Financial-i OTC Derivatives Processing

52 Financial i · Q3 · 2008 Special Report - Derivativ es processing There has been no end of debate, particularly on the buy side, as to how firms can efficiently process OTC derivatives. The processing challenge for the buy side is similar to that faced by the investment banks, complicated by new instrument innovation and rising volumes. Manual and semi-automated processes that could just about cope five years ago are woefully inadequate today, both in their ability to scale to meet the volume demands of flow or ‘vanilla’ products, and to process increasingly complex, highly structured instruments. 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. We can see the effect of increased operational risk at firms that choose to withhold capital (assets allocated to OTC derivatives portfolios) until sufficient process automation is in place. Once controls are established, they are able to release more assets to OTC derivatives positions. Crucially, reliance on manual processing is also much more expensive, which impacts directly on profitability. Where firms limit assets allocated to derivatives trading until operational controls are in place, presumably these limits, while prudent, constrain performance and the ability to generate alpha. This is a real opportunity cost. 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 tended to focus on how the buy- and sell-side work within a trade. Utilities such as the DTCC’s Deriv/SERV and MarkitWire have created infrastructures to improve confirmations, payment reconciliations and other post-trading functions. However, this has only made a small impact, as highlighted by the rising number of outstanding confirmations firms faced during the early stages of the credit crunch. As the front office is chomping at the bit to trade these new instruments, organisations cannot process them because the middle and back office are struggling to cope. The reams of paper being generated by contracts and the 35% year-on-year growth in volumes are creating processing bottlenecks that carry significant operational and reputational risk. When new derivative types, using multiple underlying instruments and rolling settlement dates, are added into the mix of outdated systems and rising volumes, the case for greater automation is clear. The automation challenge Automation of elements of the transaction are possible today and are increasing all the time as firms and vendors gain a clearer view of the exact requirements for an efficient Delivering lifecycle automation The front office may be “chomping” at the bit to trade ever more complex derivatives, but as Mark T aylor , business development director, Asia Pacific, SmartStream argues, the middle and back office are struggling to catch up.

Financial-i OTC Derivatives Processing

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