OTC Derivatives:

Erratic Manual Processes, Fragmented Systems Increase Risks in OTC Derivatives Processing

Originally published April 28, 2008

NEW YORK — Even after witnessing many improvements in automating processing of credit derivatives trades, including credit default swaps, achieving electronic processing of the broader category of over-the-counter (OTC) derivatives remains a “herculean” task in the marketplace. “There simply is no telling when the job will be complete,” says Denise Valentine, Senior Analyst at consultancy Aite Group, author of a study entitled, “OTC Derivatives Processing: Life on the Edge.” Outside of credit derivatives, OTC derivatives processing remains a highly manual process.

The International Swaps and Derivatives Association (ISDA) has set definitions for a range of OTC derivatives, along with a “Master Agreement” defining specific economic details of OTC derivatives trades, such as net asset value (NAV) termination events, dealer credit changes, collateral terms and select trading terms.

ISDA’s efforts have unified the swaps market concerning standard contracts and procedures, according to Kevin McPartland, Senior Analyst at consultancy The Tabb Group, although many parties in the OTC derivatives trading marketplace still need to be convinced about the value of the FIX [Financial Information eXchange] standard in their operations, he adds. “Systems have improved dramatically to help with OTC processing; however, there is no one-stop shop,” says McPartland. “Users are still left to piece together numerous systems to create an infrastructure suitable to their specific needs. Even those brokers who build most of their software in-house still look to vendors for parts of their OTC processing infrastructure.”

Although about 90 percent of credit-default swaps transactions are now confirmed electronically, many “less vanilla” OTC transactions are still confirmed using paper faxes, according to McPartland. “One investment bank says that nearly 90 percent of its overall OTC volume is confirmed manually.”

The processing of an OTC derivatives trade begins at the source. BlackRock Financial Management is an example of a firm making strides in automating derivatives processing, says Ila Eckhoff, Director at BlackRock. “In our portfolio management group, when a trade is executed, everybody owns a piece of the transaction all the way through the settlements, cash flows and collateral management downstream,” she says. “So it’s important to manage your portfolio managers and [ensuring that they are] putting [in] their trades in [a] timely [manner] and confirming [them] on trade date. So we put a lot of emphasis on getting trades into the system accurately and correctly.”

BlackRock’s trade entry methods include putting term sheets on trade tickets so its operations staff can confirm the economics of the trades on trade date, according to Eckhoff. “First you need a good process,” she says. “Then you can talk about using vendor platforms to make the process more efficient and able to handle the volume. With the right process in place, for purposes of automating the confirmations, everyone understands how important it is to get data into the system, to ensure it’s correct, to ensure that it is checked before it flows to all the downstream platforms, such as DTCC.”

Accuracy is also important, in tandem with process, stresses Neil Burke, Executive Director, Operations, at Morgan Stanley, who oversees the firm’s Client Relationship Management program. Leave alone complex derivatives, even straightforward affirming of equities trade facts can sometimes be a challenge. “We hammer our desks all day long to make sure they are doing [data input of] trades accurately and correctly, so we can go back out to the client on a transaction,” says Burke. “If data goes in wrong, there can be a ton of different downstream issues, such as incorrect market calls, wrong positions and settlements that don’t happen correctly. So we partner with our desks globally to makes sure we all know, on a daily basis, what we have on our books.”

To be sure, accurate handling of data is crucial to valuation of OTC derivatives, observes Ashley Smith, Head of Business Development at ValueLink, a data service provider based near London. “We help eradicate the risks associated with the processes of physically collecting all the data and reconciling it,” he says. “These are common problems and the industry is obviously right to be concerned. It’s not addressing risk and the valuation or operational ends.”

Proposals such as ISDA’s “Master Agreement” are designed to make sure that trades, once executed by the front office, are confirmed and entered into operational processes as quickly as possible, adds Ian P. Blance, Vice President of Strategic Sales at OTC Valuations Ltd., an independent derivatives valuation provider with offices in London and Vancouver. “Some worried that there were trades that after three months still hadn’t been correctly settled and confirmed,” says Blance. “What they were most worried about with the delay in confirmation and settlement was counterparty risk. Something can happen between when you strike the deal and settle it, and when the money changes hands.” As a result of this typical delay, data and valuations that are key to post-trade management were not updated regularly, monitored correctly or properly accounted, according to Blance. “That in its own right created risk for the firms who were involved,” he says. “There is a second set of issues after the trade happens and the whole process begins. As it stands today, that’s equally, if not more, manual and erratic than the actual confirmation and settlement process.”

Clients in the marketplace want independent valuations, as well, notes Ahmad Sharif, Managing Director of Global Products at BNY Mellon. “Typically, we go to independent vendors like Markit Partners or SuperDerivatives,” he says. “No one institution is good at everything, but using several can get fairly decent pricing.”

BlackRock has a second pricing team separate from the operations group that prices positions continually each trading day, according to Eckhoff. “We also go out and canvas the dealers and have a multitude of different sources that we pull market data from to do valuations,” she says.

The duration of some derivatives instruments can be a factor in automation, according to Eckhoff. “No matter how much you automate on a 10-year swap, you’re still dealing with a 10-year swap and its flows over a long time,” she says. “You’re interpolating when there are short coupons. You’re getting in and out of trades all the time. The nature of the derivatives market is that it’s always changing. There will always be a trader with the next, more structured product that systems don’t easily lend themselves to handle. That’s where the human capital component and skill level will have to keep increasing.”

In addition, volatility in the markets has further exposed problems in processing of OTC derivatives, according to both Blance and Smith. “In more stable market conditions, people rely more on a single source,” says Smith. “If they have some single-source exposure at present, that’s being heightened to them — more client demand for benchmarking to a second source is very common now. Anything that people traditionally single-sourced, at the moment, they’re questioning whether one source is sufficient.”

With increased volatility, manual processes start to break down. Also, with greater volatility, spreads in valuations increase, according to Eckhoff of BlackRock. “My traders could stop trading for 30 days and the collateral management team and payments team would still be working long hours day in and day out with the current volatility,” she says. “It’s not just about trading volume, but the volatility. The confirmation is the beginning of these trades, not the end. Unlike the cash market where you confirm the trade, settle it the same day, and the next day or two days later, you’re done, derivatives transactions live much longer and are repeatedly analyzed from a margin perspective, and from a payments perspective monthly, quarterly or semi-annually. To do this effectively, it’s not just about getting it right on trade date, but managing all the other downstream processes.”

When firms have to contend with multiple OTC derivatives processing systems, they face integration and timeliness issues, according to Valentine of Aite Group. “Most vendors wish they faced this challenge more frequently as there is not large take-up in the market from the buy side for OTC derivatives processing,” she says. “Vendors still have relatively few [buy-side] clients where firms are buying or looking for an OTC derivatives processing solution.” Buy-side firms will purchase OTC derivatives processing solutions that also support other functions. Indeed, this has been the case with multi-asset-class online marketplace TradeWeb’s TradeXpressSTP [straight-through processing] solution, or with SmartStream Technologies, used to reconcile all asset classes. “Buy-side firms consider the lack of automation in the OTC derivatives market to be the brokers’ problem and responsibility,” says Valentine. The lack of a proactive buy-side push may pose a risk in itself.



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