OTC Derivatives
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Outsourcing Taking Hold in Derivatives Processing
October 6, 2008
As the asset management and brokerage communities place increasing emphasis on over-the-counter derivatives, their middle and back offices are struggling with the demands. Many are turning to outsourcing for help with the complex administrative needs.
Recent events have highlighted the need for automation. "Counterparty risk has existed in the OTC market from day one, long before the credit crunch took place," says Colm Gaughran, global product head of JP Morgan Chase & Co.'s Derivatives Collateral Management (DCM) service. "However, market turmoil and regulatory intervention have increased the focus on the risks, and created an impetus for change."
The European Union's Undertaking for Collective Investments in Transferable Securities directive and the move toward liability-driven investment strategies have spurred many long-only asset managers to invest in sophisticated derivative products. Fund managers say they have anywhere from several hundred to several thousand open positions daily. That figure is exponentially higher for bulge-bracket brokerages, which account for the largest portion of the OTC derivatives market.
"The need to continually reconcile positions and value and monitor collateral--over several years or even decades--makes life-cycle management of over-the-counter derivatives far more difficult than vanilla equity or fixed-income products," says William Gates, SVP of marketing at London-based SmartStream Technologies, which recently adapted its trade monitoring platform to accommodate OTC derivatives.
Vendors including Calypso Technology, Fiserv subsidiary CheckFree Corp., Message Automation, Misys and Murex have also developed systems to fill the middle- and back-office gaps in the OTC market. Depository Trust & Clearing Corp. (DTCC) and Markit Group in July formed a joint venture encompassing their affirmation, confirmation, trade management and settlement services. But for many buy- and sell-side firms, Excel spreadsheets are still the norm.
Setting up the necessary automation infrastructure can cost a firm tens of millions of dollars. David Young, consultant at Morse, notes that "the use of derivatives is not increasing as quickly as one would expect--and as investment managers would desire--because of the operational limitations of managing and processing them."
One-Stop Shop
Many firms choose to outsource their reconciliation and collateral management processes, or even the full gamut of front- to back-office functions, to global custodians like JP Morgan, State Street Corp. and Northern Trust Corp. or specialist providers such as GlobeOp Financial Services and Citadel Solutions. "Outsourcing to a one-stop shop may appear to be an obvious solution but there is no custodian supplier that has the capability to offer this," says Young.
London-based Morse will soon issue a study of the OTC processing habits of 62 investment managers. About half of those interviewed said they do not believe a single outsourcing solution can meet all their needs.
Custodian banks say they can integrate margin and collateral processes directly into their clearing and custody platforms, but they typically don't handle the full range of OTC derivatives. And many who tout a seamless operating system are actually cobbling together multiple platforms, depending on the type of derivative instrument.
"One of the biggest challenges faced by fund managers when using banks is that they are interfacing with multiple trade booking, collateral and margin systems which do not have a common data standard or definition," says John Buckley, president of Chicago-based Citadel Solutions. "That ultimately results in different outputs from disparate systems within the same service provider, which contributes to incremental operational risk."
