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OTC Derivatives - Taking the next steps to operational excellence

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This article was originally published as a joint White Paper with Geoff Harries, VP Product Strategy CheckFree Investment Services Software:

The stall has been firmly set out. The recent letter from the Operations Management Group (OMG) to the Fed set out some tough, but clear, guidelines for organizations to adhere to. The OMG letter outlined some major operational guideline changes in which 85% of electronic trades are to be processed on T+0 and 94% of confirmations are to be processed without modification, including novations. This means existing silo based platforms and manually intensive operational procedures are no longer viable. The pressure is on for institutions to improve internal operations, which will mean a cultural shift for many organisations. As a result, firms need to address the way OTC derivatives are processed across multiple sub asset classes in order to man- age operational risk more effectively. Firms can take a number of practical steps to meet the seven key goals and deadlines highlighted to the Fed.

Reducing Operational Risk

There are four main areas identified by the OMG for improvements which will deliver operational efficiency through required changes in procedures, process and IT infrastructure.

Electronic processing of eligible trades to enhance trade date confirmation issuance and execution

To process trades efficiently through electronic platforms, certain building blocks must be in place. An adoption of FpML as the lingua franca of OTC automation is essential to en- sure interoperability with counterparties and market infrastructure. The challenge lies with front- end trade negotiation tools, which do not contain all of the reference data information necessary to create a valid FpML message. Passing contract details to a specialised post- trade event management sys- tem ensures that trade enrichment and validation occurs in an automated environment, eliminating the need for additional manual intervention.

Elimination of material confirmation backlogs

An efficient post-trade process that captures, enriches and routes contracts to the appropriate destination will eliminate material confirmation backlogs. The industry benchmark for operational efficiency is constantly being raised and these targets can only be achieved by investing in scaleable solutions supporting the adage of “get it right first time - everytime”. This is only possible to achieve by removing the main cause of bottlenecks, errors and rework, namely manual processes. Manual intervention should be limited only to where business exceptions fall outside of a pre-defined auto- mated process.

Risk mitigation of paper trades

There has been a rapid expansion in the use of derivatives structures across a number of investment vehicles. With this growth comes the operational pressure to deal with the in- creasing volume of events, both pre-trade and post-trade. Volumes have been handled as a siloed department with manual input to third-party terminals. This was typically viewed as an appropriate solution; however, as the number of contracts increases, so do the number of post-trade events. Whilst spreadsheet upload acts as a temporary solution to bulk process transactions, it does not offer the resilience, scale and compliance necessary to support core OTC derivative investment strategies.

Streamlined trade life cycle management to process events between upstream trading and confirmation platforms and downstream settlement and clearing systems

Post-trade event management is the only way to effectively control the by-products of OTC derivative investments. With each open trade there are a number of outcomes that need to be managed over the trade lifecycle. From the point of confirmation to the eventual termination or novation, management of the contract is crucial as it may be amended, increased, decreased or partial events may be applied to sections of the contract. Streamlining the lifecycle is only part of the challenge. Equally important is the ability to manage and monitor the contracts that are in play on top of the new volume entering the process.

Operational response

There are a number of different options available for firms looking to make the transition from manually intensive operational procedures to the desired state of automation and control.

Point- to-Point

This involves developing a single asset class strategy to solve the immediate challenges of trade confirmation automation across a specific electronic platform. This approach is most relevant when the derivatives operation is separate from the cash securities and other asset classes. Establishing an integrated internal front-end sys- tem into the post-trade process provides a reference data management framework that enables contracts to be processed more efficiently.

Multi-Asset Class

If the requirement for automation cuts across a number of OTC derivatives products and other asset classes, then a multi-asset class approach needs to be considered. Capturing trades and contracts from multiple order management and trading systems is complex, but not uncommon. Organizations gain economies of scale through specialization in the front office in terms of people and process and consolidating with a single post- trade processing platform that supports the operational aspects of confirmation, settlement and post-trade event management. An OTC derivatives post-trade event management solution can sit within a single solution, capable of supporting multiple business models for trade confirmation and settlement. This can extend across geographies and instrument classes, providing the efficiency of a single interface to manage all exceptions, and providing connectivity to under- lying market infrastructure.

Reducing Systemic Risk

Reducing systemic risk is also of paramount importance when looking at the whole process. The following three industry goals relate to the industry’s commitment to improve the infrastructure to reduce the systemic risk of the OTC derivatives market.

Global use of central counterparty processing and clearing to significantly reduce counterparty credit risk and outstanding notional net positions

There are currently several initiatives underway in the market to provide on-exchange clearing for OTC contracts.

This is seen as a necessary step to reduce systemic risk by allowing for exposure netting and centralised position management. Some contract types already have facilities in place, such as LCH.Clearnet’s Swap- clear service for rates contracts, or ICE and Clearport in the commodities markets. The credit market has seen raft of new entrants, however other contract types, such as equities, may take longer to follow suit. This is because the road- map towards central clearing will be drawn up once the volumes of electronic processing of these products increase.

Continued elimination of economically redundant trades through trade compression

One of the few positive out- comes from the recent turmoil was the efficient way in which the various facilities for trade compression worked. Also known as “tear-ups” these services allow dealers to en- sure reductions in unnecessary exposures. This can be achieved by netting off matching positions and allowing market participants to reduce counterparty credit, funding liquidity and operational risks. Used by the dealers and the larger man- agers, the services provided by Markitwire and TriOptima have become a sine qua non for all derivative users – so much so that during 2008 the large in- vestment banks “tore up” more than $30,000 billion worth of credit derivatives (the equivalent of almost half the notional amount outstanding on these contracts at the start of the year).

Central settlement for eligible transactions to reduce manual payment processing and reconciliation

Intrinsically linked to the question of central clearing, the industry requires the use of central services to simplify the often convoluted web of manual processes and multiple reconciliations. All participants, including dealers, managers, custodians, outsourcers and prime brokers are involved in this process. Therefore a central point for settlement (such as that provided by CLS bank for Deriv/SERV’s Trade Information Warehouse) needs to be implemented for all products.

Operational Response

The above industry initiatives may seem somewhat removed from sphere of the average as- set management user of OTC products, but there are some important operational implications embedded in these developments that the industry needs to respond to:

Liquidity Management

In illiquid times, liquidity be- comes of paramount importance. The onset of central clearing for OTC products will put a further onus on operational procedures. Managers will not only need to respond, but anticipate margin calls emanating from the clearers and/or dealing counterparties. Some may al- ready have these procedures in place for exchange traded products. For others this will require the implementation of margin calculation processes to value contracts and perform what-if forecasting. Timely communication of this information between front, middle and back offices is also necessary to ensure that fund managers have the requisite information on a daily and intra-day basis. Exactly how dealing counterparties will pass- through these exchange requirements to their asset management clients remains to be seen. It is likely that there will be a hybrid model of OTC collateral management and ETD margining existing side by side – processes that do not necessarily co-exist in current operating models. What is certain however is that cash will be king and the occurrence of managers using stocks as collateral will diminish.

Reconciliation Processes

As a corollary to the above, cashflow reconciliation processes will also need to be examined to ensure that managers have the correct tools to reconcile to the clearing and settlement systems and dealing counterparties. This may require changes to the current processes or the implementation of new reconciliation tools. These processes will need to include both collateral and margin amounts as well cashflows from the actual contracts themselves to ensure proper cashflow management. Clearly automating these processes will require connectivity and agreed data formats with counterparties, as well as exception processing for efficient management oversight. The increasing pressure from the likes of OMG is welcomed in many quarters as it will require organisations to not only consider new IT infrastructure and operational procedures, but also change their mindset as to how confirmations are processed. Only with this new focus can organisations hope to reduce the number of paper trades through the use of electronic platforms, eliminate material backlogs and streamline the OTC lifecycle.

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