Due to lack of investment, over-the-counter derivatives trading practices remain hopelessly unautomated. But, as Natasha de Terán reports, an industry-wide solution using web-based technology is in the pipeline.
The technology and processes that support over-the-counter (OTC) derivatives trading have never been the most glamourous parts of the business. But they have been rising up the OTC business agenda ever since the UK’s Financial Services Authority (FSA) first warned that banks’ middle and back offices were ill-equipped to cope with the rapid growth of the credit derivatives market.
The FSA’s warning came in early 2005. The same year, the New York Federal Reserve followed that up by calling a meeting of the 14 most active users in the credit derivatives market and demanding that they step up their processes.
Ever since then, banks have put renewed focus on their operations, investing heavily to meet the Fed’s stated and anticipated demands. Front office staff now claim the “operations” are at the top of their priority and investment lists and that the pejorative terms “back-office jubs” and “techno-geeks” are no longer heard in their organisations. They even say that strong state-of-the-art operations are now “critical” to winning and retaining client business.
Lack of automation
Most of that is just posturing. The OTC derivatives market – even the credit derivatives segment, on which hundreds of millions of dollars have been spent in the past few years – is hopelessly lacking in automation. The trades may be complex but the market is young and enormously profitable, yet little investment has been made in the supporting technologies in the past 20 years.
Michael Paull, CEO of Hattrick Software, says: “Automation has only just scratched the surface of the OTC derivatives markets – it is only really used in affirmations and the confirmations, and there is no automated method as yet of amending trades, managing collateral or novation functions.” The figures support this claim: according to the latest International Swaps and Derivatives Association (ISDA) operations survey, on average less than 50% of all post-trade processes in the OTC market were automated.
The issue of automation is important: manual trade confirmations are calculated to cost, on average, up to five times as much as automated confirmations. Correcting wrongly input trade details or chasing down the details of unconfirmed trades can cost far more.
Desire for change
The industry would like to improve this situation. Many within it readily admit the regulators’ attention was useful in spurring action, but they also regret that the solutions put into place have been far from satisfactory.
At the most basic level, the regulators focused on the many outstanding confirmations in the credit derivatives market, telling dealers to slash their backlogs. The dealers engaged in lock-in meetings and the US Depository Trust & Clearing Corporation (DTCC) stepped in with an automated solution for trade confirmations. Some targets were met but there was no long-term solution: the DTCC’s system addressed the downstream issue of confirmations but not the upstream affirmation process. Only now is the market working to get to grips with this back-to-front approach to the trade process.
The wider problem is the lack of industry standardisation and the absence of any market-wide solution. Mr Paull says: “What you see if you look across the market, is a patchwork of automated or semi-automated solutions that have been designed to address specific issues. Some address affirmations or confirmations, rates or credit markets, pre-trade or post-trade processes, the buy-side or sell-side segments, but there is no single, standardised, easy-to-use, low-cost, scalable solution spanning the OTC markets.”
Mr Paull is right, yet it is doubtful that the wary OTC community would manage to agree on (much less be willing to see itself locked in to) a single processing utility.
Instead, the industry is now seeking to unshackle itself from the providers. Perhaps aware of how quickly it could become subject to the interests of a mass of demanding providers, the industry has been keen to impose order on the OTC landscape.
New technology
The industry’s efforts are based on a new web-based technology – Web Services Choreography Description Language (WS-CDL). This is a technical standard from the World Wide Web Consortium (W3C), which is believed to be the emerging standard for representing web services’ interaction. The driving force behind WS-CDL was W3C director Tim Berners-Lee, who wanted to shift internet use up a gear, taking it from the rather basic information retrieval and communication capability it is used as today, to become a more sophisticated business tool that can support highly complex, long-lived business processes.
Through the W3C, Mr Berners-Lee created the Choreography working group to develop CDL as a new capability that would allow these complex transactions to be automated over the internet without any centralised point of control.
WS-CDL enables the exchange of information and management of complex business processes. This is achieved by the use of so-called “choreography descriptions”: scripts that provide standardised descriptions of the ‘roles’ involved within a given business process and ensure the correct messaging sequences.
Stephen Ross-Talbot, co-chairman of the W3C Choreography working group, who was instrumental in delivering the WS-CDL standard, says: “It quickly became apparent that WS-CDL would be relevant for the OTC markets because it enables participants to develop the correct and unambiguous description of the message processes for automating the economics of OTC products. Using WS-CDL, IT specialists are able to design CDL-based templates or blueprints for every stage of an OTC trade, irrespective of the product type.”
Andrew Parry, vice-president at JPMorgan says:“CDL provides a powerful formal model that can check whether specifications are complete and correct, which is why it is viewed as such a promising technology.”
Promising solution
CDL quickly reached the attention of the ISDA, the trade association that has been behind most of the industry-wide initiatives to date. Karel Engelen, policy director of the ISDA, says the association had been looking at developing ways to represent OTC business processes for some time and found that WS-CDL gave the association the ability to do it in a very practical way.
“If there is a single industry standard way of describing a trade confirmation process, it will be easier to communicate between service providers, who may otherwise be working with very distinct processes, as well as between individual firms,” says Mr Engelen.
WS-CDL is only one of the topics the ISDA FpML Standards Committee will be looking at this year, but the industry’s plans for CDL are well under way. The ISDA recently published its FpML 4.2 trial recommendation, which includes WS-CDL-based language that will allow for peer-to-peer communication between asset managers and custodians.
JPMorgan has also developed some further WS-CDL descriptions, which are being reviewed by peers, and are expected to be adopted as ISDA standards. Based on the feedback from the FpML working groups, the new descriptions will either be revised or adopted in full as standards.
The current idea is that once OTC CDL descriptions are approved by the industry, they will be established as standards and published on an open-source basis – leaving each OTC market player (or service provider) free to download, upload and use these to automate their processes. “Once a full set of descriptions has been approved and integrated, the means will be there for firms to do all their OTC business electronically,” says Mr Engelen.
“This will take some time but it is a very important and exciting development. The ISDA hopes that the industry will then use the standard descriptions in peer-to-peer communications in the trade, pre-trade and post-trade processing environment,” he says.
Catering to the little guys
Banks and investor groups with large OTC businesses will easily be able to manage these CDL uploads and integrations themselves, but the smaller players have also been catered for. Mr Ross-Talbot joined forces with Mr Paull, formerly of UBS, Bank of America and Citibank, and Alex Wilkinson, former head of futures at Dresdner Kleinwort Wasserstein, to form Hattrick Software, which developed an out-of-the box software kit called ClearGate that functions as a CDL messaging gateway between firms and their trading partners.
Mr Paull explains: “Major banks have the bandwidth and resources to build hand-coded gateways to automate their derivatives processing transactions but, beyond that group, there are thousands of other entities without the resource and in-house expertise to build and maintain hand-coded gateways.
“This is why we are delivering ClearGate: a pre-packaged gateway solution encoded using WS-CDL that comes with all the components necessary to automate derivatives processing, including standard interfaces to all internal and external messaging layers and adaptors to all commonly used databases.
“ClearGate delivers a low-cost, rapidly implemented, low-maintenance solution to the automation of all OTC derivative products – from indications of interest to the end of the economic lifecycle of each transaction.” he says.
Changing the landscape
If CDL lives up to its promise, it will do more than allow for a radical upgrade of OTC trade processes; it could also dramatically alter the provider landscape. Eventually, it is hoped, the open-source CDL library will contain the formalised, correct specifications of OTC business processes. These specifications will, in turn, allow for easy peer-to-peer communication. In other words, participants in the OTC markets will be able to relay pre-trade, trade and post-trade processing messages and instructions back and forth between themselves easily and efficiently, without necessarily having recourse to external providers or hub-and-spoke models as they do today.
In spite of this, it is hoped that the OTC service providers will look positively on CDL and increasingly seek to incorporate open standards into their own systems. Recent evidence suggests that providers like the DTCC might be willing to listen. “We recently had an approach from the DTCC, asking us how we would like to see its business processes specified. That was a great step forward,” says Mr Parry.
“As a customer, I am enormously encouraged that it is coming to us now, and asking us how to specify its processes better. It hasn’t gone the next step, saying that it will do everything on an open-source basis, but it is at least willing to specify its closed business model better and being more responsive to our interests.”
Although CDL has some key players behind it, including JPMorgan and the ISDA, it will need to gain much wider support if it is to take off and transform the industry as envisaged. And there are all sorts of vested interests and substantial amounts of reputational risk at stake if it does not succeed.
