In a research note published today, “OTC Derivatives Processing: Blazing a Trail to Automation,” TABB Group says that although top-tier, sell-side broker dealers have invested millions of dollars since the mid-1990s developing best-of-breed 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 service, a problem that has not gone unnoticed by the 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. As recent credit market turmoil has shown, simply adding staff to solve a problem is insufficient,” says Kevin McPartland, senior analyst at TABB Group and author of the note.
He goes on to explain that during a three-month period, June to August 2007, the total number of backlogged confirmations jumped 250%.
“Many firms continue to rely on daily, even weekly, reports because its often difficult and expensive to implement more frequent tracking,” says McPartland. 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, the 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.
McPartland also explains that credit default, interest rate and equity swaps transactions not handled by electronic confirmation platforms, averaging about 1000 transactions per firm per month, continue to be handled through paper-based confirmations. In addition, almost all non-vanilla trades, averaging as many as 4000 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, “but without the right solution,” he says, “it can be the most complicated. In fact, one major investment bank estimated that nearly 90% of its non-vanilla OTC derivative trades are still sent by fax.”
TABB Group forecasts that the $70 million to be spent on OTC derivatives processing automation software in 2008 will experience a compound annual growth rate (CAGR) of 30% over the next two years, bringing the overall market size to nearly $120 million by 2010. In addition, with vendor installations to manage the post-trade capture process costing over two million dollars each in licensing fees, market size for the sell side alone, says McPartland, is approaching $30 million annually and as OTC derivative volumes increase, this will rise to over $45 million annually.
Unfortunately, while nearly 1,000 of the worlds hedge funds use OTC derivatives, only a fraction of those 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 $40 million annually by 2010, rising from only $20 million in 2007.
The research note is based on in-depth conversations with bulge bracket broker-dealers, software providers and industry-wide utilities. Operations staff and technologists presented views of the state of OTC derivatives processing and solutions geared toward automation.
The note 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 services is headed.