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Special Report - Derivatives processing

Delivering lifecycle
automation
The front office may be “chomping” at the bit
to trade ever more complex derivatives, but as
Mark Taylor, business development director,
Asia Pacific, SmartStream argues, the middle
and back office are struggling to catch up.

There has been no end of debate,
particularly on the buy side, as to
how firms can efficiently process OTC
derivatives. The processing challenge
for the buy side is similar to that
faced by the investment banks,
complicated by new instrument
innovation and rising volumes.
Manual and semi-automated processes
that could just about cope five years
ago are woefully inadequate today,
both in their ability to scale to meet
the volume demands of flow or
‘vanilla’ products, and to process
increasingly complex, highly
structured instruments.
Manual processing is unreliable and
error prone; it can become extremely
complex and introduces risk to the
point where regulators have felt
compelled to intervene. We can see
the effect of increased operational risk
at firms that choose to withhold
capital (assets allocated to OTC
derivatives portfolios) until sufficient
process automation is in place. Once
controls are established, they are able
to release more assets to OTC
derivatives positions. Crucially,
reliance on manual processing is also
much more expensive, which impacts
directly on profitability. Where firms
limit assets allocated to derivatives
trading until operational controls are
in place, presumably these limits,
while prudent, constrain performance
and the ability to generate alpha. This
is a real opportunity cost. While
hiring more staff may overcome some
immediate issues, automation is
needed to ensure adequate systems
and controls are in place to deliver a
true picture of asset values, positions,
liabilities and funding requirements.
To date automation initiatives have
tended to focus on how the buy- and
sell-side work within a trade. Utilities
such as the DTCC’s Deriv/SERV and
MarkitWire have created
infrastructures to improve
confirmations, payment reconciliations
and other post-trading functions.
However, this has only made a small
impact, as highlighted by the rising
number of outstanding confirmations
firms faced during the early stages of
the credit crunch. As the front office
is chomping at the bit to trade these
new instruments, organisations cannot
process them because the middle and
back office are struggling to cope.
The reams of paper being generated
by contracts and the 35% year-on-year
growth in volumes are creating
processing bottlenecks that carry
significant operational and
reputational risk. When new
derivative types, using multiple
underlying instruments and rolling
settlement dates, are added into the
mix of outdated systems and rising
volumes, the case for greater
automation is clear.
The automation challenge
Automation of elements of the
transaction are possible today and are
increasing all the time as firms and
vendors gain a clearer view of the
exact requirements for an efficient

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processing environment. STP has lost
some of its meaning and force, but its
underlying objectives - reducing
manual intervention to deliver lower
operational risk and cost - are as
relevant in today’s market as ever.
Research by Celent, commissioned by
SmartStream, argues that OTC
derivatives operations should be
examined in terms of three principal
objectives of automation – process
acceleration, error reduction and
processing capacity.
Celent found that confirmations and
affirmations still constitute more than
50% of OTC post-trade processing
costs, clearly an area that both the
industry bodies and firms should
concentrate automation efforts on.
Moreover, they found that buy-side
firms are intent on investing in
technology to address post-
confirmation process – the other 50%
- in order to reach the next level of
efficiencies. Here is where firms see
the big automation benefit. “Within
the boundaries of the enterprise, buy-
side firms are focused on flexible
systems, which can accommodate or
‘plug in’ with existing systems and
offer workflow and trade lifecycle
monitoring ….” says Celent.
The Celent research also revealed
that buy-side firms are looking to
invest in improved technology
solutions, which provide the
appropriate architecture and
components for a true path to STP.
The critical areas for consideration
when looking to deliver greater
automation are:
19:16 Page 5
Special Report - Derivatives processing
The reams of paper being
generated by contracts and
the 35% year-on-year
growth in volumes are
creating processing
bottlenecks that carry
significant operational and
reputational risk.
Mark Taylor
SmartStream
● Risk management: Reconciliation
breaks can be key issues for risk
management in determining daily risk
exposure. This increases the
processing time.
● Mismatches: breaks and subsequent
investigation of root causes takes up
significant time for finance and
operations teams, increasing
processing costs.
● Cash management: A lack of
payment netting can degrade cash
management, increasing processing
errors.
Scalability to handle volume spikes
during volatile markets and the ability
to handle new complex OTC products
are paramount concerns. It is here
that lessons from the past – buying
point solutions on a business line or
geographical basis – have been learnt.
While firms may desire a single end-
to-end solution, the immediate need
is for software to alleviate the most
pressing areas for concern, such as
confirmations, that fits the existing
architecture and can adapt over time.
Achieving automation today
As volumes grow, hard-coded and
proprietary systems struggle to
provide the control and visibility that
firms need to process transactions
efficiently. While systems have
delivered a high throughput of trades,
pure volume capability is only a small
element of the transaction process.
Without intelligent business rules,
they create large volumes of
exceptions that overwhelm even the
largest back office teams. There is
also a perception that each derivative
contract differs to such a degree that
it is difficult to define normal practice.
While they are certainly more
complex than many other instrument
types, every contract contains
common elements that offer
opportunities for standardisation and
automation. Trade affirmation, trade
allocations, reconciliation and
renovations are all areas where
proven software exists.
The “complexity” issue
OTC derivatives add complexity due to
the unique nature of their lifecycle that
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Special Report - Derivatives processing
requires ongoing monitoring, such as
periodic or regular payments that must
be calculated to take into account rates
resetting. There is an issue, particularly
in credit derivatives, where deals are
renovated. We have seen plenty of
buy-side firms struggling to manage the
novation process with a combination of
paper-based files and Excel spread-
sheets that led to failed settlements.
Due to a lack of automation they could
not identify their counterparty and
back-office teams spent time and effort
tracking down a specific instrument
after multiple novations had occurred.
While the complexity does represent a
challenge, there are core processes that
can be automated to deliver more
proactive event management.
Portfolio reconciliation
Any technology deployed must offer
an agnostic approach to data feeds
and instruments. With the market
developing at such a rate, the ability
to take in new feeds and match on a
sufficient number of fields is critical.
It should also support workflow
through exceptions-based reporting
and deliver operational dashboards
for a clear overview of positions and
outstanding items. Portfolio reconcilia-
tions can enable firms to track day-to-
day activity with their counterparties
and prime brokers, and ensure its
records match those of the executing
broker and the prime broker.
Automating these three-way reconcilia-
tions delivers greater levels of control
and drastically reduces risk by doing
away with trade status tracking on
Excel. Reacting to exceptions as they
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Utilities such as the DTCC’s
Deriv/SERV and MarkitWire
have created infrastructures
to improve confirmations,
payment reconciliations and
other post-trading
functions. However, this
has only made a small
impact.
occur is the first step to proactive
transaction management. This requires
alerting people to an issue that may
occur and escalating it for resolution
before it becomes an exception.
Novations automation can support and
track the entire counterparty process,
providing access to transfer history,
recording changes and monitoring the
process.
Increasingly some of the bigger asset
managers are viewing OTC derivatives
as a larger reconciliation that covers all
asset classes, positions, trades,
corporate actions and cash
management, rather than a standalone
requirement. These actions can be
structured as an event-driven workflow
which models a trade from its
initiation until it reaches maturity. This
approach automatically detects events
and evaluates their impact on all
aspects of the firms' trading position,
at both a transaction and at an
aggregate level. The result; continual
monitoring and early detection of
potential errors that could lead to
failed trades. By automating all of
these areas through a single system,
firms can reconcile multiple times,
manage novations and monitor
margins for each element while
retaining an overall view of the
contract as it moves through the
transaction lifecycle.
Transaction lifecycle
Automation and the drive towards
greater STP for confirmation and
settlement of certain derivative
instruments are becoming mandatory.
This will only increase as the buy side
uses market infrastructures such as
DTCC Deriv/SERV, MarkitWire, SWIFT
and T-Zero, who have created a
number of services using FpML as the
standard for communicating trade data.
While these services have come a long
way already, firms need to leverage
their capabilities and facilitate their
integration and interoperability with
software solutions for OTC derivatives’
post-trade processes. For example, the
large volumes experienced by the most
sophisticated buy-side firms and the
increase in non-listed derivatives
business by both the boutique hedge
fund operations and larger asset
managers still requires manual
intervention. With the ongoing work of
all market participants, greater
automation is achievable across the
OTC derivatives transaction lifecycle for
the more ‘vanilla’ products. These
projects will then provide a blueprint
for increasing STP rates for the more
exotic products, delivered through an
event-driven, rules-based workflow
solution. //