The over-the-counter derivatives market needs to achieve automation and, with this in mind, its representative body, the International Swaps and Derivatives Association, has provided an estimated time of arrival. Natasha de Teran reports.
The International Swaps and Derivatives Association (ISDA) – the global representative body for the $197,100bn over-the-counter (OTC) derivatives market – closed 2003 by setting out an ambitious strategic three-year plan for the industry. By 2005, the body said, the professional marketplace should have achieved full trade automation of the major derivatives product classes. By 2006, banks should also have systems in place that could undertake cross-product matching and netting of cashflows across all OTC transactions for any settlement date.
ISDA believes that the automation of trade processing will reduce operational risk by facilitating straight-through-processing (STP), bi-lateral settlement reconciliation and collateral matching within agreed timeframes.
More importantly, the association hopes the measures will reduce operational risk, lower the administrative burden on banks, boost the market and deflect some of the high profile criticisms that have been directed at it: the move came against a backdrop of surging volumes in the OTC markets, and calls by sceptics for increased regulation.
Farid Amellal: ‘The board is advocating an increase in the automation of all the processing of OTC derivatives transactions’
Robert McWilliam: ‘Growing trend for increased outsourcing at smaller firms will gather momentum’
Bob Pickel: ‘Automation is essential to help settle the growing volume of derivatives trades and reduce risk’
Automation essential
Bob Pickel, chief executive of ISDA, believes automation is essential to help settle the growing volume of derivatives trades, reduce risk and enhance productivity for industry participants – and he is adamant the project has industry support. This stance seems to be borne out by Farid Amellal, global head of credit derivatives at BNP Paribas (BNPP). “The board is advocating an increase in the automation of all the processing of OTC derivatives transactions. This will significantly reduce the risks associated with trading in these markets and we fully agree with and support the project,” he says.
By laying down the rigid timetable Mr Pickel believes the industry will focus closely on these issues and get them resolved speedily. He says: “We really felt like we had to put markers down to give the industry a calendar to work to – the key thing with the deadlines is that we are now all working together to address the issue.”
According to Karel Engelen, policy director at ISDA, no one has suggested the timetable is unrealistic. He says: “The impending arrival of Basel II means that minds have been focused on these issues, and resources have been dedicated to the projects. All our members realise they have to get there.”
Forming a strategy
The strategy paper was developed by ISDA’s operations strategy group, which comprises the operational heads of 20 large and small banks. Mr Engelen says the document took some time to develop because of all the different interests involved, and believes these were all addressed. He goes on: “We had individual consultations with banks and software providers, and there was also an extended vetting process to ensure the plan was feasible.”
Even so, the work that lies ahead is significant. Although many exchanges and clearing organisations, software providers and other third-party services have been moving to prepare products to meet ISDA’s initiative, much will still need to be done internally. Moreover, while many of the larger banks and more active players in the derivatives market will be able to argue for dedicated resources, and to amortise the costs involved through the sheer size of their operations, the lower volume players will be challenged in doing so.
Mr Engelen says that, in order to overcome this, ISDA has been busy seeing vendors who are looking to provide solutions for smaller banks. Another possible route being discussed is that the larger banks take up part or all of the costs involved in ensuring that the systems can also be used by end-users and smaller banks. “As yet, we don’t know to what extent this idea will be taken up,” he admits.
Although ISDA has conducted no in-depth analysis of the costs of implementing these recommendations, Mr Engelen claims to have talked to senior operations staff from the major firms involved, and they have been satisfied that the benefits will justify the costs in the long term. As Sandy Broderick, a senior interest rate swaps trader at SG CIB in London, points out, under the new regulatory environment of Basel II, all banks will be penalised for the operational risk that this type of trading activity gives rise to – regardless of scale. Moreover, because the current methods are also intensive on staff costs, any move to reduce those costs must be welcomed by all.
Working together
Mr Broderick believes the greatest issue will be ensuring that the market acts cohesively. He says: “The market will have to if this is to work – and as we know that can be difficult. We will need a more proactive set of user groups. Moreover, the impetus for these moves will have to come from the larger banks – the small banks will not necessarily have the same incentive or means to achieve them.”
Robert McWilliam, head of counterparty exposure management at ABN AMRO in London, and European co-chair of ISDA’s collateral committee, believes the onus will be on the larger players who will have to move first.
“We tend to have the largest issues with reconciliations and trade processing, and can achieve the economies of scale that will justify the investment that we are making today. Smaller firms tend to have much more manageable volumes, and can reasonably easily cope with their processing in the timeframes required. I am not sure how much they feel there is such a need for automated solutions either,” Mr WcWilliam.
Instead he believes that the growing trend for increased outsourcing at smaller firms will gather momentum, leaving them free to focus on their core activity, and enabling them to benefit from the infrastructure that larger firms have put in place. He adds: “It does not make sense for all the smaller customers and end users to have their own internal back-office processes – nor would it help the market advance in increasing the amount of automation.”
Concurrent initiatives
The moves from industry-wide consortia and exchanges will do much to support the banks and meet ISDA’s efforts. Over the last 18 months there have been several concurrent initiatives from bodies as diverse as the Depository Trust & Clearing Corporation (DTCC), the central US clearing securities house, derivatives consortium Swapswire, the London Stock Exchange, Liffe, the Deutsche Börse Group and the Chicago Mercantile Exchange.
The DTCC is one of the most advanced in its plans. Having made its mark in the US equity and credit cash markets, the DTCC went into the OTC market by launching a credit derivatives matching service last year. It now plans to extend its service further into the credit derivatives market, as well as to cover the global interest rate swap and foreign exchange markets.
The DTCC’s electronic credit default swap (CDS) matching service went live in November last year, introducing the first automated and standardised operation dealing in credit derivatives. Swapswire followed by launching a similar service which it also plans to extend outside the narrow confines of its own consortium.
BNPP has been using the DTCC’s service from the very beginning and, according to Mr Amellal, has found it is working very well. He claims it has helped the bank reduce the risk and costs associated with these transactions, and as all BNPP’s checking with other DTCC participants is now automated, the bank has been able to continue to increase its volumes without increasing the burden of its operations staff.
Mr Amellal adds: “The DTCC’s service is a very positive development and actually allows to make this market more commoditised and automated as the associated risks are being reduced. It is a very good initiative and we are glad to have supported it The service is very helpfully open to less active counterparties as well as end users who will hopefully use it more widely in the future. It is crucial that services like these do not discriminate against the smaller users, otherwise the market will not be able to move on as one.”
Swap market tools
Another initiative comes from Sweden’s TriOptima. TriReduce allows banks to collapse their swap portfolios, releasing them from capital and credit charges and eliminating costs. The service is deemed immensely valuable for the credit-intensive interest rate swap markets, as it effectively frees up valuable capital for participating banks. A single run of the system can effectively terminate thousands of interest rate swaps, reducing each bank’s portfolio of existing swaps, and liberating credit lines.
Mr McWilliam says: “Systems like TriOptima have huge value – they reduce volumes while allowing banks to focus on the areas where there may be genuine difficulties. Being able to close out trades with little economic value left makes a lot of sense.”
Changing conditions
The growing focus on the mechanics behind the OTC trading business, and the rigour of the impending arrival of the new Basel Accord will considerably change the ways banks address this side of the business. Already there have been marked changes. According to Bhaskar Dasgupta, director of Front Capital Systems at SunGard, the heads of trading previously didn’t really care what happened to a trade once it was done – it would be up to the operations side to deal with it. But more recently, he says that heads of trading have started taking a personal interest in the effectiveness of the STP chain. He adds: “Our conversations are now frequently with them – not just with back-office people. Heads of trading now want and need to know how they can reduce the breakages in the chain. They realise that one single break in a trade can wipe out margins on 50 trades, and are thus taking a more proactive approach to this side of the business.”
Mr McWilliam points out how some time ago the CME tried to develop a collateral exchange, but the project was not then well received by the market. He admits the CME’s design and implementation was not all it could have been, and that the project was somewhat before its time. But, because the market has since increased in size and has begun to focus on these issues more closely, he believes it might now be a suitable moment for a similar venture to be launched. He adds: “There might even be a scope for an information bureau, which would replace the current bilateral fax,e-mail and phone processes.”
