OTC Derivatives Processing: Blazing a Trail to Automation

The importance of automation is growing as fast as the last decade's growth in OTC derivatives, and even the recent turbulence cannot slow the OTC market down.

Since 2002, the outstanding notional value of all OTC interest rate, currency, credit and equity derivatives has grown nearly 30 percent a year. Additionally, between 2006 and 2007 that growth rate rose to over 40 percent.

As of mid-2007 (the latest available data), there was over $400 trillion " with a T " of notional value in outstanding OTC derivative contracts. That is tens times more than the GDP of all the world's countries combined. And even in the midst of billion dollar write-downs, anecdotal evidence only points to continued leaps in trading volume.

In today's world where hundreds of millions of dollars are invested in non-standard products, human error can lead to huge losses and must be closely managed. With investors and the media more critical than ever of the magnified risk inherent in derivatives trading, every step must be taken to ensure efficient confirmation of these contracts through well-implemented technology and workflow processes.

Regardless of whether confirmations are stored on FAX paper or as an XML file, the creation management process is critical to efficiently confirming trades and reducing operational risk.

Just as the printing press allowed newspapers to print more with fewer errors, automation of the confirmation process will allow firms dealing in OTC derivatives to not only handle more volume but also do so with much less operational risk.

It is no longer acceptable for trades to go unconfirmed and escape risk management systems for weeks on end. Compliance and risk officers now keep a close eye to ensure that trades, and the models behind them, are tracked and managed closely.

Although the technology exists for real-time monitoring, many firms still rely on daily or weekly reports, as it is often difficult and expensive to implement more frequent tracking. This has forced the major dealers to weigh the cost of additional people and enhanced automation with the level of risk they are willing to carry. If the growth of a business knocks that scale off balance, something has to give.

Now is the time for dealers and consumers of OTC derivatives to stop putting the needs of the back office behind those of the front office. There is no question that the business is based on the quant and traders that create and execute the deals, however their creativity and sales prowess provides little value if the agreed upon transaction cannot be carried out.

Only through truly understanding your firm's distinct process and the technology available to improve it can efficiency through automation be achieved.

The "OTC Derivatives Processing: Blazing a Trail to Automation" report is based on conversations with bulge bracket broker-dealers, software providers and industry-wide utilities. Operations staff and technologists all presented unique views of the state of OTC derivatives processing and the solutions geared towards its automation.

The report outlines the steps required to process an OTC derivatives trade, potential solutions for each part of the problem and views on where the market for these solutions is headed.

Kevin McPartland is a senior research analyst, TABB Group, a New York- and London-based research and consulting firm focused solely on capital markets.