The OTC derivative environment is burdened by volumes of paper, spreadsheets and phone calls associated with deal tickets, deal contracts, legal contracts and counterparty management. Growth in the derivative market has outpaced operational capacity and expertise. The nature of derivatives is a high degree of processing interdependency among market participants and continual development of new structures, as well as a dynamic life cycle subject to external events, such as defaults and trade transfers. The challenge for money managers and broker-dealers is to automate processing. Potentially, the next five years will be a new era of collaboration and technological creation, and an amazing race in which the finish line is a win for all.
The trading world is filled with interdependencies and short time frames with efforts geared to affirmations within a few days of trade execution. Money managers need to advise brokers of trade allocations before broker confirmations can be sent out. Lack of affirmation from a counterparty can create an opportunity for downstream delays in accurate payment. Further, hedge funds work with multiple prime brokers in order to protect confidentiality and mitigate risk. There are instances of relatively small firms with $100 million in assets under management using three prime brokers. The trading and operational challenges multiply.
It is estimated that up to 30 percent of OTC derivative trade confirmations contain an error(s) and require subsequent handling for rebooking or amendment. Most OTC derivative trading is conducted by phone or fax. The operational nightmare of backlogs, errors and staffing shortages are a reality for many firms. Industry market participants and regulators alike are concerned. The cumulative costs of errors and the potential trade exposures are too huge to ignore, particularly in light of the mainstreaming of the derivative market and the increase in cross-border trading. The global regulatory agencies more and more are coordinating their efforts to enhance not only local market stability but also global stability in the financial markets.
According to a previous Celent report on European post-trade processing, "The majority of respondents indicated that less than 50 percent of derivatives processing is automated. The lack of STP in derivatives was mainly attributed to the complexity of transactions and lack of standards. As a result, 35 percent of respondents cited derivatives as the No. 1 priority for STP projects as opposed to other instrument classes."
Buy Side Slow to Automate
What's clear to brokers -- and to many in the technology sector that service the brokers -- is that the buy side is not shifting to the automation paradigm as actively as is needed. Firms may delay because there are few multisecurity systems, there may be additional costs or they do not feel their volumes justify an additional technology implementation.
The buy-side purchaser of technology for derivatives processing is still a rare bird. A quick count of the leading providers in this space not affiliated with an execution platform show about 1,000 hedge funds and asset manager clients. Lack of adoption reflects the still relatively young technology. The buy-side community still is coping with front-office trade automation and other technology priorities, such as compliance, risk analytics and portfolio management systems for investment of derivatives.
The market likely is waiting for further advancements in the field, as well as its own derivative volume to increase in order to justify the expenditure. Many are simply relying on whichever processes and tools the broker-dealers provide. Looking to a broker-dealer to provide support and to adapt operational procedures based upon what is free in the market is common.
Unlike the broker-dealer community, which has greater technology and financial resources, most buy-side firms prefer to purchase technology that is multifunctional, product-neutral and designed to handle any security type. Many of the vendor solutions today are geared to a single type of security. Since the broker-dealer community is behind much of system development and firms typically operate in a silo structure, single-security systems are not as burdensome. Buy-side firms will postpone a shift to new technology if they believe the vendor market is in transition and are willing to make trade-offs even if the result is more manual labor. If existing systems provide some element of support, all the better -- and all the longer the postponement.
Growth and Lack of Standards
The derivative world is simultaneously coping with a growth boom and the need for standard protocols and procedures with agreement from a myriad of market participants. The key drivers to change are the broker-dealer community and organizations such as ISDA, DTCC Deriv/Serv and the regulatory agencies, as well as very large traditional asset managers and hedge funds. It is a collaborative effort that will take time but is launched on the heels of success in credit derivatives.
The general lack of broad buy-side adoption of third-party solutions to automate the post-trade/pre-settlement environment is partly a measure of progress of these leading figures. A quick count of the number of buy-side clients on leading applications not affiliated with an execution platform is about 1,000 firms -- not high, considering the thousands of money managers worldwide that might be dabbling in unlisted derivatives. DTCC Deriv/Serv, a key vendor in the trade confirmation service, has approximately 800 investment firms, and that figure has exploded from three years ago. Deriv/Serv has gained the greatest penetration in the credit market, although not universally across OTC derivatives.
So what is delaying broad adoption by the buy-side firms? Are they not as encumbered in the OTC derivative processing dilemma as the broker community?
Outside of active hedge funds with sophisticated strategies and traditional money managers of very large funds, the overall trade volume for the bulk of firms may be considered too small to warrant additional budget for these software applications. Firms are content to cope with manual processes on small trading volumes. Others just rely on free services, such as prime broker-provided Web portals. Given the size and interdependency in the markets, it might well be time for the buy side to make a greater contribution to industry problems.
In buying technology, most asset managers prefer to choose from a variety of competitive solutions that handle multiple products versus a single type of OTC derivative. Few are eager to be the first to sign up for a new solution. The buy side often adopts a wait-and-see approach to optimize expenditures on a clear leader or to allow enough time for the technology to evolve a generation. Buy-side firms also look at vendor reputation, and in a new technology sector such as post-trade/pre-settlement, where change still is occurring, it takes time to validate credentials.
However, vendor options will grow -- and soon. The sector is a long way off from commoditization, regulators are collaborating globally, and the brokerage community is determined to make the pain go away.
Mayiz Habbal is managing director of the Securities & Investments Group at Celent and is based in the firm's New York office. His areas of research focus on enterprise architectures and aligning business strategy with IT initiatives. He brings with him more than 15 years of experience in the management and development of software and engineering of IT strategies, predominantly in the investment banking industry. Before joining Celent, Habbal held positions with Oracle Siebel, Bank of America and Dresdner Kleinwort.