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Reducing Operational Errors With OTC Derivatives

May 4, 2011
By Chris Kentouris

Regulators may be well-intentioned in trying to help financial firms mitigate risk in the $700 trillion over-the-counter derivatives market. But new legislation is causing fund managers plenty of operational angst – and money.

Greater oversight of the OTC derivatives market by the Securities and Exchange Commission and Commodity Futures Trading Commission will require an upgrading of front, middle and back offices for managers to exchange data between different trading counterparties, clearinghouses and trade repositories.

To prevent a repeat of the September 2008 crisis when the sundering of the OTC derivatives market helped tank the global economy, Congress decided to require standardized over-the-counter derivatives such as interest rate and credit default swaps to be traded on exchanges or “swap execution facilities.” Transactions are to be cleared through centralized clearinghouses and reported to a trade repository.

Just how prepared are fund managers? “They span the gamut from completely paper-based to completely automated and everything in between,” says Mitch Schulman, president of Integridata, a New York-based financial technology consultancy specializing in investment firms.

But automation doesn’t necessarily translate into efficiency. Some fund managers have either adapted – or tried to rejigger -- systems specializing in processing of equities and fixed-income transactions to take care of over-the-counter derivatives. Yet others have developed a hodgepodge of disparate systems which don’t communicate with each other. “Even the most technologically advanced fund managers often have to mix in manual processing,” says Schulman.

Regulatory requirements aside, improving infrastructure and procedures can only boost performance; better and faster investment decisions can be made and fund managers can trade far more lucrative OTC contracts while maintaining effective risk management. That’s good news for pension plans, mutual funds and other investment funds wanting the reassurance that fund managers can maximize their investment performance safely.

But fund managers will need to start spending on electronic confirmation services, collateral management, valuation and data management software, according to fund management experts. That is because the exchange of data must be handled by machines, in an uninterrupted string of transactions. Fund managers could easily add to their operational risk should they continue to rely on emails and paper-based communications.

How much will this cost? None of the dozen asset managers questioned by Securities Technology Monitor would say. New York research firm Tabb Group has predicted that the top 15 OTC derivatives dealers would spend about $675 million in technology alone in 2010 and 2011 to respond to Dodd-Frank financial reform legislation.

That doesn’t even include the cost of documenting procedures and training operations staff. “Throwing money into technology alone won’t cut it, if there aren’t enough middle and back-office employees to understand how OTC derivatives processing works and what potential errors to look for,” says one operations executive at a New York fund management firm.

Too many fund managers are relying on “generalist” operations executives who may be expert in equities and fixed-income securities but have little experience in OTC derivatives, such as interest rate and credit swaps. Few, except for the largest, have dedicated OTC derivatives experts.

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