Study Reveals Massive Paper Backlog in OTC Derivatives Market

Paper-based processes of contract negotiations and confirmations in the $400 trillion over-the-counter (OTC) derivatives market have created a huge backlog of trade confirmations, according to a study by TABB Group.

Since 2002, the estimated outstanding value of all OTC interest rate, currency, credit, and equity derivatives has grown nearly 30 percent a year, TABB Group said.

But as the OTC derivatives market expanded, the automation of customer communication management processes such as contract negotiations and confirmations has not kept pace.

From June to August 2007, the total number of backlogged confirmations jumped 250 percent, TABB Group revealed.

"In this world where hundreds of millions of dollars are invested in nonstandard products, human error can lead to huge monetary losses and litigation," said Kevin McPartland, TABB Group Senior Analyst.

"Automation of the customer communications process is a must-have for any business competing in this market, as the potential for loss could be devastating," he said.

The backlog of trade confirmations has resulted in poor transparency and left the financial services sector exposed to unnecessary risk. In many cases, confirmations were not only unsigned, but uncreated, the study revealed.

Source URL: http://www.financetech.com/showArticle.jhtml?articleID=208800330
Publish Date: June 23, 2008

Sell Side to Spend $70 Million on Derivatives Processing in ’08, Buy Side Far Less, Says TABB Group

The TABB Group forecasts that top-tier broker/dealers will ramp up spending on OTC derivatives processing automation software at a compound annual growth rate of 30% over the next two years.

In a research note published today, "OTC Derivatives Processing: Blazing a Trail to Automation," the TABB Group says that although top-tier, sell-side broker dealers have invested millions of dollars since the mid-1990s developing best-of-breed processing for their burgeoning OTC derivatives businesses, many other counterparties, including mid-tier banks, hedge funds and other trading firms, have yet to implement any kind of automated solution, a problem that has not gone unnoticed by the Federal Reserve.

According to Kevin McPartland, senior analyst at TABB Group and author of the note, "When the Fed first instructed major dealers in 2005 to catch up on unconfirmed trades, additional personnel provided most of the ammunition for shrinking the confirmations backlog. As recent credit market turmoil has shown, simply adding staff to solve a problem is insufficient." He goes on to explain that during a three-month period, June to August 2007, the total number of backlogged confirmations jumped 250%.

Although the technology exists for real-time monitoring, he points out, "many firms continue to rely on daily, even weekly, reports because it's often difficult and expensive to implement more frequent tracking." This forces the major dealers to weigh the cost of additional staffing and enhanced automation with the level of risk they are willing to carry. For years, the front office quants and traders always gained the attention of senior management, IT staffs and independent service providers for trading systems, high-speed data and algorithms that stole the spotlight and budget. "For OTC derivatives," McPartland says, "a new day has finally dawned. A process so critical and complicated, it is simply screaming out for automation."

McPartland also explains that credit default, interest rate and equity swaps transactions not handled by electronic confirmation platforms, averaging about 1,000 transactions per firm per month, continue to be handled through paper-based confirmations. In addition, almost all non-vanilla trades, averaging as many as 4,000 transactions per month for the largest firms, also use paper-based confirmations. Creating these confirmations is one of the most crucial steps in the trade lifecycle, "but without the right solution," he says, "it can be the most complicated. In fact, one major investment bank estimated that nearly 90% of its non-vanilla OTC derivative trades are still sent by fax."

TABB Group forecasts that the $70 million to be spent on OTC derivatives processing automation software in 2008 will experience a compound annual growth rate of 30% over the next two years, bringing the overall market size to nearly $120 million by 2010. In addition, with vendor installations to manage the post-trade capture process costing over two million dollars each in licensing fees, market size for the sell side alone, says McPartland, is approaching $30 million annually and as OTC derivative volumes increase, this will rise to over $45 million annually.

Unfortunately, while nearly 1,000 of the world's hedge funds use OTC derivatives, only a fraction of those have automated processing systems. Combining increased usage with existing users still in need of processing systems, TABB Group forecasts the market for software packages for hedge funds at nearly $40 million annually by 2010, rising from only $20 million in 2007.

By Penny Crosman

Source URL - http://www.financetech.com/showArticle.jhtml?articleID=206904327
Publish Date - 18 March, 2008

Spending on OTC derivatives automation to surge - Tabb

Banks will spend $70 million on automating over-the-counter (OTC) derivatives processing in 2008, rising to $120 million in 2010 - a compound annual growth rate (CAGR) of 30%, according to estimates from Tabb Group.

In a research note Tabb says that, whilst top-tier, sell-side broker dealers have invested heavily in developing processing for OTC derivatives, many other counterparties, including mid-tier banks, hedge funds and other trading firms have yet to implement any kind of automated system.

OTC derivatives processing has suffered in recent years as banks diverted budgets to trading systems, high-speed data and algorithms, says Tabb.

Tabb identifies hedge funds as particularly slow on the up-take with nearly 1000 trading OTC derivatives, but only a fraction of these using automated processing systems. Tabb forecasts the market for software packages for hedge funds will reach nearly $40 million by 2010 - double the figure for 2007.

Kevin McPartland, senior analyst, Tabb, says when the Federal Reserve first instructed dealers to clear settlement backlogs and tighten back office risk management procedures in 2005, most firms invested in extra staff to deal with backlogs.

But McPartland argues that the credit crunch shows employing extra personnel is not enough to solve the problem.

Despite technology existing for real-time monitoring "many firms continue to rely on daily, even weekly, reports because it's often difficult and expensive to implement more frequent tracking", says McPartland.

He says credit default, interest rate and equity swaps transactions not handled by electronic confirmation platforms - averaging about 1000 transactions per firm per month - continue to be handled through paper-based confirmations. In addition, almost all non-vanilla trades - averaging as many as 4000 transactions per month for the largest firms - also use paper-based confirmations.

"For OTC derivatives a new day has finally dawned. A process so critical and complicated, it is simply screaming out for automation," says McPartland.

Tabb's research comes a year after the Bank for International Settlements called on financial firms to introduce automated systems to cut confirmation backlogs in the over-the-counter derivatives markets.

The Committee on Payment and Settlement Systems, the public policy forum of the central bankers' collective, called for improvements across the complete post-trade environment in the booming OTC markets.

Source URL - http://www.finextra.com/fullstory.asp?id=18234
Publish date - 18 March, 2008