OTC Derivatives Begin Journey onto Screens
Byline: Phillipa Leighton-Jones
A growing interest in derivatives products among fund managers looking to offset portfolio risks means the manner in which over-the-counter (OTC) derivatives are traded now needs to be addressed, according to analysts at Meridien Research, the US consultancy. OTC derivatives trading is currently a manual process. This means orders are sent and received by telephone and fax, with all contractual arrangements deliberated by the same means. Such processing has been largely abandoned in equities and, to a lesser extent, the fixed-income markets as it increases the risk of mistakes being made through information being misheard or misinterpreted.
However, while several alternative trading systems have emerged in the OTC derivatives area, the pace at which these will be adopted could be slower than in other areas of the market. This is due largely to the complexity of derivatives contracts.
Damon Kovelsky, an analyst at Meridien Research, which has recently published a report on the adoption of electronic trading in the OTC derivatives market, says: 'Vendors and participants have acknowledged that over-the-counter derivative trading will become electronic over time, not overnight. It is now accepted wisdom that not all derivative products, highly complex derivatives, for example, are suited for electronic trading.'
He says although the fax machine - ubiquitous now in OTC derivatives trading - may become obsolete as industry accepts new electronic means of trading, it may be five or more years before faxed confirmations become extinct.
Kovelsky says: 'We believe that at least three strategic areas in OTC derivatives trading - dissemination, confirmations and clearing - must start to change before alternative trading systems become standard and the accepted way of trading.'
One way to decrease manual trading and processing is through an alternative trading system. These are systems that electronically match Buy and Sell orders within certain parameters that are defined by the system's algorithm. Kovelsky says: 'Besides matching orders, alternative trading systems can also provide a bulletin board for orders that are currently within the system, reconcile trades after execution, and send electronic confirmations that can be imported into a firm's back office.'
However, OTC derivatives contracts require not only the determining price, the amount to be traded, reconciliations and settlement, but also the payment schedules, length of the contract and legal responsibilities. …