Fund Managers: Automating Risk Out of Derivatives Matching

The financial risk following discrepancies — or breaks — in matching trade details for derivative transactions can be serious business.

Fund managers can easily encounter over a thousand trade breaks annually.When the process goes bad, it can go very bad and a widely anticipated growth in trading volume of exchange-traded derivatives (ETDs), makes an argument for greater automation compelling.

While much of the attention on post-trade automation in the buy-side community has focused on over-the-counter (OTC) derivatives market, one analyst is drawing attention to the inefficiencies in communicating post-trade details in the exchange-traded market.

Kevin McPartland, head of market structure and technology research at Greenwich Associates in Greenwich, Conn., warns that fund managers investing in ETDs should be paying more attention to automating post-trade communications. If anything stands in the way of speed and accuracy in acknowledging the details of ETD transactions with their broker-dealers, on-time settlement could go out the window.

McPartland’s recommendation: it would be operationally best for operations executives at fund management shops to rely on the same automated post-trade systems for both ETDs and OTC derivatives when it comes to the confirmation and reconciliation process.

There’s no reason to run separate processes now that regulatory requirements are converging, says McPartland, who co-authored a research report on the matter. “While many of these cleared [OTC] products will not be technically traded on exchanges, their characteristics are similar. And the operational process is nearly identical,” he writes.

Both ETDs and OTC derivatives must now be traded on automated platforms, processed through clearinghouses and reported to trade repositories based on the new requirements imposed by the US Dodd-Frank Wall Street Reform Act and its European peer European Market Infrastructure Regulation (EMIR).

As the requirements for OTC derivatives are relatively new, fund managers have naturally focused their middle and back-office efforts on complying with those rules, apparently leaving strategic planning of the post-trade work of ETDs out in the cold. Or so McPartland’s research suggests.

Processing both ETDs and swaps through the same infrastructure, would eliminate duplication of efforts and allow fund managers to benefit from a consolidated view of market and counterparty exposure rather than have to break it down by product. What’s more, a single cross-product automated solution should provide the scale needed to deal with expected increases in trade flow, he believes.

A former director of the electronic trading team at BlackRock, McPartland apparently has good reason for concern. In his research report entitled “Cleared Derivatives Processing: A Strategic Approach,” he shows that despite the growing use of electronic messaging to confirm trades, worrisome paper-based methodology remains. Of the 51 buyside operations specialists participating the study, less than half report that they confirm and reconcile their trades with broker-dealers in real-time. Even those performing those tasks at the end of the day still leave plenty of time open for the portfolio manager to rely on inaccurate or incomplete data to make its next investment decision.

Even worse, about two-thirds of the respondents say they use manual methods such as phone, email and fax, slowing down the subsequent clearing and settlement process. The breakdown: 51 percent sometimes rely on email; 41 percent sometimes rely on instant messaging; 34 percent on phone communications and 4 percent sometimes rely on fax. Seventy six percent rely on FIX and SWIFT message interfaces; however, that doesn’t necessarily mean they do so with all of their broker-dealer counterparties or all the time, according to McPartland.

Hence, even that high figure doesn’t reflect an ideal scenario. SWIFT officials were unavailable to comment by press time on the use of their network for matching ETD trades. The FIX Trading Community, which has been promoting the use of its message types for local matching of trade information between fund managers and broker-dealers has expanded its reach from equities and fixed-income instruments to derivatives. While officials representing the trade group would not specify the number of buy-side firms using the FIX message protocol, there is plenty of uptake, they insist.

McPartland’s sampling of buy-side operations experts is limited, yet it does highlight that the status quo won’t be sustainable, as about a third of the participants in the survey say they could shift their asset allocation from over-the-counter products to futures — a stance often coined futurization.

Based on responses from fund managers in North America, Europe and Asia, McPartland found that Omgeo tied with broker-dealer portals as the favored third-party platform for post-trade communications. Only Bloomberg was a viable competitor in Asia-Pacific.

“For those using software, the majority are working with in-house systems, put in place before off-the-shelf systems were readily available and proprietary technology was seen to provide an edge. Broker portals are also a popular choice as they come at no additional charge assuming investors are paying commissions to the broker,” writes McPartland.

Capitalizing on its prominence in the post-trade communications market, Omgeo is naturally promoting automation. “In order to prosper in the exchange-traded derivatives market, industry participants must ensure they have automated solutions in place that mitigate risk, process post-trade transactions consistently across all clearing methods and asset classes and meet regulatory demands and industry best practices,” says Ted Leveroni, executive director of derivatives strategy and external relations at Omgeo. “Automation is the only way to bridge the gap and drive consistency and operational excellence across firms.”

Bad Breaks

When trade details between fund managers and broker-dealers are not correctly matched, fund managers can at a minimum miscalculate — either overestimate or underestimate– their market and counterparty risks. Potential trade breaks also mean that trades won’t be settled on time and cleanup costs will ensue.

On average, a fund manager might experience only 100 trade breaks a month, less than one percent of the total number of trades which must be settled. But just one break alone could lead to a substantial operating loss.

While McPartland’s report did not quantify the costs related to the lack of automated post-trade communications and did not compare the ETD market to the OTC market, it warned that as a rule of thumb, operations executives dedicated to ETDs are being unfairly forced by upper management to rely on existing technology and staff. “In North America, budgets are leveling out after a big push for Dodd-Frank compliance,” says McPartland. “Operations teams are focused on reducing the number of breaks and reducing the average cost per break.”  

The scenario in Europe mimics North America, but with a three-year lag as the implementation of EMIR is now underway and MiFID II –the second incarnation of legislation requiring financial firms follow best execution practices when trading — has yet to be finalized. “Money managers in Europe are planning for a dramatic increase in spending, double in some cases to ensure compliance and capacity in the next few years,” says McPartland. However, that increase in spending relates to both OTC derivatives and ETDs as transactions in ETDs must be reported to trade repositories. Not so under the Dodd-Frank legislation.

As trading volumes in exchange-traded derivatives increase, the need for automation will become apparent, ten US C-level fund operations specialists tell FinOps Report. “Because there are a lot of similarities between the product lines in terms of the required data fields, it would make sense to rely on a single platform,” says one expert. But, as he adds, “It’s far tougher when it comes to actual analytics, risk metrics and collateral management work.”

It remains to be seen whether fund managers will buy into the idea that it is operationally best to always use the same technology platforms to process both ETDs and over-the-counter derivatives. And it is unclear whether they will want to part with any home-grown technology for ETDs.

McPartland’s report focuses on the post-trade communications and reconciliation process between fund managers and broker-dealers and doesn’t explicitly address collateral management,  or portfolio management — two other critical operational requirements for ETDs.

Therefore, the recommendation to use a single technology provider only reflects the post-trade confirmation and reconciliation process where the similarities between OTC and exchange-trade derivatives is greatest, explains Leveroni. That may not be the case for other post-trade functions such as portfolio management and collateral management, he acknowledges.

Change is Tough

While relying on a single third-party solution for all post-trade procedures sounds like an ideal scenario, it requires fund managers who have already installed either proprietary applications or other third-party software to reengineer their workflows into a new technology platform. And the presumption is that a one-size-fits-all solution will solve significant operational risk challenges may not reflect that availability of technology out there today.

Not all of the third-party platforms cited in McPartland’s report are suitable for both ETDs and OTC derivatives. Omgeo’s Central Trade Manager, does encompass a wide product range and global reach, but when it comes to derivatives, it only allows fund managers and broker-dealers to centrally match their listed futures and options trades. Officials at Traiana, which McPartland’s analysis showed trailed Omgeo in popularity, say that Traiana’s Harmony platform does provide post-trade communications capabilities for ETDs, credit default swaps and equity derivatives, among other asset classes. However, fund operations specialists who spoke with FinOps insist that Harmony is used far more often for post-trade communications for OTC derivatives than ETDs.

Dave Tolman, co-chair of the FIX Trading Community’s Post-Trade Working Group and technology manager for the professional  services group at Greenline Financial Technologies, maintains that the FIX protocol is also being used for acknowledging post-trade details, albeit on a bilateral basis, for OTC derivative trades on platforms such as Tradeweb, Bloomberg and MarketAxess.

“Such a scenario [relying on a single platform] will only work if the single third-party provider offers the exact same functionality and performance levels for ETDs as for over-the-counter derivatives,” one East Coast fund operations specialist tells FinOps Report. “That may or may not be the case, so we would need to make some tough evaluations on our technology expenditures.”

It could be difficult convincing C-level management, at least in the US, that change is needed. Based on McPartland’s analysis, there are clear operational and risk-related benefits, especially with a  new regulatory landscape. However, until fund managers believe that the risk is less attractive than the technology investment, overcoming budgetary hurdles and organizational inertia may make uptake slow.