The path to derivatives automation

Front office trading strategies increasingly constrained by the back office’s ability to process OTC derivatives and other structured products.SmartStream and two leading derivatives consultants discuss the path togreater automation and the barriers that stand in the way.

With the raised profile of risk with regards tostructured products, has this had a significantimpact on the industry’s awareness of the need for automation?Steve Miller | I think it has sharpened the focus incertain areas, but the inherent problems in post-trade processing of OTCs have been well-known forsome time. As ever, the key question is the degreeof latency and inertia in the industry. How long canfirms put off spending money on the problem? Theflipside of this is opportunity cost, particularly in the‘traditional’ buy-side community, who are losingground compared to the more agile new boys on theblock amongst the hedge funds and others.

Grant Cooper | It has certainly highlighted the needfor robust control and processing architecture -independent from the front office.

Has it changed the way in which the industryfundamentally looks at these aspects? No I don’tthink so. Regulation hasn’t changed dramatically so banks/ asset managers will continue to take the path of least resistance.

Are organisations doing enough to monitor theirrisk exposures in the middle and back office? Sean Sprackling | No. All too often financialorganisations focus on the calculation ofinvestment risk to the detriment of operational risk exposures. Industry participants now realisethat operational efficiency and other risk mitigating factors such as collateral managementare as important a focus as daily VaR calculationsand stress testing.

Steve Miller | No they are not, primarily becausemost of them don’t know what their exposures are.This is one of the fundamental issues. Trades can be novated and the exposure shift silently from one counterparty to another.

Grant Cooper | Banks and fund managers arefundamentally in very different positions withregards how they monitor exposures and risk. Interms of where these things should be monitored,the middle office is the wrong place. They are stillworking for the front office and so are always subjectto a certain amount of sway from traders.

Grant CooperPartner

Capital Black

Sean SpracklingPartner, Investment

Solutions Consultants LLP

Steve MillerSenior Product Manager

SmartStream

ROUNDTABLE DISCUSSION

Where do the weakest links lie in?Sean Sprackling | The weakest links in gaining anenterprise-wide view of a firm’s risk profile are,firstly ensuring that each derivative is independentlypriced in a timely and accurate fashion. Secondlyit’s being able to incorporate that valuation in aform that is useful to management. Often this maymean presenting data at a number of levels –individual positions, trading strategy, portfolio andenterprise-wide.

Steve Miller | Lack of adoption of the marketinfrastructures and standards that do exist,integration between these infrastructures, andincomplete asset class coverage amongst thevarious utilities.

Grant Cooper | The weakest link is the lack ofintegrated architecture, or at least architecture that can understand the whole suite of products. Sothere’s a lot of duplication of work in getting bothfront and back office systems (if one exists) in synch. The operations teams who manage theprocess are also both under-skilled in theseproducts, leaving more scope for errors.

Is the buy-side significantly behind the sell-sidein terms of coping with the processing ofcomplex and structured products? Sean Sprackling | The buy-side was clearly slower to adopt the industry matching utilities, the likes of DTCC Deriv\SERV and Markit Wire. It is howevera myth to think that the sell-side has it all sown upas the spike in outstanding confirmations lastsummer proved. The buy-side has just started itsjourney down the road of full automation. Somehave already started, some are just beginning, butfew are within reach of the end of the line yet.

Steve Miller | Yes they are. Sell-side firms havehistorically made much wider use of derivativeinstruments for their own-account trading activitiesand hedging against market (interest rate, currency)risk. That said, it usually means that they haveploughed large amounts of their own money intobuilding bespoke, in-house solutions that are oftennot flexible or future-proofed enough to cope withthe diversity of demands now placed on them.

Grant Cooper | If I was to put a number on it, I’dsay the buy-side is currently anywhere between five and nine years behind the sell side, in the waythat it processes derivatives

What needs to change to put STP higher up the priority list?Sean Sprackling | Finding experienced resources ispart of the problem. Buy-side firms cannot just shipin people from the sell-side as their knowledge isoften focussed on only one asset class, and thebuy-side needs resources with wider knowledgethan that. There also needs to be a culture changeat all levels regarding the way that operatingderivatives is thought of. People are howeverstarting to realise that having a fully automatedoperating model for derivatives is not just a tweakto incumbent systems and processes, it requiressignificant thought and planning to achieve.

Steve Miller | It’s a question of what pain pointsand opportunity cost are highest in any oneorganisation’s priority list. Resourcing is an issue forthe buy-side because they typically do not have alarge pool of experience to draw from in dealingwith complex structured products.

Grant Cooper | Resources is an indirect part. Thereis a larger part, which is a lack of understanding bymanagement of the issues, solutions and STPpossibilities. As a result, STP doesn’t figure highlyon the to do list. However, STP rates are becoming aprecursor to gaining new business it is gaining

The buy-side has just started its journey down the road of full automation. Some have

already started, some are just beginning, but few are within reach of the end of the line yet

greater management attention. Higher rates meannew products can be handled more easily and henceclients are willing to invest if a firm is viewed as ableto provide better product coverage and flexibility.

How are the various industry associationshelping in the drive for standards? Sean Sprackling | There are a large number ofindustry associations looking at this problem at themoment. Corrigan’s CRMPG III report, ISDA, SIFMAand the Operations Management Group, IOSCO andso on. The danger here is of course that the industryas a whole needs a joined up approach to tacklingthe issues and this may get lost in the raft ofinitiatives taking place.

Grant Cooper | Industry associations are helping,but at the moment since the percentage of thevolume in derivatives is centred on the sell-side, the involvement is biased to their needs. This willchange, but it is a slow process and so the buy-sidereally has to take stock and realise that in thismarket they won’t be able to get everything theirown way. However with some lateral thinking and a little compromise, a valuable solution can befound. The buy-side just need guidance in reachingthis conclusion.

Steve Miller | ISDA is driving the standardisationprocess in the world of FpML, and crucially, movingaway from defining message content alone towardsthe higher-level business process definitions andorchestration of the various interactions necessarythroughout the lifecycle. There are obviously technicalbarriers to adoption in that FpML and businessprocess management technology are sophisticatedcomponents of a firm’s infrastructure that not allplayers in all markets are yet geared up to exploit.

What are the main drivers for increased STP in the area of derivatives processing? Sean Sprackling | The main drivers for a changeafter any burst bubble, in this example a credit bubble,tend to be regulatory. The only difference here is thatthis crisis has been so severe that many investmentmanagers are not waiting for the regulatory responseand have started their own initiatives.

Steve Miller | To a degree there are regulatorypressures, but the most compelling driver of all iscompetitive pressure. On the buy-side, firms arelosing ground where they cannot move quickly into new markets and asset classes.

What are the main barriers to STP in thederivatives area for buy side firms?Sean Sprackling | Budgets in a falling market and astill nascent view of what best practice looks like.

Grant Cooper | It’s cultural too as they’ve never hadto scrutinise and control a process as closely as thisbefore. Then there’s the fear of change because thebuy-side are not used to the cycle of change in thesame way as the sell-side. This means solutionstend to be significantly more conservative addingmanual ‘checks’, which in real terms add no valueand just remove any benefits that technology can provide.

Steve Miller | There are two huge operationalbarriers: the continual use of faxes and firms having spreadsheets all over the place.

About SmartStream TechnologiesSmartStream Technologies delivers operationaladvantage to clients through enterprise-wide,real-time Transaction Lifecycle Management(TLM®) solutions that automate, track andcontrol financial transactions and processeswithin and beyond the enterprise.

Built on SmartStream’s TLM Enterprise ControlArchitecture, TLM solutions provide greatertransaction visibility to create exceptions-based operations capable of automatingcomplex and high volume transaction flows.Operational risk and cost is reduced, whilecustomer service levels are improved.

SmartStream is owned by Dubai InternationalFinancial Centre (DIFC) and has global operationssupporting over 1,000 clients, including morethan 75 of the world’s top 100 banks.

For more information please visit:www.smartstream-stp.com

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Have firms merely been bolting on additionalfunctionality to allow their equities systems tocope with other products?Sean Sprackling | Yes, historically many firms havetried to shoehorn derivatives into their existing,equity-based systems. This is slowly being replacedby a realisation that selling products that requiresignificant derivatives volumes requires a best-of-breed approach.

Grant Cooper | Yes they have and its not they wayto do it. Traditional equities systems are completelythe wrong toolset to drive a strategic solution for derivatives.

Are firms taking a long-term view or is it a caseof trying to manage/overcome current issues?Steve Miller | Systems, and on a larger perspectivemiddle- and back-office processing, have alwaysbeen secondary to the immediate need to drive thebottom line. The front office will always attract thelion’s share of investment, and in the middle andback office it will always be a case of plugging thegaps for least cost as opposed to grand strategicvision. However, in the current climate that view is starting to change.

Sean Sprackling | It depends entirely on the firm inquestion. I have worked with several who have putin longer term and more wide ranging plans – butthere are still many who are fire fighting issues.

Grant Cooper | The problem most asset managershave is that they struggle to comprehend thecurrent processing nuances of derivative productsand so the future products are just too exotic to contemplate.

It comes back to outlook; where a bank would look at the next 10 years of products, an assetmanager struggles to get past 18 months ofproduct development.