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OTC Derivatives Regulation Ready or Not

OTC Derivatives Regulation – Ready or Not?
8 things you need to worry about now           

With the passage this summer of sweeping regulatory reform in the US, there’s been a lot of discussion around the impact on the over the counter (OTC) derivatives market.   There are a number of challenges we think many market participants will face as they get ready for the move of more OTC derivatives transactions to the exchanges, particularly around back offices processes like reconciliation. 

How ready are most market participants to handle this new load?  Before contemplating back office automation around OTC derivatives, firms that today trade derivatives on exchanges (CME, Eurex, LCH Clearnet, etc.) are taking a closer look at their existing systems and processes.  Are they ready to handle big increases in volume and complexity?   Many that we talk to acknowledge that their existing systems and processes are creaking at the seams, and would admit that today they would struggle to take on more.  Most rely on a hodgepodge of manual, unconnected processes that are inefficient and often error prone.    

In our view, here are eight key areas of focus that we encourage market participants to consider, in determining how well they are handling existing exchange traded reconciliation, and how easily they could manage more. 

Eight key considerations in evaluating derivatives reconciliation processes

  1. Costs associated with developing and maintaining a large number of dynamic exchange feeds
  2. Costs and operational risks associated with manual processes
  3. Ability of current systems to cope with the increasing volumes
  4. Access to a consolidated view for exchange reconciliation
  5. Adequacy of audit control
  6. Ability to meet existing client demands for real time margining and reporting
  7. Need to integrate or replacing disparate, unconnected regional systems
  8. Transparency around collateral

Not all firms suffer the above equally – so it’s worth taking clear stock of current processes and capabilities of existing staff and systems, in order to assess where the greatest pain – and the greatest gain – can be found within the current infrastructure. 

And the challenges don’t stop there.  Many market participants lament that price transparency will ultimately squeeze profit margins on these transactions.  However, many market analysts postulate – and we agree - that the operational efficiency gains of automation in trade execution, trade processing and related back office functions  should outweigh the margin loss.  Further, the counterparty risk reduction and increased ability to get near or real time views of trades and positions will be transformational to the markets.    Standardization will be a first important step towards achieving gains from operational efficiency, but hurdles will be significant.  What are your views?

 

 

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Comments: (2)

A Finextra member
A Finextra member 16 November, 2010, 16:22Be the first to give this comment the thumbs up 0 likes

I think they are extremely important questions, but I think I would add two more:

1. Can the OTC contracts we are talking about really be standardised? (Have the regulators looked at an actual contract for an OTC derivative recently?)

2. What will the margin call be on an extremely illiquid, one off, OTC contract? How will it be marked to market to create this call? (Bearing in mind that many OTC derivs are marked to market once every 30 days - they are now required to be marked to market at least daily...)

I am still not convinced of the benefits of clearing OTC derivatives, and I haven't yet found an answer to my two questions. Any thoughts?

I think once these answers are found, firms may begin to be able to look at the practicalities of how they will achieve cleared derivative contracts. Bearing in mind that these are the same firms that struggle to automate standard equity contracts.

Jennifer Hanes
Jennifer Hanes - SunGard - Boston 17 November, 2010, 20:00Be the first to give this comment the thumbs up 0 likes

Absolutely concur with the challenges associated with moving OTC derivatives onto exchanges.  The regulators have a tall task in front of them, and need input from the industry prior to finalizing rules in mid-2011.  The time is now to voice those concerns. 

For additional perspective on this topic, I'd recommend reading Tabb Group's recent report:  "The Global Risk Transfer Market - Developments in OTC and Exchange Traded Derivatives" at www.tabbgroup.com