First in a series of interviews with technology leaders whose views are relevant to AMG members.

Interview with David Lefferts, Director, Markit Group Limited

Asset Management Group: What are some market trends likely to develop in 2007?

David Lefferts: There continues to be a great deal of activity and innovation in credit derivatives and structured finance. It's almost never 'business as usual' because firms are constantly finding new ways to manage and hedge risk.

In other areas of the capital markets some of the structural changes many of us have been talking about for years appear to finally be coming to fruition — for example the globalization of securities markets has extended beyond the over-the-counter markets and investors and exchanges are now embracing it whole-heartedly. Other structural changes such as the ability to easily trade across asset classes are still not a reality but market participants seem eager to cater to this need, so 2007 could be very exciting.

Hedge funds have led the way in wanting to actively manage and trade risk across instruments. This has resulted in some banks (and in particular those with Prime Brokerage operations) reorganizing their desks to trade across the capital structure of issuers. For example, a bank may co-locate the Ford equity trader, CDS trader and cash bond trader.

We'll also continue to see a lot of innovation on the front-end in terms of structuring instruments or baskets - for example ABCDS (CDS of ABS) and LCDS (loan CDS). Naturally, new structures will need to be designed with the middle and back office in mind. Issues relating to the timely processing of all these trades (particularly for CDS) has been a major cause for concern among market participants and regulators. Fortunately, streamlining of documentation and the application of technology have largely broken the back of these initial concerns.

Markit's trade processing service helps the buy-side and sell-side deal with these increasing volumes. Initially, the drive was to be able to handle and process these trades with reasonable efficiency. Now, the focus is to improve trade processing from the point of trade all the way through its lifecycle, in order to minimize risk by processing transactions flawlessly to avoid fails, and subsequently bolster investment returns and generate alpha.

Asset Management Group: What is the outlook for the derivatives market?

David Lefferts: For years, straight-through processing, or STP, was the "Holy Grail" in the cash markets. Controlling back office costs and reducing fails was always a major focus as far back as 10 years ago. Those issues have largely been solved in the liquid instruments with electronic trading and distribution systems.

What we're seeing now in CDS is increased efficiency through services such as ours and utilities such as the DTCC that are helping automate and streamline trade processing.

Many of the processes which were previously done manually are now being automated. In addition to making the process more efficient, technology allows for complete audit trails and record retention. The ability to go back and show auditors or regulators a transaction from end-to-end is a great step forward. It's important in all markets to have this information readily available, but especially in the OTC derivative markets where the trade itself is a privately negotiated long-term contract between two counterparties.

Asset Management Group: Regarding the delivery of data, what innovations are being made in that area that serve the needs of the dealers and investment management firms?

David Lefferts: Until recently, many of the cash bond and derivative data sets were not consolidated or widely available. This availability in and of itself was novel. Going forward, the focus will be on how to add value to the information and combine the data sets. For example, at Markit we're finding ways to integrate and leverage this new data into the trade processing, portfolio reconciliation, and portfolio valuation processes to provide end users with tools that bring greater transparency and efficiency.

We're in a unique position because we have rich, accurate data sets drawn from the leading dealing firms with which we calibrate our valuation models. We can then provide portfolio valuations for complex, illiquid instruments.

It is of great benefit to investors to have access to an independent source for price verification.

Asset Management Group: How does electronic trading fit into larger discussions about compliance and best executions?

David Lefferts: With the breadth of data sources that are available now, market participants are increasingly using them for purposes of understanding fair value and best execution. Electronic trading, in those pockets of the market that have achieved some traction, is one more source of real-time data. The market has multiple data sources each of which addresses specific needs. For example, real-time data serves the purpose of aiding price discovery pre-trade. End of day marks serve another purpose — they are typically used for marking a position to market. Consequently, end of day marks go through a rigorous data cleaning process with validation checks for stale or outlying data.

Another frequently asked question is "how does regulated post-trade transparency (e.g., TRACE) fit with end of day valuations and pricing?" If there's a traded price, what's the better measure of fair value - the traded price or the dealer mark? If something trades and is liquid, a recent traded price is clearly a meaningful input when determining the value of that security. So it certainly should be part of the process. However, different pricing sources have different degrees of utility. For example, it's sometimes difficult to understand what price discovery a traded price actually represents - a bond price may represent the unwinding of a CDS position rather than a price driven by views on relative value. In addition, a large portion of the market may not trade on any given day. At Markit, we're careful to use the best information provided to us by leading market makers to calibrate our models and determine fair value.

Asset Management Group: What about the buy-side?

David Lefferts: Traditional fund managers have daily processes in place to price the securities in their portfolios. However, regulators have been voicing concerns about the source of these prices and questioning their independence. Are they truly end-of-day marks or do they simply reflect intraday price movements? Is the bid, the offer or the midpoint the correct price for valuing positions?

Asset Management Group: With so many categories of pricing, is there a specific service that is attracting most interest from the buy-side at this time?

David Lefferts: We see interest across the whole spectrum. Historically end of day (or next day) and end of month has been the thrust of our offering, but our clients have varying needs both pre- and post-trade so we also provide same-day and intraday prices. The intraday offerings serve as a valuable complement to end of day as they provide portfolio managers and traders a means to spot intraday moves and activity, generate trade ideas and monitor real-time P&L. While an intraday dataset alone does not provide the breadth or depth in coverage required for most financial institutions, the combination with our end of day offerings has proven to be compelling.

Asset Management Group: What was behind Markit's recent acquisition of ABSReports?

David Lefferts: The credit derivatives and structured finance markets have been growing at a phenomenal pace, and that's a trend unlikely to abate in the short term. We are consequently seeing demand for services that offer price transparency and a greater understanding of deal performance. This is particularly true in the European ABS market, where investors have been asking to see our price data next to performance information on deals. Our acquisition of ABSReports will now allow us to provide our clients with ABS prices as well as access to deal data, original servicer reports and access to an archive of more than 1,500 European transactions as well as news and research.

In addition, last fall Markit rolled out the Reference Cashflow Database (RCD), a tool for monitoring bond performance and determining settlements of U.S Home Equity single name ABCDS trades. The service has done extremely well and we are currently planning on expanding our current coverage into other asset classes. The acquisition of ABS Reports gives us an immediate presence in Europe with more than a decade of performance history.