Rapid growth in the use of OTC derivatives within the asset management industry is creating a raft of new complications in the middle and back office. KRIS DEVASABAI reports

The evolution of the UCITS regulations in Europe and the move by pension fund clients towards liability driven investment strategies have spurred many traditional long-only asset managers to increase their use of sophisticated OTC derivative products.

Estimates from JPMorgan indicate that while only ten percent of fund managers invested in OTC derivatives currently have more than fifty open positions, the bank expects this figure to increase exponentially as the industry becomes more familiar with these instruments.

JPMorgan's recent experience with major clients reveals that there is often a rapid jump to around five hundred open positions, followed by a more gradual increase to a few thousand.

But while the front office is rapidly developing an appetite for these complex instruments, the back office is finding the manually intensive processing requirements of OTC derivatives hard to stomach.

Terri Humphreys, head of market activities at Baring Asset Management, says the anticipated growth in volumes poses a major operational challenge for the back office.

"We can cope with small volumes but the reality is that processing OTC derivatives is manually intensive and volume sensitive."

She says efforts to automate the processing chain at Baring Asset Management have been hampered by the lack of technology that addresses the needs of the buy-side.

"Ideally we would like to implement a multi asset end-to-end processing system for OTC derivatives, but it doesn't exist."

Market fragmentation

The lack of a credible single system solution for the buy-side reflects the sheer complexity and underlying lack of market practices and standards in this area.

While pricing and execution platforms such as TradeWeb and MarketAxess offer the possibility of trading electronically, the majority of trades are still brokered over the phone and manually entered into order management systems.

This breaks the straight through processing (STP) chain at the outset and creates major inefficiencies in the middle office around trade capture, affirmation and confirmation, which then flow through to lifecycle management and valuation.

The technology currently on the market addresses some of these issues, but the overall landscape is highly fragmented. Companies such as Murex, Misys and Calypso offer core processing platforms specifically designed for OTC derivatives, but these are costly, and, because they were initially designed with the sell-side in mind, not entirely user friendly for the buy-side.

The situation in the middle office is more complex, with firms typically forced to run separate processing streams based on different technology platforms to deal with trade capture, affirmation, confirmation and reconciliation.

Many buy-side firms use T-Zero and DTCC AffirmExpress to electronically capture and affirm the details of an OTC contract at the point of trade, while utilities like SwapsWire and DTCC Deriv/Serv have helped the industry to clean up the confirmation process.

According to Henry Hunter, chief marketing officer at SwapsWire, widespread adoption of electronic confirmation has been a major step towards improving processing efficiency further downstream.

"Confirmation delays have created a situation where potentially flawed trade information is being used to drive downstream processes, leading to huge inefficiencies in the back office.

"If trade details are electronically confirmed on trade day then everything else becomes that much easier, faster and more efficient," he explains.

A recent Z/Yen survey found that adoption of SwapsWire and Deriv/Serv had led to greater levels of automation across the industry, resulting in the average cost of processing an OTC derivatives contract falling from $275 to $172 over a 12 month period.

However, the industry continues to struggle with instrument types that are ineligible for confirmation through Deriv/ Serv and SwapsWire.

A host of technology firms, including Markit, CheckFree and ValueLink, are developing systems to plug the gaps, while Euroclear and TriOptima have recently launched the next generation of portfolio reconciliation services which could help to ease another of the major pressure points facing the industry.

But industry consultant Dr. Chris Sier says that while these systems and services successfully address specific problem areas, their limited scope creates its own problems for the buy-side.

"The technology that is out there attacks different pieces of the puzzle - the complexity lies in bringing it all together under an effective operating model," he says.

The road ahead

The industry has been working on developing common standards and protocols to cut through the fragmentation, and the decision by SWIFT to carry the FpML messaging standard for complex financial instruments on its SWIFTNet platform should help to further oil the wheels of STP.

A pilot group of asset managers and custodians, including Barclays Global Investors, PIMCO, State Street and Brown Brothers Harriman (BBH), are currently testing the SWIFTNet FpML infrastructure, though the first live trade messages are yet to be sent.

"Until SWIFT decided to adopt FpML asset managers and custodians did not have a clear idea of where the industry was going," says Cherie Graham, head of the derivatives product group at BBH.

"SWIFT has put a stake in the ground. The industry can now automate around FpML with confidence that we are on the right track."

There are also hopes that consolidation among vendors could lead to the emergence of more integrated solutions for the buy-side.

In December the technology and market data vendor Markit agreed in principle to acquire the confirmation utility SwapsWire.

Markit currently provides a trade capture and document management system, known as Markit Trade Processing, which converts faxed documents into electronic form and consolidates the confirmation workflow around all types of derivatives onto a single platform.

If the deal to buy SwapsWire goes through as expected Markit plans to combine SwapsWire's confirmation capabilities with its trade processing workflow platform to create a cross-asset trade processing solution for OTC derivatives.

Jeff Gooch, executive vice president and head of trade processing and valuations at Markit, says the company will also look into applying the SwapsWire confirmation tools to a wider range of instruments.

"We are really trying to push the concept of the buy-side using one application to manage trade capture and confirmation for all their OTC derivatives trades," he says.

Cost concerns

The overall cost of setting up a middle and back office infrastructure for OTC derivatives in today's environment can run into tens of millions, leading many firms, including Baring Asset Management, to view outsourcing as a potential solution.

"We came to the conclusion that building an in-house system would be expensive and unlikely to be future proof," says Humphreys. "For that reason we have decided to outsource everything post document management to a third party service provider."

But outsourcing is not necessarily the easy option that it may first appear to be.

According to Sier, service providers are still scrambling to put together an outsourcing service that appeals to the buy-side.

"There is a lot of interest in outsourcing the derivatives middle and back office but there is virtually no one in the market who can provide a credible service to the buy-side," he says.

"The service providers fit into two broad categories: the global custodians who are yet to develop the technical capabilities, and the sell-side institutions that are still trying to come up with a service model that works for the institutional investment manager."

Philippe Rozental, co-head of asset servicing at Société Générale Securities Services (SGSS), admits that building an OTC derivatives outsourcing service is a challenging proposition for global custodians, who face many of the same challenges as buy-side firms.

"The lack of standardisation in this space means that service providers have to develop very open platforms that can cope with clients sending information to you in a multitude of different formats," he says.

Even with a core processing system in place manual processes have to be maintained to deal with the exceptions, which actually tend to be the rule rather than the exception where OTC derivatives are concerned.

"Recruiting staff with knowledge and experience of OTC derivatives is a major challenge in this regard," says Rozental.

So what are the options?

The OTC derivatives outsourcing service launched by SGSS two years ago is one of the few solutions in the market for firms that want to take a modular approach and outsource just the OTC derivatives component of their middle and back office.

Rozental says around 40 buy-side firms are currently using the service, which is widely acknowledged as one of the best outsourcing solutions available to the buy-side.

JPMorgan is another of the service providers leading the way. The bank has created a specialist Global Derivatives Services unit and merged some of the reporting lines across its investment bank and global custody business in a bid to improve its services in this area.

"We are trying to leverage the experience and knowledge in the investment bank by having our operations staff on the securities services side reporting into the same senior managers and heads of operations as the investment bank," says Jon Lloyd head of JPMorgan Global Derivatives Services.

JPMorgan currently handles OTC derivatives processing for a number of clients who have outsourced their entire middle and back office to the firm, but the service is not available to asset managers looking to outsource just the OTC derivatives part of their middle and back office.

"Our focus is on providing a multi asset class outsourcing solution," says Lloyd. "We are seeing an increasing interest in outsourcing just OTC derivatives processing, and while we have the capability to handle that, it's not our key focus at this point in time."

 Alternative options

But while global custodians struggle to develop their services others are looking to muscle in on the action.

Earlier this year the hedge fund administrator GlobeOp Financial Services announced that it was making its OTC derivatives outsourcing service, GoOTC, available to mutual funds and custodian banks active in the UCITS III space.

GlobeOp has been processing OTC derivatives on behalf of hedge funds for a number of years, and currently handles around 1,300 trades per day.

Ron Tannenbaum, head of marketing at GlobeOp Financial Services, says the modules of this service have been spun out into an outsourcing platform for traditional buy-side firms that can handle everything from trade capture and confirmation through to lifecycle management, valuations, collateral management and risk analytics.

"I think we are unique in being able to provide a fully integrated service," he says.

He says Globe Op is already working with leading bulge-bracket global investment managers such as pioneer investments.

GoOTC is also being made available as a ‘white label' service for custodian banks that are looking to provide an OTC derivatives processing service for their clients, and Tannenbaum says GlobeOp is working closely with some custodians on that basis.

Sell-side institutions are also beginning to take an interest in providing an outsourcing service for the buy-side. Lehman Brothers opened up its back office infrastructure to the buy-side five years ago and currently processes fixed income instruments for a client base of around 40 firms.

This is now being extended to cover equity derivatives, while swaps and options are expected to be included by Q1 and Q2 of 2008 respectively.

Paul Cummins, managing director of derivatives services and capital markets prime services, says Lehman Brothers is looking to position itself as a specialist outsourcing provider in the OTC derivatives space.

According to Cummins the service will eventually handle the end to end processing and valuation requirements of all types of OTC derivatives, while the firm is also developing a reporting service to help asset managers better understand the risk and performance implications of their positions.

"The whole concept of measuring risk and performance is becoming much more complex due to the use of derivatives," says Cummins. "At Lehman we have the capacity to think about these issues in a non-linear way and help clients to track whether an underlying structure or overlay is having the desired effect at a portfolio level."

Today, choosing the right outsourcing provider remains a tricky proposition. The services available on the market are yet to mature while the overall market is still evolving, with global custodians, hedge fund administrators and investment banks all jostling for position.

"I think there will be a few twists and turns in this space in 2008 as global custodians look to quickly buy, build or insource capabilities while the investment banks and hedge fund administrators try to crack what, for them, is an unfamiliar market," says Sier  

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A driving force: DTCC drives STP forward

The DTCC is driving ahead with its ambitious vision of creating an integrated STP infrastructure for OTC derivatives that spans the full back office value chain from affirmation and confirmation through to lifecycle management and settlement.

"We saw a tremendous opportunity to leverage the data fl owing through the Deriv/Serv confirmation engine, which captures all the key data fields required to support a derivatives transaction over its lifecycle, to develop a number of additional centralised services for the market," says Frank de Maria, DTCC managing director responsible for Deriv/SERV's TIW.

"That was the driver behind the Trade Information Warehouse (TIW)," he adds.

The TIW holds a ‘golden copy' of every transaction confirmed through Deriv/Serv and allows users to reconcile to a central source rather than to multiple counterparties.

"Creating that central information hub is just the first step in the vision - there is no end to the services that can be provided on the back of the TIW," says de Maria.

"For example, calculating the settlement amounts for a CDS is simple math if you have access to all the relevant trade records," says de Maria.

The DTCC has now teamed up with CLS Bank to develop a central settlement service for contracts housed in the TIW. The service went live with a selection of sell-side institutions in December 2007, but de Maria says buy-side firms are also seeing the benefits.

"We are calculating the settlement amounts for all the contracts housed in the TIW and making those available to all our counterparties irrespective of whether or not they are part of central settlement.

"This means that buy-side clients now have an independent source to confirm the calculation amounts being provided by the dealer," he adds.

The industry as a whole will enter a new world of automated lifecycle management when central settlement is finally opened up to the buy-side later this year.