Over-the-counter derivatives, once known for their obscurity, are center stage in the Securities and Exchange Commission's lawsuit against Goldman Sachs and President Obama's financial reforms. When values went south in 2007 and 2008, an inability to properly judge and react to the risks contributed to the bankruptcy of Lehman Brothers and the near-failure of AIG.

Operations executives heading to the Securities Industry and Financial Markets Association's 2010 conference in Palm Desert, Calif., this week agree regulation is imminent.

And that spells plenty of operational headaches. According to Jon Williams, managing director and head of U.S. markets for online marketplace operator TradeWeb, the most likely changes include mandates for more transparency on pricing of derivative contracts before trades are made, the creation of a central counterparty for clearing standard contracts and regulators' interest in monitoring trading activity through the data repositories.

The overarching goal, of course, is to monitor and reduce systemic risk to avoid the collapse of financial firms of such size that a domino effect could blow up economies around the world.

Yet operations specialists say they face plenty of risk in deciding how to prepare for the most likely outcome: a required central clearinghouse for many OTC contracts.

In the past, buy- and sell-side firms' middle and back offices have only dealt with exchange-traded instruments or transactions negotiated "bilaterally" by two parties, generally over the phone. The changes will affect how post-trade functions, such as reconciliation, collateral management, margin calls and valuations are handled.

The challenges for small- to mid-tier mutual fund managers and broker/dealers will be far more difficult than for large ones with deeper pockets-and add another level of brokerage services.

"Fund managers may decide to rely on brokers for clearing rather than face the expensive and time-consuming task of building connectivity to individual clearinghouses," said Jeff Gooch, chief executive of MarkitServ, a joint venture between Depository Trust & Clearing Corp. and Markit Group, a global financial data, valuations and trade processing firm.

Bottom line: for each product, fund managers will need to pick a clearing broker and decide which clearinghouse to use for their over-the-counter derivatives.

That's no easy task because they will have to interpret just which contracts out of $450 trillion worth of derivatives can be considered "standardized" over-the-counter contracts, Gooch said.

Morgan Stanley has estimated that up to 60% of OTC derivatives will move through a central clearinghouse over the next two years-leaving 40% remaining at the bilateral, paper-based level.

Last December, Intercontinental Exchange's ICE Trust and the Chicago Mercantile Exchange's CME Clearing beganofferinginstitutions access to clearing services for credit default swaps. Clearnet did so for interest-rate swaps. Nasdaq has also entered the fray offering a clearinghouse for interest rate swap futures contracts called International Derivatives Clearinghouse.

The clearinghouses offer proprietary interfaces to their processing systems, but data suppliers and market operators such as Bloomberg, Tradeweb and Markitprovide links as well. Bloomberg's VCON service allows buy-side firms to execute orders on the phone and affirm them electronically before sending them to multiple clearing firms and clearinghouses, said Bloomberg Director of Credit Trading George Harrington.

Markit's MarkitServ goes further than Bloomberg in permitting OTC derivative trades to be electronically confirmed with a legally binding agreement between counterparties for onward delivery either to a clearing B/D or clearinghouse. Among the other front-end functions are allocations and innovations.

TradeWeb claims it also provides a "complete electronic workflow" for institutional fund managers and allows fund managers to engage in price-discovery with multiple broker/dealers. In so doing, it offers a "competitive auction" of sorts, which Bloomberg does not, for credit-default swaps.

The decision on which provider to use when linking to a single or multiple clearinghouses is just the tip of the iceberg in the technology spend institutional investors must make.

The Great Reconciliation

Next up is how to reconcile their positions and records with their clearing broker and the clearinghouse. In short, this adds yet another player to the post-trade processing equation; a fund manager and B/D can't simply settle any differences between each other.

"In the world of bilateral clearing outside a centralized clearinghouse, the counterparties would match up their positions; then decide on the daily valuations of the OTC derivatives for efficient collateral management and margin calls," explained John Burchenal, director of market growth for Omgeo, which provides post-trade communication services. "But once the central clearinghouse is put in the middle, there needs to be further reconciliation of positions and margin requirements between the fund manager and the B/D, and the B/D and the clearinghouse, and vice-versa back down the food chain." Omgeo offers a reconciliation and collateral management platform for fund managers and broker/dealers.

Even if the details of each trade were the same if each trade was automatically confirmed, there could be discrepancies in the total number of open or closed transactions, resulting in differing initial collateral requirements. Additional margin requirements can also vary, based on how contracts and collateral are priced. To protect itself against a fund manager's potential default, a clearing broker could also ask the manager to post more margin than the clearing broker.

These innumerable discrepancies leave plenty of room for errors that inevitably fall into the laps of middle- and back-office operations executives. The price tag could easily amount to more than $1,000 per trade, according to one OTC derivatives operations executive.

Calypso Technology, a San Francisco-based risk management software vendor, says there is one surefire way the derivatives industry can reduce-if not eliminate-discrepancies: Get the fund manager, clearing broker and clearinghouse to rely on the same software to keep track of the same underlying data and pricing models for the calculations for their positions, margin requirements and valuations.

"That means creating one version rather than multiple versions of the truth," said Calypso Senior Vice President Gerard Rafie.

"Most of the differences will likely be on exotic contracts that are bilaterally cleared rather than standardized ones cleared through a clearinghouse," agreed Jon Anderson, vice president for GlobeOp, a hedge fund administration firm. "It won't be too operationally difficult for our fund manager clients that already trade in exchange-listed futures and options because we have links to dealers who will be clearing members."

GlobeOp also provides position reconciliation and collateral management for exchange-traded derivatives.

So what will determine whose software is used?

"Whether it provides the necessary position-keeping, connectivity and other risk management tools they need for not only OTC derivatives but other products as well," said Eric Bernstein, chief operating officer of North America for Sophis, which offers these capabilities.

Operations executives at two fund management firms in New York acknowledged that most small- to mid-tier fund managers will opt for such a platform.

"The best-of-breed approach is often used by larger firms, but there are substantial integration costs and time to market," said one operations exec. "Because we aren't a large player in the OTC market, we would prefer to rely on a single service provider."

Drastic Changes

When large and respected financial firms can't figure out just what securities they own and exactly how much they are worth, it is time to make drastic changes. Those should be before any new laws go on the books.

"By now, it's likely that most firms already have some measures in place to value their [over-the-counter derivatives] contracts so the legislation won't shake their strategies too much," said Jerry Hanweck, founder of Hanweck Associates, a New York-based quantitative financial analysis firm.

Firms with large portfolios of OTC contracts on their books will still need to ensure they have the right procedures in place to meet the requirements for ongoing valuations of their assets and to comply with fair-value accounting rules.

Pricing Complex Derivatives In Four Simple Steps

1. Get the Basics Right: No OTC derivative contract can be accurately priced if the details of the trade are not accurately captured and stored through an order-management or trade-execution system.

2. Validate: Ask for explanations on the methodology used by any outside valuation expert, in case there are differences of opinion.

3. It's OK to be Different: Valuations can and should be performed separately by back-office, accounting and risk-management groups, as well as front-office teams. Each unit can rely on different models and input so valuation professionals should be careful to use assumptions that are appropriate for a given pricing model and current market conditions.

4. Document, Document, Document. Write down the procedures for the inputs and models that will be used for pricing each type of over-the-counter derivative and each business unit involved in that pricing.

That includes determining who on the valuation committee will be responsible for the final say on the valuation if there are differences between your firm's valuation of its assets and those from outsiders such as specialist providers, clearing brokers and clearinghouses. Although exotic complex products are often cited as having the most pricing discrepancies, "even similar credit default swaps contracts can be priced differently," cautioned Kevin Borrett, managing director of portfolio valuations for Markit Group.

(c) Copyright 2010 Money Management Executive and SourceMedia Inc. All rights reserved.

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