Rapid growth in the global over-the-counter (OTC) equity derivatives market is being constrained by absence of adequate infrastructure and automation, according to a report released today by the Aite Group, an independent research and advisory firm focused on the impact of technology and regulation on the financial industry.
The report, "Trends in OTC Equity Derivatives," says that the extended length of time required to confirm OTC equity derivatives transactions is causing concerns among market participants and regulators in many countries. Many of the delays, which can last for weeks and even months, largely stem from the very complex legal documentation required, according to the report.
The Aite Group study is one of the first to analyze trends shaping the OTC equity derivatives market and the challenges it faces in bringing greater efficiency to the market place.
High Error Rates
Increased attention from regulators such as the Federal Reserve Bank of NY and the Financial Services Authority (FSA) and the findings of this report could bring greater focus among market participants to improve their operational practices. The current manually based, paper-intensive environment is fraught with excess operational risk for market participants, the Aite report noted. Other observations are that:
- about one trade in five is subject to some type of processing or trade capture error, based on figures provided by ISDA;
- because of these error rates, a large number of trades have to be rebooked. The need to rebook stems from improperly entered trades in a bank’s or client’s system. Rebooking is quite an issue, as it means incorrect data has been entered into trading, risk and accounting systems, and it has yielded inaccurate risk and exposure profiles;
- as a conservative estimate, approximately US$400 billion in notional trade amounts initiated between June 2005 and June 2006 had some type of error or was rebooked.
Complexities in Documentation
The global OTC equity derivatives market grew to $6.4 trillion in notional value outstanding as of June 2006, a 12-month increase of 32%, according to The International Swaps and Derivatives Association, Inc (ISDA®). These products are actively traded in Europe, the Americas and Asia, with a wide range of market participants and a myriad of products existing in the market.
"The primary barriers we observed to increasing automation in the market place are the complexities that arise between trading firms in the legal documentation of OTC equity derivatives transactions," said Brad Bailey, senior analyst, Aite Group. "Understanding these complexities and identifying ways to simplify the execution of Master Confirmation Agreements (MCAs) between market participants would be an important first step to ease the processing issues in these products."
The Aite report states:
- Currently, not all the dealers have signed MCAs between them. To get the proper documentation to their buy-side clients, dealers need to establish which products and regions are important to each client and have that documentation put in place as a starting point. In many cases, large packets of legal documentation, spanning multiple regions and products are sent to clients, overwhelming them.
- The potential combinations of product and regional documentation present a very cumbersome array of possibilities. They quickly add up to a significant universe of documents from both a dealer’s and a buy-side client’s point-of-view. For instance, a typical, large buy-side firm with just five OTC equity derivative dealer relationships would be looking at about 80 possible combinations of product and regional legal documents.
The current market environment for OTC equity derivatives begs a solution, notes the Aite Group. In the long-term, it sees such a solution probably evolving "around a unified set of documents that can be used across a wide range of geographical regions, products and clients." The Depository Trust & Clearing Corporation (DTCC) sponsored the study by the Aite Group to try and identify underlying issues inhibiting market growth, causing risk and increasing customer costs.
Recently, DTCC hosted summits in New York and London to discuss challenges buy- and sell-side firms face in executing their MCAs and to facilitate the execution of MCAs between buy- and sell-side firms. In conjunction with these summits, DTCC has begun helping firms to identify the specific products for which MCAs are needed from their counterparties and relevant counterparty contacts. By acting as the conduit that connects these parties together, DTCC’s aim is to help make the early stages of MCA execution more efficient.
"Because equity derivatives are a complex market, the documentation requires a great deal of attention," said Gina Ghent, vice president, business development, DTCC. "DTCC is working closely with market participants to facilitate the signing of MCAs between market participants as a way to help bring these firms into our automated environment. We have the capability to automate the broad and dynamic range of equity derivatives products, but without accelerating the pace of MCA execution, market automation will not occur as rapidly as it should."
DTCC provides automated processing for OTC equity, interest rates and credit derivatives through its Deriv/SERV matching and confirmation service.
