OTC Derivatives: Substantially Reducing Risk Through Automation

OTC derivatives and the challenges they pose for financial services firms continue to garner attention from both inside and outside the industry. In March a Newsweek article titled "Surviving the Crunch" cautioned consumers against dabbling in the hype of derivatives and other "adventuresome" investment vehicles: "Definitely not as easy as it sounds," the magazine advised, "and best not tried at home." A month later an article in The Economist was headlined "Taming the Beast: It Is Time to Simplify Derivatives Trading—But Not to Stunt It." OTC derivatives could certainly benefit from some positive PR in the mainstream media, but what these so-called adventuresome investment products really need are the benefits of a new technology focus called customer communications management (CCM).

CCM enables organizations to automate the creation and delivery of highly customized communications, including contracts, policies, statements, and correspondence. The ability to manage contract negotiations and confirmations online in a secure and easy-to-use environment expedites complex OTC derivatives processes with granular-level risk management capabilities.

According to TABB Group, an independent financial markets research and strategic advisory firm, paper-based contract negotiations and confirmations still pose a threat to the OTC derivatives market some three years after the US Federal Reserve urged financial services firms to improve their processing and tracking practices. During a single three-month period alone, June to August 2007, the total number of backlogged confirmations jumped 250 percent. The backlog of trade confirmation documents—the legal records—has left the financial services sector exposed to unnecessary risk and poor client and shareholder transparency.

In the study Blazing a Trail to Automation: Confirmation Creation for OTC Derivatives, TABB Group reports that the outstanding notional value of all OTC interest rate, currency, credit, and equity derivatives has grown nearly 30 percent a year since 2002. As of mid-2007 more than $400 trillion of notional value existed in outstanding OTC derivatives contracts. Yet as the market continues to expand, the automation of processes such as contract negotiations and confirmations has not kept pace. Indeed, nearly 10 percent of the world's hedge funds use OTC derivatives as part of their strategies, but only a fraction of those have automated processing systems.

Master agreements, confirmations, and workflow processes for OTC transactions all present unique challenges to financial services firms. Negotiating a complicated master agreement, for example, requires frequent back-and-forth counterparty communication, most of which is still performed manually, leading to the significant backlogs. Each trade might have 100-plus data points to affirm with the counterparty before a custom confirmation document can be created. The creation of this document is at the heart of the OTC derivatives backlog, which has resulted in unnecessary risk and poor transparency.

Customer communication management solutions allow for the acceleration of online negotiation of trades, no matter how complex. In fact, the more complex, the more these automated solutions are needed.

CCM has the ability to provide contract creation, negotiation, approval, and execution workflow for all types of contracts and other negotiated agreements, including prime brokerage agreements, margin agreements, ISDA master agreements, and CSAs. It could include a real-time dashboard that tracks and sorts every outstanding agreement, enabling load balancing, tracking, and auditing. In addition, it can offer detailed search and advanced tools for comparing all existing agreements down to the granular content level, highlighting potential exposure and managing risk. Risk management capabilities are also included to quickly review key risk metrics, including NAV triggers, collateral events, withdrawal provisions, and other data points. The goal is to boost automation, reduce risk, and expedite complex OTC derivatives processes.

That's what a CCM solution brings to the OTC derivatives market.

TABB Group Senior Analyst Kevin McPartland, author of the study cited above, summarized the market in a manner most mainstream media audiences could easily grasp: "The market has made strides toward automating the confirmation and overall processing workflow. There are third-party products to help solve this problem, and the innovations in the past few years have been nothing short of amazing. Now it is up to market participants to acknowledge the need for automation—not only through press releases but also through action."

McPartland adds, "Both producers and consumers of OTC derivatives must invest time and money to create necessary systems and processes that are both smarter and straightforward, allowing the most obscure instruments to be handled without human intervention. New product creation and smart trading decisions may drive profits, but unless treated with the utmost care and respect, the overall confirmation process can act as a mugger on payday. Let's not just work harder, but smarter."

Here's to working smarter.