Back offices buckle under OTC volume surge

Back offices buckle under OTC volume surge

Despite concerted efforts since 2005 to improve operational efficiency in the credit derivatives markets, trading surges in the OTC markets since the credit crunch have resulted in corresponding spikes in unconfirmed trades clogging up back offices.

According to data released by UK-based Markit Group, average outstanding confirmations in the OTC derivatives markets jumped from around 6000 per dealer bank to about 13,000 between June and August 2007, at the same time as monthly trading volumes rose from an average of around 20,000 to more than 25,000 per dealer.

However the situation has improved over the past few months. Following a dip at the end of 2007, trading volumes rose again to near-peak levels of 25,000 trades per dealer for each of the first three months of 2008, but the average number of outstanding confirmations remained lower at around 7000 per dealer per month.

But despite the improving picture, regulators are still concerned about operational inefficiencies in the credit derivatives markets. Last month the Federal Reserve Bank of New York said the volume surges in mid-2007 showed that "processing challenges" still persist in the markets and warned that in order to support long-term growth "the processing infrastructure must be capable of processing transactions efficiently through periods of sustained high volume and market volatility".

A recent report from the Financial Stability Forum also cited the surge in unconfirmed credit derivatives trades during the credit crunch as an area of concern.

"Despite the significant progress that the industry has made in automating the infrastructure of the OTC derivatives markets during the last two years, the industry has not achieved a "steady state" in which spikes in trading volume do not lead to operational problems," says the FSF report.

Earlier this month reports surfaced that group of at least 10 major credit derivatives brokers are working to establish a central clearing house that would take direct exposure to counterparty risk.

According to a Reuters report Athanassios Diplas, chief risk officer for global credit trading at Deutsche Bank, told the annual meeting of the International Swaps and Derivatives Association (ISDA) that the clearing house would help "take a lot of risk out of the system" by enabling banks to trade without the fear that the default of a dealer could cause a shock to the market.

Some bank executives and analysts have voiced concerns that the default of a major derivatives broker could lead to a chain of counterparty failures and defaults, says the report.

It is thought the central clearing house would require counterparties in credit default swaps to put up collateral as well as initial margin to cover any decline in market value.

The brokers involved in the programme would contribute to a guarantee fund for the clearing house to cover potential losses from defaults, says the report.

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