Regulatory flack fell on operational shortfalls in the over-the-counter derivatives business early last year. In a round table discussion hosted by The Banker, market participants ponder the potential repercussions on the buy-side and sell-side.
DERIVATIVES ROUND TABLE
THE PARTICIPANTS:
Peter Best STP implementation & support manager, ICAP
Natalie Bohmer operations manager, Cheyne Capital
Penny Davenport director of credit products and RED, Markit Group
Natasha de Terán contributing editor (derivatives), The Banker
Ian Hunt head of derivatives projects, Threadneedle Investments
Henry Hunter head of marketing, Swapshire
Andy Murfin manager, wholesale investment banks, Financial Services Authority
Serge Shinkar OTC derivative trade processing services, Markit Group
Oliver Stuart global co-head of credit product operations, Morgan Stanley
Bill Stenning vice-president for business development, Depository Trust & Clearing Corporation
Sean Taylor EMEA regional head of client onboarding, UBS Investment Bank
Solomon Teague Hedge Funds Review
Kevin Thorogood director, Thunderhead
The over-the-counter (OTC) derivatives business presents both lucrative opportunities and hefty challenges, some of which were highlighted last year when regulators turned their attention to the operational shortfalls lurking in the credit derivatives market. This year, the IMF’s Global Financial Stability report devoted an entire chapter to the credit derivatives market – and a good portion of that to related operations. Together with Markit Group, The Banker recently hosted a round table discussion to discover how banks have been addressing these issues and to investigate what related problems may lie ahead.
Volume growth and product innovation have traditionally been the two most closely watched parts of the OTC market. That changed dramatically after the UK’s Financial Services Authority (FSA) penned a ‘Dear CEO’ letter to the heads of UK-regulated firms in February 2005. The letter came as a jolt. It called bankers to task on operational shortfalls in the credit derivatives segment of their OTC businesses – most notably their backlogs of outstanding unconfirmed trades. Until then, the profitable credit derivatives market had enjoyed a spurt of unprecedented growth, unaffected by regulatory flack.
| Andy Murfin: FSA found extensive problem | At the round table, Andy Murfin, manager in the FSA’s wholesale investment banks department, for the first time explained how the issue had come to the UK regulator’s attention. This occurred in late 2004, after internal audits at a couple of banks had thrown up the issue.“One bank went as far as to stop taking on new business until it had sorted the problem. Having noted this, we went to the wider industry and found the problem was quite extensive – hence the letter,” said Mr Murfin. |
| Natalie Bohmer: welcomed regulator’s input | Natalie Bohmer, operations manager at credit-based hedge fund player Cheyne Capital, agreed. She said that her firm had unequivocally welcomed the regulatory pressure. Cheyne had already been trying to manage the problem well before the regulators reacted by “chasing our counterparts quite ruthlessly”, she said.However, Ms Bohmer found that market standards were mixed. “Some [banking] entities seemed to work on the premise that a month’s response time [for a trade confirmation] was quite adequate, and many didn’t even seem to understand why we wanted our confirmations in place so urgently. The regulatory attention brought the problem into focus and gave the issue some urgency, so it was a welcome development for us.” |
| Henry Hunter: good industry response | Henry Hunter, head of marketing at Swapswire, said that the resulting operational improvements have since allowed many dealers to redeploy staff to other areas and other urgencies. “That has been particularly noticeable in the interest rate space, where we have been active for some time,” he said. |
Shock treatment
The letter shocked the market. Sean Taylor, EMEA regional head of client onboarding at UBS Investment Bank, said that it had more impact than anything else in recent years. There was more to come. Later the same year, the US Federal Reserve (Fed) called a meeting between international regulators and bankers. “When the letter was followed up with the side-sweep from the Fed in September 2005, the derivatives business really sat up and took notice,” said Mr Taylor. “In some organisations, it appeared that senior management staff began to look at operations statistics on a 12-hourly basis. That was unprecedented.”
Since then, a vast amount of media and regulatory attention has fallen on the plumbing that supports the OTC markets. Banks have re-assigned staff and hired additional employees; they have also thrown sizeable sums of money at the problem. New entrepreneurial firms have sprung up to service the growing demand for support services, and those already in situ have grown dramatically.
Support opportunity
Support firms, particularly those offering different forms of OTC operational and automation support, welcomed the new urgency. Penny Davenport, director of credit products and RED at Markit Group, noted how the elevation of awareness and market standards had been good for Markit: “Everyone suddenly started to look for ways to automate their processes, so we saw an unbelievable surge in interest.”
Nonetheless, opinion on whether the FSA and Fed moves were warranted is somewhat divided. Round table participants, for instance, pointed out that banks were already working on these and other operational issues.
“It is easy to forget, but quite a lot had been going on before the issue was raised by regulators,” said Oliver Stuart, global co-head of credit product operations at Morgan Stanley. “The industry, particularly the major players, understood the issues and the risks, and was working to resolve them.”
Internal auditors at the major dealers had begun to highlight the issues, added Mr Stuart, observing that in some cases these had put pretty stringent demands on trading desks and operational staff.
The International Swaps and Derivatives Association (ISDA) operations working group also had a strategy plan in place, and its CDS (credit default swaps) working group had already developed and rolled out standardised short form confirmations. The Depository Trust & Clearing Corporation’s (DTCC) DerivSERV and SwapsWire were deployed and in use. And TriOptima’s swap-collapsing system was being widely utilised.
Centre of attention
It was concluded that the industry had by no means been blind to the problems prior to regulatory intervention but, crucially, that the regulators had helped to draw attention to them. “Where the regulators really helped was in increasing the sense of urgency. No-one thought the services were a bad idea, but many market participants had been slow to take the initiatives up. Their involvement helped to reduce risk in the system,” said Mr Stuart.
Ms Bohmer’s experience as a buy-side customer frustrated by a lackadaisical approach to operational issues at some dealer firms is echoed by that of Peter Best, implementation and support manager for straight-through processing (STP) at ICAP, the London-based interdealer broking giant. ICAP has long offered STP facilities to its customers. “For a long time, it was difficult to get them to prioritise the issue but over the past several months, that situation has begun to change,” he said.
Timely progress
The progress so far has been remarkable. An ISDA survey earlier this year found that considerable progress had been made in the few months since the Fed meeting. It showed a reduction in time taken to generate and send credit derivatives confirmations to counterparties once they had verbally agreed the trades: about 53% of the survey respondents were sending confirmations by trade date plus 1 (T+1) or within one day of trading, up from 33% the year before. Similarly, 67% of respondents were sending confirmations by T+2, compared with 50% a year earlier. All but 9% were remitting their confirmations by T+5. Those statistics were well received, but by June, ISDA was able to go one further, when it reported the dealer firms had slashed the backlogs of outstanding trades by 80%, beating the industry’s own target of a 70% reduction.
In light of such achievements, some self-congratulation among the round table participants would be understandable. The FSA’s Mr Murfin said: “Overall, we are pleased with the way the industry has responded, and it has been particularly pleasing that this has been achieved with a collaborative regulatory approach.”
However, the sentiment at the discussion was far from complacent: the focus fell on how much more needs to be done. Perhaps the biggest challenge facing the banking industry is not the interbank segment, but the customer-facing side of the OTC market. “Dealers are typically split by asset class but the buy-side are seeking commonality of approach and processes. They want a single standard,” said Bill Stenning, vice-president for business development at the DTCC.
Ian Hunt, head of derivatives projects at Threadneedle Investments, agreed. Although he is no stranger to OTC derivatives, he said that the involvement of mainstream fund managers in the OTC markets is only just beginning – presenting the buy and sell sides with more than a few challenges. “And as the arguments that support wider derivatives usage continue to take hold, more and more managers will become OTC customers for banks,” he said. “The problem they will face is that buy-side and sell-side views are fundamentally different. Banks are often siloed by asset class, while we on the buy-side are necessarily not. They look at synthetics, individual derivative classes and cash instruments separately. We want a portfolio view.”
Buy-side holy grail
According to Mr Hunt, the holy grail for him and his fellow buy-siders is a single architecture that integrates all instruments and asset classes, and embraces everything from trade capture and compliance through to performance reporting, with full STP. “Such systems do not exist yet on the buy-side, but we will move as fast as we can in that direction. And the sell-side will have to adapt to work with us to provide a coherent portfolio view.”
Delivering Mr Hunt’s coveted holy grail will not be easy for banks nor for the support service companies that they have been sponsoring in the OTC market. So far, there is little sign that his vision has taken hold. Rather, the US-based DTCC has appeared to stake its claim on the operations behind the credit derivatives market, and Swapswire on the interest rate side, and both are battling for the equity segment. Here they compete with others, including the London-based exchange, Euronext.Liffe, which runs the so-called ABC suits of clearing products.
Ms Bohmer is a fan of these, particularly of BClear, a quasi-OTC exchange facility. “BClear has proved a very exciting development for the OTC options world. It has not required any integration or investment on our part, yet it allows us to process our bilateral options trades as though these were listed instruments. Instead of waiting two weeks for confirmations, we get them T+1 from our prime broker by way of a give-up through BClear,” she said.
How the sell-side of the industry and its providers will eventually face up to the de-linkage between its own asset class divides and the buy-side imperative is unclear. For now at least, Mr Hunter said that the idea that a single system would take hold across all asset classes was “unrealistic”. Although he believes that buy-side companies will increasingly become the unifying force behind the market, driving vendors to work together, there is little immediate relief for the vast numbers of fund managers queuing up to debut in the OTC markets.
Wider problems to consider
Perhaps because the strong regulatory spotlight fell on the credit segment of the OTC markets in isolation, there are wider problems outside it that now require urgent attention. Ms Bohmer, for instance, said that her firm felt that banks could now devote some attention to equity derivatives. She was not alone. Mr Taylor said that alongside these, commodities, foreign exchange and even interest rate derivatives needed attention.
Mr Murfin conceded that the feedback to the FSA had been that the problem in the equity market was “not quite so extensive” as in the credit sector. That said, he stressed: “What we would like to see now is that good work being exported to other OTC markets.”
Such work, it was agreed, was already well under way, although many participants said they expected regulators to take a closer look at the non-credit sector of the OTC markets next. Another ‘Dear CEO’ letter was imminent, stressed Mr Stenning: “[It’s] a question of when, not if.”
In the meantime, OTC operations remain as high on the agenda as OTC volumes. Mr Taylor perhaps summed up the sentiment best by asking: “Does operational efficiency now make you a winner in this business? Personally, I think so.”
