In the late 1960s, as transaction volumes surged, the New York Stock Exchange had to close one day a week to allow member firms to dig out from under a mountain of unprocessed paper documents. That bottleneck prompted the securities industry to embark on its first great wave of automation, led by two
data-processing utilities formed in the early 1970s -- the Depository Trust Co. and Securities Industry Automation Corp. Thanks to those early actions and frequent technology upgrades, the Street hasn’t faced another serious back-office crisis.
Now the pressure is on the derivatives industry to increase its efficiency. Banks are beginning to buckle under the burdens of processing and clearing interest rate, foreign exchange and other privately negotiated, over-the-counter derivative products. The market for OTC instruments is growing rapidly: The total notional value of the underlying securities was nearly $200 trillion in December 2003, up from $80 trillion in 1998, according to the Bank for International Settlements.
Though the products are sophisticated, the infrastructure for processing them is not. Unlike exchange-traded options and futures, OTC derivatives lack streamlined mechanisms for price discovery, order management, clearing and settlement. That deficiency concerns regulators, who see automated market systems as a bulwark against systemic breakdowns.
In March 2003, Federal Reserve Board chairman Alan Greenspan raised the issue in a speech at a Bank of France symposium in Paris. “Despite, or perhaps because of, the rapid pace of product development, the derivatives industry still executes trades predominantly by telephone and confirms them by fax,” Greenspan noted. “It is disappointing that so little progress has been made in adopting efficient and reliable means of executing and confirming trades.”
Greenspan’s words had an effect. A year later the International Swaps and Derivatives Association formally launched an effort “to achieve substantial automation in the processing of OTC derivatives” by the end of 2006.
The first steps to streamline posttrade processing -- in interest rate and credit derivatives -- are scheduled to be completed by December 2004. The timetable must be aggressive, both to keep pace with the industry’s current rate of growth and to prevent profit margins from dwindling, particularly on plain-vanilla derivatives trades. David Myers, London-based head of the capital markets practice of consulting firm Capco, warns that without greater automation, “the system will fall over.”
ISDA’s ambitious goals include industrywide adoption of the Financial Products Markup Language data protocol as well as straight-through processing methods to ensure that transactions are verified and ready for settlement on the trade date -- a timetable known as T+0.
The derivatives project resembles the Securities Industry Association’s campaign to shorten the settlement cycle on equities trades to T+1 from T+3 by 2006. Although SIA members balked at the costs and shelved the plan in 2002, they have continued to make strides in straight-through processing, which tends to mitigate settlement glitches and other system failures that fall into the category of operational risk.
Big derivatives dealers like Citigroup, Deutsche Bank and J.P. Morgan Chase & Co. -- which with 16 other top firms have endorsed the ISDA plan -- have a strong incentive to minimize operational risk: The impending Basel II capital rules will require them to measure such risk and set aside a reserve to cover it.
Because profits had been flowing, “it didn’t seem to be a priority to integrate the work of the people in the front office doing the trades with those in the back office processing and clearing the trades,” notes Tim Lind, a senior analyst with Needham, Massachusettsbased research firm TowerGroup. Now automation is a priority, and the clock is ticking.
