The Hidden Workload of OTC Derivatives
The process of executing OTC derivative trades has evolved over the past few years due to the increased activity in the market by corporations. Previously, the clearing of trades has been a uniquely manual process. There are now systems and vendors that provide automation that is suitable for corporations and buy-side financial firms.
OTC derivatives are negotiated instruments that can closely match the risk they are hedging. Coupled with the ability to have expiry dates in years as opposed to months, these instruments offer many advantages over exchange traded instruments. Instead of a basket of trades that must be rolled every three to six months, a single instrument can be purchased for the duration of the hedging period.
With this power there are some additional processing requirements. OTC derivatives use paper confirmations created by the International Swaps and Dealers Association (ISDA). These documents confirm all the parameters of the trade and provide the legal framework. ISDA has created a library of confirms for many different instruments, such as interest rates, credit exposure, energy, commodities, equities and others.
This is different from an exchange traded derivative where the clearing house handles cash flows, accounting and paperwork. An OTC derivative is a trade between the corporation and the sell-side bank. Since the trade is directly between the parties, there are more legal conventions that are covered in the ISDA confirmation. As in exchange traded derivatives, the counterparties negotiate a master agreement that sets up the terms for all trading activities. ISDA has also created standard master agreements. All agreements are usually negotiated before any trading takes place. This starts with the master agreement and is then followed by the confirmation for each instrument traded.
The OTC derivative confirmation is more detailed because the trade is tailored to the needs of the buyer. It is far more difficult to sell the trade to a third party if the buyer cannot honor the terms of the trade. In an exchange traded environment, the bank simply sells the derivative in the market and absorbs the margin cash. This is not the case in the OTC derivatives market. The OTC market does not have a clearing market through a central exchange. Therefore, these contingencies are listed in the confirmation and have been bolstered by case law over the years.
There has been very sharp growth in the OTC derivatives market over the past 12 months. Volumes in some instruments are growing by 40 per cent per quarter. This explosive growth has created a backlog of unconfirmed trades that reached a point where the US Federal Reserve and the UK FSA commented on the need for new conventions and the greater use of technology.
The final factor in OTC derivatives is the requirement for specialized knowledge. It is very useful to have staff with knowledge of ISDA confirmations if you plan to do more than a few OTC derivatives per year. For very low volume, it would be more efficient to use outside counsel that specializes in OTC derivative confirmations.
Even with the requirement to have ISDA confirmations and experienced staff, the benefits of OTC are great and can eliminate complex hedging requirements in a single trade. The banks have had considerable profit growth in this area and are interested in providing automation to ease the burden of trading OTC derivatives.
The first step to automate the market was the creation of several consortia to match OTC derivatives. These matching services were originally created to facilitate confirmations between sell-side banks.
The matching services reduce the workload in OTC derivatives trading by providing a uniform master agreement, transfer of economic terms as opposed to a full confirmation and the use of a uniform template for the trade parameters. Instead of master agreements negotiated between each party, there is a single agreement that all parties sign that has the matching service as the central party.
This master agreement describes the use of an electronic matching service to exchange the economic terms (notional amount, trade date, expiry date, etc) between the trading parties and the matching service. This eliminates the need to negotiate and create a paper confirmation. It also provides the same documentation for all banks connected to the matching service. It is possible to obtain several price quotes with one set of agreements.
The agreement also lists the different trade parameters that will be matched. Typically this information is exchanged using the Financial Products Markup Language (FpML) which is a representation in XML. As experience with the system increases and new instruments are added, the FpML definitions are updated.
The matching services are more interested in being a messaging utility and provide limited tools to connect to the service and manage messages. This follows from the creation of these matching services by large banks. The sell-side banks have the volume to justify a large information technology staff to create the interfaces to the matching services. The interfaces to the matching service require considerable effort to gather all the information and format it to their specifications. The interface requirements of the matching services were a considerable barrier to entry that successfully excluded the buy-side and corporations. These were the groups that had the highest number of unconfirmed trades and the greatest need to use an automated service.
It is only in the past few months that the matching services have been considering the use of their services by corporations and the buy-side. Their first attempts to provide services to these constituencies were mismatched as they had concentrated on industrial quantity transmissions. They are now more concerned with the buy-side and corporations, as these groups were highlighted by the investigations by the Federal Reserve and the FSA.
The sell-side banks have created structured products desks and are interested in creating hedges for corporations. The ability to create complex hedges that very closely follows the risk profile makes the effort of OTC derivatives worthwhile. The recent developments in the technology offerings have lowered the workload to the treasury department and made them easier to add to their hedging operations.