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The Complex World of Finance and the Role of Derivatives Within It (July 17, 2007)

Location: New York
Author: Shahin Shojai
Date: Tuesday, July 17, 2007

In a world where many famous people are simply famous through association with truly famous people, it is surprising to see how the world of financial derivatives has become infamous through association.

It seems to be blamed for most of the world's ills. When there is a backlog of uncleared credit derivatives contracts, which are nothing more than insurance contracts, and there are concerns that it could cause systemic risk to the industry, everyone blames derivatives, simply because the instrument has the term derivative in its title. When CDOs issued on sub-prime mortgages fail, like the recent Bear Stearns hedge fund problems, everyone blames derivatives, since many are synthetic in nature; and anything synthetic is believed to be a derivative instrument.

The fact is that the advances made in the valuation models of derivatives, which have also augmented pricing models used for securitized assets, have helped the world of finance identify ways in which to distribute risk that many could not have even dreamed of just a couple of decades ago.

We have all learned how to distribute risk among members of our own industry, across our borders to other industries, such as insurance, and even within instruments, such as synthetic CDOs that breakdown a single instrument into a myriad of repayment dates and credit quality instruments. The opportunities created as a result of the development of derivatives pricing, and especially the fact that most assets are now viewed through the derivatives prism, has helped make the world of finance significantly safer and more exciting.

Consequently, while derivatives should be thanked for creating the environment and the possibility of manufacturing this incredible array of new instruments, they should not be blamed for failures that take place outside of their own remit.

Of course, as the true benefits of these models received broader recognition the complexity of the instruments created increased, making it more difficult for the bank's internal pricing models to keep up. As a result, few engineers have taken shortcuts and in the process caused financial damage to their own organizations and given the entire industry a bad name.

However, it is through such trials and errors that ever more exciting instruments can be created and our knowledge of their potential inherent risks increases.

In the meantime, while all this exciting innovations are taking place, someone has to find a way to clear and settle them, an area that most financial engineers do not even think about when compiling these fascinating new products. Processing these ever increasing complex products has become a major concern for most financial institutions.

If one considers that by the end of June 2006, according to ISDA, the total notional value of credit derivatives outstanding was U.S.$26 trillion and the notional outstanding value of OTC equity derivatives was $6.4 trillion, the challenge that is facing our industry becomes clear. And the situation seems to be getting worse as everyone wants to get in on the act.

Many investors are now using derivatives to improve returns on their investments, rather than simply using them to hedge, as was the case in the past. And regulations such as the UCITS III Directive, which has enabled mutual fund managers to expand the range of permissible investments to include derivative instruments and to use derivatives to add long/short investment strategies to regulated funds offered to retail investors, are also helping fuel the growth of the industry. They are no longer the preserve of hedge funds and the proprietary trading desks.

The problem is that processing OTC trades is especially tricky because the contracts involved do not share common characteristics in the same way that more vanilla instruments do.

OTC derivatives come in multiple forms, such as credit default swaps, total return swaps, asset swaps, foreign exchange swaps and contracts for differences etc. Even within these broad categories, there may be a host of refinements designed to suit the counterparties, making the OTC a highly complex and individual transaction.

These complex trades are not readily supported by the banks' main processing engines, requiring greater manual intervention, and as a result placing the technological and operational infrastructure that underpins banks and other financial firms under immense pressure. At present, total annual OTC derivative processing costs range between U.S.$2.1 billion and U.S.$2.3 billion in the U.K. alone, of which, it has been estimated, between U.S.$346 million and U.S.$574 million are back-office costs.

It is not only the back-offices of the major investment banks that are having a tough time. Custodians are also finding it very difficult to build scalable, standards-driven OTC derivative trade processing platforms that are capable of servicing multiple clients and their service providers, at low cost.

For a start, the processing of OTC derivatives exposes custodians to extra expense, as subscription to specialist trade confirmation services such as DTCC Deriv/SERV and T-Zero is necessary.

To make matters worse, unlike cash instruments, OTC derivatives do not generate cash balances from which margins can be earned (in a Credit Default Swap, for example, the cash stays in the fund, and is used only if required in an event of default).

Furthermore, limited standardization of documentation in the OTC derivatives markets pushes the cost processing higher.Although ISDA has published a standard document to which term sheets are supposed to refer, in reality, counterparts negotiate detailed bilateral agreements which depart from its terms and conditions. As a result, custodians are obliged to review separately the documentation of every OTC derivative transaction agreed by the client and its counterparty. Worryingly for custodians, HSBC Securities Services estimates that it now costs up to fifty times more to process and value an OTC derivative transaction than its costs for an equity transaction.

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