The backlog of unconfirmed derivatives trades has grown at an alarming rate over the past few years. During this same period, these financial instruments have also witnessed an increase in the volume of failed trades. Current trading volumes are outstripping the business process designed to support them. With derivatives straight-through processing (STP) still a distant goal, much talent is being squandered on the manual processing and confirmation of these trades, a problem that is draining the profitability of these highly lucrative financial instruments, as well as increasing operational risk for the institutions that trade in these products.
These issues are of growing concern for banks. But recently they have also piqued the interest of regulatory agencies such as the Financial Services Authority. While this has not resulted in new regulatory requirements as yet, it has led to a greater commitment from these banks to undertake more self-regulation and increase efforts to automate.
While STP has become standard practice for traditional trading operations, the inherent complexity of interest rate, equity, foreign exchange and OTC derivatives has made this ideal more challenging in this arena. The innovative nature of the derivatives market is further complicated by growing varieties of transaction types and expanding instances for exceptions. According to SWIFT, 59% of trade instructions require rework. As a result, many firms continue to generate confirmations manually, which requires higher staffing levels and makes handling volume fluctuations increasingly difficult.
In the foreseeable future, it is unlikely that derivatives products in the more exotic and complex spectrum will be processed in an STP environment. The vision of every derivatives product being processed, cleared and settled straight through is a long way off. However, derivatives trading firms must find ways to maximize automation wherever feasible, while more efficiently managing manual exception processing. Although many companies presume this will require separate systems, by integrating leading business process. Content management and document generation technologies, derivatives traders can manage both STP and non-STP trades within the same environment. Indeed, they should think of this as an important strategy that will help them get closer to their STP goals.
These efforts to improve operational efficiencies will also have an important impact on reducing risk. From faxing documents to verifying details, the manual trade confirmation process is often error prone. For example, it is necessary to back up credit derivatives trades with often-complex documentation that outline the terms of the deal. This often creates a backlog in confirming the trade, which in turn poses a massive risk for the industry, as the trade is not valid until both parties have signed the confirmation. As a result, the International Swaps and Derivatives Association (ISDA) estimates that 21% of OTC Credit derivative trades require rebooking due to missing information, up from 7% in the 2004 report . During the period that trades are unconfirmed, the bank is exposed to the risk that a transaction may not be valid, and therefore not honored by the counterparty. Automated trade and exception processing systems will play an important role in minimizing this risk and maintaining market viability.
ISDA targets for verification, confirmation and legal execution of OTC derivatives, as well as increasing expectations for counterparty personalization and delivery channel flexibility, have also put substantial pressure on derivatives operations. This and the move toward electronic matching of trades using initiatives such as FpML and DTCC have led many companies to look to technology to improve operational performance. The backlog in electronic processing amounts to no more than a paper crisis that can be resolved through the intelligent application of technology. The only way to effectively meet these varied needs is by combining business process and content management to address each step of the trade confirmation process. This must include automation of even the most complex stages, including document generation, as well as effective management of all types of critical trade information.
By combining all of these elements, derivatives trading firms can turn what has traditionally been a linear, fragmented process into a collaborative, parallel processing environment that increases efficiency, reduces costs, and keeps highly paid staff concentrating on high value activities. While in the past some companies have relied on legacy systems to address at least part of this challenge, the lack of flexibility and demand for significant IT support has hampered the effort. This points out a number of key considerations derivative firms should look at when evaluating methods for achieving STP objectives:
Business process and exception management automation. Historically, efforts towards STP objectives and improved exception management have been undertaken independently, with one effort emphasizing automation, and with the other the coordination of input from a variety of parties, including legal, traders, brokers, and counterparties.
Automated document generation with format flexibility. The proliferation of new document delivery channels including DTCC, FpML, and email have put the burden on investment banks to forecast what will become the future standard. Intelligent derivatives trade processing systems will accommodate all formats seamlessly. In addition to future-proofing the platform, this enables banks to transition from fax to electronic transfer methods in a manner that suits their individual timeline.
Integrated compliance capabilities. The sheer volume of trade confirmation templates organizations have to manage exacerbates the situation further and adds complexity to compliance. Trading organizations need to ensure their solutions leverage technologies that are able to reduce dramatically the amount of templates and resulting template management burden, as well as providing a complete audit trail of content use.
Seamless integration with internal and external systems and sources. Effective process automation and exception management require access to the right content at the right time. Superior exception management demands immediate access to relevant content to streamline price discovery, order management, clearing and settlement.
For the derivatives trading organization, straight-through-processing objectives and improved exception management offer an important opportunity to turn the application of technology into greater profitability. From more efficient use of human resources to reduced risk and compliance with self-regulatory and legal jurisdictional differences, organizations that combine business process and content management in a singular STP and exception management solution will encounter advantages in every step of the trade confirmation process.
The industry will gain from improved operational efficiency and the banks will be able to achieve greater trade volumes more cost effectively.
