The OTC derivatives market is a highly fragmented one, especially when it comes to the processing of trades by different market participants. Over time, firms and market participants have established their own data formats and representation of trade events. This leads to a high degree of data normalization and reconciliation at the time of processing and largely through manual efforts. This increases costs, operational risks while greatly reducing efficiencies and scalability across the post trade landscape.
To this effect, the International Swaps and Derivatives Association (ISDA) has come up with a Common Domain Model (CDM). This model would eliminate the above inconsistencies and help standardize the trading and management of derivatives throughout their trade life cycle. The main business areas that CDM is expected to standardize are trade affirmation and trade management, collateral management, regulatory reporting, reconciliations, exercises and settlements.
The various events involved in the processing of derivatives trades are standardized by the CDM, ensuring data consistency across the life cycle or the distributed ledger technology. However, in order for this to be implemented, all market participants need to implement the CDM to ensure uniformity.
The CDM defines the events that can be standardized and automated in two categories: independent and dependent. Independent events are those which are free of, or do not rely on the economic logistics of the derivative and can include events like creation, termination, cancellation or amendment of a derivative. Dependent events are those which affect the economic value of the derivative and include events like exercise of an option or settlement of a derivative trade.
The standardization process as defined by the CDM consists of several steps. The different parts of a derivative contract are segregated and then ranked based on effectiveness and efficiency of each part in determining the benefits of standardization. Following this, the terms of the derivative contract are then converted to a uniform formalized form from everyday language. Next, the formalized form is classified into different functions for the purpose of automation or use with distributed ledger technology. These functions are then combined into standard templates which are validated in terms of the consistency of the legal effect from the original derivative contract. These data in the templates are converted and stored in a digital format.
ISDA has released a new version of the CDM titled CDM 2.0, which encompasses a wider range of functions and products when compared with its earlier version. The salient features of CDM 2.0 are as follows:
- Detailed representation for credit default swaps, interest rate swaps and an initial representation for equity swaps. These are in addition to the futures and options from the previous version.
- A more detailed representation of the calculations to be carried out, especially the day count fractions for fixed and floating rates for swaps and other OTC derivatives. These otc derivatives have been shown as machine executable definitions.
- A more detailed representation of the lifecycle events of a derivative, with special respect to allocation, clearing, settlement and collateral management.
- Representation of the initial margins.
- A detailed repository of examples of events and documentation to help market participants align with the CDM easily.
CDM can effectively play the role of a building block for emerging trends and technologies, like Blockchain and smart contracts, that make use of a Distributed Ledger Technology (DLT) and which are expected to decrease the complexities and costs of derivatives processing through the use of a common database for storing and processing of trade data.
The common database or smart contract requires a uniform set of data which the CDM can address by delivering common standards for data formats, transactional data and business processes. CDM also provides a link between the different DLT solutions for different market participants by removing duplicate, fragmented data that is being processed by the participants.
In addition to reducing costs, increasing efficiencies and undertaking transformation of processes through DLT and Artificial Intelligence, CDM dlt solutions ensure transparency across different participants improving regulatory compliance and risk management. However, for these CDM dlt solutions to be effective, it has to be implemented by all market participants (investment banks, custodians, payment banks, clearing houses, central counterparties, trading centers etc.) and in smart contracts. At present, Fintech companies like REGnosys are developing a proof of concept along with ISDA to integrate with emerging technologies. Once implemented, CDM 2.0 has the potential to change the manner in which derivatives are processed.
- ISDA CDM 2.0 CFTC Technology Advisory Committee – tac032719_ISDACDM20 -
- ISDA’s Common Domain Model - TAC022620_ISDACommonDomainModel