Reduction of settlement costs: a post-crisis risk management perspective

In times where cost cutting is not so much a trend as a necessity, fund managers are trimming budgets everywhere with information technology (IT) and operations being no exception.

by Jan Vendel Petersen, Domain Manager for Settlement, SimCorp

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While cost cutting for some organisations is achieved either by stopping investing in people or by introducing redundancy packages, leading technology providers argue that cost savings can be achieved through investment in new technology. The Over-The-Counter (OTC) post-trade environment and corporate actions are both fields where reduction in operational costs could be achieved by improving efficiency through:

• reducing the likelihood of human error;
• eliminating the need for numerous internal spreadsheet solutions;
• offering the ability to meet the rapid changes introduced by regulatory bodies; and last but not least
• offering the ability for potential growth.

OTC Post-Trade Processing

A lot of investment has gone into the development of front office solutions where traders are able to execute OTC derivative trades in the blink of an eye. But post-trade processing, such as trade confirmation, settlement, portfolio reconciliation, exposure calculation and collateral management are still slow, highly labour intensive and prone to operational risk.

In today’s market where billions of dollars are invested in non-standard products, human error can lead to huge losses and must be closely managed. With investors and the media more critical than ever towards the magnified risk inherent in derivatives trading, every step must be taken to ensure efficient confirmation of contracts through wellimplemented technology and workflow processes.

It is no longer acceptable for trades to go unconfirmed and inevitably escape risk. Compliance and risk management systems now keep a close eye to ensure that trades, and the models behind them, are tracked and managed closely. Now is the time for dealers and buyers of OTC derivatives to stop putting the needs of the back office behind those of the front office. There is no question that the business is based on traders that can create and execute the deals; however, their creativity and sales power provide little value if the agreed upon transactions cannot be processed.

To support the evolution in OTC derivative trading, a number of infrastructure and software providers such as DTCC Deriv/Serv, MarkitWire and T-Zero have developed or enhanced electronic trading platforms specifically for this purpose. Although the rate of adoption by fund managers has been relatively low, this may be about to change. OMG together with ISDA, MFA and SIFMA on 31 October 2008 suggested a number of radical changes to the Federal Reserve Bank of New York and many of these changes are now being implemented across the industry. There is an increased focus on electronic processing with priority given to the equity derivatives market and already now the major dealers will no longer accept novation consents by e-mail but only consents that are submitted on electronic platforms. Although users can use the infrastructure to manually enter their consents, this is a labour-intensive procedure that leaves plenty of room for human error. The challenge of the software providers is to ensure that their products can interface to the infrastructure and support the functionality that is already offered by the existing infrastructure.

In the weeks after the Lehman collapse many fund managers wished that they had a solution in place that could assist them in managing the numerous novations that needed to take place. Where the buy-side client normally represented the outgoing party they suddenly found themselves in a situation where they were the remaining party.

Collateral Management

Collateral management is another area that has attracted a lot of attention lately. The ISDA Collateral Committee is working on a number of enhancements:

• best practice to ensure trade and position data integrity and the timeliness and accuracy of valuation data, on which accurate collateralisation in turn depends;
• possible benefits of standards for electronic communication of margin calls between firms, including the potential use of standard product definitions;
• changes to market practice to further mitigate risk between firms of collateralised derivatives by tightening timeframes for margin calls and settlement and shortening cure periods, thus reducing the scale of residual unsecured exposures;
• definition of market practice for the calculation of exposure under the ISDA Credit Support Annexes;
• common practice for the process of portfolio reconciliation, including the timing of trade file exchange, process automation across the market, and the consistency of data between trade files and the margin calls to which they relate.

Prior to the credit crunch and the Lehman collapse the buy side may have considered the management of collateral as an operational task of lesser importance, something that was controlled by inhouse developed spreadsheets or administrated by prime brokers or third party collateral service providers. Today the management of collateral is one of the most critical operational areas where efficient workflow processes and solutions are a must, not least due to the change in collateral preference (see figure 1). Noncash collateral has been considered as old fashioned and not as attractive but it has become trendy again. These days the king of collateral may no longer be cash but rather non-cash collateral. The buy-side will be looking for solutions that among other things allow them to monitor transactions, to view positions, to monitor recall opportunities, to track collateral under a rehypothecation agreement, to handle substitutions, to address disputes, to identify issuer and credit risk, and to monitor upcoming corporate action events on pledged securities.

Figure 1

Corporate Actions

Although a lot of investment has gone into the development of solutions that will help fund managers to automate the processing of corporate actions, the industry still seems to be struggling to find the ideal solution. Some organisations have created in-house solutions, others have acquired one of the available best of breed solutions but most organisations are still considering which route to take.

The optimal solution that the market is looking for seems to be one that supports the import of information from multiple sources, includes some sort of data cleansing capability, such as comparison of information from two independent sources, includes functionality to notify decision makers of any upcoming corporate action events at a very early stage, a solution that supports defaults election decisions per event type and not least the communication to/from custodians and reconciliation of the resulting cash and nominal amounts.

While corporate actions have, in the past, mainly been considered an operational task for positions in equities and bonds, this task has now expanded not only to include support for corporate actions on underlying securities in securities lending, repo and collateral transactions but also to include support for corporate actions on synthetic positions used in OTC derivatives such as Contracts for Difference (CFD) and Total Return Swaps (TRS).

The constant increase in complexity and growth in the number of transactions, and the shift from local to global, means that this business area is surrounded by a constant threat of failure and error which may result in losses.

Jan Vendel Petersen is Domain Manager for Settlement within SimCorp’s Strategic Research group. He is the architect behind the development of the securities lending area and has recently been focusing on corporate actions and collateral management. Previously, Jan Petersen worked for several years in the financial industry.