Over-the-counter derivatives, specifically credit derivatives, have exploded on to the trading scene in recent years. In a technologically rich, standardised environment, the processing of OTC products still has a way to go. Alan Duerden reports.

The use of over-the-counter (OTC) derivatives – contracts that are traded and negotiated directly rather than via an exchange – has enjoyed a growth spurt in recent years. This has given the parties processing these trades in the middle and back office a substantial headache.

Since the Bank for International Settlements (BIS) reported on OTC derivatives in September 1998, the total notional amount of contracts outstanding has increased at an average annual rate of almost 20% with a further burst of activity in 2006. According to the global trade association for OTC derivatives, the International Swaps and Derivatives Association (Isda), by the end of 2006, notional contracts outstanding were worth $34,500bn.

Not only have ballooning volumes complicated the job for the middle and back office but the investment strategies of OTC derivatives are bespoke by nature, with high levels of customisation around them, making it increasingly complex for the middle and back office.

Seen as an ever fruitful way to make money, OTC derivatives – specifically credit derivatives – are becoming more widespread as investment banks are being joined by custodians and investment managers who also want a slice of the alpha pie. In a yield environment, the desire to use OTC derivatives is increasing.

Infrastructure needed

The problem here, however, is that the processing of OTC derivatives currently requires certain technology and infrastructure capabilities that historically may not have been needed by most of the new players entering this space.

“Traditionally, Wall Street and London trading shops are geared towards flow-based products,” explains Jason Ekberg, senior job manager, strategic IT and operations at Oliver Wyman, a financial services consultancy. “Now, however, there is a shift in the marketplace where OTC products are becoming much more lucrative and the original systems that people could push transactions through on are no longer viable.”

Some institutions, such as Citigroup, have used this as competitive advantage by leveraging the experience of their investment bank, custodial and fund administration capabilities.

Jervis Smith, managing director, Citi financial institutions, head of managed funds and Middle East for Citigroup, believes his institution is better positioned than new entrants to the market such as pure custodians and investment managers that may not have the skill sets in place to deal with this new and evolving product.

“We are one of the few organisations that has a major investment bank that markets and sells OTC derivatives and has a history of being able to process and reconcile them, while at the same time having a world-class custodian and fund administration outfit,” he says. “We see that as a competitive advantage over some of the pure custodian banks that simply don’t have the systems or people for the valuation and the modelling of OTC derivatives.”

A clumsy settlement process, coupled with the increased volumes generated from new entrants in the OTC derivatives space, potentially makes for processing backlogs – a real danger from a risk perspective. In 2005, the credit derivatives market went into turmoil when Ford and General Motors credit ratings were downgraded by the major rating agencies, and hedge fund holdings suffered severe losses.

Lack of standards

The lack of standards in this space only serves to exacerbate the problem. Jitters in the derivatives market, such as the Ford and General Motors debacle, has caused regulating bodies such as the US Securities and Exchange Commission (SEC), the UK’s Financial Services Authority (FSA) and the Bank of England to step in and reassess contract documentation and the backlog of outstanding trades.

Karel Engelen, policy director and head of financial products mark-up language at Isda, believes the importance of standards that allow automated communication between systems will only increase. “The derivatives industry has taken early initiatives in this area, for example, with the development of FpML (financial products mark-up language). With the expanding range of participants, the use of these standards becomes more important, to continue to enhance automation of post-trade processing,” she says. FpML is an Isda-recommended protocol to enable e-commerce activities in financial derivatives.

Standardisation slow

Standardised processes are part of the maturing landscape for OTC derivatives but there is still a long way to go, says Michael Paull, CEO of Hattrick, a transaction solutions provider.

“The Depositary Trust & Clearing Corporation (DTCC), which provides clearing and settlement services, has one process; SwapsWire, a network for OTC transaction confirmations, has another; while different participants – such as hedge funds and banks – are sending information in multiple formats,” he says.

The derivatives industry is initiating change, as seen with the development of FpML, but the market appears to be waiting for the process to standardise.

IT solutions providers are falling over themselves to help institutions dealing with OTC derivatives implement systems that process trades through standard interfaces, and the processing of credit derivatives has reached a higher degree of automation than any other of the OTC derivative asset classes.

Companies such as Misys, a supplier of IT solutions to the banking industry, see the virtue in having all trades running through one system, which then interfaces with the various industry communication tools of the DTCC and SwapsWire.

“Getting rid of all the miscellaneous closed systems and spreadsheets that are in the banks would help. If they can get one cross-asset system that manages all the OTC derivatives in all the asset classes then this would reduce operational risk a lot and help reduce their costs,” says Misys.

However, not everyone believes this to be such a clever proposition and some argue that the rate of change and innovation in the credit derivatives space makes it near-impossible to implement such a solution.

One such critic is Oliver Wyman’s Mr Ekberg, who believes that from a risk and data capture perspective, a single colossal solution would pin the user into a box unless it was agile enough to plug into architecture that allows functionality to evolve easily.

“I’m not sure a colossal solution is even viable,” he says. “The long-term vision is moving towards SOA [service-oriented architecture]-targeted functionality that you can roll in and out of as the market evolves.”

This approach would take some co-ordination among vendors and institutions because the whole argument of automation assumes that the complexity residing in many institutions is manageable. New entrants to OTC derivatives, especially in the investment management space, are running dozens of different systems and the re-architecture process is not an easy one.

Mature demand

As new products or asset classes are introduced to the market, the manual pushing through of transactions is allowed to evolve at a pace that is in line with the new product. The OTC derivatives space, by comparison, offers a more interesting picture, with products that are immature by age yet mature by demand.

While regulating bodies and industry groups are making quick strides towards more standardised methodologies around OTC derivatives, sharp spikes in volumes, complexity of products and new entrants to the market all serve to make the task of processing these trades more difficult.

To find the antidote for the processing headache, institutions must first decide whether they feel this is a technology and software issue or whether they need to rethink what their core competencies are.

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