Asset managers across the industry now commonly use OTC derivatives. They are based on virtually every asset class. At the end of 2022, they had an incredible notional market exposure of $618 trillion. They also had a market value of $20.2 trillion, dwarfing the equity, bond and listed derivative markets.
The operating model to support OTCs, however, continues to pose many challenges. Typical pain points clients experience are:
Trading:
A variety of platforms to interact with, plus voice transactions. Many asset manager franchises have their OTC derivative dealing carried out by their central equity or fixed income dealing desks. These desks typically deal mainly in equities and bonds. They do not have the specialist skills to deal in OTC derivatives and obtain the best prices.
Asset managers must appropriately design, solution, and implement a front-to-back office operating model.
Data:
Difficulty in loading standard and non-standard vanilla OTC derivatives into the asset manager’s applications; an Interest Rate Swap, for example, has 20 of these fields.
Managers must map fields from trade input to the security master record. They must structure more bespoke derivatives—such as total return swaps and customised equity index options—to the security master record to accurately capture their economics. Analysts or developers often need to design and feed the underlying index on which these derivatives are based to obtain correct valuations and assess risk. If required, they must engage an external valuation agent to properly value these bespoke derivatives.
Valuation:
Choosing the valuation source for centrally cleared swaps for Investment Book of Records (IBOR) and portfolio analysis, valuing nonstandard OTCs, independent price verification (IPV), and bringing pricing sources for non-supported exotic such as Markit & BVAL.
Selecting the best valuation methods for both internal valuations and those that go into the NAV. An Independent Verification Process (IPV) should be created to ensure the integrity of internal and NAV valuation and those used for collateral and margin management.
Collateral & Margin:
Validating collateral and margin calls.
A risk-based framework based on the derivative’s risk measures at portfolio and asset level can be developed to manage this validation process. This reduces unnecessary escalations and delivers a timelier agreement on collateral and margin calls.
Fund Administrator:
Interaction, data representation, and transfer.
A key part of an OTC derivative life cycle is working with the fund administrator. This is to create a smooth communication and valuation process. This involves mapping the asset manager’s data to the fund administrator’s data, helping them with their in-house NAV valuations, or advising on using an external valuation agent.
Expertise:
Confined to the front office and lacking in the middle office and operations.
A firm should seek to deepen its in-house expertise and knowledge of OTC Derivatives across all parts of the business. They can deliver targeted training sessions or collaborate with consultancies to develop operating models for the OTC Derivatives life cycle, building in-house knowledge throughout the process.
Davies has over 50 years of experience working with OTC derivatives at major investment banks and asset managers. We have expertise in complex OTC derivatives. These are across the front, middle and back-offices, designing and implementing OTC derivative systems and processes.
We have successfully migrated a 6,000 book of OTC derivatives to a new system, including custom-made Total Return swaps and Equity Index options, building a full life cycle OTC derivatives operating model.
