Thu, 11/09/2008 - 07:00
While trade capture and confirmations/affirmations still constitute over 50% of OTC post-trade processing costs, the buy side desires technology which addresses the post-confirmation process in order to reach the next level of efficiency.
In a new report 'OTC Derivatives Operations: The Path to STP', the Boston-based strategic research firm Celent, in research sponsored by SmartStream, set off to understand the drivers of industry automation for OTC derivatives and examine the relative costs for different parts of the OTC derivatives operations processing chain.
Celent conducted more than 20 in-depth, one-on-one interviews with knowledgeable executives over the course of two months and forged a strategic assessment of the overall cost structure of OTC derivatives operations. The overall results allowed for the identification of the fundamental building blocks of a true multi-asset STP solution for OTC derivatives.
The report's findings conclude that while trade capture and confirmations/affirmations still constitute over 50% of OTC post-trade processing costs, the buy side desires technology which addresses the post-confirmation process (the other half) in order to reach the next level of efficiency. To accomplish this feat, a wave of new and improved technology solutions must provide the appropriate architecture and components for a true path to STP.
"Beyond the boundaries of the enterprise, the buy side is in favor of centralization and user communities for STP," says David Easthope, senior analyst with Celent's Capital Markets group and co-author of the report.
"Within the boundaries of the enterprise, the buy side is focused on flexible systems which can accommodate or plug in with existing systems and offer workflow and trade lifecycle monitoring. While some market participants may wish for an end-to-end solution, the immediate need is for point solutions which can fit the existing architecture of the enterprise and expand or adapt over time," he adds.
Celent identifies the fundamental building blocks of an STP solution for OTC derivatives as the following combined components: Dynamic Trade Modeling, Reference Data, Confirmation/Affirmations, Pricing and Valuation, Reconciliation Engines and Utilities, and Collateral Management.
"We believe the role of event-driven architecture is what will bring all of these components together into a single framework," says Mayiz Habbal, head of Celent's Capital Markets group and co-author of the report.
Key findings of the report include:
• OTC derivatives trades have witnessed explosive growth over the last five years. The number of events related to OTC derivatives trades (new trades, confirmable amendments, partial and full terminations, increases/decreases, and novations) are on the rise for all instruments. This trend is expected to continue, with more growth expected in exotic OTC derivatives. This growth is driven by the fact that as vanilla OTC derivatives are now mostly commoditized, their margins are dropping, and enterprises in the OTC derivatives marketplace are constantly looking for new instruments to increase their revenues and gains.
• Despite the recent growth of exotic OTC derivatives instruments, they all follow a similar pattern: the terms of the trade are negotiated, captured, and transmitted to the operations center. Each side then affirms the details of the trade are correct, via phone or electronically. Following the affirmation, confirmations are created from a template, the proper entries are entered, either automatically or through a manual data entry into risk and booking systems, and the final product is delivered in the form of settlement with the counterparty.
• The processing steps that the post-trade process consists of can be classified into three functional groups: front office (trade negotiation, execution, and capture), middle office (confirmation/affirmation, risk management), and back office (pricing and valuation, settlement, collateral management, and accounting). The majority of costs are concentrated in the front office (over 60% for all instruments), as compared to less than 10% in the back office. An Oliver Wyman study from June of 2007 showed that in the UK alone, the annual OTC derivatives processing costs range between US$2.1 and US$2.3 billion. Of these numbers, an estimated US$346 to US$574 million are back office costs, which indicates that around 15-25% of the processing costs are in the back office.
• Beyond the boundaries of the enterprise, the buy side is in favor of centralization and user communities for STP. Within the boundaries of the enterprise, the buy side is focused on flexible systems which can accommodate or "plug in" with existing systems and offer workflow and trade lifecycle monitoring. Moreover, scalability to handle spikes in volumes as well as the skill to handle new complex OTC instruments are paramount concerns. While some market participants may wish for an "end-to-end" solution, the immediate need is for point solutions which can fit the existing architecture of the enterprise and expand/adapt over time.
• The nature of OTC derivatives operations do not resemble cash markets and a perception shift toward the processing of "events" rather than trades is required. Celent believes the role of an underlying event-driven architecture is what will bring crucial processing components together into a single framework. Unfortunately, there are currently no end-to-end solutions which offer the following components combined: dynamic trade modeling, reference data, confirmation/affirmations, pricing and valuation, reconciliation engine and utilities, and collateral management.
• The main issues that propelled OTC derivatives to the forefront of regulatory and governmental interest are the losses that have been incurred by the buy side over the last decade and the obvious difficulties among the buy side in mastering the economic terms of these contracts and the underlying risk that is inherent in trading them. The fact that OTC derivatives operations are the biggest challenge middle and back office executives are facing is not news. The news is that what was once a manageable problem can no longer be characterized as such.
Celent's view is that successful trade lifecycle platforms will be able to model OTC derivatives trades as a two-phase operation: an initial negotiation by the counterparties of an OTC derivative contract in order to agree on the terms of the trade, followed by periodic unilateral or bilateral series of cash flows according to the terms and conditions of the contract. However, several challenges arise in modeling OTC derivatives trades: exotic derivatives proliferation, multiple data formats, lack of consistency, and manual processing.
Celent believes that any successful standard for OTC derivatives post-trade processes will be based on XML. The attractiveness of XML is that it enables enterprises to represent business data in a self-descriptive format and has the potential to address two of the most important failings of standards-that they are either overengineered and inflexible, or too flexible to constitute a standard. XML is highly flexible since it is extensible, so market participants can define fields in any way that meets their needs. In addition, XML is rigid, since once specifications have been agreed, messages can only be sent if formatted precisely. Challenges facing using reference data for OTC derivatives include: lack of standards, barriers to standardization, standardization shortcomings, data definition and integration difficulties, trade capture systems errors, and XML data management.
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