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FpML for Credit Derivatives (Part I)

Ben LisChairman of the FpML Credit Derivatives Working Group

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What we will cover

Business Case The Working Group Subschema Tour Getting Involved

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Business Case

State of the Market State of the Technology Credit Default Swap: What and Why

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State of the Market

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Alan Greenspan’s Comments on Credit Derivatives

“New financial products have enabled risk to be dispersed more effectively to those willing, and presumably able, to bear it…A significant amount of exposure to telecom debt had been laid off through credit risk mitigation instruments, such as credit default swaps…The still relatively small, but rapidly growing, credit derivatives market has to date functioned well, with payouts proceeding smoothly for the most part.“

Quoted from a speeches made at the Institute of International Finance in New York on April 22, 2002 and at the Bank of England on September 25, 2002.

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State of the Technology

More systems support for vanilla swaps and FRAs than for credit derivatives.

Front-office trade data errors are most common for credit derivatives.

Outstanding Confirms (sent not finalized): FRAs – 7 days Vanilla Swaps – 9 days Credit Derivatives – 21 days

Of respondents with no current automation, 80% said they would automate credit derivatives.

(Source: 2002 ISDA Operations Benchmarking Survey)

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Why focus on the Credit Default Swap?

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What is a Credit Default Swap? Buyer pays fixed rate to Seller in consideration for

Protection against a Credit Event experienced by a Reference Entity.

Two possible outcomes: No Credit Event occurs. Protection Buyer pays all

required premiums. Swap terminates on maturity with no additional cash flows.

A Credit Event occurs. Protection Seller compensates Protection Buyer and contract terminates.

Basis Points per annum

Contingent payment based on

Credit Event of Reference Entity *

* Failure to pay, bankruptcy, restructuring (modified restructuring for US credits).

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Credit Default Swap Challenges

Documentation laden: 120+ terms on the ISDA confirm. Market Practices Evolving:

Reference Entity Identification Restructuring Greater Standardization

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What we will cover

Business Case The Working Group Subschema Tour Getting Involved

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The Working Group

Scope Timeline Keys to Success Participants Full Confirm vs Economics of the Trade

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Credit Derivatives WG Scope (4.0)

Extend product coverage of the FpML standard to include credit default swaps.

Produce an XML Schema together with supporting documentation.

Determine whether it’s best to represent only the economics of the trade or the full ISDA confirm.

Compatible with the ISDA 2002 Credit Derivatives Definitions. Consistent with the rest of FpML. Recommend other credit derivative products to include in

future versions of the standard.

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Timeline

May ’02: Proposal to add credit derivatives to FpML submitted by JP Morgan, UBS Warburg and creditex.

June ’02: ISDA issues a call for participation in an FpML credit derivatives working group.

July ’02: Credit derivatives WG begins meeting on a weekly basis.

November ’02: Rough draft of FpML credit default swap schema completed.

January ’03: Working draft of FpML 4.0 credit derivatives completed.

Spring ’03: FpML 4.0 Last Call Working Draft Summer ’03: FpML 4.0 Trial Recommendation 3rd Qtr ’03: Work commences on FpML credit derivatives II.

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Keys to Success

Aggressive milestones. Well defined target: 2002 ISDA Confirmation Agreement. Reuse of existing FpML components. Organizational expertise. Excellent group of people on the working group.

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Active Participants

AIG (Daniel Partlow) Bank of America (Elain Bannerman, Kurt Vile) BNP Paribas (Geoff Norris) Credit Suisse First Boston (Gareth Connolly, Ian Thomas) creditex (Ben Lis, Mazy Dar) Deutsche Bank (Kathy Andrews) JP Morgan Chase (Ben McGill) Goldman Sachs (Christina Yeung, John Weir) ISDA (Karel Engelen, Tony Hernandez) SunGard (Amir Khwaja, John Cobbledick) SwapsWire (Guy Gurden) UBS Warburg (Tim Black)

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Full Confirm vs. Economics of the Trade

What is the universe of data items that we will model? Full Confirm

Exhibit A of the 2002 ISDA Credit Derivatives Definitions Long Form

Economics of the Trade: Exhibit B.II. of the 2002 ISDA Credit Derivatives Definitions (?) Short Form Transaction Supplement

Economics of the Trade subset of Full Confirm

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Advantages Full Confirm:

Comprehensive Consistent with FpML philosophy.

Economics of the Trade Simpler Complete enough to handle a large % of interdealer trades.

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Decision: Best of Both Worlds Do Full Confirm. Subschema should also support specifying Economics of the

Trade. Strong consensus amongst the WG members. Not substantially more work than Economics of the Trade by

itself.

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What we will cover

Business Case The Working Group Subschema Tour Getting Involved

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Subschema Tour

Big Picture Reference Entity: Standardization Credit Events: Schema

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Start at the root. <FpML> root element of all FpML documents <party> and <trade> key child elements of <FpML>

<FpML version=“4-0” currencySchemeDefault = “http://www.fpml.org/ext/iso4217”...>

<trade>

...

</trade>

…

<party>

….

</party>

</FpML>

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<party>

One party element for each trade participant – principals & 3rd parties (e.g. broker).

S.W.I.F.T. Bank Identifier Code (BIC) is the recommended coding scheme for identifying business entities for inter-firm communication.

<party id=”JPMORGAN">

<partyId>CHASGB2L</partyId>

</party>

<party id="BARCLAYS">

<partyId>BARCGB2L</partyId>

</party>

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<trade>

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<tradeHeader>

Contains non-product specific information, e.g. trade date.

<tradeHeader>

<partyTradeIdentifier>

<partyReference href="#JPMORGAN" />

<tradeId tradeIdScheme="http://www.jpmorgan.com/id">SW123</tradeId>

</partyTradeIdentifier>

...

<tradeDate>2001-03-12</tradeDate>

</tradeHeader>

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<creditDefaultSwap> is a <product>

Like the other financial instruments covered by FpML, the credit default swap is defined as an extension of product.

<complexType name = "CreditDefaultSwap">

<complexContent>

<extension base = "Product">

<sequence>

<element ref = "generalTerms"/>

<element ref = "feeLeg"/>

<element ref = "protectionTerms"/>

<element ref = "settlementTerms"/>

</sequence>

</extension>

</complexContent>

</complexType>

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<creditDefaultSwap>

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<generalTerms>

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General Terms in the 2002 ISDA Definitions

1. General Terms: 

Trade Date: [                ]

Effective Date: [                ]   Scheduled Termination Date: 11:59 p.m. Greenwich Mean Time on [insert date]   Floating Rate Payer: [Party A][Party B] (the "Seller").  

Fixed Rate Payer: [Party A][Party B] (the "Buyer").   Calculation Agent: [                ]   Calculation Agent City: [                ]   Business Day: [                ]   Business Day Convention: [Following][Modified Following][Preceding] (which shall apply to any date referred to in this Confirmation that falls on a day that is not a Business Day).   Reference Entity: [                ]

  [Reference Obligation(s):] [                ] 

[The obligation[s] identified as follows:  Primary Obligor: [ ]  Guarantor: [ ]  Maturity: [ ]  Coupon: [ ]  CUSIP/ISIN: [ ]  All Guarantees: [applicable][not applicable]  Reference Price: [ %] 

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Reference Entity Identification: An Industry Issue

Legal disputes have occurred over what issuer the credit default swap agreement covers.

Armstrong Holdings vs. Armstrong World Industries. A widely available database of standard reference entities

names and reference obligations would be a big step forward for the market.

Project RED under development by Goldman Sachs, JP Morgan Chase and Deutsche Bank.

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FpML & Reference Entity Standardization

FpML’s goal: XML-based definition of the credit default swap. Reference entity needs to be part of that definition. Standard reference entity database being developed outside of

FpML. FpML allows reference entities to be specified by:

Legal name (I.e. text string). Reference to an external database.

FpML is compatible with RED.

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<referenceInformation>

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FpML Schemes

Mechanism for defining a permitted list of values. Used extensively in FpML:

CUSIPs BIC Business day convention

Identified by a URI. Similar to enumeration. Continue to be used in the schema version of XML where:

# of valid values large enough to make enumeration impractical. List of valid values is apt to change.

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<referenceInformation>

Reference entity scheme is not required. A default scheme can be specified on the root element. A scheme is defined as an attribute of an element or type.

<referenceInformation> <referenceEntity referenceEntityScheme = "http://www.creditex.com/reference-entity-1-0">CITIGROUP INC.</referenceEntity> <referenceObligation> <obligationId instrumentIdScheme = "http://www.fpml.org/spec/2002/instrument-id-CUSIP-1-0">172967BJ9</obligationId> </referenceObligation></referenceInformation>

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Fixed Rate Payer Information

Represented in the feeLeg element. Supports the following schedules:

Fixed Rate, Regular Schedule Fixed Amount, Regular Schedule Fixed Rate, Month-End Rolls Fixed Rate, Initial (Short) Stub Fixed Rate, Initial (Long) Stub Fixed Rate, Final (Short) Stub Fixed Rate, Final (Long) Stub Fixed Amount, Single Payment Upfront Fee and Fixed Rate, Regular Schedule Irregular Payment Schedule

Allows optional cashflows representation.

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<feeLeg>

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feeLeg: example

The FpML in the next slide represents the following payment schedule:

Effective Date: 1 November 2002 Scheduled Termination Date: 1 November 2007 Notional Amount: USD 5MM Fixed Rate: 85 bp Payment Frequency: Quarterly Day Count Fraction: ACT/360

Fixed Rate – Regular Schedule

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<feeLeg> example<creditDefaultSwap>

<generalTerms>

<effectiveDate>2002-11-01</effectiveDate>

<scheduledTermination>2007-11-01</scheduledTermination>

.

.

</generalTerms>

<feeLeg>

<periodicPayment>

<paymentFrequency>

<periodMultiplier>3</periodMultiplier>

<period>M</period>

</paymentFrequency>

<rollConvention>1</rollConvention>

<fixedAmountCalculation>

<fixedRate>.0085</fixedRate>

<dayCountFraction>ACT/360</dayCountFraction>

</fixedAmountCalculation>

</periodicPayment>

</feeLeg>

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<protectionTerms>

Information contained in the Floating Rate Payer section of the ISDA Credit Derivatives confirm is contained in the protectionTerms element of the FpML creditDefaultSwap.

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creditEvents: XML schema

Representing credit events in XML presents an interesting design challenge:

Some are simply applicable or not (e.g. bankruptcy). Some are applicable or not, but if applicable have additional data

(e.g. failure to pay with a grace period). The restructuring credit event is a focal point of industry discussion

and may continue to evolve. Ideally, our representation should be able to gracefully support

the evolution of market practice.

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<creditEvents>

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creditEvents: substitution group

Example of how the adoption of XML schema allows for better design.

XML schema provides a construct called a substitution group that is very similar to inheritance in a programming language:<xsd:element name = "creditEvent" type = "CreditEvent" abstract = "true"/><xsd:element name = "failureToPay" type = "FailureToPay" substitutionGroup = "creditEvent"/><xsd:element name = "bankruptcy" type = "CreditEvent" substitutionGroup = "creditEvent"/><xsd:element name = "obligationDefault" type = "CreditEvent" substitutionGroup = "creditEvent"/>

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creditEvents: example The FpML in the next slide indicates that these credit events

apply: Bankruptcy Failure to Pay with a 30 day grace period and payment requirement

of USD 1,000,000. Repudiation/Moratorium Obligation Acceleration Restructuring (R) Default Requirement of USD 10,000,000.

That these conditions to credit event notice settlement apply: The Seller is the notifying party. Notice of Publicly Available Information is a Condition to Payment –

defaults apply for Public Source(s) and Specified Number.

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<creditEvents> example<creditEvents> <bankruptcy/> <failureToPay> <gracePeriodExtension> <gracePeriod>

<periodMultiplier>30</periodMultiplier><period>D</period> </gracePeriod> </gracePeriodExtension> <paymentRequirement> <currency>USD</currency><amount>1000000</amount> </paymentRequirement> </failureToPay> <repudiationMoratorium/> <obligationAcceleration/> <restructuring>R<restructuring> <defaultRequirement> <currency>USD</currency><amount>10000000</amount> </defaultRequirement> <creditEventNotice> <notifyingParty>Seller</notifyingParty> <publiclyAvailableInformation/> </creditEventNotice></creditEvents>

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creditEvents: restructuring

No restructuring: no restructuring element Restructuring applies: restructuring element Form of restructuring specified in the element’s content. Valid values defined by an FpML scheme:

R modR modmodR

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What we will cover

Business Case The Working Group Subschema Tour Getting Involved

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Getting Involved

Staying in the Loop WG’s Goals & You Learning Resources

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Staying in the Loop: Email

Email list of the credit derivatives WG: http://www.fpml.org/wg/joining/join-form.asp

Chairman’s email: cd-wg-chair@fpml.org General FpML: http://www.fpml.org/mailing-lists/index.asp

FpML Discussion Group: General discussions about FpML efforts. FpML Announcements: News and announcements about the FpML

standard, organization, working groups, etc.

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WG Goals & You: Approval Process

The WG’s deliverables (I.e. subschema and documentation) go through various phases:

Working Draft Last Call Working Draft Trial Recommendation Recommendation

A basic understanding of these phases is needed to appreciate our short-term goals.

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Approval Process: Working Draft

Work in progress. Where we are today. Documentation needs to be completed. Minor changes to schema. Completion date: January 15th, 2003.

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Approval Process: Last Call Working Draft

WG feels it’s done. Working Draft published. Input solicited from interested parties. Standards committee promotes to this status. Spring ‘03

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Approval Process: Trial Recommendation & Recommendation

Trial Recommendation: Stable working draft. Implementation feedback and experience from the community. Summer ’03

Recommendation: Appropriate for widespread deployment & adoption. Standard

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Getting Involved Short Term (next six months)

Sign up for the credit derivatives WG email list. Review the standard and provide comments during the Last Call

Working Draft phase. Be an early implementer and provide feedback during the Trail

Recommendation phase. Longer Term (Summer ’03 and beyond)

Become an active participant in the credit derivatives WG and help us expand the standard.

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XML Learning Resources

IBM’s developerWorks XML Zone: http://www.ibm.com/developerworks/xml/

O’Reilly XML.com: http://www.xml.com W3C XML site: http://www.w3.com/XML Robin Cover site: http://xml.coverpages.org/ Books on XML Schema:

XML Schema Eric Van Der Vlist Definitive XML Schema Priscilla Walmsley

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FpML Learning Resources

Access to Specs, Working Papers and Presentations: http://www.fpml.org/documents/index.asp

No 4.0 documents published yet. Most recently published spec: http://www.fpml.org/spec/fpml-

3-0 Architecture 1.0 spec: http://www.fpml.org/spec/2001/rec-

fpml-arch-1-0-2001-03-16 Schema Technical Notes:

Migration to XML Schema: http://www.fpml.org/documents/working-papers/technical_notes/XMLSchemaRec2002-04-03.doc

FpML 3.0 XML Schema Release Notes: http://www.fpml.org/TR/2002/FpML-3-0-Schema-Release-Notes.html