Factiva

It was a sports fan's lateral thinking that solved the sensitive political and logistical problem of organising the world's biggest investment banks to battle through the vast backlog of incomplete credit derivatives trades.

As dealers faced the wrath of regulators and back-office administrators confronted mountains of work, one bright spark at Credit Suisse realised the value of a simple piece of software used to arrange football tournaments.

Supplied with the names of the banks, it spat out a fixture list complete with home and away matches. The banks would meet up on each other's turf and plough through reams of unconfirmed, inaccurate or disputed credit derivatives contracts.

A heroic effort was called for. Regulators in the UK and US began turning up the heat on sloppy market practices around mid-2005. By then, the explosive growth of the market for credit default swaps, which offer a kind of insurance against non-payment of corporate debt, had seen outstanding volumes reach more than $12,000bn.

The problem, as Alan Greenspan, former chairman of the Federal Reserve, has noted, was that traders had been simply writing down these bilateral deals on scraps of paper. In too many cases, the full documentation for CDS contracts - which can run for as long as 10 years - was not being completed properly.

The complexity was increased when one party to a trade sold it on to a third party. In these so-called "assignments", the original counterparty was often left unaware of who was now on the other side of the deal.

"We were on a road that could have led to shut down if we hadn't changed course," says one executive involved in the clean-up operation.

Thomas Huertas, head of wholesale firms at the UK's Financial Services Authority, says: "The industry has turned an accident waiting to happen into a near miss." He draws a parallel with a car speeding through a red light - and then swerving to avoid an accident.

"It should never have let the front office run so far ahead of the back office. We do not expect firms to engage in such heroics again."

Cleaning up the mess was a grind, according to people involved. Big dealer banks, including Deutsche Bank, Goldman Sachs, JPMorgan and Morgan Stanley, had their back-office staff busy for two or three 12-hour days at a time in each "lock-in" with other banks.

And that was before dealing also with the many buy-side clients, hedge funds and asset managers, who had anything between a handful and hundreds of trades each to clear up as well.

Here, the banks ran into trouble, particularly over assignments. They proposed a new way of confirming the transfers and said they would refuse all trades that failed to adhere to it. But the buy-side took umbrage with the banks' failure to consult clients and with the very short deadline for compliance they were given.

Bond giant Pimco, for example, was one of the last to agree to the new procedures. At the time, James Keller, head of Pimco's governments and derivatives desks, said: "We don't believe it makes sense to sign an agreement that we cannot comply with at the time we sign it and we don't think this is how a good customer should be treated."

The hue and cry from customers forced the banks to be more co-operative with their clients. But from the banks' point of view there were still problems with some clients who did not invest in the move to electronic processing.

"There are certainly cases where banks have been cutting off clients and refusing to trade with them if they are not ready with the technology," says one banker.

But there are now a host of initiatives underway to address these concerns. The Depository Trust and Clearing Corporation, an industry-owned trade settlement utility, has expanded rapidly into the derivatives area. Start-ups such as T-Zero, an electronic post-trade settlement system, have also emerged.

Meanwhile, many hedge funds have devoted considerable resources to these issues. "I think there has been huge progress - people are taking this issue very seriously," says Michael Hintze, chief executive of CQS, a credit hedge fund. He used to sign faxes to confirm trades personally, but is now a heavy user of electronic systems.

On Wall Street, there is a sense of relief. "A lot of people worked long hours and weekends across the industry to clean up the backlog," says Eric Rosen, head of credit trading for North America at JPMorgan.

"I feel much better as a risk manager, we are in a lot better shape than we were a year ago."

Additional reporting by Richard Beales

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