Document Ref: OTCD001-003 27-July-09 v0-8 Draft  

Classification of derivative instruments
 

Introduction
This report has been written to identify how to extend ISO 10962 – the Classification of  Financial Instruments (ISO CFI) to support financial instruments that are primarily based around  cash flows (normally classified OTC derivative instruments). Given the nature of the financial  industry and the ever increasing regulatory requirements, over time these products are likely to  become more mainstream and therefore standardized, and may not necessarily stay in the OTC  domain.   The document incorporates recommendations from Financial Products Markup  Language(FpML) and International Swaps and Derivatives Association (ISDA).  The proposal also examines the Options and Warrants domains within the CFI and provides  some recommendations.  

Financial instruments within scope
All the instrument types identified in the Bank of International Settlement’s derivative  instrument classification publication, “Guidelines for semi‐annual OTC derivatives statistics” are  covered within this proposal as well as those identified in FpML and ISDA publications. In  addition, the ECB’s statistical classifications were also examined.   However, from a classification perspective it is important to highlight that it is only possible to  identify basic cash flow characteristics and constraints applied on those cash flows.  The products identified within this report are broken down under into the following headings:      Interest rate derivatives;  Inflation Swaps (though contractually the same as Interest Rate Swaps, the market  tends to prefer to differentiate between an agreement based on an interest rate and  one that is based on an economic rate)  Credit event derivatives;  Asset based cash flow derivatives:   o Financial assets.   Equity Swaps,   Total Return Swaps , …  o Commodities assets  Forwards. 

It is worth highlighting that derivative instruments based on underlying financial products are  semantically different from those based on commodities (including their legal definitions),  therefore these have been separated into distinct groups within the proposal, this also adheres  to the current version of the standard.  

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Business Context
The ISO CFI has two main business contexts in which it is widely used. Firstly for identifying the  appropriate allocation rule for ISINs and secondly for regulatory transaction reporting primarily  to support MiFID.   The ‘Call for Evidence’ by CESR in February 2009, to identify an appropriate mechanism for  classifying OTC derivative instruments highlighted the need for action in this area and this  report was sanctioned by TC68/SC4/WG6 to identify the appropriate solution that could be  applied to ISO 10962. Nevertheless these new classifications can be used outside of the ISO  standard, hence the use of diagrams to represent the classifications.  

Interest rate derivatives (category)
Interest rate derivative products define the exchange cash flows of interest payments between  parties, typically a fix rate steam in exchange for a variable rate.  They may also comprise of  foreign exchange component.  For interest rate swaps, currency is defined as a characteristic of a rate (Interest/Inflation)  swap. To support this, the CFI group subdivides the instruments into ‘single currency’ or ‘cross  currency’. For both these groups have the same set of attributes.    
class Interest rate deriv ativ es Interest rate derivatives Floater/Fixed - Interest rate (e,.g. interbank rate) against fix rate

Floater/Floater - Interest rate against interest rate

Attribute 1 - Cash flow legs

Single currency

Attribute 4. Redemption/reimbursement

Cancellable Attribute 2 - Floating rate leg constrainst(s) Redeemable/ Extendable Extendable Redeemable

Attribute 3 Maturity Simple Capped Floored Corridored Collared

One year or less

Over 1 and up to 5 years

Over five years

Figure 1. Classification for Single Currency Interest Rate derivative instruments  Attribute 1 ‐ Cash flow legs: classifies cash flow legs (floater/fixed, floater/floater…)  Attribute 2‐ Floating rate leg constraints: basic constraints on the floating rate leg,   Attribute 3  ‐ Unused.  Attribute 4 ‐ Redemption/reimbursement: One year or less, one to five years, or greater and  whether cancellable, redeemable, extendable… 

 

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Example Coding (Interest rate swap)
Assuming the CFI structure is followed, each element would be identified by a single character.   For example: I‐S‐F‐B‐S‐E    I = A Category of Interest rate derivatives   S = Single currency  B = Collared (Both floored and capped)  S = One year or less (Short‐term)  E = Extendable     

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Inflation based derivatives
The same structure as for Interest Rates Swaps. 
class Inflation deriv ativ es Inflation derivatives Floater/Fixed - Economic rate (e.g. inflation - CPI) against fix rate Attribute 1 - Cash flow legs Single currency Attribute 4. Redemption/reimbursement

Perpetual

Floater/Floater - Economic rate against Interest rate Attribute 2 - Floating rate leg constrainst(s) Redeemable/ Extendable Extendable

Cancellable Redeemable

Attribute 3 Maturity Simple Capped Floored Corridored Collared Over five years

One year or less

Over 1 and up to 5 years

 

Credit derivatives (category)
Under this category resides what is commonly know as credit default swaps, these are  contracts which commits two counterparties to exchange a periodic fee in exchange for a  payment contingent on an event (normally a default).  
class Credit Deriv ativ es North American Corporate Credit derivatives Emerging European Corporate Standard North American Corporate (fixed income payments) Western European Sovereign European Corporate

Debt instruments Others Stock-Equities (Miscellaneous)

Loans

Credit event/default Index Attribute 1 Underlying (reference) asset Attribute 3 - ISDA agreement types

Latin America Sovereign US Municipal Revenue

Basket Index tranche Basket tranche Cash Bankruptcy

IRS Attribute 2 - Credit event type and standard combinations of

Spread & CDO CDS FRA Future

Just a snapshot of the possible "standard" Credit event agreements, 22 in total. As more become exchange traded these variants are expected to become fewer.

As defined by ISDA Failure to Pay Restructuring Failure to Pay, Repudiation/Moratorium & Restructuring Bankruptcy, Failure to Pay & Restructuring Bankruptcy, Failure to Pay (Grace Period Extension: Applicable), Obligation Acceleration, Repudiation/Moratorium & Restructuring Bankruptcy, Failure to Pay (with Grace Period Extension), Obligation Acceleration, Repudiation/Moratorium & Restructuring (with Multiple Holder Obligation: Not Applicable)

Obligation default Obligation acceleration Repudiation or moratorium Bankruptcy, Failure to Pay & Restructuring (Modified Restructuring Maturity Limitation and Conditionally Transferable ObligationApplicable). Bankruptcy, Failure to Pay & Restructuring ( Restructuring Maturity Limitation and Fully Transferable Obligation Applicable.

Figure 2. Classification for Credit event derivative products 
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Attribute 1 ‐ Underlying asset: The type of underlying asset to which the event applies,  primarily credit events are against Debt instruments (bonds, convertibles) and loans.  Attribute 2: ‐ Attribute 2 ‐ Credit event type and standard combinations of: Identifies the type  of the event(s). ISDA identifies six kinds of events; nevertheless the most significant are  Bankruptcy, Failure to Pay and Restructuring. These six are normally not used in isolation and  tend to be grouped together in “standard” agreements, hence both the individual event types  and standardized groups are covered by this attribute.  Attribute 3 – ISDA Agreement types, There are 22 ISDA "standard" Credit event agreements. As  more become exchange traded these variants are expected to become fewer in numbers. Each  agreement type represents a standardised set of attributes used (26 in total), which are defined  in spreadsheet form published on the ISDA website (“Credit‐Derivatives‐Physical‐Settlement‐ Matrix…xls”).   The agreement types are listed as:                        Standard North American Corporate (fixed income payments)  North American Corporate   European Corporate  Australia Corporate  New Zealand Corporate  Japan Corporate  Singapore Corporate  Asia Corporate  Subordinated European Insurance Corporate  Emerging European Corporate LPN  Emerging European corporate  Latin America Corporate B  Latin America Corporate BL  Japan Sovereign  Australia Sovereign  New Zealand Sovereign  Singapore Sovereign  Latin America Sovereign  Western European Sovereign  US Municipal Full Faith and Credit  US Municipal General Fund  US Municipal Revenue 

Attribute 4 – Unused.

Asset based cash flow derivatives (category)
These are cash flow based financial instruments where the one party receives payments based  on the performance of an underlying reference asset normally in exchange for regular interest 
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payments from the other party. The performance may be a result of the change in value of the  underlyer as well as income, or just one of these two.  The payments from the reference asset  can be protected against losses (an attribute normally associated with Total Return Swaps). In  some instances parties may wish to exchange cash flows associated with the underlying assets  that they hold, without transferring ownership of the holdings themselves, these are also  supported within this category.  Under this category two groups reside, adhering to the same construct used within the existing  ISO CFI’s Futures category, thus providing a clear differentiation between financial and  commodity based financial products.   

Financial assets (group)
This group supports all swaps that are based on one or more reference assets (e.g.  Stock‐ Equity, indices, etc…).   This group encompasses Asset, Equity, Variance and Total Return  Swaps, among others.  
class Financial assets Debt instrument against floating rate Incides against fixed rate Incides against floating rate Over 1 and up to 5 years Stock-equity against floating rate Attribute 1 - Swap legs Stock-equity against fixed rate Debt instrument against fixed rate Basket against fixed rate Basket against floating rate Stock-equity against stock-equity Stock-equity against Debt instrument Stock-equity against indices Stock-equity against basket Cancellable Extendable Redeemable Redeemable/ Extendable Financial assets Debt instrument against debt instrument Other (Miscellaneous) Indices against debt instrument Indices against indices

One year or less

Over five years Attribute 4. Redemption/reimbursement

Perpetual

Indices against basket

Attribute 3 - Delivery

Attribute 2 - Reference asset(s) payment rules

For scenarios with more than two legs or other combinations not specificed within this attributre list.

Cash Physical

Cross currency + credit event(s)

Other (Miscellaneous)

Income from reference asset

Change in value of reference asset

Both income and change in value of reference asset with protection against losses

Both income and change in value of reference asset

A attribute associated with Total Return Swaps.

 Figure 3. Classification of swaps based on “Financial assets”     Attribute 1 ‐ Swap legs: Used to identify the legs of a non commodity swap. For example, swap  may comprise of an equity return paid against a fixed rate (“Stock‐Equity against fixed rate”). 

 

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Attribute 2 – Payment rules: Identifies the payment rules that apply relating to the reference  asset(s).  Payments are based on income, price change in the underlying reference asset, etc...  The “Others” definition would be used to cater for scenarios where reference assets are on  both sides and different reference asset payment rules apply or for other more complex  scenarios.  Attribute 3 ‐ Delivery:  Cash or Physical delivery.  Attribute 4 ‐ Redemption/reimbursement: One year or less, one to five years, or greater and  whether cancellable, redeemable, extendable… 

Commodities assets (group)
Fixed or variable (floating) payments are made to secure the interest in the underlying asset, in  return for payments received based on its market price.  In some instances this may result in  physical delivery.      
class Commodities I = Industrial products (Construction, manufacturing) against fix rate S = Services (Transportation, communication, trade) against fix rate A = Agriculture, forestry and fishing against fix rate

B = Agriculture, forestry and fishing against floating rate

J = Industrial products (Construction, manufacturing) against floating rate

T = Services (Transportation, communication, trade) against floating rate

E = Extraction resources (Metals, precious metals, coal, oil, gas) against fix rate

P = Power (e.g. Electricity) against fix rate

F = Extraction resources (Metals, precious metals, coal, oil, gas) against floating rate One year or less Over 1 and up to 5 years Attribute 4. Redemption/reimbursement Commodities assets Redeemable/ Extendable

Attribute 1 - Swap legs

Q = Power (e.g. Electricity) against floating rate

Other (Miscellaneous)

Over five years Perpetual Cancellable Extendable

For scenarios with more than two legs or other combinations not specificed within this attributre list.

Redeemable

Attribute 2 - Reference asset(s) payment rules Physical Attribute 3 - Delivery Other (Miscellaneous) Cash Both income and change in value of reference asset with protection against losses

Income from reference asset

Change in value of reference asset

Both income and change in value of reference asset

Figure 4. Commodity derivatives    Attribute 1 ‐ Swap legs: Used to identify the legs of a swap where one of the reference asset(s)  is a commodity.  

 

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Attribute 2 ‐ Identifies the payment rules that apply relating to the reference asset(s).   Payments are based on income, price change in the underlying reference asset, etc... The  “Others” definition would be used to cater for scenarios where reference assets are on both  sides and different reference asset payment rules apply.  Attribute 3 ‐ Delivery: Cash or Physical, this is defined in the 2001 version of the CFI as: 
P = Physical (The underlying instrument must be delivered when the option is exercised) C = Cash (The settlement of the option is made in cash)

Attribute 4 ‐ Redemption/reimbursement: One year or less, one to five years, or greater and  whether cancellable, redeemable, extendable… 

Forwards (category)
Forwards are widely used in the OTC world; however the ISO CFI currently only supports  Forwards using the 1st attribute of the “Other Assets” Category with the value of M‐M‐F‐X‐X‐X,  providing no details about the forward itself.  The proposal is to create a Forwards category and like Futures, this would be subdivided into  two major groups, financial forwards and commodity forwards.   

Financial forwards (group)
The classification for financial forwards would be broken down as follows:    
class Forw ards Forwards

Over 1 and up to 5 years Stock-Equities Debt instruments Financial forwards One year or less Attribute 1 Reference assets Over five years

Indices

Attribute 4. Redemption/reimbursement Basket Attribute 2 - Delivery Attribute 3 - Strategy Redeemable/ Extendable

Currencies Outright Spread Spot and forward pair (FX Swap)

Perpetual Cancellable Redeemable

Extendable

Physical

Others (Miscellaneous)

Cash

Forward pair (FRA)

Figure 5. Financial forwards  Attribute 1‐ Identifies the reference assets.  Attribute 2 ‐ Delivery: Cash or Physical.    Attribute 3 ‐Strategy :  Outright forward, spread, FX Swap (spot and a forward), FRA (two  forwards)… 
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Attribute 4 ‐ Redemption/reimbursement: One year or less, one to five years, or greater and  whether cancellable, redeemable, extendable… 

Commodities forwards (group)
class Forw ards A = Agriculture, forestry and fishing against fix rate E = Extraction resources (Metals, precious metals, coal, oil, gas) against fix rate Attribute 1 - Underlying assets I = Industrial products (Construction, manufacturing) S = Services (Transportation, communication, trade) against fix rate Redeemable/ Extendable Attribute 3 Strategy P = Power (e.g. Electricity) against fix rate Attribute 2 - Delivery Physical Forwards

Over 1 and up to 5 years One year or less Over five years Commodity forwards

Attribute 4. Redemption/reimbursement

Perpetual Redeemable

Extendable

Cash Cancellable Outright Spread Swap Others (Miscellaneous)

Figure 6. Commodity forwards   This group has essentially the same attribute as financial forwards, however with a different  set of reference assets.  Attribute 1: Underlying assets as defined for Commodities futures, extended in Bold/Blue:  E = Extraction resources (Metals, precious metals, coal, oil, gas)  A = Agriculture, forestry and fishing  I = Industrial products (Construction, manufacturing)   S = Services (Transportation, communication, trade)  P= Electricity? 

 

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Option Considerations
Exchange-traded options
Exchange‐traded options are always on a Stock‐Equities or a Future on an underlyer (i.e. the  holder has the rights to purchase/sell the Future not the underlyer). For example, one can have  an option on a Future of an interest rate or an option on a Future of a bond. Therefore, if one  adheres to the text in the standard, "the type of underlying assets that the option holder is  entitled to purchase or sell", the 2nd attribute: Underlying assets should only be set to "S" or  "F". Other than these two the use of any other value is rather confusing as a result. 

Swap options (Swaptions and Credit derivative options)
In its current form, the standard is unable to properly support swaps. Swaps cannot be  classified as either a call or put options, as they are options on agreements that define the flow  (cash or assets) between parties, the parties are either the receiver or payer.   Therefore a Swap options category is proposed broken down by the following groups Financial  Swaptions, Commodity Swaptions and Credit Derivatives.    
class Financial sw aptions American Swap Options Attribute 4 - Unused Attribute 1 - Excercise option style European

Burmuda

Attribute 3 - Unused

Financial swaptions Stock-equity against floating rate

Debt instrument against fixed rate Debt instrument against floating rate

Incides against fixed rate Basket against fixed rate Basket against floating rate Stock-equity against stock-equity Stock-equity against Debt instrument Stock-equity against indices

Stock-equity against fixed rate

Incides against floating rate

The right to enter into a swap agreement that is made up "Attribute 2" swap legs.

Floater/Fixed - Interest rate (e,.g. interbank rate) against fix rate

Attribute 2 - Swap legs Stock-equity against basket

Floater/Floater - Interest rate against interest rate Floater/Fixed - Economic rate (e.g. inflation - CPI) against fix rate Floater/Floater - Economic rate against Interest rate Debt instrument against debt instrument Other (Miscellaneous)

Indices against basket

Indices against debt instrument Indices against indices

For scenarios with more than two legs or other combinations not specificed within this attributre list.

Figure 7. Financial swaptions       
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class Commodity sw aptions American

Attribute 1 - Excercise option style

European

Burmuda Attribute 4 - Unused

Swap Options A = Agriculture, forestry and fishing against fix rate B = Agriculture, forestry and fishing against floating rate E = Extraction resources (Metals, precious metals, coal, oil, gas) against fix rate

Attribute 3 - Unused

Commodity swaptions

Attribute 2 - Swap legs

F = Extraction resources (Metals, precious metals, coal, oil, gas) against floating rate

The right to enter into a swap agreement that is made up "Attribute 2" swap legs.

P = Power (e.g. Electricity) against fix rate

I = Industrial products (Construction, manufacturing) against fix rate S = Services (Transportation, communication, trade) against fix rate J = Industrial products (Construction, manufacturing) against floating rate

T = Services (Transportation, communication, trade) against floating rate Other (Miscellaneous)

For scenarios with more than two legs or other combinations not specificed within this attributre list.

Figure 8. Commodity swaptions   

 

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class Credit ev ent/default options

American Attribute 1 - Excercise option style

Swap Options

European

Burmuda Attribute 4 - Credit event type and standard combinations of (see Credit Derivatives)

Loans

Debt instruments

Credit derivatives

Stock-Equities Attribute 2 Underlying reference/asset Others (Miscellaneous)

Index

Basket Index tranche Basket tranche Cash

Spread & CDO Attribute 3 - ISDA Agreement types (see Credit Derivatives) The right to enter into a credit event/default agreement based on a specific type of underlyer identify by "Attribute 2".

IRS

FRA

Future

CDS

Figure 9. Credit derivative options 

 

Warrant Considerations
There is a requirement to extend Attribute 1 – Underlying assets to include a definition for  “Interest rate”.    

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