Survey of the OTC Derivatives Market in Australia – May 2009 5. Post-trade Practices

The final aim of the Survey was to gather information on market participants’ use of centralised infrastructure to support activities in the Australian OTC derivatives market, and in particular to support the post-trade processes and life-cycle management functions described in section 2.2. A better understanding of domestic trends in this area is essential to the authorities’ assessment of the market relative to the FSF recommendations.

This section draws out some of the emerging themes in this area, exploring evidence of a gradual shift towards more automation in post-trade processes and possible reasons for slower progress in the Australian market than in some overseas markets. It seems that, with a relatively small scale of activity across products, some participants have been reluctant to incur the high up-front costs of investing in automation. Even where a participant is connected to automated facilities, the benefits cannot be fully realised until a critical mass of its counterparties are also connected. An effort is therefore underway, particularly by the large overseas banks, to encourage more of their counterparties to use automated facilities.

5.1 Confirmations processing

The use of automated facilities to support affirmation and matching processes (ie, the validation of trade details prior to confirmation of a trade) varies considerably across products and across participants. The main reason for this seems to be differences in the scale of respondents’ OTC derivatives business: several respondents on the sell side and the buy side argued that low volumes did not justify the relatively high up-front cost of connection to automated systems. As such, some respondents expect to do so only when either costs fall or their trade volume increases sufficiently. There has nonetheless been gradual progress over recent years towards higher levels of automation in some products and several sell-side participants are actively expanding their use of automated facilities.

In credit derivatives, for instance, there has over the past few years been strong momentum behind operational enhancements, largely driven by regulators in the United States and Europe (see Box 2). As a result, the majority of sell-side Survey respondents active in this product are connected to DTCC's Deriv/SERV, a global provider of automated confirmations processing. Details of confirmed trades are also stored in DTCC's Trade Information Warehouse and available to other ancillary systems, including CLS for settlement of credit default swap premia. There has, however, been limited take-up of the service among Australian buy-side participants to date, reflecting their relatively low trade volumes and a perceived lack of urgency to shift away from manual processes. Since such facilities can only be used if both counterparties to a trade are connected, the proportion of credit trades confirmed via this channel is therefore lower in Australia than overseas.

Industry and international regulatory attention has turned more recently to operational processes for other products, such as interest rate swaps and equity derivatives. However, the use of automated facilities in the Australian market for these other products remains relatively low. For instance, only around a third of the sell-side respondents to the Survey cited active use of Markit Wire, a confirmations processing platform used widely overseas, particularly in the interest rate swaps market. Again, given more limited take-up by counterparties, even those firms that are connected cannot process as high a proportion of their Australian trades via these channels as they would like, and as is achieved internationally.

The firms making the most extensive use of automated facilities currently are predominantly overseas banks. As discussed in section 3, up to three-quarters of these banks’ OTC business derives from overseas. In many cases, overseas banks’ post-trade processing is also located offshore (Table 4).

Offshore processing may arise for a number of reasons. For instance, OTC derivatives trades in Australia are often initiated offshore in an international branch of the overseas bank, with the trade subsequently booked and processed by the initiating branch in its own name. Also, overseas banks may be able to achieve economies of scale in middle- and back-office processes by centralising these functions in a regional or international processing hub (eg, London, Hong Kong or New York). In many cases this ensures critical mass to justify investment in connecting to automated facilities.

Differences in levels of electronic confirmations processing across products are a source of observed variability in the timeliness of completion of trade confirmations (Graph 6). Among sell-side respondents, median reported confirmation lags are longest in equity derivatives, where there is limited use of electronic facilities. Survey respondents made little reference to the practice of ‘economic affirmation’, which is increasingly used internationally to agree at least the key economic terms of a trade soon after execution, thereby mitigating risks associated with a lengthy lag in confirmations processing. At the other extreme, confirmation lags are lowest in the foreign exchange market, where CLS Bank's settlement facility also offers trade matching and confirmation.^[1]

Although overseas banks make greater use of electronic facilities, median reported confirmation lags are often no lower than those of the major domestic banks, and in most cases somewhat higher. In discussion with respondents, two main explanations arose for this. First, overseas banks tend to carry out more business in complex derivatives than domestic banks. More complex, structured trades are less amenable to streamlined post-trade processing. Second, the limited take-up of electronic facilities among counterparties was cited. If a counterparty is not connected and the bank instead has to revert to manual processing, there may still be a lengthy lag in completing confirmation.

Several overseas banks, as well as some domestic banks already using automated facilities, have been actively educating both buy- and other sell-side counterparties in Australia about the benefits of using these platforms. As well as widening participation in these facilities to maximise the potential efficiencies, an expansion in their use would help the overseas banks meet their commitments to international regulators.

5.2 Life-cycle management and settlement of cash flows

Similar factors are at play in respect of market participants’ usage of third-party services to manage risks arising through the life of an OTC derivatives contract.

For instance, there seems to be less extensive use of portfolio compression (ie, the practice of identifying, via multilateral processes, trades between counterparties which can be terminated without altering market or credit exposures beyond specified tolerances) and portfolio reconciliation tools in the Australian market than overseas (see Box 2). A majority of respondents use portfolio compression services for interest rate products, but in many cases relatively infrequently. Again, the scale of business is seen by some as too low to justify more frequent use of the service. In terms of portfolio reconciliation, most respondents reconcile positions only at the point of trade or on an ad hoc bilateral basis when there is a dispute with a counterparty. This typically relies on in-house processes, although at least one respondent plans to make use of a third-party portfolio reconciliation platform (one that has gained penetration overseas). Again, it will be necessary for a critical mass of counterparties to also be connected to the service if the full benefits are to be realised.

Central counterparty clearing of OTC derivatives has been hotly debated in recent times, particularly given the prevalence of counterparty credit concerns across markets. Among the perceived benefits of increased use of central counterparties are the application of conservative risk-management tools, multilateral netting, and co-ordinated default management.

While services have emerged internationally for standardised segments of several OTC derivatives product classes, the coverage of these services has to date not typically been extended to Australian products. An exception is SwapClear, which provides a central counterparty service to the inter-dealer interest rate swaps market. The service extends to vanilla swaps in 14 currencies, across a range of maturities. Although Australian dollar contracts are covered, only a few overseas banks indicated that they currently used this service. This in part reflects SwapClear's high entry criteria, which cover not only an entity's capital and credit rating, but also the nominal value of its outstanding swaps book (which must be at least USD 1 trillion). As a result, only the largest international dealers in the global interest rate swaps market are participants. SwapClear does not currently allow ‘tiered’ participation; ie, it is not currently possible for an entity failing to meet the access criteria to clear via a direct participant.

Finally, settlement of Australian dollar cash flows arising from most OTC derivatives trades takes place in the Reserve Bank Information and Transfer System (RITS), via either SWIFT^[2] or Austraclear. The exceptions are foreign exchange outright forward and swap transactions, which are typically settled by CLS Bank. CLS has also, since 2007, offered a settlement service for quarterly premia associated with credit derivatives trades registered in DTCC's Trade Information Warehouse. This service has only recently been extended to Australian dollar cash flows, with the first settlements via this route taking place in March 2009.

5.3 Looking forward

Survey respondents were asked to offer thoughts on how post-trade processes in the Australian OTC derivatives market were likely to evolve over the coming period, acknowledging the trends towards automation and central counterparty clearing internationally.

There is an overwhelming sense that levels of automation, straight-through-processing and recourse to third-party services are set to increase, with the large overseas banks in particular continuing to actively promote the use of electronic confirmations processing and portfolio compression tools. These banks note that the strength of regulatory pressure in some jurisdictions has greatly assisted this process. Some buy-side respondents, however, expressed concern that third-party services were less accessible to buy-side participants.

There is some support for expansion of the central counterparty clearing model to other OTC products, although it is acknowledged that there are limitations to the model. For instance, there is deemed to be insufficient standardisation in some products, and risks and inefficiencies could arise if a single product class was taken out of a bilateral cross-product netting agreement and submitted to clearing. Some argue that many of the risk, operational and transparency objectives could be realised by simply further developing existing confirmations processing, warehousing, settlement and portfolio compression tools.

If central counterparty clearing is to be extended to credit products traded in the Australian OTC derivatives market, or indeed other products, respondents generally consider that the volume of business in Australia does not justify a stand-alone domestic central counterparty. It is expected that any emerging international facilities will be open to Australian products and participants, at least in the medium term.

Footnotes

Foreign exchange payment instructions received from CLS members are typically matched and confirmed electronically shortly after execution. The status of such transactions is available to members in real time, and members are immediately notified where matching is not successful. [1]

Society for Worldwide Interbank Financial Telecommunication. [2]