OTC Derivatives

The post-trade landscape for hedge funds and asset managers

Originally published in the June 2007 issue

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, continuous development of new structures, as well as a dynamic lifecycle subject to external events. It is estimated that up to 30% of OTC derivative trade confirmations contain an error or errors and requires subsequent handling for rebooking or amendment. The challenge for money managers and broker-dealers is to automate processing. Potentially, the next five years will be a new era of collaboration, technological creation and an amazing race where the finish line is a win for all.

The trading world is filled with interdependencies and shorttime 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. With derivatives, counterparties are tied to each other for the life of the contract as future payments or event requirements often exist.

Hedge funds work with multiple prime brokers in order to protect confidentiality and mitigate risk. There are instances of relatively small firms with US$100 million in assets under management using three prime brokers. The trading and operational challenges multiply.

An operational nightmare

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 are, more and more, coordinating their efforts to enhance not only local market stability but global stability in the financial markets.

A recent Celent report, European Post-Trade Processing: STP in the Back and Middle Office, October 2006, discusses an extensive survey of banks and asset managers reporting. According to Celent’s research, “The majority of respondents indicated that less than 50% 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% of respondents cited derivatives as the number one priority for STP projects as opposed to other instrument classes.” Derivatives are booming, driven by the growth in hedge funds and the pursuit of higher returns than the lacklustre traditional capital markets. Interest in these products also extends to traditional managers, who see the opportunity for new products that bridge the gap between traditional money management and ‘aggressive’ hedge funds. The securities and investments businesses continually reinvent the financial world through new strategies and products. Over time, more derivatives will make their way into a greater number of traditional portfolios. Generally, this means plain vanilla types of derivatives. Clearly the more aggressive derivatives and structured deals are the realm of hedge funds.

The rise and rise of derivatives

Over the 2000 to 2006 period, credit default swaps have grown the fastest, at an annualised rate of 206% to US$34.5 trillion. This is not surprising given the extensive press coverage; commodities are next in line with a growth rate of 204% and a notional outstanding value of US$9.2 trillion. Equity derivatives grew to a notional value of US$7.2 trillion, with an annualised growth rate of 148%. Interest rates, the largest segment of the derivatives market with US$285.7 trillion notional outstanding, grew at an annualised rate of 147% over the six year period. Foreign exchange grew at 126% to US$37.6 trillion. Celent anticipates that these categories will continue to experience tremendous growth.

M&A activity in the asset management industry is going strong, and the market consensus is that this will continue. Clearly alternative investment firms are one of the drivers in the consolidation. The changes are likely to create drivers of profitability as firms innovate with new products and leverage distribution channels. The M&A activity will also contribute to the demand for OTC derivatives. And it creates greater demand for technology as firms review their infrastructure. Whether funded by larger multinationals or venture capital money, there will be new and perhaps more investment in technology and intense pressure for innovation to alleviate operational pain points and control the firms’ risk.

Keeping up withthe technology

What’s clear to brokers, and to many in the technology sectors that service the brokers, is that the buyside is not shifting to the automation paradigm as actively as is needed. Certainly large and very active asset managers and hedge funds are engaged, but adoption is not universal. Firms may delay because there are few multi-security systems, there may be additional costs, or they do not feel their volumes justify an additional technology implementation.

FpML, or Financial products Markup Language, is considered by most the industry-standard protocol for complex financial products. It is based on Extensible Markup Language (XML), the standard metalanguage for describing data shared between applications. The protocol is used for sharing information electronically in terms of both derivative product descriptions and business processes. FpML describes the data that needs to be exchanged within business processes, as well as the message flows. Examples of processes include Request for Quote, Confirmation, Affirmation, Novations, Terminations, Increases, Amendments, Credit Event Notice, Allocations, and Cash Flow Matching.

Launched in 1999, FpML was designed by JP Morgan Chase and PriceWaterhouseCoopers. Other industry participants joined the effort forming FpML.org to lay the groundwork for broad adoption. In late 2001, FpML.org and the International Swaps and Derivatives Association (ISDA) teamed to incorporate the protocol into ISDA initiatives. In the first half of 2007, the Society for Worldwide Interbank Financial Telecommunication (SWIFT) intends to launch a pilot program using FpML for the first time. The pilot will test trade notifications, and messaging, such as novations, on credit derivatives and interest rate swaps in the settlement environment. A successful pilot will make the service available to SWIFTs’ 8,000 global members. By the end of 2007, the organisation intends to offer a translation service between its established MT message series and FpML. FpML is an open source project, which can lead to variations. However, nearing a ten-year anniversary, FpML has made headway in OTC derivative automation. Full and complete adoption among all industry participants is mostly a question of when rather than if. There are firms dedicated to FpML application, providing consulting and development tools.

Standardising the process

ISDA established formal derivative definitions to aid counterparties in defining trades. The most recent definitions are the ISDA 2002 Equity Derivative Definitions, the ISDA 2003 Credit Derivative Definitions and the ISDA 2006 Definitions for interest rate. Further support is provided by the Master Agreement, Master Confirmation, and Matrix Approach used for credit derivatives.

The purpose of these standardised documents is to reduce the risks in derivatives, promote enforceability of contracts, and improve operational processes. A master agreement serves as an umbrella contract setting forth the legal relationship between two parties and the contingencies (for example, close-out netting in case of default of a counterparty). A master confirmation sets default values for a particular transaction type that can shorten the confirmation review process. Master confirmations can vary by jurisdiction and derivative type; for example, an equity index option master confirmation would differ between the Americas and Japan. A matrix approach is used solely for the credit derivative market. The Matrix, which lists standard elections for certain transaction types, is maintained on behalf of the industry by ISDA, and republished when changes in market practice occur. The Matrix approach speeds up the implementation and allows for changes to be universally applied without the need to renegotiate bilateral MCAs. On the trade confirmation, firms note the trade is in accordance with terms “as published by ISDA.” The terms include the more standard elections. This reviews bilateral renegotiation and contract signing among counterparties.The documents arequite extensive in length, and, in some instances, the number of variables can reach 100-for a single relationship and trade.

In 2003 The Depository Trust & Clearing Corporation established Deriv/Serv. Deriv/Serv is a fundamental part of OTC derivative trade confirmation, matching, and settlement as well as payment reconciliation and settlement. Technology vendors in the post-trade/pre-settlement area typically link to Deriv/Serv for legal confirmation purposes.

An important global initiative launched in November 2006 by Deriv/Serv is the Central Trade Information Warehouse, currently underway for credit derivatives. Deriv/Serv estimates it is receiving 80-85% of the credit derivative confirms.

The second phase

Currently, broker-dealers have entered the second phase of the project, which entails back loading trades by broker-dealers and buyside firms. This phase is likely to take the balance of 2007. When completed, it will further support the ongoing bilateral administration and automation. Deriv/Serv clients include 800 buyside firms, of which DTCC estimates there are 550-600 hedge funds. There is no cost to the buyside.

The dealer community is setting aggressive goals. Automation will extend to a more comprehensive list of derivatives types with equity derivatives most likely to capture the next wave of attention. ISDA will continue to work to establish a comprehensive roster of confirmation templates to put everyone on the same page.

The goal for vanilla products confirmed electronically is to issue confirmations by T+1 and to complete confirmations by T+5. For more complex products, the goal is to issue confirmations by T+1 and complete confirmations by T+30. The group of dealers, now 18 strong, have agreed to work toward a goal of affirming the principal economic terms of complex products by T+3.

Looking for buy-side support

Although these are tough goals, success in the credit derivatives market supports the industry’s momentum. The next phase will take time. And it will require greater support from the buyside in terms of responsiveness to broker initiatives, and perhaps adding automation tools at their own expense. Derivative product development is continuous, and the most complex of deals will never automate. That said, the goals are necessary because the industry must start somewhere, and certainly the discovery that unfolds will lead to initiatives and developments that are not on anyone’s mind today.

The buyside purchaser of technology for derivatives processing remains rare. A quick count of the leading providers in this space not affiliated with an execution platform show about 1,000 hedge funds and asset managers’ clients. Lack of adoption reflects the still relatively young technology. The buyside community is still coping with front office trade automation and other technology priorities.The market is likely to wait 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 process and tool the broker-dealer provides. For a good number of firms this is standard procedure: to look to the broker-dealer to provide support and to adapt operational procedures based upon what is free in the market.

Unlike the broker-dealer community, which has greater technology and financial resources, most buyside 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. For the buyside, maximising a single solution across the firm is always a consideration.

Why the delay?

Buyside 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 labour. If existing systems provide some element of support, all the better, and all the longer the postponement. 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, organisations like 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 buyside 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 buyside clients on leading applications not affiliated with an execution platform is about 1,000 firms. Not high, considering the thousands of money managers worldwide who 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.

Time for buyside to act

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

Outside 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 amounts of trading. Others just rely on free services, such as a prime broker-provided website portal. There is generally a high degree of reliance on the brokerage community to supply technology to the asset management community and to rectify capital market issues. Given the size and interdependency in the markets, it might well be time for the buyside 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 buyside often adopts a wait and see approach to optimise expenditures on a clear leader or to allow enough time for the technology to evolve a generation. They also look at vendor reputation, and in a new technology sector such as post-trade/pre-settlement, where changes are still occurring, it takes time to validate credentials.

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