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December 19, 2007

DTCC Offers Prime Brokers New Way to Match

Clearing Quarterly & Directory

By Gregory Bresiger

The explosion of hedge fund trading in government securities and repurchase agreements is leading to greater risks and clearing costs, say officials at the Depository Trust & Clearing Corp., who are offering a new service.

Prime Broker  Netting, designed for prime brokers and their executing brokers, is a new matching, comparison and clearing service of the DTCC’s Fixed Income Clearing Corp (FICC). The new service will help reduce the risks and costs of clearing,  DTCC officials claim.  The service is expected to begin operating on an extensive basis in early 2008.  

“This will lower settlement costs while reducing counterparty and settlement risk,” says Murray Pozmanter, managing director, DTCC   Clearance and Settlement Group.

Using Prime Broker Netting, the FICC, through its Government Securities Division, steps into the middle of these trades and guarantees them until they are ultimately settled. The service can be performed  on a matching only or matching and netting basis, DTCC officials say.

    

Trades can be settled on a collective basis  instead of one a bilateral basis outside of the FICC, a DTCC official says. The dealer is also eliminating the risk of getting stuck with a bad trade, he adds.  

    

“The executing broker, the minute he matches the trade through our system  with the prime, now will have FICC as the counterparty, a AAA-rated entity, as opposed to a hedge fund,” Sean Delap,

vice president for product development for clearing and settlement at DTCC, told CQ&D.

    

Hedge funds usually trade treasuries through numerous executing brokers. The brokers then rely on the prime broker to supervise the clearance of the trades. However, since prime brokers aren’t usually a legal party to these trades, there is a potential problem: They usually don’t send the trades to the FICC for comparison and netting.  

    

Executing brokers working with a hedge fund are running counterparty risk. They could be caught with a bad trade if the hedge fund goes under. Today, transactions are usually settled on a trade-by-trade basis, which means they don’t benefit from the risk reductions and lower costs of the FICC’s prior matching and trade netting.

    

But the executing broker, which clears the trade, will gain because netting reduces the number of transactions and ends the danger of getting hurt by an imploding hedge fund.

    

“All his receives and delivers come from the FICC. And if this counterparty goes out of business in the interim, he’s guaranteed by the FICC that those trades will in fact settle,” Delap says. He adds that DTCC can use a reserve system to improve  clearance. The system can protect traders against failed transactions by using the collateral from members who are in  trouble.

    

Besides the potential problem of failing hedge funds, DTCC officials say today there are often small problems  in the chain of command going from the  hedge fund to the prime broker to the executing broker.  

    

Often, there are discrepancies between what the brokers traded and what the hedge fund told the prime broker to receive from a dealer. Matching the parties—through Prime Broker Netting—will avoid these discrepancies, DTCC officials say.

    

DTCC officials say they expect prime brokers to use the service for match and net on government securities. Prime brokers using the service will be able to designate how they will use the service for each of their clients. DTCC officials say they will able to designate if a customer should use matched only or matched and netted. But even if a trade is only submitted to FICC for comparison, that should still help reduce settlement costs.