FpML: What it is and Why it is Important

1. Overview of Derivatives Industry

Since the early 1980s there has been explosive growth in the trading of financial derivatives, particular in the Over the Counter (OTC) derivatives market. At the end of 1999, the total estimated notional amount of OTC derivatives outstanding worldwide was approximately $88.2 trillion, with 10% growth in 1999 alone. Businesses and government entities are among the end users that rely on OTC derivatives to manage financial and commodity market risks inherent in their core economic activity. Financial Products Markup Language (FpML) is the emerging extensible markup language (XML)-based 'lingua franca' for enabling e-Commerce in the OTC derivatives market.

There are many automation changes currently being implemented. The OTC market has exploded in terms of growth over the last 20 years, but much of this activity is still conducted over the telephone. An OTC derivative is a privately negotiated contract between two parties. Unlike a stock or a bond, there is no unique, standardized identifier like a ticker symbol or Committee on Uniform Security Identification Procedures (CUSIP) number; each trade is a unique instrument that can only be communicated by exchanging all of the economic terms of the trade. The challenge is to transcribe the contract terms electronically in a format that supports the complexity and variety of derivative product features. XML provides an excellent framework for representing these highly structured products. FpML is the only industry-led XML standard in the OTC derivatives industry.

2. FpML.org Organization Structure and Vision

The vision of FpML is to enable e-Commerce for financial derivatives transactions and build a critical mass of support from financial institutions and software vendors to develop and support the standard. The development of FpML is coordinated and managed by FpML.org, a consortium of financial industry firms and vendors. A non-profit entity, FpML.org, Inc., was formed in July 2000. FpML.org is comprised of a Board of Directors, a Standards Committee, and various working groups that focus on business requirements and architecture.

The Board of Directors consists of senior derivatives business leaders from major market participants who set overall goals and priorities. Most major firms are represented, including banks like Bank of America, BNP Paribas, Citigroup, CSFB, Deutsche Bank, Goldman Sachs, JP Morgan Chase, Mizuho Capital, Morgan Stanley, and UBS Warburg.

The Standards Committee consists of derivatives technology and operations leaders from major market participants, as well as representatives from key vendors and industry initiatives. The committee defines the approach for developing the standard, monitors progress, and officially approves the specifications as they are produced. All of the board member firms have representatives on the Standards Committee. Additionally, institutions and vendors like IBM, Reuters, Society for Worldwide Interbank Financial Telecommunication (SWIFT), and the International Swaps and Derivatives Association (ISDA) are members as well.

The Standards Committee establishes working groups, via public calls for participation, to develop and enrich the FpML specification. A World Wide Web Consortium (W3C)-like process is used by which a technical specification is revised and reviewed until it is considered mature enough to be published as a recommendation. Various status levels of the specification prior to recommendation include: Working Draft, Last Call Working Draft, Trial Recommendation, and then finally Recommendation. FpML Version 1.0 has been in Recommendation since June 2001, and FpML Version 2.0 (as of October 2001) is in Last Call Working Draft.

3. Working Groups

There are currently 4 active working groups. They are: Architecture, Interest Rate Derivatives (IRD), Equity Derivatives (ED), and Foreign Exchange (FX).

The Architecture working group’s mission is to examine technical issues relating to FpML, including:

• Message Structure. This will consider how the FpML specification can be extended to support exchanges of business oriented messages. It should consider issues such as digital signatures, encryption, attachments and extensions.

• Versioning. FpML 1.0 provides a mechanism for determining the version associated with a particular message. This thread will examine issues relating to transitions between versions.

• Extensibility. This thread should consider and document the legal ways firms can develop proprietary extensions to FpML documents.

• An early deliverable will be the production of a recommendation for the implementation of XML schemas across FpML.

The group deliverables will be in the form of a Document Type Definition (DTD) (and potentially XML schema), samples and associated documentation.

The IRD working group was formed in July 2000 and provides definitions for various families of Interest Rate Derivatives products, such as interest rate swaps, forward rate agreements, caps, floors, collars, and various cancelable and extendible swaps.

The ED working group was formed in March 2001 and extends the FpML specification to include equity derivative products and features. The current focus is on modeling a simple, or vanilla, OTC equity option. The DTD is currently under review by the Standards Committee, and the working draft is scheduled for publication on the FpML.org web site before the end of 2001.

The FX working group was formed in May 2001 and extends the specification further to include FX and FX OTC options products. The supported product set includes spot, forwards (standard and non-deliverable), swaps, vanilla options, barriers, digitals, binaries, average rate options, and trade packages/strategies. The working group has produced a DTD that is currently under review by the Standards Committee, and the working draft is scheduled for publication on the FpML.org web site in December 2001.

4. FpML.org Objectives

The goals of FpML.org are to:

• create a stronger standard by increasing the depth and breadth of the standard;

• shorten time to market for future development efforts;

• achieve industry acceptance and use of FpML across the industry;

• reduce the costs of using FpML.

The organization expects to achieve its goals by:

• expanding asset class coverage – mechanisms to solicit interest here include public calls for interest and soliciting proposals from member organizations to provide a framework for developing. Current public interest lies in the Energy Derivatives and Credit Derivatives.

• facilitating standards development – the Board is working to create a sustainable funding model and engaging temporary staff to assist with supporting the working groups.

• expanding FpML.org membership – potential future members include additional banks and broker/dealers, exchanges and multi-dealer platforms, vendors, and buy-side firms.

• coordinating with complementary standards efforts – working with various other standards organizations such as Financial Information eXchange (FIX)protocol, SWIFT, and Treasury Workstation Integration Standards Team (TWIST) to ensure compatibility as well as product depth.

• extend the scope of FpML – the objective is to support the entire lifecycle of the trade, including trade negotiation, execution, events such as rate fixings and exercises, valuation and risk reporting, and market data.

5. An Introduction to The Specification

The specification has been organized in such a way as to separate business from technical issues. This way, the business groups can extend the specification where required, and the technical groups can ensure that the specification is resilient to technology changes. The specification itself is forward-looking yet realistic so that it can be utilized now.

The initial focus has been on IRD, although FX and ED will enhance the supported product coverage significantly. There are some key prevailing themes across the entire specification, however. There is a symmetrical view of the trade, such that the trade is counterparty neutral and will look identical to either the buyer or the seller of the trade. Precise parametric trade representation similar to other standards bodies allow for simplified trade description (e.g., 5-year swap with quarterly ratesets and quarterly payments). ISDA and SWIFT terminology is used where possible. Finally, the objective is to create a series of building blocks that can be re-used for future products and asset classes.

As an example, a foreign exchange trade is a contract between two parties to exchange one amount of currency for an amount of different currency at an agreed-upon rate, on a particular date. This could optionally include how the funds will be paid. This is a simple, standard FX contract. Below is a graphical representation of how this contract is defined in FpML.

Below is what the xml would look like for a simple FX contract.

6. Expected Uses of FpML

Today, over 50% of financial firms generate and exchange their own documentation with their trade counterparty for matching. An electronic platform can generate a single FpML view of the trade that can be sent to both counterparties. A single trade view eliminates the need for trade matching and reduces the error rate, reducing processing costs. Currently, over 1 billion US dollars are spent annually processing derivatives. A recent survey conducted amongst end users found only 2% currently use the Internet to negotiate or purchase OTC derivative contracts. However, 12% expect to be doing so by the end of 2002, and 25% expect to be doing so a year after that. Straight through processing requirements will be essential for electronic trading to provide the operational benefits and cost reductions that the user expects, and it will be critical to have a standard in place that facilitates these objectives.

There are a number of protocols that already exist in the financial services area. The focus of FIX is on negotiation and execution of listed securities. SWIFT has focused on confirmation and settlement of widely traded products. Various vendor-led initiatives have been developed for linking vendor systems. However, FpML is the only industry-wide, XML-based standard in the OTC derivatives domain.

7. Examples of FpML being used Today

Many firms and vendors have projects where FpML is either already in use or will be used in the near future. Some of these include:

• Morgan Stanley is developing an Internet-based IRD system for institutional clients. FpML is used for exchanging trade-related data between systems.

• Swapswire is developing an online trading and negotiation network for interest rate swaps. The trade representation sent to each counterparty will be in FpML.

• Coba Technologies has developed their Netdealing OTC derivatives trading platform based on FpML.

• Cygnifi, a derivatives services company that provides online tools and services, is using FpML to describe interest rate swaps within their messaging architecture.

• Finetrix has developed a Java report generation tool that creates publication-quality Adobe PDF confirmations as output from standard FpML Version 1.0.

• Kronos Software has developed a Java toolkit for FpML that provides a set of Java classes that support the loading and generation of FpML documents.

• Reuters is rolling out the Dealing for Swaps electronic trading platform and will generate FpML documents for executed trade to facilitate straight through processing (STP).

• Sungard Trading and Risk Systems are developing an FpML converter as part of their Network Trade Model to enable FpML connectivity to their product suite.

• TWIST is a working group of several companies formed and led by the treasury operations department of Royal Dutch/Shell Group that is focused on creating standards to facilitate an efficient, controlled, and open dealing marketplace for FX and other cash instruments. This work is based upon the FpML standard.

• Wall Street Systems supports FpML documents for FX and IRD transactions to enable STP connectivity with their treasury and trading management system.

8. More Information on FpML

FpML.org maintains a web site at http://www.fpml.org. The FpML specifications are available for download on the site.

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