Joe Kohanik, VP Product Management Fixed Income / Derivatives, Linedata

The good news is that institutional brokers' innovation in structured finance and other OTC derivatives continues to grow and meet investor demand. The bad news is that understanding the new risks of this market will take some more time, and probably few more trillion dollars in capital losses. Don't be fooled by mainstream media though, the challenges won't slow things down. Even with the current market turmoil, congressional inquiries and large market participant failures, OTC derivatives are going "mainstream". They are going "mainstream" because they work in ways the traditional exchanges can't and as a result they are effective tools for corporate finance, traditional asset managers, hedge funds and banks.

The OTC derivatives markets provide a number of key advantages over exchange-traded markets:

Trade Customization: Buyer and seller can create truly unique transactions to meet their respective needs. These are commonly called, 'bespoke' trades.

Liquidity and Transparency: While we think about liquidity, we most often think about exchange markets, but how many exchange based markets can take a single trade to create or offset $100 Million or more in market exposure with close to zero market impact? Those OTC derivatives that have combined this 'liquidity' with market standardization have exploded. Interest rate swaps now exceed $470 trillion in total notional amounts outstanding (Almost 8 times the total assets under management by global asset management firms today). Credit default swaps top $50 trillion and for 2007, ISDA reports a 73% increase in CDS volumes.

Lower Costs: Transaction costs, like stamp taxes and exchange fees, can be eliminated when trading in OTC derivatives. In addition, most derivative trades require a small ante, thus, providing a way for managers to own the same underlying market exposure at minimal cost.

Efficient lower footprint portfolio management: OTC derivatives can allow for more efficient management. For example, a manager can either 'tip their hat' and buy hard equities or be more elusive via a contract-for-difference at one tenth the cost. The time for a manager to create these exposures can be significant through traditional markets, while exposure via a CFD can take minutes.

The problems with OTC derivatives: The market or your technology?

There are three key problems with the OTC market today.

Pricing and Risk Information: We are challenged to provide pricing and even risk information for privately negotiated sometimes less liquid securities. This has the effect of limiting use by some asset management firms. The root cause of this issue is a combination of less liquid markets, inconsistent securities reference information and a lack of processes to ensure adequate up to date reference information. As a case in point, counterparty novation may take weeks before notification makes its way back to the buyer.

Centralized Settlement: It was nearly 2 years ago when I first heard it can take up to 40 days to confirm a swap trade. As of 200, per ISDA, this is down to about 10 for interest rate products. Efficiency improvements are evident in this space, but still not ideal. While centralized settlement is beginning to emerge, it is far from complete. As a case in point, a 10 year interest rate swap requires that counterparties exchange cash flows, on a periodic basis, during the life of the trade. There is no intermediary that guarantees these cash flow payments, like on regulated exchanges. Hence, firms are realizing the need for more proactive management of counterparty credit risk from trade execution through final maturity. And so, OTC bulge-bracket firms are right now constructing counterparty management desks in preparation for future growth in the area. You can bet the sell side will provide the risk mitigation tools.

Legacy Technology: Let's be clear " technology today is challenged to meet the derivatives needs of firms, largely because of the previously mentioned nuances between OTC and exchange-traded markets. In equities, were there is standardization and definition, the technology solutions are much easier to build and enhance for future regulatory changes. In OTC markets, like fixed income, standardization has indeed evolved, but it has been over many years of trial and error. For many vendors and institutions alike, this has meant writing and re-writing technology solutions on top of databases that were perhaps built during the emergence of the OTC market, where foresight is minimaland data points are many.

Now fast forward to OTC derivatives and the rapid market growth. The approach most have taken to adding new securities to systems is to capture and represent the key data points from each individual security. It's a model that works well for equities and exchange traded securities where market participants clearly agree on what those data fields are. Enter the OTC derivatives markets where the exception is the rule and you can see the challenges of hard coding new securities into applications as they emerge in the market only to have to change or manage them to the nuances of different market participants.

Where do we go next?

Completing the mainstream process for derivatives without compromising the integrity of market participants will require activity from all its stakeholders:

Industry Standards Bodies: Since industry adoption in 2001, The Financial products Mark-Up Language (FpML) is the business information exchange standard for electronic communication of financial derivatives between Broker/dealers, other EMS systems, OMS systems, confirmation systems, market data systems and custody systems. Over time, further adoption of this protocol should equate to higher (straight-through processing) STP rates. As we look two years out, we know the sell-side will continue to churn out new product and that SIFMA, ISDA and other best practice groups will adopt business standards around them.

Sell-side Firms: The investment banks that innovate and bring standardization to the OTC market must be change leaders in order for more processing efficiencies to take hold. Historically, it is fact that sell-side buy-in brings industry conformance to OTC processing. Lower costs and better risk mitigation should serve as a strong incentive, but the initiative will require a strong impetus to create the industry collaborative effort that ultimately drives success.

Centralized Clearing Utilities: More and more, the industry is creating centralized settlement mechanisms and trade repositories in an effort to create more transparency and standardization. Up to now, Swapswire, Deriv/SERV, SWIFT have led the field in confirmation processing and ongoing event management. During 2008, DTCC's Trade Information Warehouse will be further rolled out to industry participants. Straight-through-processing efficiencies will no doubt follow.

Buy-Side Firms: Like sell-side firms, the buys-side needs to promote the standardization. Also, and in contrast to sell-side investment in technology, over the coming years, buy-side firms need to divert a higher percentage of money to buy or build the OTC straight-through-processing solutions.

Implications for Successful Technology Solutions

The past few years has seen many new software solution providers emerge with everything from risk and valuation to affirmation/confirmation systems. Those who embrace open standards and collaboration with the efforts of the institutional brokers and utilities will ultimately be positioned to best provide solutions to industry participants. Ultimately quick fix alternative will not stand the test of time. Integration and interoperability are the links to any straight-through-process. Although it will take a number of years to work its way out of the industry, the successful providers in the industry will continue to migrate away from custom API's and towards the industry accepted FIX Protocol, the standard for real-time electronic exchange of securities transactions. As for database management, the successful technology firm will store and manage data for ease of use with the FpML protocol.