CHICAGO - When it comes to choosing derivative instruments, some portfolio managers still think the more complicated they are, the better.

But as the stock markets become increasingly volatile and funds grapple with reducing risk to prevent further losses and investors heading to the exits, the voice of reason is growing.

Mutual fund portfolio managers, once eager for alpha and hedge fund-like strategies, are beginning to pare back their holdings in derivatives, these incredibly complicated financial contracts that are so difficult to value and that many investment professionals don't understand.

"If there is anything to be learned from the credit crisis, it is that firms need to pay sufficient attention to the more speculative, Wild West parts of the business" where product innovation and complexity run rampant, according to a new report from Celent, titled "Managing OTC Derivatives Risk: Building Capabilities to Tame the Giant."

Over-the-counter derivatives, in particular, have exploded over the past five years. As simple, "vanilla" derivatives have become commoditized, their margins have been dropping, encouraging alpha seekers to look for more exotic instruments to boost performance, assets and revenue.

"Here to Stay"

"Derivatives can either act as weapons of mass destruction or as tools of effective management," said John Perlowski, managing director and funds treasurer at Goldman Sachs Asset Management, speaking recently at the Investment Company Institute's annual tax and accounting conference held here. Regardless of their role in the current financial crisis, Perlowski continued, "Derivatives are here to stay in the mutual fund industry. In order to support these complex instruments, we need to come together."

Perlowski said the number of credit default swaps has increased by nearly 80% a year over the past few years.

"The numbers are daunting," he said. "It is incumbent on all of us to deploy solutions. We need to redouble our efforts to provide more information on these instruments."

A July study by Deloitte found that about 76% of firms said they are interested in exotic derivatives, versus 24% who said they were sticking with plain-vanilla instruments. This increase in size and complexity of OTC derivatives raises the question of whether the risks from these contracts are being properly managed, Celent said.

"Although derivative instrument risks cannot be eliminated, firms can build capabilities to reduce and control unintended risks," said Cubillas Ding, a senior analyst at Celent and the author of the report. "The hot spots specific to OTC derivatives encompass areas such as data management, model management, valuation and pricing, collaterization, reporting, limits management, payments and portfolio reconciliations."

While derivatives are viewed as tools for financial risk management, the underlying mechanism to manage risks is also a source of risk, he said.

"Regardless of the ultimate purpose for the use of OTC derivatives, the past 20 years have no doubt shown that they are not easy to decipher, comprehend and master," Ding said. "The many instances of banks, hedge funds and pension funds that suffered losses from dealing with these instruments is a clear testimony to their volatility and inherent risk."

Need For Automation

Experts say OTC derivatives could greatly benefit from automation and standardization. For example, derivatives are still being written out by hand at many firms, increasing their potential for error.

The average OTC derivative has between 20 and 30 fields to communicate, said Thomas Forrester, senior vice president of investor services in the U.S. for State Street Corp. In some cases, there are 100 fields to be communicated on a single OTC product. The more complicated and confusing a product is, the riskier it is to those who don't understand its intricacies.

Anytime a firm inputs data manually, it needs to carefully review it, Forrester said. Firms must create a reporting system around the back-end to find and highlight errors, he said.

In addition to checking for potential errors, handwritten OTC derivatives need to be manually updated and then faxed, Forrester said. "You can have one wrong field, and you have an error."

"If you're doing a lot of trading of derivatives, you need to use FpML [Financial products Markup Language]," the industry-standard protocol for complex financial products, based on an eXtensible Markup Language (XML), the standard meta-language for describing data shared between applications, Forrester said.

By converting the files into an electronic format, it becomes much easier to tag them with FpML coding, he said, and by using a standardized system, it allows everyone to interpret and use the data in a multitude of ways. Standardization leads to simplification, and hopefully to greater understanding.

"As FpML becomes more widespread, these instruments will be able to interface more and hopefully these issues will go away," he said.

"We as an industry are starting to move in the right direction," Forrester said. "We still face many operational challenges, but we are well on the way to more automation."

(c) 2008 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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