OTC derivatives trading remains a slow process, report finds

Industry group promises improvements, but no quick fix likely

While the processing of the over-the-counter derivative transactions has improved over the past few years, it is still a surprisingly slow process.

That state of affairs was underscored by a report released today by Aite Group. In it, Aite reports that the bulk of over-the-counter derivatives processing is done by hand. That, in turn, can lead to errors.

A single contract traded verbally and recorded on paper can involve between 80 and 100 variables in terms and conditions. In addition, many parties take part in the process, including not only a buyer (such as a hedge fund) and a seller (such as an insurance company), but also processing entities such as broker-dealers and prime brokers.

Part of the problem stems from the staggering growth in the market. The derivatives market stood at $516 trillion in outstanding notional value as of June 2007, according to the Bank for International Settlements, and it continues to grow. Interest-rate derivative contracts represent the largest chunk of the market, but credit derivatives are the fastest growing segment.

Trading systems have not kept pace, and industry players are clearly aware of the problem. In late March, a group of trade associations and major broker-dealers submitted a letter to the Federal Reserve Bank of New York and other regulators that confirmed their commitment to improving the processing of credit and equity derivatives.

The Aite report noted that a firm can upgrade to a fully automated system and still see little gain. Why? “OTC derivative trade processing is unique is that counterparties are tied to each other in a way that does not exist in the listed markets,” wrote Denise Valentine, senior analyst with Aite Group. “Ultimately, a firm is only as automated as its counterparty’s processing capability.”

To satisfy customer requests, many broker-dealers are paying for the development of electronic systems. “Yet, the large volumes and lack of automation in the non-listed derivative business still mean a manual maintenance routine for many firms,” the report noted.

By Marine Cole

Source URL: http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080403/REG/998586512/1036
Publish Date: 03 April, 2008