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The Buy Side Jumps on Board the Push to Automate OTC Derivatives

Now that traditional buy-side firms and hedge funds are increasingly investing in credit derivatives, the fastest-growing product in the OTC derivatives space, the industry is focusing on automating post-trade processes to reduce operational risk.

Why It's Important: As traditional asset managers make the transition from cash instruments to derivatives, many conduct the trades over the phone with a dealer and then manually rekey the deals into order management systems because of the lack of automation in the industry for processing derivatives trades. With regulators pressuring the sell side to clean up the backlog of unconfirmed trades, the onus to eliminate inefficiencies and adopt best practices also is shared by the buy side.

Where the Industry Is Now: Buy-side firms are being urged to confirm derivatives trades electronically through DTCC DerivSERV, the industry's electronic confirmation matching service. For traditionally more-standardized credit default swap (CDS) contracts, the market now is processing about 80 percent of the trades electronically via DerivSERV, up from 15 percent in 2004. At least 600 buy-side firms had connected to DerivSERV as of Q4 2006 - the service is being offered free of charge to the buy side. Buy-side firms are relying on their OMSs to tie in analytics and pricing services, or connect into DerivSERV, though they also can use a Web portal.

In addition to trading CDS indices, the two leading fixed-income ECNs, TradeWeb and MarketAxess, both offer different straight-through processing solutions for derivatives processing. TradeWeb's TradeXpress connects to DerivSERV on the back end, and TradeWeb recently integrated prime brokerage trades into the TradeXpress offering.

Focus in 2007: The DTCC launched the Trade Information Warehouse in November 2006 to serve as a central electronic trade repository for all confirmed CDS trades, and the industry will stress the adoption of DTCC's Trade Information Warehouse for credit derivatives. All eligible CDS trades that are confirmed through DerivSERV will be fed into the Warehouse, while dealers are backloading past trades. At the same time, the industry is shifting its focus to the automation of equity derivatives. The next step for equity derivatives is to develop a standardized confirmations template; once that is done, equity derivatives can be included in the Warehouse.

Industry Leaders: Buy-side firms such as Loomis Sayles, PIMCO and Fischer Francis Watts & Trees are major players in credit derivatives. They are expressing their operations perspective through the Asset Manager's Forum (AMF), which is the buy-side operations committee within the Securities Industry Financial Markets Association (SIFMA). SIFMA brings both the buy- and sell-side point of view to the table and has worked with the International Securities Association for Institutional Trade Communication (ISITC) on bringing custodians into the fold, and with the International Swaps and Derivatives Association (ISDA) to create standard documentation.

Technology Providers: Buy-side OMSs - including Charles River, INDATA and Latent Zero - are trying to add functionality for CDSs by connecting to third parties. Alliances are taking place between different OTC derivatives specialists, such as the deal between T-Zero, an agnostic trade messaging and trade affirmation service, and Bloomberg. Markit, a leading source of data valuations for credit derivatives, has teamed with several OMSs and T-Zero. Vendors, such as Thunderhead and Scritura, supply workflow and alerts for processing OTC derivatives.

Price Tag: Aite Group estimates that buy-side institutions in North America and Europe will spend approximately $200 million on technology to automate credit derivatives. Most of the spending is on OMSs and connectivity to the various tools for post-trade processing. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio

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