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Hedge funds still lack automated processing for OTC derivatives, says report

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Although top-tier sell-side broker dealers have invested millions of dollars since the mid-1990s developing automated processing for their burgeoning OTC derivatives businesses, many other

Although top-tier sell-side broker dealers have invested millions of dollars since the mid-1990s developing automated 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, according to a new report.

In a research note entitled OTC Derivatives Processing: Blazing a Trail to Automation, Tabb Group senior analyst Kevin McPartland says that the problem that has not gone unnoticed by the US Federal Reserve.

‘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,’ McPartland says.

‘As recent credit market turmoil has shown, simply adding staff to solve a problem is insufficient.’ During the three-month period from June to August 2007, he reports, the total number of backlogged confirmations jumped 250 per cent.

Although the technology exists for real-time monitoring, he says, ‘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, McPartland argues, 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, a new day has finally dawned,’ he says. ‘A process so critical and complicated, it is simply screaming out for automation.’

According to the report, 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, McPartland says, ‘but without the right solution, it can be the most complicated. In fact, one major investment bank estimated that nearly 90 per cent of its non-vanilla OTC derivative trades are still sent by fax.’

Tabb Group forecasts that USD70m will be spent on OTC derivatives processing automation software in 2008 and the amount will swell by a compound annual growth rate of 30 per cent over the next two years, bringing the overall market size to nearly USD120m by 2010.

In addition, McPartland says, with vendor installations to manage the post-trade capture process costing USD2m each in licensing fees, market size for the sell-side alone is approaching USD30m annually and as OTC derivative volumes increase, this will rise to more than USD45m.

While nearly 1,000 of the world’s hedge funds use OTC derivatives, only a fraction of them 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 USD40m annually by 2010, up from just USD20m last year.

The research note, based on interviews with bulge bracket broker-dealers, software providers and industry-wide utilities, outlines the steps required to process an OTC derivatives trade, potential solutions for each part of the problem, vendors serving the OTC derivatives processing area and views on where the market for these solutions is headed.

Founded in 2003 and based in New York and London, Tabb Group is a research and strategic advisory firm focused exclusively on capital market. It uses an interview-based research methodology developed by founder Larry Tabb to analyse and quantify the investing value chain linking the fiduciary, investment manager, broker, exchange and custodian.

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