Derivatives Dealers Must Co-Operate And Automate, Concludes Isda Survey

LONDON--Automation of back-office processes and standardisation of settlement terms are issues that over-the-counter derivatives dealers must address if they want to improve the efficiency of their businesses. That is the conclusion made by Isda's first operations processing benchmarking survey.

In the 2000 Operations Benchmarking Survey, published in October, the International Swaps and Derivatives Association identifies serious problems in the back office at OTC derivatives dealing houses.

"The OTC derivatives market suffers from a lack of standard terminology and trade characteristics, and this emerges as a principal source of delay and dispute between counterparties," says Isda. "Even where standard documentation exists, some institutions might amend the wording or supplement with their own customised clauses." The time taken to review these non-standard additions can cause considerable delays.

The survey uses data from 39 firms, 79% of which say they are meeting T+1 (settlement on the day after the trade) for vanilla derivative products, such as interest rate swaps and forward rate agreements (FRAs). But only 24% are meeting T+1 for structured products, with more than half taking three days or more. Largely manual documentation processes with high error rates are to blame for this, and would benefit from increased automation.

Most respondents report a backlog of trades waiting to be processed. More than half (55%) say they have an average of 1.1 days' worth of paperwork for confirmations yet to be sent out. Andrew Nicholson, co-chair of the Isda advisory committee that oversaw the survey, says this figure is not bad considering that it represents both simple and complex trades. But the implication is that it could be better.

However, the number of confirmations sent out but not actually returned is high -- accounting for on average 5.8 days' ticket volume. Forty per cent are still outstanding after 30 days. This figure includes all deals, but complicated deals are more likely to account for the delays, because of their complex non-standard terms and procedures, which are the prime causes of disagreements.

While banks have made progress towards standardisation and automation, Nicholson says they still have some way to go. For example, straight-through processing (STP) is an industry target in terms of automation, but due to the lack of standard terminology, there is no single industry definition of what it means. Half those surveyed have no OTC derivatives capable of STP. Of those that do, the volume of trades processed in this way ranges anywhere between 3% and 90%.

Automation is well under way in areas such as confirmations generated from books and records, contact information, and standard settlement instructions, and is finding its way into the trading process. On average, 62% of FRAs and 41% of vanilla interest rate swaps processing are now fully automated. The volume of automated trades increases with the size of firm, as does the average number and cost of operations professionals. As automation cuts overheads by an average of at least 18% and reduces error rates by more than 25%, the potential rewards are obvious.

But it is the absence of market standards for settlement -- with regard to terms, documentation and procedures -- that contributes most to delays and disagreements.

Non-standard language is a major source of concern. 70% of firms surveyed cite lack of a standard cash settlement language as a cause of counterparty disputes. Isda's Nicholson says such disputes are generally minor and infrequent and that the complexity of the language depends on the complexity of the trade.

One problem is that counterparties make their own additions to prepared documents. Another is the reluctance of firms to sign documents from counterparties, most preferring to have the counterparty sign their confirmations instead. 15% will sign, 15% refuse, and the remaining 70% may only sign in "limited or exceptional circumstances".

Nonetheless, 90% have adopted Isda's standard market templates. 80% have adopted the 1991 Isda Definitions and its 1998 supplement, and the rest plan to do so when possible. Many are looking to Isda to offer further help. And Isda has done so, with the release of its 2000 Definitions. But were Isda to go even further and develop industry-wide, standardised documentation, there is no guarantee that its members would stick to it.

However, Nicholson notes a trend towards co-operation. For example, his own bank -- Credit Suisse First Boston -- is becoming more flexible in accepting other firms' documents, he says. He believes standardisation will play an important role in achieving the further automation required. Once standardisation is achieved, automation can begin in earnest. And with OTC derivatives trading costing the industry $1 billion per year, there is every incentive to co-operate to reach these goals.

Indeed, the majority of firms surveyed are participating in a market-wide automation initiative. Eleven are FpML (Financial products Markup Language) Board members, who actively support the development of standard FpML templates for commonly traded products.

An example of this increasing co-operation is SwapsWire, the electronic swaps trading platform established by leading derivatives dealers. SwapsWire now has 24 bank participants, and is expected to adopt FpML standards. In contrast, Swift is developing its own standard, SwiftML -- a version of the common electronic language XML, used by FpML.

But SwiftML could take two years to develop fully, by which time another industry standard may be in place. JP Morgan vice-president Brian Lynn hopes this will be FpML.

Lynn, co-chair of the FpML Standards Committee says that FpML will cut time and costs by providing standard trade definitions for automated trading that include an element of flexibility. This will be necessary since all trades in the $88 trillion derivatives market are "essentially unique two-party contracts".

But there is an obstacle standing in the way of increased co-operation. The Isda survey collects detailed quantitative data on the processing of OTC derivatives, allowing operations managers to compare their procedures with those of their competitors on an anonymous basis. But Isda members work in competition, and the survey noted "reluctance" and "sensitivities" among respondents over sharing information -- even confidentially for their own benefit. For example, nearly half quantify the processing cost of transactions, but are generally unwilling to share such information.

Nonetheless Isda intends to publish the industry-sponsored survey annually. Work has already begun on next year's survey to identify a set of benchmarks that are likely to be more precise than the broad results of the initial survey.

The aim is to find ways to streamline processes and reduce costs and risk. Once it achieves this, Isda will develop recommendations and monitor progress in future surveys.

--Max Bowie