Swift is pioneering the automation of OTC derivatives transactions but a number of asset managers are not joining the scheme. Instead they are saving costs by using their custodians to link into the Swift network. Nik Pratt looks at the implications …
Over-the-counter (OTC) derivatives have been the subject of much operational angst for buy- and sell-side traders alike, with both sides of the market unable to process these instruments with the level of efficiency they would like due to the lack of automation.
The importance of a more efficient OTC derivatives market is not lost on anyone, particularly the asset servicing companies who realise that the ability to offer a compelling processing service for these largely manual instruments is the key to gaining market share in an increasingly competitive arena. Also, with the volume in the OTC market growing at an unrestrained rate, they realise just how much the manual processes involved are costing them in time and labour.
For their part, the asset managers just want an end-to-end processing solution for their OTC derivatives and, as yet, no such system is available. Progress has been gradual with most industry initiatives germinating within the US securities industry and looking to address the whole issue by taking it one process at a time – contract definitions, instrument identifiers, trade capture, matching, confirmations and reconciliations.
So far the DerivServ service from the US-based Depository Trust and Clearing Corporation (DTCC) has been relatively successful in trying to automate the matching and confirmations process and this is where the majority of effort has been concentrated, not least because that link with the broker is where most asset managers feel the biggest risk lies.
Now, perhaps, attention is more likely to turn to the process between asset managers and their custodians and the trade capture process – at least that is what the custodians are hoping and also what industry-owned messaging body Swift (Society for Worldwide Interbank Financial Telecommunications) is hoping.
It was in the second quarter of 2007 that Swift announced its own OTC derivatives project to automate post-trade processing. Sensibly, Swift is aiming at the first step, contract notifications, and is looking to replace the largely fax-based current practice with automated messages sent through its SWIFTNet messaging infrastructure and based on the financial product mark-up language (FpML) XML standard developed by the International Swaps and Derivatives Association (ISDA).
Swift recruited a number of custodians and large asset managers to participate on the pilot via a series of closed user groups and in July announced that it had completed the successful transmission and reception of its first test message – between Barclays Global Investors and Brown Brothers Harriman (BBH) – and anticipated that the pilot phase would be completed by the middle of 2008.
Start date approaches
So with this period approaching is Swift still confident that it is on schedule? “We are ready and we expect the first live messages to be sent by the end of Q2 this year,” says Michel Keulemans, head of Swift’s pre-settlement programme. This is not to say the process has been completely hitch-free.
“We realised that there some gaps in the FpML portfolio. For example, there was no definitive message for a cancellation of notification so there was a small delay while this was fixed over the Christmas period and it is now something that will be a part of the portfolio once it goes live at the end of Q2.”
The service will be a complete one, says Keulemans, with notifications and cancellations for asset managers to their custodians and a number of confirmation messages, where it will be dealer to dealer. He also says that Swift will be looking to add to its instrument coverage for notifications. While the initial emphasis has been on interest rate and credit default swaps, which together account for near 85% of the total volume of OTC transactions, Swift is also looking to include the syndicated loans not so far covered by ISDA.
The involvement of ISDA represents a slight change for Swift, which is used to having an autonomous role in its projects rather than being reliant on an external body for the definition and management of the standard involved, and Keulemans accepts that this has been a challenge. There are pros and cons to ISDA’s involvement, he says. On the one hand there is a lack of direct control, something which Swift has tried to mitigate by being involved in as many working groups as possible. On the other hand, there is not the set release date time that usually comes with Swift standards, meaning that the FpML project can work outside this somewhat rigid framework and there can be multiple releases during the year.
The major challenge for Swift, however, is in encouraging enough asset managers to take part. So far the asset managers involved that are prepared to go public are Barclays Global Investors and US-based Western Asset Management while State Street Investment Management Services has taken on an insourcing role for asset managers. There are other large asset managers that are involved in the pilot, however they are yet to make their participation public knowledge.
Big business
It is no surprise that it is the large asset managers that are so far involved as Swift membership has always been a volume-driven decision for asset managers. Any fund manager wanting to be involved with the SwiftNet FpML project will first have to pay out for Swift membership and the ongoing costs associated with using the Swift network. They will also have to upgrade their technology to be able to connect to the SWIFTNet platform. Finally they must have the capability to send data files in an FpML format.
For the larger asset managers this investment is not overly prohibitive. Many of them will already be Swift members and their large transaction volumes will bring them substantial discounts from Swift. As Ahmad Sharif, managing director and head of derivatives product management at BNY Mellon, acknowledges, a certain volume of OTC derivatives transactions would certainly help make the SWIFTNet project more compelling. “The linkages are not cheap to implement because the fund managers need to invest in the technology,” says Sharif. “And if you are only sending one or two faxes a day, why would you care?”
Subverting Swift
The other challenge for Swift is that while asset managers may adopt the FpML standard, there is no obligation for them to send or receive their messages via the Swift network. Instead they can simply connect to their custodians via a direct link, as is the case for one of BNY Mellon’s pilot clients that had the 4.1 version of FpML installed but did not want to go through the expense and coding of upgrading to the 4.2 version necessary to go via SWIFTNet.
So how is Swift encouraging asset managers to opt for sending their FpML messages via the Swift network rather than going directly through their custodian? Keulemans says that he is expecting the custodians to push the case for SWIFTNet as it would mean more standardisation in terms of the messages they receive from their asset managers as well as the added security and validation associated with Swift.
The standards argument can also work the other way, as Cherie Graham, senior vice president and head of derivatives products, BBH, says: “If I was an asset manager with multiple service providers, I wouldn’t want to have to subscribe to lots of different standards – I would want one common standard.”
Nevertheless there is a certain agnosticism for custodians as to whether asset managers use FpML via SWIFTNet or via a direct link – just as long as they stop sending faxes. There is also a realisation that Swift membership and the associated costs may be too much for some asset managers; consequently custodians such as BBH are offering alternatives.
“We’ve been looking at ways to help asset managers phase this investment and many have been using our Infomediary service as a way of outsourcing their Swift messaging,” says Graham. “They are able to send a proprietary data file to Infomediary which will then translate that file and send it in an FpML format to Swift.
“Any of our asset managers that trade derivatives have expressed an interest in FpML. Those that trade them in large volumes are interested in the SWIFTNet pilot but many of the others that do not trade as much volume are not interested in SWIFTNet and are looking at either using Infomediary or sending messages directly to their custodians.”
Cost implications
Swift is also aware of the cost of its service and is in the stages of developing a Lite version of its SWIFTNet platform, a more affordable version aimed at asset managers. So far, says Keulemans, Swift has been concentrating on the Lite service it has developed for corporates and it tends to focus on one ‘community’ at a time. However, fund managers are next in line and Keulemans says the Lite service may be available by the end of the year.
By this point, there will be live FpML-based contract notification messages being sent and received via SWIFTNet, say those involved, but this is likely to be restricted to the large players rather than the industry at large. And while a more affordable, ‘lite’ version of SWIFTNet will help, and the importance of automating OTC derivatives transactions is not lost on anyone, no-one is expecting an overnight revolution once the Swift project goes live.
“I do not think this will give us immediate relief. It is a multi-year effort and progress will be gradual,” says BNY Mellon’s Sharif. “We will get some volume but it will be some time before we can say that 50% of OTC derivatives trades are coming through Swift.”
© funds europe 2008
