OTC Derivatives Automation: Playing a Waiting Game?
You couldn’t accuse the over-the-counter (OTC) derivatives markets of being boring. However with so much uncertainty due to new regulations such as Dodd-Frank Act, MiFID II, EMIR and Basel III, it is unclear what shape market infrastructures may take and the impact that will have on post-trade operations.
What is certain is that manual and semi-automated processes that could barely cope three years ago are woefully inadequate today. Their inability to scale to meet the current volume demands of flow or vanilla products and to process increasingly complex, highly structured instruments, is already causing issues in the middle and back office.
Manual processing is unreliable and error prone. It can become extremely complex and introduces risk to the point where regulators have felt compelled to intervene. Crucially, the reliance on manual processing is also much more expensive, which impacts directly on profitability. While hiring more staff may overcome some immediate issues, automation is needed to ensure adequate systems and controls are in place to deliver a true picture of asset values, positions, liabilities and funding requirements.
To date automation initiatives have created infrastructures to improve confirmations, payment reconciliations and other post-trading functions. However, this has only made a small impact on the issue, as highlighted by the rising number of outstanding confirmations firms faced during the early stages of the credit crunch. The reams of paper being generated by contracts and the year-on-year growth in volumes are creating processing bottlenecks that carry a significant operational and reputational risk.
It is apparent that the restructuring of operations and their supporting technology will be needed to prepare for the advent of central clearing, oversight and reporting, and increased reconciliations. Initial estimates suggest that with the reforms, between 60-70% of current OTC contract volume will be centrally cleared. Moving from an embedded monthly, sometimes weekly business cycle to an intraday one presents a significant challenge but not an impossible one.
So where do you start? Automation of elements of the OTC transaction are possible today and crucially, increasing all the time, as firms and vendors gain a clearer view of the exact requirements for an efficient processing environment.
Research by Celent, released in 2010, argued that OTC derivatives operations should be examined in terms of the three principal objectives of automation – process acceleration, processing error reduction and processing capacity. Celent found that confirmations and affirmations still constitute over 50% of OTC post-trade processing costs, clearly an area that both the industry bodies and firms should concentrate automation efforts on.
Moreover, they found that buy-side firms are intent on investing in technology to address the post-confirmation process, the other 50%, in order to reach the next level of efficiencies. The Celent research also revealed that buy side firms in particular are looking to invest in improved technology solutions must provide the appropriate architecture and components for a true path to STP.
The critical areas for consideration when looking to deliver greater automation are:
As volumes grow, hard-coded and proprietary systems struggle to provide the control and visibility that firms need to process transactions efficiently. While systems have delivered a high throughput of trades, pure volume capability is only a small element of the transaction process. Without intelligent business rules, they create large volumes of exceptions that overwhelm even the largest back office teams.
There is also a perception that each derivative contract differs to such a degree that it is difficult to define normal practice. While they are certainly more complex than many other instrument types, every contract contains common elements that offer opportunities for standardisation and automation. Trade affirmation, trade allocations, reconciliation and novations are all areas where proven software exists. The step change that firms will take on board is the need to integrate and manage these individual sub-processes across a unified transaction lifecycle.
OTC derivatives add complexity due to the unique nature of their lifecycle that requires ongoing monitoring such as periodic or regular payments that must be calculated to take into account rates resetting.
There is an issue, particularly in credit derivatives, where deals are novated. We have seen plenty of buy-side firms struggling to manage the novation process with a combination of paper-based files and Excel spreadsheets that led to failed settlements. Due to a lack of automation they could not identify their counterparty and back office teams spent time and effort tracking down a specific instrument after multiple novations had occurred.
While the complexity does represent a challenge there are core processes that can be automated to deliver more proactive event management. This ensures firms have greater visibility into positions, can reduce risk and crucially, lower transactional costs.
Any technology deployed must offer an agnostic approach to data feeds and instruments. With the market developing at such a rate, the ability to take in new feeds and match on a sufficient number of fields is critical. It should also support workflow through exceptions-based reporting and deliver operational dashboards for a clear overview of positions and outstanding items.
Portfolio reconciliations can enable firms to track day-to-day activity with their counterparties and prime brokers, and ensure its records match that of both the executing broker and the prime broker. Automating these three-way reconciliations delivers greater levels of control and drastically reduces risk by doing away with trade status tracking on Excel.
Reacting to exceptions as they occur is the first step to proactive transaction management. This requires alerting people to an issue that may occur and escalating it for resolution before it becomes an exception. Novations automation can support and track the entire counterparty process, providing access to transfer history, recording changes and monitoring the process.
Increasingly some of the bigger asset managers are viewing OTC derivatives as a larger reconciliation that covers all asset classes, positions, trades, corporate actions and cash management, rather than a standalone requirement. These actions can be structured as an event-driven workflow which models a trade from its initiation until it reaches maturity.
This approach automatically detects events and evaluates their impact on all aspects of the firms’ trading position, at both a transaction and at an aggregate level. The result: Continual monitoring and early detection of potential errors that could lead to failed trades.
By automating all of these areas through a single system, firms can reconcile multiple times, manage novations and monitor margins for each element while retaining an overall view of the contract as it moves through the transaction lifecycle.
The most beneficial approach for firms is to automate as efficiently as possible those areas that can be automated with the right technology. It is not a case of gaining a better understanding of positions, of when an underlying instrument to a complex derivative needs to reconciled and a payment notice sent. Rather, it’s about gaining an understanding of the position in the first place, which some firms still lack.
With the ongoing work of all market participants greater automation is achievable across the OTC derivatives transaction lifecycle for the more vanilla products. These projects will then provide a blueprint for increasing straight-through-processing (STP) rates for the exotics over the coming years, delivered through an event-driven, rules-based, workflow solution. This will support the move towards greater exchange execution of instruments and the use of central counterparties (CCPs) bought in by new regulations.