Electronic trading system and method for pricing transactions to account for risk
An electronic trading system and method are described in which credit risk associated with a transaction is captured as a price adjustment on a trade-by-trade basis. In one preferred embodiment, a “request for quote” (RFQ) trading model is presented in which each dealer receiving an RFQ determines a base price as well as an additional credit risk adjustment amount by which the base price should be modified to account for credit risk. In other preferred embodiments, an exchange trading model is presented in which traders submit buy and sell orders whose prices are appropriately adjusted for presentation to each potential counterparty to account for credit risk associated with potential transactions. System designs are also presented to address the technical challenge of permitting each trading participant to apply its own credit risk algorithms and methodologies while avoiding their disclosure to other trading participants.
1. A request for quote system for buying and selling swap-based financial instruments, having extended maturity periods, the system comprising:
an order management server that:
receives a request for quote for a swap-based financial instrument from a first entity;
provides the request for quote to a second entity;
receives a base price for responding to the request for quote;
generates a response to the request for quote, the response to the request for quote comprising a response price determined from the base price and a price adjustment value; and
provides the response to the request for quote to the first entity; and
a risk processor that determines the price adjustment value by which the base price should be modified to account for risk to the second entity associated with a potential transaction of the swap-based financial instrument, the risk accounting for the potential for default over the extended maturity of the swap-based financial instrument.
2. A method for the electronic buying and selling of swap-based financial instruments, having extended maturity periods, comprising:
receiving, at an order management server, a request for quote from a first entity;
providing, by the order management server, the request for quote to a second entity;
receiving, by the order management server, a base price for responding to the request for quote;
determining, by a risk processor, a price adjustment value by which the base price should be modified to account for risk to the second entity associated with a potential transaction of a swap-based financial instrument, the risk accounting for the potential for default over the extended maturity of the swap-based financial instrument;
generating, by the order management server, a response to the request for quote, the response to the request for quote comprising a response price determined from the base price and the price adjustment value; and
providing, by the order management server, the response to the request for quote to the first entity.
3. The method of claim 2 , wherein the base price is determined by a trader of the second entity.
4. The method of claim 2 , wherein price adjustment value is determined in accordance with risk algorithms specified by the second entity.
5. The method of claim 2 , wherein the price adjustment value is determined by:
integrating the area under an expected loan balance curve to determine the size of the risk to the second entity for an interest rate swap;
multiplying the amount determined by said integration by a desired credit premium to determine an amount to account for risk associated with the potential transaction; and
spreading the amount over the total size of financial instrument to determine an equivalent number of basis points by which the interest rate swap price should be adjusted to account for risk associated with the potential transaction.
6. The method of claim 5 , wherein the financial instrument is an interest rate swap.
7. The method of claim 5 , wherein the financial instrument is a currency swap.
8. The method of claim 5 , wherein the financial instrument is a commodity swap.
9. The method of claim 5 , wherein the financial instrument is a energy swap.
10. The system of claim 1 , wherein the risk processor determines the price adjustment value taking account of the price and/or instrument.
11. The system of claim 1 , wherein the order management server is further configured to:
receive an order at a transaction price and determine if the order is valid;
separate the transaction price of a valid order into a component attributable to the base price and a credit risk component attributable to account for the credit risk associated with the transaction; and
credit the credit risk component to a risk allocation account.
12. The method according to claim 2 , wherein determining the price adjustment value takes account of the price and/or financial instrument.
13. The method according to claim 2 , further comprising:
receiving, by the order management server, an order at a transaction price and determining if the order is valid;
separating, by the order management server, the transaction price of a valid order into a credit risk component attributable to the base price and a component attributable to account for the credit associated with the transaction; and
crediting the credit risk component to a risk allocation account.