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New Report Says OTC Equity Derivatives Poses Risk Without Greater Automation
Aite Group - A Respected Industry Advisory Firm Weighs In
New York, October 26, 2006 - Rapid growth in the global over-the-counter (OTC) equity derivatives market is being constrained by absence of adequate infrastructure and automation, according to a report released today by the Aite Group, an independent research and advisory firm focused on the impact of technology and regulation on the financial industry.
The report, "Trends in OTC Equity Derivatives," says that the extended length of time required to confirm OTC equity derivatives transactions is causing concerns among market participants and regulators in many countries. Many of the delays, which can last for weeks and even months, largely stem from the very complex legal documentation required, according to the report.
The Aite Group study is one of the first to analyze trends shaping the OTC equity derivatives market and the challenges it faces in bringing greater efficiency to the market place.
High Error Rates
Increased attention from regulators such as the Federal Reserve Bank of NY and the 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 noted. 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 ISDA;
- 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. Rebooking is quite an issue, as it means incorrect data has been entered into trading, risk and accounting systems, and it has yielded inaccurate risk and exposure profiles;
- as a conservative estimate, approximately US$400 billion in notional trade amounts initiated between June 2005 and June 2006 had some type of error or was rebooked.
Complexities in Documentation
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 (ISDA®). 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 market place 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."
The Aite report states:
- Currently, not all the dealers have signed MCAs between them. 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 put in place as a starting point. In many cases, large packets of legal documentation, spanning multiple regions and products are sent to clients, overwhelming them.
- 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.
The current market environment for OTC equity derivatives begs a solution, notes the Aite Group. In the long-term, it sees such a solution probably evolving "around a unified set of documents that can be used across a wide range of geographical regions, products and clients."
The Depository Trust & Clearing Corporation (DTCC) sponsored the study by the Aite Group to try and identify underlying issues inhibiting market growth, causing risk and increasing customer costs.
Recently, DTCC hosted summits in New York and London to discuss challenges buy- and sell-side firms face in executing their MCAs and to facilitate the execution of MCAs between buy- and sell-side firms. In conjunction with these summits, DTCC has begun helping firms to identify the specific products for which MCAs are needed from their counterparties and relevant counterparty contacts. By acting as the conduit that connects these parties together, DTCC's aim is to help make the early stages of MCA execution more efficient.
"Because equity derivatives are a complex market, the documentation requires a great deal of attention," said Gina Ghent, vice president, business development, DTCC. "DTCC is working closely with market participants to facilitate the signing of MCAs between market participants 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 automation 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.
About the Aite Group
Aite Group is a leading independent research and advisory firm focused on business, technology and regulatory issues and their impact on the financial services industry. It was founded by leading industry experts in banking and securities & investments. Aite Group brings together a team of business strategy, technology and regulatory experts to deliver comprehensive, timely, and actionable advice to financial institutions and technology vendors.
It seeks to become a true partner, advisor, and catalyst by exchanging ideas and challenging basic assumptions to ensure that our clients always stay one step ahead of the competition.
Background on DTCC Deriv/SERV LLC:
DTCC's derivatives services are offered through DTCC Deriv/SERV LLC, a wholly owned subsidiary of DTCC. Deriv/SERV is a global service offering focused on automating the entire life cycle of OTC derivatives. The service line includes:
Affirmation: AffirmXpress™ is DTCC's first foray to bring automation into the front-office for OTC derivatives. It is a single-screen post-trade affirmation platform that lets traders and front-office staff affirm credit derivative trades from multiple IDBs. Initially, AffirmXpress will support credit derivatives, including single-name and index credit default swaps (CDS), and tranched index swaps. Future releases will include interest rate and equity derivatives products.
Matching and Confirmation: Deriv/SERV provides automated matching and confirmation for OTC derivatives contracts, including credit, equity and interest rate derivatives. According to major market participants, 80% of credit derivatives traded globally are electronically confirmed through Deriv/SERV, up from 15% in 2004.
Payments: Deriv/SERV provides payment matching and bilateral netting services, providing greater accuracy and straight-through processing. In 2005, more than 3.5 million payment transactions were processed through Deriv/SERV.
Trade Information Warehouse: The warehouse will comprise a comprehensive database containing the most up-to-date record of each contract, as well as a processing component that will standardize and automate "downstream" processing over a contract's life cycle. Beginning with credit derivatives, this global infrastructure solution, which is being developed in close collaboration with leading dealers and buy-side firms for launch later this year, will eventually accommodate interest rates, equities and other OTC derivatives.
About DTCC
The Depository Trust & Clearing Corporation (DTCC), through its subsidiaries, provides clearance, settlement and information services for equities, corporate and municipal bonds, government and mortgage-backed securities, money market instruments and over-the-counter derivatives. In addition, DTCC is a leading processor of mutual funds and insurance transactions, linking funds and carriers with their distribution networks. DTCC's depository provides custody and asset servicing for more than 2.5 million securities issues from the United States and 100 other countries and territories, valued at $31.2 trillion. Last year, DTCC settled more than $1.4 quadrillion in securities transactions. DTCC has operating facilities in multiple locations in the United States and overseas. For more information on DTCC, visit www.dtcc.com.
Note to Editor's: DTCC has underwritten several studies by independent research consultancies to broaden awareness on issues shaping market efficiency and risk management. Examples include the affect of corporate action events on share price and trading activity and the major issues affecting the growth of investment funds in Europe. The complete report by the Aite Group and other DTCC sponsored studies is available for download at the DTCC Web site at www.dtcc.com under "Thought Leadership" and "White Papers & Reports."
ISDA® is a trademark of The International Swaps and Derivatives Association.