End-users of credit derivatives include hedge funds,  insurance companies, pension funds, and mutual funds. 1). 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). Two Factors Largely Caused the Confirmation Backlogs at Dealers

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. For  example, a dealer would receive a premium payment from a party other  than the party with which it had entered into the trade. Confirmation Backlogs and Unilateral Assignments Increased Dealers’ Operational Risks

Although dealers were capturing their credit derivatives trades in their risk  management systems to manage the associated market and credit risks,  the substantial backlog of unconfirmed trades heightened dealers’  operational risk, potentially hampering their ability to effectively manage  other risks. For this reason, trades should be confirmed as soon as possible. Having  unconfirmed trades could allow errors to go undetected that might  subsequently lead to losses and other problems. Because dealers were typically more creditworthy than the end-users  assigning the trades, the original dealers ended up with more creditworthy  counterparties after an assignment, according to dealers and examiners. The data that the dealers have been providing to  regulators showed that they collectively exceeded each of the reduction  goals they had agreed to meet and had reduced by 94 percent the total  number of confirmations outstanding over 30 days from the September  2005 level to the October 2006 level (table 3). Bank regulators were also reviewing the banks’ efforts to ensure the  security and resiliency of their information technology systems. Through the Joint Regulatory Initiative, Regulators Are Obtaining Data to More Effectively Track Industrywide Progress on Reducing Confirmation Backlogs

Although both U.S. banking and securities regulators were individually  overseeing aspects of U.S. dealers’ credit derivatives activities, the joint  regulatory initiative provided U.S. and foreign regulators with information  that enabled them to better oversee the progress being made by the major  dealers to address the backlog issue. Such data will assist regulators in monitoring  the operational and other risks raised by OTC derivative products. Appendix I: Scope and Methodology

To identify what caused the credit derivatives dealers’ trade confirmation  backlogs and how the backlogs are being addressed, we analyzed credit  derivatives trading volume, confirmation backlog, and other transaction  data provided by the major dealers to Markit Group, a provider of  independent data, portfolio valuations, and over-the-counter derivatives  trade processing. We  also reviewed reports and relevant publications from industry  associations, industry working groups, international organizations,  companies, and academics on the credit derivatives market.
Why GAO Did This Study

Over-the-counter (OTC) credit derivatives are privately negotiated contracts that allow a party to transfer the risk of default on a bond or loan to another party without transferring ownership. After trading in these products grew dramatically in recent years, backlogs of thousands of trades developed for which dealers had yet to formally confirm the trade terms with end-users--such as hedge funds, pension funds, and insurance companies--and other dealers. Not confirming these trades raised the risk that losses could arise. GAO was asked to review (1) what caused the trade confirmation backlogs and how they were being addressed and (2) how U.S. financial regulators were overseeing dealers' credit derivative operations, including the security and resiliency of the information technology systems used for these products. GAO analyzed data on credit derivatives operations that dealers submitted to regulators, reviewed regulatory examination reports and work papers, and interviewed regulators, dealers, end-users, and industry organizations.

What GAO Found

After trading volumes grew exponentially between 2002 and 2005, the 14 largest credit derivatives dealers--including U.S. and foreign banks and securities broker-dealers--accumulated backlogs of unconfirmed trades totaling over 150,000 in September 2005. These backlogs resulted from reliance on inefficient manual confirmation processes that failed to keep up with the rapidly growing volume and because of difficulties in confirming information for trades that end-users transferred to other parties without notifying the original dealer. Although these trades were being entered into the systems that dealers used to manage the risk of loss arising from price changes (market risk) and counterparty defaults (credit risk), the credit derivatives backlogs increased dealers' operational risk by potentially allowing errors that could lead to losses or other problems to go undetected. In response, a joint regulatory initiative involving U.S. and foreign regulators directed the 14 major dealers to work together to reduce the backlogs and address the underlying causes. By increasing automation and requiring end-users to obtain counterparty consent before assigning trades, the 14 dealers reduced their total confirmations outstanding more than 30 days by 94 percent to 5,500 trades by October 2006. Through ongoing supervision and examinations, U.S. banking and securities regulators became aware of the credit derivatives backlogs as early as late 2003 and had been monitoring efforts taken by each dealer to reduce its backlog. Under the joint regulatory initiative, regulators obtained aggregate data from the dealers that allowed regulators to better monitor how backlogs were being resolved. Recognizing the potential for similar problems to arise in other OTC derivatives markets, regulators began obtaining similar data for other OTC derivative products in November 2006.