Without Greater Automation, the OTC Equity Derivatives Market Faces Increased Risk
Sponsored by DTCC, "Trends in OTC Equity Derivatives" is one of the first studies to analyze forces shaping the OTC equity derivatives market
Rapid growth in the global over-the-counter (OTC) equity derivatives market is being constrained by the absence of adequate infrastructure and automation, according to a newly released report by the Aite Group, an independent research and advisory firm focused on the impact of technology and regulation on the financial industry.
Called "Trends in OTC Equity Derivatives," the study was sponsored by DTCC and is one of the first to analyze forces shaping the OTC equity derivatives market and the challenges it faces in bringing greater efficiency to the marketplace.
The study reports that the extended length of time required to confirm OTC equity derivatives transactions is causing concerns among market participants and regulators in many countries, inhibiting market growth, increasing risk and increasing customer costs. Many of the delays, which can last for weeks and even months, stem largely from the complex legal documentation required to complete a transaction.
Operational Risk
Increased attention from regulators, such as the Federal Reserve Bank of New York and the U.K.’s Financial Services Authority (FSA), and the findings of this report, could bring greater focus among market participants to improve their operational practices. The current manually based, paper-intensive environment is fraught with excess operational risk for market participants, the Aite report notes. Other observations are that:
- About one trade in five is subject to some type of processing or trade capture error, based on figures provided by the International Swaps and Derivatives Association, Inc.;
- Because of these error rates, a large number of trades have to be rebooked. The need to rebook stems from improperly entered trades in a bank’s or client’s system. Re-booking becomes an issue since it means incorrect data have been entered into the trading, risk and accounting systems, and have yielded inaccurate risk and exposure profiles;
- As a conservative estimate, approx-imately US$400 billion in notional trade amounts initiated between June 2005 and June 2006 had some type of error or were rebooked.
Market growth
The global OTC equity derivatives market grew to $6.4 trillion in notional value outstanding as of June 2006, a 12-month increase of 32%, according to the International Swaps and Derivatives Association, Inc. These products are actively traded in Europe, the Americas and Asia, with a wide range of market participants and a myriad of products existing in the market.
"The primary barriers we observed to increasing automation in the marketplace are the complexities that arise between trading firms in the legal documentation of OTC equity derivatives transactions," said Brad Bailey, senior analyst, Aite Group. "Understanding these complexities and identifying ways to simplify the execution of Master Confirmation Agreements [MCAs] between market participants would be an important first step to ease the processing issues in these products."
Proper documentation
Currently, not all dealers have signed MCAs with one another. In order to get the proper documentation to their buy-side clients, dealers need to establish which products and regions are important to each client and have that documentation in place as a starting point. In many cases, large overwhelming packets of legal documentation spanning multiple regions and products are sent to clients.
The potential combinations of product and regional documentation present a very cumbersome array of possibilities. They quickly add up to a significant universe of documents from both a dealer’s and a buy-side client’s point of view. For instance, a typical, large buy-side firm with just five OTC equity derivative dealer relationships would be looking at about 80 possible combinations of product and regional legal documents.
A solution
The Aite Group study sees a solution probably evolving "around a unified set of documents that can be used across a wide range of geographical regions, products and clients."
"Because equity derivatives are a complex market, the documentation requires a great deal of attention," said Gina Ghent, DTCC vice president, Business Development. "DTCC is working closely with market participants to facilitate the signing of MCAs between them as a way to help bring these firms into our automated environment. We have the capability to automate the broad and dynamic range of equity derivatives products, but without accelerating the pace of MCA execution, market auto-mation will not occur as rapidly as it should."
DTCC provides automated processing for OTC equity, interest rates and credit derivatives through its Deriv/SERV matching and confirmation service. @
[The complete report by the Aite Group is available for download at the DTCC Website at www.dtcc.com under "Thought Leadership" and "Industry Perspectives." For more information on Deriv/SERV, go to the DTCC Website at http://derivserv.dtcc.com.]