ISITC’s Derivatives Working Group recently published market practice recommendations for the communication of trade notification messages between investment managers and their accounting agents to promote the automation of this back-office process across the industry. Julia Schieffer offers insight into building a business case to secure budget to adopt best practices for this highly error-prone operational process.
Changing the OTC derivatives post-trade processing to be more operationally efficient, less costly and risky is clearly a top priority for the financial industry. Industry groups have pledged to improve derivatives post-trade processing in multiple letters to regulators (Fed letters) that outline industry-wide goals. However, these collective initiatives have focused largely on confirmation, reconciliation and central clearing of OTC derivatives and excluded other back-end operational processes that are also in need of automation and improvement. Communication of contract notification between investment managers and accounting agents (custodians and prime brokers included) is an error-prone, standards-lacking and therefore problematic operational process – and one which will only become a bigger problem as volumes grow.
ISITC has recently published market practice recommendations for the communication of trade notifications for OTC derivatives contracts between investment managers and third parties. The published report supports the use of FpML messages, the agreed message protocol for derivatives, as established in the financial messaging Investment Roadmap signed in 2006 by various industry bodies.
The completion of this best practice document took the ISITC Derivatives Working Group two years to complete. The time taken to finish this onerous task is testament to the problems inherent in this operational process and also indicates the significant benefits in risk and cost reductions that can be achieved by adopting a standardized format and automation of the trade communication process.
Improving communication of trade notifications may be a less visible project and thus not a high priority for asset management firms, but firms should find the following explanation of the newly published best practice and insight of best practice adoptees useful in justifying the budget for making this significant improvement.
The investment and time required to adopt a standardized format for electronic communication for trade notifications varies by investment manager, but the benefits of reductions in operational risk, operating costs and improvements in scale, for both the individual firms and the industry at large are significant.
Status quo
Currently, the communication of a trade notification from an investment manager to its accounting agent/custodian or prime broker is generally executed via fax or email so the actual trade details are later re-keyed into other systems by the message recipients. This current method is error prone, risky and highly inefficient.
The tools required to communicate electronically – namely FpML, the messaging protocol for derivatives, and SWIFT, the communication network – are available and use of these protocols are clearly outlined in the industry Investment Roadmap for trade communications. The Investment Roadmap clearly outlined each industry group’s (SWIFT and FpML) role in the messaging of trade information to alleviate confusion and unnecessary expenditure in adopting multiple industry messaging protocols.
Although the Investment Roadmap secured agreement on a general plan for progressing, market uptake of the tools for this purpose was slow because there was no clear and established method governing the content of the messages or the business process flows for message use. For this reason, ISITC’s Derivatives Working Group began its focus on establishing a clear best practice so all parties will use the messages consistently and efficiently across the industry.
ISITC Market Practice Document
The scope of the Market Practice includes post-allocated trade events in the OTC trade lifecycle and specifically covers the following events types:
– Initiation
– Increase
– Novation (‘Assignment’)
– Cancellation
– Termination (‘Decrease’ for partial terminations and ‘Close’ or ‘Unwinds’ for full terminations)
The process by which a notification of a contract event is communicated is illustrated in the following diagram as included in the original ISITC Market Practice Recommendation. This graph clearly shows the process and the involvement of specific parties including the investment manager and accounting agent/custodian/prime broker.
More technical specifications, such as the recommendations on the timing of contract notifications, specific recommendations for use of different FpML versions and message usage rules are also included in the best practice document.
Adoption of Best Practice
Uptake of the standards outlined in the Market Practice Recommendation is highly dependent upon the investment manager’s existing infrastructure. Firms that already support FpML or other structured messaging protocols may find development and implementation of the messaging standards less difficult than firms that rely primarily on batch files or manual processes.
Of course, this year and always, budgets are a consideration and an effective business case is important in securing support and approval for such an initiative.
According to members of the ISITC Derivatives Working Group and other market participants, many asset managers already have initiatives underway to automate messaging between themselves and the accounting agent/custodian/prime brokers and plan to use the messages in adherence with the Market Practice Recommendations. Firms that are still a little early in their assessment are reaching out to ISITC for guidance in building a business case so they can clearly articulate the tangible benefits of adopting the recommended messaging standards, as well as identify the risks of continuing with manual processes.
Building a Business Case
Building a business case to be used to prove the necessity of the project and thus secure the budget to improve the trade notification communication is the first step for all investment managers. A few investment managers have outlined some common steps in building a business case.
Buy versus Build for FpML
Investment managers have different starting points. Investment managers that currently support FpML messaging will find themselves in a much better position than those that do not. However, investment managers who support other messaging protocols such as FIX or ISO 15022 may have an advantage in terms of technology infrastructure and expertise than those that do not support structured messaging. In short, if an investment manager does not currently have a process to construct an FpML message the first step is to consider if it wants to support FpML messages internally, leverage an existing platform that can be extended to support FpML, or buy a new solution that supports the generation of FpML messages.
Data Sourcing and Integration
Once an investment manager has decided to buy or build the FpML message generation and support capability, the firm then needs to look at sourcing the data and integrating source systems with post-trade/trade notification systems.
This is often the tricky step because this involves a lot of data mapping and gap analysis. Investment managers need to evaluate if they have the data required and if this data is located in the appropriate systems as specified within the Market Practice Recommendation. Investment managers may have to first determine whether they will support only “required” fields or both “required” and “optional” fields. To complicate things further, some “optional” fields may be important to the recipient of the message and thus are not really ”optional” though initially labelled as such.
Beyond the data mapping and gap analysis the next steps are often easy for many investment managers who already use SWIFTNet for the transport of other message types. Naturally an investment manager not currently using SWIFT would have to need to onboard SWIFT or determine whether other transport mechanisms or options are available.
Budgeting & Priorities
Another major obstacle is how to prioritize the project of automating trade notification messages among a long ‘To Do List’ for a firm’s operations department.
This is not necessarily just budgeting for trade settlement versus corporate actions for instance, because today many investment managers look at operations and future projects holistically and therefore need to prioritize relative to everything else.
ISITC plays an important role in this process, providing the information and education required by firms that need assistance in developing a business case and effectively articulating the benefits of such an initiative. The existence of a published and supported best Market Practice recommendation is also an essential first step in justifying the automation of trade notification messages. Having something to build to and that will be used by the industry at large is a significant help in validating any project. Access to Working Group chairs and members who can share their experiences, and answer questions about market practice and the tangible benefits expected assist firms in the building of individual business cases is also important.
The main benefits highlighted in a business case are:
– Automation of manual processes
– Increased timeliness in the communication and processing of transactional data
– Reductions in risk due to incomplete or inaccurate data
– Ability to scale operational processes in support of increasing volumes
Perhaps an unexpected benefit of automating trade notification is the support it will offer for a more holistic strategy for derivatives processing.
‘Enterprise-wide’ is a new buzzword more commonly used with data strategies but many financial institutions are looking at their derivatives processing capability from an end-to-end perspective (from trade execution to confirmations, settlement and even collateral management and reconciliation). For investment managers who take this comprehensive view of their operations it makes sense to have a standardized messaging structure on the back end to integrate the entire processing lifecycle.
Messaging is a crucial component of any end-to-end solution and as one asset manager pointed out, it is hard to claim you are getting maximum benefits out of an end-to-end solution if at the end of the processing chain your systems spit out a fax or email. One could argue this is merely partial automation but this break in the automation chain means the risk is transferred to the message recipient (accounting agent, custodians, prime brokers) who has to rekey in the information. In short, the improvement and automation of the communication of trade notification is also about automating the final link of the processing chain and linking all systems together in a core infrastructure to maximize efficiency.
Finally, the best practices have evaluated the data requirements of both parties in the communication of trade notifications so adherence to best practice also ensures an investment manager is providing all of the data the accounting agents require to do their job properly.
What’s Next?
For the ISITC Working Group, the main focus is on raising awareness and providing support to users of this Market Practice recommendation. The group regularly corresponds with market participants to answers questions and help other firms build business cases for internal use.
The Derivatives Working Group is also looking to extend the Market Practice recommendation beyond the original asset types of vanilla credit default swaps and interest rate swaps to also incorporate swaptions and total return swaps. Next up, the group will incorporate contract for differences (CFDs) upon the request of some ISITC members who have higher volume of CFDs.
Footnotes:
1. The Investment Roadmap specifies that FpML is to be used as the messaging protocol for the transferral of derivatives trade information and SWIFT, the established messaging network for securities, will work with FpML to ensure its network supports the use of this message protocol as to avoid investment in multiple networks and moves towards establishing consistency in trade communication. Full details on the Investment Roadmap.
2. The Market Practice Recommendation
* This feature is based on information provided by the ISITC Derivatives Working Group and interviews conducted by Julia Schieffer with other financial professionals active in this space.
More Information & Related Links:
Derivatives Working Group Mission Statement:
The mission of the OTC Derivatives Working Group is to work in conjunction with the AMF and other industry groups to create market practice standards around derivatives processing, focusing on trade notification, reconciliation, collateral movements, and interest payments (resets).
ISITC Working Group press release
