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. 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. 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. 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. 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.