with monthly data for measuring dealers’  progress.
To enable the regulators to monitor the dealers’ progress as part of the  joint regulatory initiative, the 14 dealers agreed to collect data on their  credit derivatives activities, including trading volume, unconfirmed trades,  and trades confirmed using automated systems. Under the agreement, the  dealers provide their individual data to Markit Group, a provider of  independent data, portfolio valuations, and OTC derivatives trade  processing. In turn, Markit Group aggregates the data across the dealers to  protect the confidentiality of each dealer’s data and then provides the  regulators with aggregate data in a monthly report.
In February 2006, FRBNY hosted a follow-up meeting with the dealers and  their regulators to discuss the progress and stated that it was encouraged  by the progress that had been made. Following the meeting, the dealers  sent FRBNY a letter committing to further improvements in market  practices to “achieve a stronger steady state position for the industry.”  Among the commitments the dealers made were (1) to ensure that all  trades with standardized terms that were eligible for automated  processing would be processed electronically, and (2) to work with DTCC  to create a central depository to store electronically the details of all credit  derivatives contract terms. In September 2006, FRBNY hosted a third  follow-up meeting with the dealers and regulators to discuss the dealers’  progress.
Since the initial meeting in September 2005, the 14 dealers have  significantly reduced the number of outstanding confirmations. As shown  in figure 3, the aggregated data that has been provided to regulators  showed that the 14 dealers had reduced their total number of  confirmations outstanding from 153,860 in September 2005 to 37,306, or by  about 76 percent, by the end of October 2006.
Under the joint regulatory initiative organized by FRBNY, each dealer  committed to incrementally reducing its number of confirmations  outstanding more than 30 days by various amounts over the course of the  following 9 months. The data that the dealers have been providing to  regulators showed that they collectively exceeded each of the reduction  goals they had agreed to meet and had reduced by 94 percent the total  number of confirmations outstanding over 30 days from the September  2005 level to the October 2006 level (table 3). The dealers were able to  achieve this reduction even though their monthly trading volume in credit  derivatives generally increased during this period.
After October 2006, four additional foreign dealers have joined the original  14 dealers in providing monthly confirmation backlog and related data to  Markit Group for aggregation and distribution to the regulators. As shown  in table 4, with the inclusion of the additional dealer data, the total number  of outstanding confirmations over 30 days has increased in comparison to  the level at the end of October 2006, especially in March 2007. At the same  time, table 4 shows that monthly trading volume has increased beginning  in January 2007, and the number of confirmations outstanding more than  30 days as a share of the total number of outstanding confirmations has  decreased slightly during this period. U.S. regulatory staff characterized  the rise in the confirmation backlog as modest and attributed it generally  to the increase in trading volume and noted that the automation of the  confirmation process has helped dealers handle the increased volume.
section_title: Dealers Reduced Backlogs through Various Steps
paragraphs: To achieve these reductions in their unconfirmed trade backlogs, dealers  took various steps. For example, dealers engaged in events called “lock  ins” with other dealers and, to a lesser extent, end-users. Under a lock in,  operations staff from either two dealers or staff from one dealer and one  of their key end-user customers convened in a room and compared the  trades they had conducted together until all or almost all were reconciled  and confirmed. Dealers and end-users also used “tear-up services” to  reduce the total number of open trades and thus eliminate the number of  trades that needed to be confirmed. In a tear-up process, an automated  system matches up offsetting positions across many market participants,  allowing those trades to be, in effect, terminated and thereby removing the  need to confirm such trades.
To prevent new trades from adding to the backlog, the dealers also  increased their use of automated confirmation systems and set deadlines  for confirming trades. First, as part of the joint regulatory initiative, the 14  major dealers committed to use DTCC’s automated system, Deriv/SERV, to  confirm trades made with other dealers by the end of October 2005 and to  require their active clients to use it or a comparable automated system,  such as SwapsWire, by mid-January 2006. As shown in figure 4, the share  of the total monthly trades confirmed electronically increased from 46  percent to 85 percent between the end of September 2005 and the end of  October 2006. Moreover, at the end of October 2006, the dealers  collectively had 3,900 active clients—of which 98 percent, on average,  were using an automated confirmation system or were in the process of  subscribing to one.
Second, the 14 dealers committed to electronically confirming all trades  that could be confirmed electronically (i.e., contracts with standardized  terms) within 5 business days of the trade date, by the end of October  2006. Deriv/SERV has continually expanded its capabilities to  electronically confirm not only a wider range of products but also changes  to existing contracts, including assignments. At the end of October 2006,  about 90 percent of the total trades were eligible to be confirmed  electronically, and about 94 percent of those eligible trades were  electronically confirmed, according to the data provided by the 14 dealers.  Of the trades confirmed electronically, 84 percent, on average, were  confirmed within the stipulated 5 business days. In addition, the industry  has taken steps to help ensure that new products do not create backlogs.  Officials at DTCC and ISDA said that they have formed industry working  groups and revised certain procedures to reduce the time it takes to  standardize the legal documentation for new credit derivatives, in turn  enabling these products to be confirmed electronically by Deriv/SERV.
section_title: Market Participants Agreed to End Unilateral Assignments and Thereby Addressed a Key Factor Contributing to the Backlogs
paragraphs: An additional step taken to prevent further confirmation backlogs was to  end the practice of unilateral assignments, which ISDA and market  participants had been attempting to address since at least 2002. For  example, ISDA published a novation agreement to document assignments  in 2002, issued provisions governing credit derivatives assignments as part  of its 2003 documentation standards for credit derivatives, and issued  novation definitions and guidance on best practices for assignments in  2004. Despite such efforts, an ISDA working group found that market  participants were using different practices to process assignments,  increasing risks to counterparties and creating operational inefficiency  and backlogs in processing trades.
ISDA officials told us that in early 2005 they had the working group start  (1) to develop a protocol to streamline practices for dealers and end-users  to follow to assign a trade and (2) to reach out to end-users as part of the  effort. In the summer of 2005, the working group began circulating a draft  protocol for comment. Shortly before the regulators initiated their joint  action in September 2005, ISDA issued its voluntary Novation Protocol,  and major dealers signed up for it. In their October 2005 letter to FRBNY,  the dealers committed to finalizing a guide to support the protocol’s  implementation. By signing the protocol, a party seeking to assign a trade  agrees to obtain the consent of its original counterparty through e-mail or  other electronic means. Although the major dealers signed the protocol in  September, some end-users were initially reluctant to sign, in part because  they were concerned that dealers would not be able to consent to  assignments promptly. In response, all the major dealers agreed to reply to  assignment requests within 2 hours. By November 30, 2005, 2,000 market  participants had signed the protocol. Most of the major hedge funds have  signed the protocol, according to officials from the Managed Funds  Association, which represents the majority of the largest hedge funds.
According to some dealers and U.S. financial regulators, the widespread  adoption of the ISDA Novation Protocol has effectively ended the practice  of unilateral assignments, eliminating a key factor that had contributed to  the backlogs. Because the vast majority of assignments become dealer-to- dealer trades, the protocol enables dealers to monitor each other to ensure  that clients are complying with it. If a dealer were to allow its client to  assign a trade without obtaining the original dealer’s consent, the original  dealer would discover the compliance failure when it discovered the  assignment. To facilitate the confirmation of assignments, Deriv/SERV also  expanded its system in mid-2005 to electronically confirm assignments. As  a result of the ISDA protocol and automation of the assignment process,  the number of unconfirmed assigned trades outstanding for more than 30  days declined from around 39,500 at the end of September 2005 to around  940 at the end of October 2006 (fig. 5), even though the number of trades  being assigned during this period generally increased. From the end of  September 2005 to the end of October 2006, the share of assignments  confirmed electronically has increased from 24 percent to 82 percent.
section_title: Dealers Found Benefits in the Joint Regulatory Initiative
paragraphs: The dealers and other market participants we interviewed uniformly  viewed the joint regulatory initiative as instrumental in reducing the  backlog, automating the credit derivatives market’s infrastructure, and  bringing the industry together to address the confirmation backlog  problem. The market participants noted that regulatory support was  crucial in encouraging cooperation among dealers and end-users to  address problems related to the confirmation backlog. Specifically, they  said that regulators’ involvement helped to persuade certain end-users to  agree to adhere to ISDA’s Novation Protocol. In addition, they told us that  the joint regulatory initiative catalyzed industry efforts to move to  automated confirmation matching services such as DTCC’s Deriv/SERV— bringing about automation sooner than it otherwise would have occurred.  Such intervention expedited the adoption of automated tools by end-users,  enhancing dealers’ efforts to implement such tools as Deriv/SERV.  Additionally, the joint initiative led to the formation of a group composed  of dealers that meets weekly to discuss, among other things, operational  issues. Two dealers told us that this group has helped to resolve problems  in processing confirmations and also allowed the dealers to hear the views  of end-users.
section_title: Dealers and Other Market Participants Continue to Work to Reduce Backlogs, Diminish Operational Risks, and Improve Market Infrastructure
paragraphs: While the dealers have made significant progress since 2005, they have  continued their efforts to reduce backlogs and improve the infrastructure  of the credit derivatives market. First, in addition to committing to confirm  virtually all standardized trades electronically within 5 business days of  the trade date, the dealers have committed to confirming all  nonstandardized trades within 30 days after trade date. Because  nonstandardized trades are complex and customized, such trades must be  confirmed manually, according to ISDA officials. According to data  provided by the dealers to regulators over the last 3 months, these trades  have accounted for less than 10 percent of the total credit derivatives  trading volume. According to regulators and dealers, these trades are  generally complex and involve issues that require time to be legally  negotiated before the trades can be confirmed. However, Federal Reserve  and OCC staff have expressed concern that taking 30 days to confirm  nonstandardized trades is too long and are continuing to work with  dealers to reduce the confirmation time. The 14 dealers have made  considerable progress in promptly confirming their nonstandardized  trades, reducing the number of such trades remaining unconfirmed for  more than 30 days from around 5,600 at the end of September 2005 to  fewer than 440 by the end of October 2006. However, as the four additional  dealers began providing their data after October 2006, the number of  unconfirmed nonstandardized trades rose, reaching around 6,800 at the  end of March 2007. To mitigate the risk of any unconfirmed  nonstandardized trades, the dealers have committed to verifying the key  economic terms of such trades informally within 3 business days of the  trade date. As of the end of March 2007, dealers were meeting this  commitment, on average, for around 54 percent of their nonstandardized  trades.
Second, under the joint regulatory initiative, the dealers have worked to  reduce operational risks by committing to improvements in the settlement  process for credit default swaps. For example, credit default swaps  generally require that the purchaser of credit protection under a credit  default swap deliver the bonds (or loans) referenced in the contract to the  counterparty if the bond issuer goes bankrupt. In exchange, the  counterparty pays the par, or face, value of the bonds to the protection  purchaser. This settlement method avoids difficulties that could arise  when the bonds are valued after a bankruptcy. However, situations can  arise in which the amount of bonds needing to be delivered exceeds the  amount of outstanding securities. For example, when the auto parts  maker Delphi filed for bankruptcy in 2005, credit derivatives on its bonds  and loans totaled an estimated $28 billion in notional amount, but Delphi  had only $5.2 billion in bonds and loans outstanding. In addition to  increasing the difficulty of meeting the delivery obligation under a credit  derivatives contract, a temporary shortage of bonds also could cause the  price of the needed securities to increase immediately following a default.  To facilitate settlement in this type of situation, ISDA has developed  protocols to allow contracts to be settled in cash rather than by delivery of  the debt. Under this process, the bond’s price is established through an  auction, and the counterparties providing credit risk protection pay their  counterparties in cash based on the difference between the bond’s auction  price and par value. Since 2005, ISDA has used its protocols to facilitate  cash settlement in seven credit events involving U.S. firms. The protocols  covering the first six credit events enabled cash settlement of only credit  default swap indexes. In its most recent form, the protocol permits cash  settlement in index, single-name, and certain other credit derivatives. ISDA  plans to include the cash settlement mechanism in its revised  documentation standards for credit derivatives in 2007.
Finally, DTCC is working with dealers and end-users to implement a  central trade depository to automate trade processes other than  confirmation and thus reduce operational risks. Under the joint regulatory  initiative, the dealers committed to work with DTCC to create (1) a  database to electronically store the official legal record of all credit  derivative contracts eligible for automated confirmation, taking into  account subsequent changes made to the contracts, such as assignments,  and (2) a central infrastructure supporting the warehouse to standardize  and automate post-trade processes over the life of each contract.  Specifically, the warehouse will support premium payment calculations  and facilitate not only the bilateral payment settlement of electronically  confirmed trades but also reconciliations for collateral management and  credit event processing. DTCC launched the warehouse in November 2006,  with all new trades electronically confirmed through Deriv/SERV  automatically loaded into the warehouse. In addition, dealers are inputting  their trade data for their existing credit derivatives contracts into the  warehouse to create a complete database, and this effort is expected to  continue through 2007. Two dealers told us that the trade input process is  an extensive project, because around a million trades need to be inputted.  DTCC also plans to expand the warehouse to support central payment  calculation and settlement capability in 2007.
section_title: The Joint Regulatory Initiative Enhanced U.S. Regulators’ Oversight of Dealers’ Efforts to Reduce Their Backlogs
paragraphs: U.S. financial regulators were overseeing the operational and other risks at  individual credit derivatives dealers through their continuous supervision  and examinations. After the joint regulatory initiative, the industrywide  data from the major dealers provided the regulators with more effective  means of monitoring the resolution of the backlog and related problems.
subsections: section_title: Federal Bank Regulators Were Monitoring Efforts Taken by Banks to Address Confirmation Backlogs through Continuous Supervision and Examinations
paragraphs: The Federal Reserve and OCC were aware of the confirmation backlogs at  banks and were monitoring efforts to address them before the joint  regulatory initiative. Of the 14 dealers participating in the joint regulatory  initiative, nine are U.S. or foreign banks. Five of the banks are chartered as  national banks and individually supervised and examined by OCC through  its teams of examiners. Each of these banks is a subsidiary of a bank  holding company or financial holding company supervised by the Federal  Reserve. OCC staff told us that the five U.S. banks conduct around 90  percent of their credit derivatives activities within the bank, not in their  holding companies or other subsidiaries. As a result, OCC bank examiners  are primarily responsible for overseeing the banks’ credit derivatives  activities but coordinate their oversight with their Federal Reserve  counterparts. Federal Reserve officials told us that their examiners also  oversee the U.S. operations of the foreign banks that are major dealers  participating in the joint initiative.
At the four national banks and one foreign bank we reviewed,  management had become aware of the confirmation processing and  backlog problems at their own banks primarily through internal audit  reports or management information reports tracking outstanding  confirmations. The timeframes in which the problems surfaced at the  banks and were brought to management’s attention varied, with one  bank’s management learning about the problems in late 2003 and another  bank’s management not until the summer of 2005. Nonetheless, according  to examiners of these banks, as bank management became aware of these  problems, they provided these audit or management reports or had  discussions with the bank examiners supervising their institutions. Bank  examiners told us that they continually supervise how the banks are  identifying, monitoring, and managing their operational, credit, market,  and other risks posed by credit derivatives and other products through  reviews of internal audit and management reports, meetings with key bank  officials, and examinations.
After learning of the backlog problems at the banks, the examiners said  that they monitored each bank’s efforts to address the processing  problems and reduce the backlog, such as by periodically reviewing  reports tracking the backlog, meeting with bank management and staff, or  conducting examinations. Through their supervision, for example, the  examiners reviewed the level of resources the banks were devoting to  processing their credit derivatives trades. They also examined to varying  degrees the credit derivatives confirmation process of four of the five  banks between 2004 and 2006. For example, in 2004, examiners reviewed  the progress that two banks were making in reducing their confirmation  backlogs and in addressing the causes of the backlogs, including  assignments of credit derivative trades. Based on examinations done in  2005, examiners directed two banks to develop plans to ensure that their  infrastructures were capable of supporting the trading volume of credit  derivatives, and the examiners said that the banks had developed such  plans. In addition to focusing on the confirmation backlogs, examiners  generally examined how well each of the five banks was managing its  market, credit, and other risks associated with its credit derivatives  activities. The examiners did not examine one bank’s confirmation  process because the bank was in the process of implementing a plan to  address its backlog, but examiners monitored the bank’s progress through  informal reviews.
Bank regulators were also reviewing the banks’ efforts to ensure the  security and resiliency of their information technology systems. Managers  at the four national banks we interviewed described taking various steps  to ensure the security of their credit derivatives systems. For example, the  systems used at these banks included restrictions on who could input or  access data in the systems. Managers at these banks also were responsible  for periodically reviewing and testing their staff’s access rights to the  systems to ensure that they were appropriate. According to bank staff, the  security controls were reviewed or tested regularly by internal and  external auditors—for example by conducting penetration tests in which  auditors would attempt to obtain unauthorized access to the systems. In  addition, the bank officials told us that they have taken steps to ensure the  resiliency of their systems, including processing their credit derivatives in  several different locations, creating off-site backup facilities, and  developing disaster recovery plans. The examiners of these banks told us  that they had tested or reviewed whether the banks were complying with  controls designed to protect the security and resiliency of their  information technology systems. For example, examiners told us that they  reviewed managers’ oversight of their staff’s access rights to the systems  and checked for testing of business continuity plans.
section_title: SEC Also Conducted Oversight of Credit Derivatives Confirmation Backlogs at Major Broker- Dealers
paragraphs: Unlike the bank regulators, SEC only recently began providing oversight of  the credit derivatives activities of broker-dealers because such activities  have generally been conducted in affiliates not subject to SEC regulation.  According to SEC staff, the five U.S. broker-dealers that are active in the  credit derivatives market generally book their trades in unregulated  affiliates that are not subject to SEC supervision because they are not  registered, nor required to be registered, with SEC. However, in June  2004 SEC instituted its Consolidated Supervised Entity (CSE) program,  under which large broker-dealers may qualify for alternative net capital  rules in exchange for consenting to supervision on a consolidated basis by  SEC. The five U.S. broker-dealers engaged in credit derivatives trading  applied for and were granted CSE status. Under the SEC’s CSE program,  SEC supervises the broker-dealers on a consolidated basis, with its  prudential supervision extending beyond the broker-dealers to their  unregulated affiliates and holding companies. The five broker-dealers  participating in the CSE program are also participating in the joint  regulatory initiative.
Although aware that backlogs for OTC derivatives were an issue, SEC staff  became aware of the extent of the credit derivatives backlogs at U.S.  broker-dealers through continuous supervision and examinations  conducted after these firms applied to the CSE program. SEC officials  noted that although they were generally aware of the backlog in  confirming credit derivatives through a study of the credit derivatives  market conducted by the Joint Forum in 2004, they were surprised at the  extent of the problem by the summer of 2005. According to SEC staff, in  2005 risk managers and internal auditors at the CSE broker-dealers told  SEC staff about the confirmations backlog and its potential impact on the  credit derivatives market. Broker-dealer staff, during the summer of 2005,  were periodically discussing with SEC the resources they were devoting to  reducing their backlogs and the associated risks. For example, one firm  devoted about 30 full-time staff and 20 consultants to reducing its backlog,  according to SEC staff. Supplementing this information about the  confirmations backlog, examinations conducted as part of the CSE  application process also assisted SEC in learning more about the nature of  the backlog and related concerns. As part of the application process, SEC  examined the firms’ internal risk management systems and controls,  issuing examination reports from November 2004 through January 2006.  SEC targeted credit derivatives products within the scope of all but one of  its five application examinations, choosing products that posed the  greatest risks and represented the highest volume in the firms.  Examination findings related to the credit derivatives confirmation  backlog included delays in issuing confirmations promptly after the trade  date and discrepancies between confirmation documentation and output  data from systems used to input trades. Broader examination findings  included concerns that internal audits at some firms did not always  document processes or sufficiently follow up on recommendations and  that some firms did not accurately compute counterparty credit ratings, in  some cases for hedge fund counterparties. The findings were shared with  the firms, and SEC has monitored the firms’ implementation of its  recommendations.
In addition to overseeing firms’ credit derivatives backlogs, SEC staff told  us that their CSE broker-dealer examinations conducted at the time of  application also addressed the security and resiliency of these firms’  information technology systems, including those that are used for credit  derivatives activities. For example, at the broker-dealers, SEC staff  reviewed reports by firms’ internal audit departments on security and  resiliency of information technology systems in general, as some of these  systems handled credit derivatives transactions. In addition, SEC  examinations included business continuity planning reviews based on  draft interagency standards on protecting the resiliency of the U.S.  financial system.
section_title: Through the Joint Regulatory Initiative, Regulators Are Obtaining Data to More Effectively Track Industrywide Progress on Reducing Confirmation Backlogs
paragraphs: Although both U.S. banking and securities regulators were individually  overseeing aspects of U.S. dealers’ credit derivatives activities, the joint  regulatory initiative provided U.S. and foreign regulators with information  that enabled them to better oversee the progress being made by the major  dealers to address the backlog issue. While the individual regulators had  data on the backlogs at the dealers under their supervision, no one  regulator supervised all 14 major dealers and thus had data on the size of  the problem across all dealers. Under the joint regulatory initiative, U.S.  financial regulatory staff said that they told the 14 dealers what  information they needed in order to track dealers’ progress in addressing  the backlog and related problems. Based on the capabilities of their  management information systems, the dealers collectively developed a  template to collect standardized metrics. The data include information on  trading volume, trade assignments, trades confirmed electronically and  manually, and confirmations outstanding based on length of time the  trades remained unconfirmed. Under the arrangement, each dealer  provides the standardized data to its primary regulator at the end of the  month. For example, the U.S. broker-dealers provide their data to SEC,  and the national banks provide their data to OCC. In addition, each dealer  provides its data to Markit Group, which aggregates the data across all the  dealers to preserve the confidentiality of each dealer’s data and computes  averages for the metrics, such as the average number of outstanding  confirmations for the dealers. In turn, Markit Group provides the U.S. and  foreign regulators and dealers participating in the joint regulatory initiative  with a set of the aggregate data.
According to U.S. and foreign financial regulators, the aggregate and  individual dealer data have provided regulators with an effective tool for  tracking overall and individual dealer progress. According to U.S.  regulators, using a template to standardize data collection has helped to  ensure the comparability of the data across the dealers. The regulators  also told us that the data are critical to the joint regulatory initiative,  because the combined data provide transparency, enabling the regulators  to track the progress of individual dealers under their supervision and  helping each dealer to see how well it is doing relative to the average.  Similarly, FSA officials told us that the aggregate data has provided  regulators with a simple way to monitor the backlog level for the entire  market and to compare individual dealers’ backlog levels against the  average. The officials also said that the common set of measures has  helped to instill discipline among the dealers.
Under the joint regulatory initiative organized by FRBNY, the U.S. and  foreign regulators are continuing to monitor the credit derivatives market  and have expanded their efforts in September 2006 to address  confirmation backlogs in the market for OTC derivatives based on  equities. According to dealers, it takes longer to confirm an OTC equity  derivative trade than any other type of OTC derivative trade, because such  trades are processed largely through manual rather than automated means  because of the lack of standardized trade documentation. Based on data  provided by the major dealers to the regulators, they had over 81,000  unconfirmed trades at the end of November 2006, with around 31,000, or  54 percent, of these trades remaining unconfirmed for over 30 days. In a  November 2006 letter to FRBNY, 17 dealers committed to working with  industry organizations to improve the efficiency of the equity derivatives  market, in part through the greater adoption of automation. Among other  things, the dealers committed (1) to reduce by 25 percent the number of  unconfirmed trades outstanding more than 30 days by the end of January  2007 based on dealers’ highest level of outstanding confirmations from  July to September 2006 and (2) to use at least one industry-accepted  electronic confirmation service and one other such platform by the end of  March 2007. U.S. regulatory staff told us that dealers met the first goal but  that, as of April 2007, one dealer had not yet fully met the second goal. At  the end of March 2007, the number of unconfirmed equity derivative trades  outstanding more than 30 days rose to around 43,000 trades. U.S.  regulatory staff said that the increase generally resulted from the inability  of the manual processes used by dealers and end-users to confirm trades  to keep pace with the increase in trading volume. The dealers also agreed  to continue to provide the U.S. and foreign regulators with standardized  data not only on credit derivatives but also on OTC equities, interest rate,  foreign exchange, and commodity derivatives. U.S. regulators said that  they wanted to track data across the major OTC derivatives products to  ensure that work done in connection with equity derivatives does not  hamper the ability of the dealers to process their other OTC derivative  trades in a timely manner. Such data will assist regulators in monitoring  the operational and other risks raised by OTC derivative products.
Given that individual efforts could not fully resolve the backlog problem,  U.S. and foreign regulators we interviewed said that the joint regulatory  initiative proved instrumental in ensuring that the problem was addressed.  According to representatives of FSA, bringing together the various  financial regulators from throughout the world was an approach that  worked very well to ensure collaboration among regulatory bodies.  Similarly, U.S. bank examiners told us that the joint regulatory initiative  served an important role in getting the dealers to work collectively and by  providing a level regulatory playing field. U.S. and foreign regulators and  dealers are already applying this model to address similar issues in the  OTC equity derivatives market.
section_title: Agency Comments
paragraphs: We provided a draft of this report to the Federal Reserve, OCC, and SEC  for their review and comment. The Federal Reserve and SEC provided  technical comments, which we incorporated as appropriate.
As agreed with your offices, unless you publicly announce its contents  earlier, we plan no further distribution of this report until 30 days after the  date of this report. At that time, we will send copies of this report to other  interested congressional committees and the Chairman, Federal Reserve;  the Comptroller of the Currency; and the Chairman, SEC. We will also  make copies available to others upon request. The report will be available  at no charge on the GAO Web site at http://www.gao.gov.
If you or your staff have any questions regarding this report, please  contact me at (202) 512-6878 or jonesy@gao.gov. Contact points for our  Offices of Congressional Relations and Public Affairs may be found on the  last page of this report. Key contributors to this report are listed in  appendix II.
section_title: Appendix I: Scope and Methodology
paragraphs: To identify what caused the credit derivatives dealers’ trade confirmation  backlogs and how the backlogs are being addressed, we analyzed credit  derivatives trading volume, confirmation backlog, and other transaction  data provided by the major dealers to Markit Group, a provider of  independent data, portfolio valuations, and over-the-counter derivatives  trade processing. We also analyzed operations and other data that dealers  provided to the International Swaps and Derivatives Association (ISDA), a  global over-the-counter derivatives trade association. We conducted data  reliability assessments for the Markit Group and ISDA data and  determined that the data were sufficiently reliable for our purposes. We  also reviewed reports and relevant publications from industry  associations, industry working groups, international organizations,  companies, and academics on the credit derivatives market. Of the 14  dealers participating in the joint regulatory initiative, we interviewed  operations and other staff from three U.S. banks, one foreign bank, and  four U.S. securities broker-dealers. We selected these dealers to ensure  that we included a range of characteristics, based on type of regulator  (bank or broker-dealer), trading volume (high or low), and headquarters  location (United States or foreign). We also interviewed staff from the  Federal Reserve, including its examiners for two banks; the Office of the  Comptroller of the Currency (OCC), including its examiners for three  banks; the Securities and Exchange Commission (SEC); and the U.K.’s  Financial Services Authority (FSA). We reviewed examinations conducted  between 2004 and 2006 and other supervisory materials covering the eight  dealers we interviewed and two other dealers that also participated in the  joint regulatory initiative. In addition, we interviewed representatives from  industry associations, including ISDA, the Managed Funds Association  (representing hedge funds) and the Securities Industry and Financial  Markets Association (representing securities firms, banks, and asset  managers). Finally, we interviewed officials from the Depository Trust  and Clearing Corporation about its automated services for processing  credit derivative trades and an official from a hedge fund.
To determine how U.S. financial regulators were overseeing the dealers’  operational risk, including related information technology systems  associated with credit derivatives activities, we reviewed examination  manuals and other supervisory or regulatory guidance prepared by the  Federal Reserve, the OCC, and the SEC. We also reviewed and analyzed  supervisory strategies prepared and examinations conducted between  2004 and 2006 by the Federal Reserve and the OCC on the credit  derivatives activities of five banks participating in the joint regulatory  initiative. In addition, we reviewed and analyzed examinations conducted  between 2004 and 2006 by SEC covering the holding companies of the five  securities broker-dealers participating in the joint regulatory initiative.  Also, we interviewed staff at the Federal Reserve, OCC, and SEC  participating in the joint regulatory initiative. We also interviewed Federal  Reserve or OCC examiners assigned to supervise and examine five of the  banks participating in the joint regulatory initiative and SEC staff who  examined the holding companies of the five securities broker-dealers  participating in the joint regulatory initiative. Finally, we interviewed FSA  officials to understand their efforts in identifying the confirmation  backlogs and in participating in the joint regulatory initiative.
We conducted our work in Charlotte, North Carolina; Chicago; New York;  and Washington, D.C., from August 2006 to March 2007 in accordance with  generally accepted government auditing standards.
section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Cody Goebel, Assistant Director;  Robert Lee; Paul Thompson; Marc Molino; Emily Chalmers; and Richard  Tsuhara made key contributions to this report.
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