Today much of the delay is due to inconsistencies on reference entity spelling, mismatches of reference obligations or simple overload. But, under pressure from regulators worried about industry-wide operational risk, credit derivative dealers have reduced average settlement times to no more than a few days. However, the market is still a long way from the ultimate goal of instant or T+0 settlement.
Hedge funds’ move into the credit derivatives market in recent years has exacerbated settlement problems. This is not necessarily because hedge funds are less efficient at carrying out confirmation tasks than other counterparties – though some of them undoubtedly do have poor back office procedures. The big issue is that hedge funds are high-volume traders, putting on and then reversing positions often within the same day. This has added greatly to the volume of new confirmations being written.
A related issue is that hedge funds make frequent use of novations (also called assignments). A novation is the process of transferring an outstanding contract from one dealer to another. It is commonly used by hedge funds that unwind trades in order to get the best price available in the market.
In the past, novations have mainly been carried out by spoken communication, and dealers complain that this has played havoc with their record keeping and ability to process confirmations quickly. As a result, derivative market participants agreed a new system for novations in late 2005 (see article opposite).
A key development in the emergence of a more robust settlement system for the credit derivatives market is the DerivServ trade confirmation system created by the US-based Depository Trust & Clearing Corporation (DTCC) in 2003 and which quickly became an industry standard.