OTC derivatives are now commonly used right across the asset management industry. They are based on virtually every asset class. At the end of 2022, they had an incredible notional market exposure of $618 trillion and 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 and do not have the specialist skills to deal in OTC derivatives and obtain the best prices.
A front to back office operating model needs to be appropriately designed, solutioned and implemented.
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.
Fields need to be mapped from trade input to the security master record. More bespoke derivatives, such as total return swaps and customised equity index options, must be structured to the security master record to capture their true economics. The underlying index on which these derivatives are based often needs to be designed and fed to obtain the correct valuation and risk. If necessary, an external valuation agent may need to be found to value these bespoke derivatives correctly.
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 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. This can take the form of targeted training sessions or working jointly with a consultancy to develop operating models for the OTC Derivatives life cycle, where in-house knowledge is built up during 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 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.
