Monday, November 20, 2006

Train wreck ahead chapter 2

At the Sibos conference in Sydney, Karen Cone CEO of TowerGroup described the lack of automation in the derivatives space as a "train wreck waiting to happen". Click here to see post.

Analysts like to use colourful language when it comes to describing processing inefficiencies and regulators don't like to mince their words when it comes to calling on banks to automate or else.

The reason for all the concern. Well derivatives volumes are growing at a 'meteoric' (I thought I would try to be as colourful as the analysts) rate, with business in credit default swaps increasing by 52% in the first six months of this year to $26 trillion, according to ISDA figures.

When any business that is complex and not automated grows at such a rate, the regulators start biting their fingernails, then it is left to the industry to work out a way to help the regulators sleep at night.

Such is the case with OTC derivatives. However, the conclusions drawn from a recent roundtable event sponsored by enterprise content manager provider Interwoven and comprising representatives from buy-side firms, suggests that regulators' blanket approach to automation, may be ignoring some of the finer points and idiosyncrasies that make OTC derivatives 'unique'.

The roundtable concluded that the proliferation of initiatives to automate OTC derivatives had failed to consider the systemic risk implications. In other words, as buy side firms are not well acquainted with the "structuring" of OTC derivatives, automating them may lull firms into a false sense of security about the level of risk exposure.

"The discussion on automation has to have a huge caveat against it because there is systemic risk in automating a product [firms] do not truly understand," said Jos Stoop, general manager, financial services solutions, Interwoven. The roundtable stressed that OTC derivatives are "unique, bespoke products" and that automation may seek to standardise where no ‘standard’ exists.

Despite efforts to tackle the backlog of confirmations for "vanilla" credit derivatives, roundtable participants indicated that there may be a "two year time lag" between new products being developed and participants agreeing on processes and standards for automating confirmations.

Some indication of the complexities associated with automating derivates was given by Bill Stenning, vice president, business development of the DTCC's Deriv/SERV. Whilst the DTCC has been successful in deploying master confirmations to cover credit default swaps, he said that it was difficult to produce standards for the more structured end of the market, which was always one step ahead of standard setters.

According to Stoop, automating derivatives confirmations is not just about standardising data but standardising communication and then leaving it to counterparties to agree on what the data should mean.

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