While cleared derivatives volumes are on the rise due to a combination of product selection and regulation, nearly two-thirds of institutional investors still use manual processes to confirm trades, and more than half do not match trades on a real-time basis, according to research by Greenwich Associates.
The report, commissioned by Omgeo, found that the race to meet regulatory deadlines for cleared derivatives trading caused some firms to bypass best practices in order to be ready on time.
“The U.S. has scrambled to get ready over the last few years, and in some cases that’s caused firms to put in as-best-as-we-can-do solutions to be ready in time for the deadlines, but not in all cases are those strategic solutions. So that’s what they need to focus on now,” says Kevin McPartland, head of the Greenwich Associates market structure and technology advisory service. “In Europe they’re still in that process, but they’ve got a few more years, and they’ve been at it as long as [the U.S.] has, so you would hope that the out-of-the-gate solutions will be closer to the strategic solutions.”
In addition to the manual processes, buy-side firms use an average of 12 execution brokers and 4 clearing brokers for swaps trades, creating additional workflows and operational risk. While complexities of swaps trades are growing, regulation could shrink trade sizes due to increased trading costs, the report says, pushing some firms into trading futures. As evidence of this trend, Greenwich notes that CME saw an 11% increase in volume in the fourth quarter of 2013.
“This is a story that’s barely starting to play out now,” says McPartland. “The clearing mandates in the U.S. last year really got the ball rolling for people to start to understand what clearing will cost. With Basel III still very much in the works and EMIR and such also still just getting going, there’s still a lot chips that need to fall for people to understand the cost/benefit in all cases, but it was that clearing implementation that got people to think a lot harder about what products they use for what situations.”
Still, the report notes that the overall trend seems to be toward more cleared derivatives in general, and the lines between futures, which are exchange-traded, and swaps, which are cleared OTC, should perhaps not be as distinct.
“While many of these cleared products will not be technically traded on an exchange, their characteristics are similar, if not identical [to exchange-traded derivatives]… Hence the term cleared derivatives [for both] is now much more accurate,” the report says. “Institutional investors should begin to think about processing both futures and cleared swaps through the same infrastructure. This will eliminate duplication of efforts and allow operations teams to take a portfolio view of derivatives exposure rather than one broken down by product legal designations. If implemented properly, this single industry standard solution should also provide the scale needed to handle expected increases in trade flows regardless of whether futures or swaps become the instrument of choice.”
The report also determined that buy-side firms globally spend an average of $800,000 a year on cleared derivatives processing, with 60% on human resources. In the U.S., the average is lower, with expected spend at $650,000 this year, but this is expected to rise 12% to $725,000 in three years. In Europe, however, spend is expected to be $950,000 this year and shoot up to $2.2 million in three years. Yet 80% of all participants said they have no plans to make new hires over the next few years, meaning this new spend is likely to go toward post-trade technology.
“In some ways we’re rebuilding a market from scratch,” says McPartland. “This is the chance. When something goes wrong, it’s your opportunity to make change, and that’s what we have here…These are complex products that will always require some level of human intervention, but you just want to make the shift from humans dealing with every trade to humans only dealing with the exceptions. Your technology should be good enough that you’re matching a very high percentage of what goes through, with people only having to step in when something goes wrong.”
Cleared Derivatives Processing Does Not Meet Best Practices, Says Report
While cleared derivatives volumes are on the rise due to a combination of product selection and regulation, nearly two-thirds of institutional investors still use manual processes to confirm trades, and more than half do not match trades on a real-time basis, according to research by Greenwich Associates.