A changing market and regulatory landscape requires the buy side to take account of its OTC derivatives operations. DST Global Solutions’ Geoff Harries explains how addressing internal storage of OTC contracts is the starting piece in the design of a coherent derivatives operational structure.
The recently published ISDA 2010 Operational Benchmarking Survey gives us some indication of the state of the union in OTC Lifecycle processing, but what it does not provide is effective insight into the operational challenges specifically for the buy-side.
With less than 3% of the respondents being either an asset manager or a hedge fund, it is difficult to use the ISDA results to benchmark a buy-side firm against these industry metrics. What they do provide however, is a guide to the common challenges to be faced. The buy- side matures in its search for solutions to the problem of building an operational capability to support the investment strategies of the front office, specifically in alternative asset classes.
The operational maturity of the buy side is significantly less than the one of investment banks and securities firms who developed the inter-dealer market many years ago. Given the volumes in the inter-dealer market in comparison to the dealer to buy-side market, it is not surprising that the operational capabilities are far less advanced, but the same risks and operational challenges exist, albeit at a different order of magnitude.
What the ISDA survey does show us is that the volume measured by events to be processed is still increasing and therefore the operational pressure to service existing contracts as well as handle net new volume is still a significant issue. The survey indicates a continued increase in event volume year over year with average monthly event volume aggregated across all instrument classes still increasing, but at a slower rate. The 2007 growth of 30% could not be sustained, but the accumulated post-trade processing volume is still maintained.
Why the need for action now?
There are still a number of uncertainties in terms of the maturity of the post-trade processing landscape, including areas such as the independent pricing of illiquid securities and the development of new collateral management and margining capabilities. Achieving progress in all areas depends on one fundamental building block – the use of a central internal repository of validated contracts.
Action now for internal motivations, whether it is for operational efficiency, investment control or to meet internal compliance requirements, can be better controlled and thought through with use of a centralised storage mechanism for OTC contracts. Use of such a repository would allow organisations to piece together the OTC operational jigsaw in a more coherent fashion.
Another driver is changes to the regulatory environment. A pressured response to pending regulation in tight timeframes naturally results in compromises that do not deliver the required operational improvements and therefore the desired end operational capability.
With both the European Commission and the G20 having derivatives firmly in their sights on implementing changes to reduce market and counterparty risk, increase transparency, and improve market integrity and oversight, this will quickly move from the regulatory and political agenda into regulatory impacts that will require an operational response.
Dealing with new regulations we know is costly and diverts focus. So to make the responses less painful, having a solid base built in 2010 from which to make responses to regulatory reform in a 2011-2012 timetable would appear a prudent step as the focus on derivatives process is not going to go away any time soon. Making phased investments into operational capabilities is going to allow the internal operational environment to mature over time, rather than knee-jerk responses and need for capital investment in a short space of time.
Where to start?
There needs to be an acknowledgement that there has been under investment in the operational capabilities to support OTC investment strategies in both the middle and back-office and the downstream asset servicing of these instruments through post-trade event management. Under-investment at its worst, manifesting itself in dealing caps placed on the front office, due to an unacceptable level of risk exposure, both counterparty and operational, based on the capacity of the operational areas to service the investment volume. As the amount of errors, rework and claims for interest increase, the weaknesses in the operating procedures expose themselves as costs associated to rework and making good on client instructions that have not been executed correctly.
Whilst there are industry initiatives afoot to reduce operation risk by promoting standardisation of legal terms of derivatives and focus on reducing counterparty risk by mandating central counterparty (CCP) clearing for standard derivatives contracts, there are internal operational changes that need to take place to enable firms to operate in the new environment.
For instance, to deliver on G20 and European Directive requirements of increasing transparency, participants need to record positions and transactions not cleared by a CCP in trade repositories. The new requirement is to have a validated internal repository, with which to populate the external trade repository. This is likely to be further enforced under the banner of increased transparency of trading as part of the Markets in Financial Instruments Directive (MiFID) and its pending revisions.
Robust OTC derivatives trade capture needs to be the first piece of the operational jigsaw considered in any OTC operational improvement project to provide an internal validated repository of contracts as the bedrock on which other improvement projects can be delivered. Making improvements further down the OTC Lifecycle chain first, will only uncover data quality issues when they are implemented if the first part of the post-trade process has not been locked down.
To drive the interaction with affirm/confirm models on matching services, notify interested parties as well as the asset servicing requirements of collateral management and booking to investment accounting, requires a clean contract flow and activity flow from the middle office. However, an internally centralised repository of OTC contracts provides more benefit than simply a mechanism for downstream processing. It can provide the operational control and visibility required for internal reporting of counterparty exposure both existing and for those contracts in draft stage.
Where has the focus been to-date?
Much of the focus in the last two years has been on the confirmations backlog across a number of different OTC derivatives sub classes. The most notable success reflected in the ISDA benchmarks has been the confirmation rates on credit products through electronic platforms. Whilst the end result, measured by the confirmation backlog decline, is a significant achievement, we cannot become complacent and need to take a more detailed look at how this was achieved. In many cases the operational improvement was achieved by taking a collection of spreadsheet based term sheets across the organisation and loading them up into the central platforms. This removed some of the confirmation issues and counterparty risk but did not resolve the root cause of the problem and left many of the internal operational inefficiencies in place. It was a tactical response to growing volumes.
What will the focus be in 2010?
With the increasing focus on post trade transparency, greater focus on exposure reporting and ability to aggregate exposure across a number of asset classes, that collection of spreadsheets will be questionable as a robust and auditable repository of contract information. Streamlining the OTC trade lifecycle has to start at source and this will become the focus in 2010 to enable the downstream processes to work off centralised internal repositories of clean contract information. Contract and term sheet information being transparent, accessible and available in a way that can drive the OTC Lifecycle is a fundamental building block for internal OTC derivatives operational control and efficiency and meeting external regulatory requirements.
In the same way that data management and data quality are a way to gear the organisation and provide a tangible business benefit, so addressing the internal storage of OTC contracts to enable to the post-trade process and asset servicing activities will become a focus to ensure operational control and efficiency objectives are achieved.
* Geoff Harries is Global Head of Asset Servicing, DST Global Solutions
