Section 2 - FTSE

AUTOMATING OTC DERIVATIVES
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Henry Hunter, chief marketing office for SwapsWire in London, an
electronic processing platform for OTC derivatives, says the low level
of automation in interest rate swaps reflects a buy side that includes
a large number of participants who trade so infrequently they aren't
concerned about operational overload from manual confirmations.
Those trades still flow through the two dozen major dealers, however,
where they cause real headaches. Photograph supplied by
SwapsWire, October 2007.
two years. The volume of outstanding confirmations
shrivelled between September 2005 and December 2006,
but crept back up in the first half of 2007 as the market
expanded even faster than before. It’s a safe bet the third
quarter report will show backlogs ticked up over the
summer for both credit derivatives and other contracts.
T-Zero tackles the problem by trying to squelch errors up
front. It receives trade details directly from dealers’ trade
capture systems and transmits it to buy-side counterparties
for affirmation, then allocates the trade among the various
sub-accounts. In effect, counterparties have an obligation
to spot errors before dealers do any further processing. The
system shifts responsibility for allocations over to the buy
side, too. “It makes the middle office more accurate and
scalable,” says Beeston, “It also removes the source of
operational errors before errant trade data flows
downstream to cause them.”
Many market participants expected Depository Trust &
Clearing Corporation’s (DTCC) electronic matching and
documentation services to eliminate all their processing
problems. It hasn’t worked out that way in practice.
Although a huge improvement over manual confirmations,
DTCC’s services do not eradicate settlement risk because
matching still does not occur until one or more days after
the trade date. By the time an error shows up in the
documentation process, it may have already caused a
payment break and possibly a bad margin call as well as an
incorrect calculation of counterparty risk exposure.
Janet Wynn, general manager and managing director of DTCC
Deriv/SERV, says the firm's electronic platform and data warehouse
have already proved their worth. For example, when a troubled hedge
fund is taken over, the entire credit default swaps portfolio can be
assigned to an acquirer through DTCC's platform in just a few days.
In the past, a buyer had to print out and pore over thousands of pages
of documentation just to see what was in the portfolio and how to
handle the assignments, a process that could take several weeks.
Photograph kindly supplied by the DTCC, October 2007.
“Electronic matching addresses a symptom,”Beeston says,
“We address the disease, which is inaccurate trade data.”
It is a disease of epidemic proportions. According to the
International Swaps and Derivatives Association’s (ISDA’s)
2007 Operations Benchmarking Survey, 20% of credit default
swaps, 20% of equity derivatives and 18% of interest rate
derivatives executed by large dealers have to be rebooked.
The ISDA speculates that efforts to cut confirmation
backlogs may have inflated the numbers somewhat, but it
is a huge burden on the back office because every break
requires manual intervention.
The sheer complexity of OTC derivatives provides many
more opportunities for breaks to occur than in
conventional transactions. Cash market trades have just
three fields: price, security identification number and
volume. In addition to those, a derivatives trade has to
specify the precise legal counterparties, margins, collateral
arrangements and fees. Multimillion dollar novations can
be held up over differences as small as $50 because firms
use a different number of decimal points to convert fees the
traders express in basis points into a dollar amount the
back office must enter into DTCC’s system.
For cash instruments, fixing errors a day or two after
trade date inflicts a mark to market gain or loss but no
counterparty risk. In OTC derivatives, which are typically
more volatile than cash securities, participants have to
accept counterparty risk, too. John La Vecchia, director of
credit sales for Thomson TradeWeb LLC, says the failure of
NOVEMBER/DECEMBER 2007 • FTSE GLOBAL MARKETS