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Over the counter derivatives are notorious for their complexity, with some transaction life cycles taking a decade to complete. The industry is crying out for a technology standard to improve straight through processing, reduce the risk involved and ease the burden of backlogs. How far has the technology come to relieve the strains and stresses?
The over the counters derivatives market is plagued by confirmation backlogs. What makes OTC derivatives different from securities is that every single trade is unique. When each trade is done, its terms are different from the trade done yesterday because it has a different start date and end date and a set of coupons that fall on different dates.
Derivatives are by definition term contracts — something that plays out over a period of time — so they create a long term relationship. There is typically no upfront settlement, so it is possible that the first time anything happens between the participants, as far as delivery or cash, can be six months down the line. “Therefore there is more to the systems and operations side than getting the trade done and booked — there is an ongoing maintenance with that transaction and there are a set of actions that have to take place over time,” says Henry Hunter, chief marketing officer at Swapswire, the industry utility electronic network owned by 21 major derivatives dealers that specialises in trade capture and confirmations.
And pressure is on the institutions dealing with derivatives to come to terms with the complexity in an exploding marketplace. Karel Engelen, International Swaps and Derivatives Association policy director and head of FpML (Financial products Markup Language) product management, says: “When you have the very rapid growth in volumes, rapid growth in new products, with continually new players entering in the industry and the whole industry is expanding, the challenge to the institutions is to always make sure that their systems get updated, that they necessarily get up to speed and all the departments get sufficient staffed. I think that banks are up to it and they are making a lot of effort to make sure they comply with all these challenges.”
Threats
In 2006 the Federal Reserve Bank of New York and the Financial Services Authority decided to take this problem in hand in order to reduce the mounting risk brought on by an explosion in backlogged, or unsettled, credit derivatives. Isda estimated that the value of outstanding contracts in credit derivatives alone was around $17 trillion at the end of 2005. So the Fed spurred the industry into action by threatening to shut it down.
A group of 14 major dealers, the “Fed 14”, as well as 15 supervisors, including the New York Stock Exchange, the Securities and Exchange Commission and the Financial Services Authority, got together and reduced the confirmations backlog by about 70% by bringing in more staff and attempting to use the technology available to automate trade processing.
Last September, the regulators, industry bodies and major dealers got together again to review the progress and turn their attention to another area of OTCs — equity derivatives. The equity derivatives market has grown by a year on year rate of 32% with $6.4 trillion in notional value as of June 2006, according to Isda.
But that is not the last word on credit derivatives. Although the regulators agree much progress has been made, there is still work to do because the credit derivatives market is still growing rapidly. Engelen says: “I think there will be a partial shift but both institutions and regulators will keep focusing on at credit derivatives.”
And they are using some of the lessons they employed in the credit space to address issues in equities, even though equity derivatives have different challenges. It has a smaller market volume, and therefore fewer confirmation backlogs, but the products themselves have more regional variances and multiple combinations. One challenge is to ensure that these different regional varieties get covered to start with in the legal documentation and everyone signs up to the master confirmation agreement to reduce the need for long form confirmations, explains Engelen.
Master confirmation agreements are the standard de facto default documentation broken down into the various products. MCAs document the agreements of the default terms, which could be merger events, hedging mechanisms and other variables. This allows for the confirmations to be agreed upon using a short form, instead of having to write every point of the agreement out.
Gina Ghent, vice president of business development at DTCC, a clearing and settlement industry utility, agrees with the industry focus on standards and MCAs. “We can only get to the point of matching certain terms when the market becomes standardised and the MCAs are standardised. The challenge is that dealers need to first execute these MCAs between and among themselves, and also their buyside clients. Then the second step is to hop on an electronic platform.”
Promises, promises
In late November, 17 of the major dealers sent a letter to Timothy Geithner, president of the Federal Reserve Bank of New York, outlining their plans to improve the efficiency of the equity derivatives market and to monitor the interest rate, currency and commodity derivatives markets through the use of MCAs and increasing the use of electronic processing to reduce manual intervention. The group, which includes the likes of Bank of America, Barclays Capital, Société Générale, Citigroup, Deutsche Bank and Wachovia, have taken the initiative to take as much risk out of these markets as possible, beating the regulators to the punch.
In the statement, the 17 signatories, working in partnership with Isda, the Asset Management Group of the new Securities Industry and Financial Markets Association, and the Managed Funds Association, committed themselves to creating an environment over the next two years where:
Frequently traded products are supported by streamlined documentation using MCAs;
The majority of confirmable events are able to be processed electronically and electronic processing is widely used by dealers and their institutional clients; and
Confirmations are executed on a timely basis, by T+5 business days on electronic platforms and by T+30 calendar days for new or more bespoke transactions relying on long form confirmations.
They agreed that each dealer should reduce equity derivatives confirmation backlogs and achieve a 25% reduction in its number of confirmations outstanding over 30 days by 31 January 2007. They also agreed to operate on at least one industry-accepted electronic confirmation processing platform by 31 March 2007 for all equity derivative product types that are currently eligible, as well as operating credibly on one other such platform. Tight timelines, but Ghent believes that although this will put a bit of stress on the market, they will achieve their aims.
The DTCC is running a series of summits to talk about how it can assist the market. “We are the tail wagging the dog. We are the last stop to automation — eventually you can get to us but you have to do x, y and z beforehand. We have run these summits to try and assist the marketplace, and we are thinking strategically here to do everything that we can to ensure that the community can meet these deadlines pledged to regulators,” says Ghent.
In mid-November, the DTCC launched the Trade Information Warehouse to which transactions that go through Deriv/SERV’s matching and confirmation service are automatically fed. The warehouse automates many processes that occur throughout a contract’s life cycle that involve significant manual effort, including bilateral contract and cash flow reconciliation. Other post-confirmation processes, such as credit event and assignment processing, will be made more efficient. From a risk management perspective, the warehouse will help firms ensure accurate balance sheet information for corporate and regulatory reporting purposes, support accurate collateral management, and promote correct and complete payments. It has gained acceptance from the likes of Interwoven and Thunderhead, who both announced support for the warehouse within a month after its launch.
Isda is also looking to see how it can help improve automation through standardisation. “From the standards side there is a lot of work that has happened in the last year or two documentation for example master confirmations equities where a lot of work is happening now. If you look at the technical standards like FpML, we have done a lot of work as well in the credit and equities derivatives space to make sure that the different products get covered,” says Engelen.
FpML is the business information exchange standard for electronic dealing and processing of financial derivatives instruments. Isda is involved in a project which is specifically looking at the investment manager/asset manager to the custodian space with regards to the transport of FpML over SwiftNet. The industry body is working with Swift to bring a high level of automation to this area where a lot of the processing is still done manually.
Engelen continues: “The challenge at the end of the day for everybody is, even if you have the standards in place, documentation and technical standards, you need to have the system providers that are willing to invest in those areas — which a lot of them are doing right now. You still have to make sure that everything works together and that is a lot of work. I think all the means are there but it doesn’t mean that it isn’t a lot of work. Many things still have to be accomplished.”
Geoff Harries, director of STP product management at CheckFree, adds: “The reality is that a lot of people are waiting for enhancements to various systems to be able to trade some of these products. I spoke to a bank and they were saying that they weren’t able to trade credit indices and credit tranches because they haven’t got the systems in place to be able to process them. Once those technology gaps have been plugged then the volumes will start to increase on those particular instrument types.
“The issues then start to float downstream, so you may be able to trade them but you still have to be able to settle them and manage the volume of your payments processing. Again it is starting to put a squeeze on people’s operations in terms of when they scale their volume — they don’t want to scale their cost base at the same rate. That is where technology will play a strong role in making sure they can scale their volumes exponentially and don’t have a linear growth in their cost base. The only way they can do that is by putting solid systems in place that enables them to manage that and aren’t reliant on head count to be able to manage the increase in volume,” he says.
2007, concludes Harris, will not necessarily be so much about new technology, but about the application of existing technology to solve a growing demand on the buy-side.
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