Wholesale Market Brokers Association Defends OTC Derivatives Against WFE’s Statement

Association backs central counterparty for clearing, but rejects exchange execution platforms.

The Wholesale Market Brokers Association (WMBA) rebuffed a statement by the World Federation of Stock Exchanges that blamed over-the-counter derivatives markets (OTC) for the recent financial crisis. The statement reported in press coverage said that "unregulated (OTC) markets were at the core of the recent crisis and that OTC markets are unregulated," according to the WMBA.

The WMBA, representing the world's largest interdealer brokers contends the crisis is the result of "several seismic economic and financial forces." WMBA attributes the crisis to the transformation of bank lending into highly complex credit products, that originators, rating agencies, buyers, and sellers of protection found difficult to value correctly, find liquidity for, or to hedge, according to WMBA's statement.

Refuting the perception that the OTC derivatives markets are unregulated, WMBA said the primary regulatory focus in OTC markets is on the participants themselves based on their activity, the nature of counterparties and types of assets involved. According to WMBA, it is misleading to suggest that exchange traded markets have a more robust regulatory model. There are still instances of failure in the exchange- traded model, it points out, implying that individuals or organizations should be the focus of supervision.

Instead, there is a danger that policy decisions are being made that could force OTC products onto exchanges, resulting in a dramatic reduction in liquidity and flexibility in markets essential for trading and hedging. WMBA contends that OTC markets are more appropriate for hedging non-standardized risks. It pointed out that billions of Euros of OTC trades are currently centrally cleared on a daily basis, adding there should be no confusion

However, WMBA supports the move towards a central counterparty (CCP) as an effective step to improve the settlement of credit default swaps and other OTC products generally. Acknowledging that there will be regulatory changes as a response to the crisis, WMBA insists the focus should be on" regulation of participants and not on mandating of monopolies in the execution of financial products."

Source URL: http://www.financetech.com/showArticle.jhtml?articleID=214501800

OTC Derivatives: Substantially Reducing Risk Through Automation

OTC derivatives and the challenges they pose for financial services firms continue to garner attention from both inside and outside the industry. In March a Newsweek article titled "Surviving the Crunch" cautioned consumers against dabbling in the hype of derivatives and other "adventuresome" investment vehicles: "Definitely not as easy as it sounds," the magazine advised, "and best not tried at home." A month later an article in The Economist was headlined "Taming the Beast: It Is Time to Simplify Derivatives Trading—But Not to Stunt It." OTC derivatives could certainly benefit from some positive PR in the mainstream media, but what these so-called adventuresome investment products really need are the benefits of a new technology focus called customer communications management (CCM).

CCM enables organizations to automate the creation and delivery of highly customized communications, including contracts, policies, statements, and correspondence. The ability to manage contract negotiations and confirmations online in a secure and easy-to-use environment expedites complex OTC derivatives processes with granular-level risk management capabilities.

According to TABB Group, an independent financial markets research and strategic advisory firm, paper-based contract negotiations and confirmations still pose a threat to the OTC derivatives market some three years after the US Federal Reserve urged financial services firms to improve their processing and tracking practices. During a single three-month period alone, June to August 2007, the total number of backlogged confirmations jumped 250 percent. The backlog of trade confirmation documents—the legal records—has left the financial services sector exposed to unnecessary risk and poor client and shareholder transparency.

In the study Blazing a Trail to Automation: Confirmation Creation for OTC Derivatives, TABB Group reports that the outstanding notional value of all OTC interest rate, currency, credit, and equity derivatives has grown nearly 30 percent a year since 2002. As of mid-2007 more than $400 trillion of notional value existed in outstanding OTC derivatives contracts. Yet as the market continues to expand, the automation of processes such as contract negotiations and confirmations has not kept pace. Indeed, nearly 10 percent of the world's hedge funds use OTC derivatives as part of their strategies, but only a fraction of those have automated processing systems.

Master agreements, confirmations, and workflow processes for OTC transactions all present unique challenges to financial services firms. Negotiating a complicated master agreement, for example, requires frequent back-and-forth counterparty communication, most of which is still performed manually, leading to the significant backlogs. Each trade might have 100-plus data points to affirm with the counterparty before a custom confirmation document can be created. The creation of this document is at the heart of the OTC derivatives backlog, which has resulted in unnecessary risk and poor transparency.

Customer communication management solutions allow for the acceleration of online negotiation of trades, no matter how complex. In fact, the more complex, the more these automated solutions are needed.

CCM has the ability to provide contract creation, negotiation, approval, and execution workflow for all types of contracts and other negotiated agreements, including prime brokerage agreements, margin agreements, ISDA master agreements, and CSAs. It could include a real-time dashboard that tracks and sorts every outstanding agreement, enabling load balancing, tracking, and auditing. In addition, it can offer detailed search and advanced tools for comparing all existing agreements down to the granular content level, highlighting potential exposure and managing risk. Risk management capabilities are also included to quickly review key risk metrics, including NAV triggers, collateral events, withdrawal provisions, and other data points. The goal is to boost automation, reduce risk, and expedite complex OTC derivatives processes.

That's what a CCM solution brings to the OTC derivatives market.

TABB Group Senior Analyst Kevin McPartland, author of the study cited above, summarized the market in a manner most mainstream media audiences could easily grasp: "The market has made strides toward automating the confirmation and overall processing workflow. There are third-party products to help solve this problem, and the innovations in the past few years have been nothing short of amazing. Now it is up to market participants to acknowledge the need for automation—not only through press releases but also through action."

McPartland adds, "Both producers and consumers of OTC derivatives must invest time and money to create necessary systems and processes that are both smarter and straightforward, allowing the most obscure instruments to be handled without human intervention. New product creation and smart trading decisions may drive profits, but unless treated with the utmost care and respect, the overall confirmation process can act as a mugger on payday. Let's not just work harder, but smarter."

Here's to working smarter.

Source URL: http://www.financetech.com/showArticle.jhtml?articleID=208800884
Publish Date: June 25, 2008

OTC Derivatives Face Post-Trade Challenges

What will it take to automate the post trade landscape?

By Mayiz Habbal

The OTC derivative environment is burdened by volumes of paper, spreadsheets and phone calls associated with deal tickets, deal contracts, legal contracts and counterparty management. Growth in the derivative market has outpaced operational capacity and expertise. The nature of derivatives is a high degree of processing interdependency among market participants and continual development of new structures, as well as a dynamic life cycle subject to external events, such as defaults and trade transfers. The challenge for money managers and broker-dealers is to automate processing. Potentially, the next five years will be a new era of collaboration and technological creation, and an amazing race in which the finish line is a win for all.

The trading world is filled with interdependencies and short time frames with efforts geared to affirmations within a few days of trade execution. Money managers need to advise brokers of trade allocations before broker confirmations can be sent out. Lack of affirmation from a counterparty can create an opportunity for downstream delays in accurate payment. Further, hedge funds work with multiple prime brokers in order to protect confidentiality and mitigate risk. There are instances of relatively small firms with $100 million in assets under management using three prime brokers. The trading and operational challenges multiply.

It is estimated that up to 30 percent of OTC derivative trade confirmations contain an error(s) and require subsequent handling for rebooking or amendment. Most OTC derivative trading is conducted by phone or fax. The operational nightmare of backlogs, errors and staffing shortages are a reality for many firms. Industry market participants and regulators alike are concerned. The cumulative costs of errors and the potential trade exposures are too huge to ignore, particularly in light of the mainstreaming of the derivative market and the increase in cross-border trading. The global regulatory agencies more and more are coordinating their efforts to enhance not only local market stability but also global stability in the financial markets.

According to a previous Celent report on European post-trade processing, "The majority of respondents indicated that less than 50 percent of derivatives processing is automated. The lack of STP in derivatives was mainly attributed to the complexity of transactions and lack of standards. As a result, 35 percent of respondents cited derivatives as the No. 1 priority for STP projects as opposed to other instrument classes."

Buy Side Slow to Automate

What's clear to brokers -- and to many in the technology sector that service the brokers -- is that the buy side is not shifting to the automation paradigm as actively as is needed. Firms may delay because there are few multisecurity systems, there may be additional costs or they do not feel their volumes justify an additional technology implementation.

The buy-side purchaser of technology for derivatives processing is still a rare bird. A quick count of the leading providers in this space not affiliated with an execution platform show about 1,000 hedge funds and asset manager clients. Lack of adoption reflects the still relatively young technology. The buy-side community still is coping with front-office trade automation and other technology priorities, such as compliance, risk analytics and portfolio management systems for investment of derivatives.

The market likely is waiting for further advancements in the field, as well as its own derivative volume to increase in order to justify the expenditure. Many are simply relying on whichever processes and tools the broker-dealers provide. Looking to a broker-dealer to provide support and to adapt operational procedures based upon what is free in the market is common.

Unlike the broker-dealer community, which has greater technology and financial resources, most buy-side firms prefer to purchase technology that is multifunctional, product-neutral and designed to handle any security type. Many of the vendor solutions today are geared to a single type of security. Since the broker-dealer community is behind much of system development and firms typically operate in a silo structure, single-security systems are not as burdensome. Buy-side firms will postpone a shift to new technology if they believe the vendor market is in transition and are willing to make trade-offs even if the result is more manual labor. If existing systems provide some element of support, all the better -- and all the longer the postponement.

Growth and Lack of Standards

The derivative world is simultaneously coping with a growth boom and the need for standard protocols and procedures with agreement from a myriad of market participants. The key drivers to change are the broker-dealer community and organizations such as ISDA, DTCC Deriv/Serv and the regulatory agencies, as well as very large traditional asset managers and hedge funds. It is a collaborative effort that will take time but is launched on the heels of success in credit derivatives.

The general lack of broad buy-side adoption of third-party solutions to automate the post-trade/pre-settlement environment is partly a measure of progress of these leading figures. A quick count of the number of buy-side clients on leading applications not affiliated with an execution platform is about 1,000 firms -- not high, considering the thousands of money managers worldwide that might be dabbling in unlisted derivatives. DTCC Deriv/Serv, a key vendor in the trade confirmation service, has approximately 800 investment firms, and that figure has exploded from three years ago. Deriv/Serv has gained the greatest penetration in the credit market, although not universally across OTC derivatives.

So what is delaying broad adoption by the buy-side firms? Are they not as encumbered in the OTC derivative processing dilemma as the broker community?

Outside of active hedge funds with sophisticated strategies and traditional money managers of very large funds, the overall trade volume for the bulk of firms may be considered too small to warrant additional budget for these software applications. Firms are content to cope with manual processes on small trading volumes. Others just rely on free services, such as prime broker-provided Web portals. Given the size and interdependency in the markets, it might well be time for the buy side to make a greater contribution to industry problems.

In buying technology, most asset managers prefer to choose from a variety of competitive solutions that handle multiple products versus a single type of OTC derivative. Few are eager to be the first to sign up for a new solution. The buy side often adopts a wait-and-see approach to optimize expenditures on a clear leader or to allow enough time for the technology to evolve a generation. Buy-side firms also look at vendor reputation, and in a new technology sector such as post-trade/pre-settlement, where change still is occurring, it takes time to validate credentials.

However, vendor options will grow -- and soon. The sector is a long way off from commoditization, regulators are collaborating globally, and the brokerage community is determined to make the pain go away.

Mayiz Habbal is managing director of the Securities & Investments Group at Celent and is based in the firm's New York office. His areas of research focus on enterprise architectures and aligning business strategy with IT initiatives. He brings with him more than 15 years of experience in the management and development of software and engineering of IT strategies, predominantly in the investment banking industry. Before joining Celent, Habbal held positions with Oracle Siebel, Bank of America and Dresdner Kleinwort.

Publish Date - July 30, 2007
Source URL: http://www.financetech.com/showArticle.jhtml?articleID=201201909

Credit Markets Eye Automation

Industry leaders who attended a market summit on over-the-counter (OTC) derivatives operations in London are urging major credit derivatives dealers to band together and form a central clearing agent to clean up a market where regulators want to see transaction processing become more automated.

The service could be based upon a structure similar to SwapClear, which was launched in September 1999 by London-based clearinghouse LCH.Clearnet to provide clearing for plain vanilla OTC interest rate swaps, according to the panel of three senior representatives from the buy side and sell side and an industry clearing and settlement service.

"Any one of the major prime brokers [in the credit derivatives market] could take that leap of faith and suggest operating a clearing house," says Chris Bentley, head of operations at London-based hedge fund Cairn Capital, which manages portfolios worth $30 billion. "This could potentially be done just for their clients to start off with and if this started a precedent, others may join to form a consortium of banks operating the system. This will reduce the logistics of confirmation matching payments. You would give all your trades to the clearinghouse and match them off," he adds.

Major dealers in the credit derivatives market—which include Bank of America, Citi, Goldman Sachs and JPMorgan—have already taken steps to make transaction processing more automated, such as confirming a higher percentage of trades electronically and adopting new functionality from electronic clearing and settlement firms such as the New York-based Depository Trust & Clearing Corp. (DTCC).

The big backlog in unconfirmed trades in the credit derivatives market—which stemmed from manual processes at banks with some dealers still using pieces of paper to register trades—first fell under regulatory scrutiny in September 2005 when Timothy Geithner, president of the Federal Reserve Bank of New York, spearheaded a drive to clean up the backoffice processes of 14 of the largest dealers in the market. The 14 banks have since reduced backlogs on outstanding confirmations by more than 80 percent.

However, Val Wotton, vice president, equity derivative and structured products documentation at Citigroup, points out that investment firms will face further technical challenges if they are to integrate their trade processing systems with an external clearing agent.

"There are issues around matching workflow and your internal workflow management. How do you actually internally control your documents and your payments and then leading on from there, how do you then process them to an industry client solution such as one provided by SwapClear. There are also questions around how you link back into your internal systems and close the loop," says Wotton.

New York-based electronic brokerage Creditex's credit derivatives trade processing platform T-Zero—which offers market participants a messaging system for the electronic affirmation of credit default swap trades—was also suggested by the summit panel as a possible centralized clearing agent in the future.

However, Bill Hodgson, first vice president derivatives services at the DTCC, says the fragmented buy-side market presents a challenge to the development of "focused" buy-side services. "It is not hard to build a platform. Getting people to use it is a different matter," he says.

"An integrated approach needs 300 buy-side firms to come to the table. Unless there is some form of an industry forum for the buy side [to express their view] we are not going to have that," says Bentley.

Hodgson says the exchange and cash markets have taken decades to formulate integrated trade processing systems. "Generally, firms buy solutions that plug into their food chain. In derivatives, SwapClear and T-Zero have bits of the food chain. Even though we are working quickly on the trade information warehouse for credit, I think it will be quite some years before you see a mature and comprehensive global settlement solution that is integrated across all OTC asset classes by one provider," he says.

Meanwhile, global regulators continue to monitor the infrastructure used by major industry dealers to process equity, interest rate and commodity derivatives. The New York Fed announced in May that 18 major market participants in the equity derivatives market had made progress in automating post-trade processing infrastructure. Dealers have succeeded in reducing equity derivatives confirmation backlogs by 25 percent in the period from November 2006 to Jan. 31 of this year.

Source - http://www.watersonline.com/public/showPage.html?page=457137
Publish date - July 1, 2007