Talking Point

The devil in derivatives processing

Wednesday 20 February 2008 00:00 London/ 19.00 (- 1 day) New York/ 08.00 Tokyo

Full-cycle exposure management is discussed by Frank Reiss, director and head of derivatives product management at Euroclear Bank

The OTC derivatives market continues its meteoric surge. Bank for International Settlements statistics show that notional amounts in all OTC derivatives classes grew a record 135% in the first half of 2007 compared to the second half of 2006, to leave some €354trn outstanding. However, the global OTC derivatives market is sitting on a timebomb caused by extremely low levels of processing automation.

It's amazing that an industry with triple-digit growth rates remains stuck in the dark ages when it comes to confirming deals between trading parties. The average number of outstanding confirmations doubled year-on-year from 2006 to 2007, according to Markit's key operational statistics, among the top 18 OTC dealers.

In addition to confirmation backlogs, the lack of processing automation is hitting operational performance. Tradebooking errors are common in up to 20% of all credit derivative transactions, and higher for some of the more exotic derivative types.

Today, firms wrestle with reams of unprocessed paper for OTC transactions, as well as grappling with reconciliation breaks, unsettled cashflows and problems with collateral and exposure management further downstream. Derivatives managers are desperate for ways out of this processing quagmire.

Controlled exposures
Solutions exist for firms to confirm OTC derivatives transactions and calculate portfolio exposures arising from their trading activity. For example, the Depository Trust & Clearing Corporation (DTCC) offers Deriv/SERV – an OTC derivatives confirmation matching service for credit derivatives, designed to streamline the confirmation of trades.

In the domain of interest rate and equity derivatives, SwapsWire provides an electronic network for trade-data capture. In Europe, organisations like ISDA, together with SWIFT, Euroclear Bank and the Collateral Framework Group, are co-ordinating their findings and furthering standardisation and automation.

Euroclear Bank has subsequently delivered a unique exposure-management solution called DerivManager. Launched at the end of 2007, it enables counterparties to accurately track all of their portfolio exposures arising from OTC derivatives trading.

Based on client-provided valuation data of their bilateral derivatives contracts, Euroclear Bank automatically standardises and compares the two data sets, and detects and reports any discrepancies in the mark-to-market values of these trades across entire portfolios. Subscribers get a precise overview of their aggregated exposures. They can also outsource the management of collateral covering exposures to an established triparty agent like Euroclear Bank to take advantage of a fully automated and secure STP environment.

By outsourcing the administrative tasks associated with bilateral collateral management, firms are effectively veering away from operational risk. AutoSelect, Euroclear Bank's automated collateral selection and substitution module, is designed to follow pre-determined collateral acceptance criteria. Concentration limitations, set bilaterally by both counterparties, are respected while extending collateral flexibility to almost any type of transaction requiring collateral movements.

Accurate pricing data is key to any third-party offering in order to mitigate exposure-reconciliation disputes and provide both trading parties with a realistic view of their risks and exposures to manage. Use of multiple data sources is vital. Equally important are frequently refreshed valuations of the collateral required to cover the exposures.

Full-cycle exposure management
With the cloud of the sub-prime crisis still lingering, firms are opening their eyes to the operational risks they face by operating in sub-optimal conditions. Granted, derivatives transaction processing follows a different set of rules and practices than fixed income and equities, but there is definitely room for better OTC derivatives processing to eliminate the risks intrinsically linked to manual intervention.

Euroclear Bank's DerivManager takes both counterparties to an OTC derivatives deal to a higher ground by matching the trades, reconciling portfolio discrepancies and ultimately collateralising the net underlying exposures with Euroclear Bank acting as a neutral triparty agent. There is a way out of the derivatives processing quagmire.

Attend CORE '08 to hear from senior representatives of leading buy-side and sell-side institutions as they discuss operational challenges, procedures and solutions in the credit derivatives market. For further details about the conference and the full agenda, please visit www.structuredcreditinvestor.com/core08/.

20/02/2008