Sell Side to Spend $70 Million on Derivatives Processing in ’08, Buy Side Far Less, Says TABB Group

In a research note published today, "OTC Derivatives Processing: Blazing a Trail to Automation," the TABB Group says that although top-tier, sell-side broker dealers have invested millions of dollars since the mid-1990s developing best-of-breed processing for their burgeoning OTC derivatives businesses, many other counterparties, including mid-tier banks, hedge funds and other trading firms, have yet to implement any kind of automated solution, a problem that has not gone unnoticed by the Federal Reserve.

According to Kevin McPartland, senior analyst at TABB Group and author of the note, "When the Fed first instructed major dealers in 2005 to catch up on unconfirmed trades, additional personnel provided most of the ammunition for shrinking the confirmations backlog. As recent credit market turmoil has shown, simply adding staff to solve a problem is insufficient." He goes on to explain that during a three-month period, June to August 2007, the total number of backlogged confirmations jumped 250%.

Although the technology exists for real-time monitoring, he points out, "many firms continue to rely on daily, even weekly, reports because it's often difficult and expensive to implement more frequent tracking." This forces the major dealers to weigh the cost of additional staffing and enhanced automation with the level of risk they are willing to carry. For years, the front office quants and traders always gained the attention of senior management, IT staffs and independent service providers for trading systems, high-speed data and algorithms that stole the spotlight and budget. "For OTC derivatives," McPartland says, "a new day has finally dawned. A process so critical and complicated, it is simply screaming out for automation."

McPartland also explains that credit default, interest rate and equity swaps transactions not handled by electronic confirmation platforms, averaging about 1,000 transactions per firm per month, continue to be handled through paper-based confirmations. In addition, almost all non-vanilla trades, averaging as many as 4,000 transactions per month for the largest firms, also use paper-based confirmations. Creating these confirmations is one of the most crucial steps in the trade lifecycle, "but without the right solution," he says, "it can be the most complicated. In fact, one major investment bank estimated that nearly 90% of its non-vanilla OTC derivative trades are still sent by fax."

TABB Group forecasts that the $70 million to be spent on OTC derivatives processing automation software in 2008 will experience a compound annual growth rate of 30% over the next two years, bringing the overall market size to nearly $120 million by 2010. In addition, with vendor installations to manage the post-trade capture process costing over two million dollars each in licensing fees, market size for the sell side alone, says McPartland, is approaching $30 million annually and as OTC derivative volumes increase, this will rise to over $45 million annually.

Unfortunately, while nearly 1,000 of the world's hedge funds use OTC derivatives, only a fraction of those have automated processing systems. Combining increased usage with existing users still in need of processing systems, TABB Group forecasts the market for software packages for hedge funds at nearly $40 million annually by 2010, rising from only $20 million in 2007.