Over-The-Counter (OTC) derivatives are experiencing phenomenal growth. Long used by sell-side banks in their risk control operations, buy-side firms have now embraced OTC derivatives as another asset class. In short, OTC derivatives are being utilised as if they were exchange traded instruments.

Such sharp growth in volume has, however, created a backlog of unconfirmed trades. While exchange traded instruments have been subject to great improvements in automation, the sudden surge in OTC derivatives has taken many a back office by surprise. The US Federal Reserve and the UK Financial Services Association (FSA) became so concerned that both have been placing pressure on the industry to introduce new conventions. Such regulatory guidance in the market is encouraging the adoption of technology that reduces risk in the matching and confirmation process, and that clears the backlog of trades.

The focus of attention by the Federal Reserve and the FSA has been on the credit derivatives market, where the total value of outstanding contracts is estimated to top $12,000bn. The industry’s response came in the form of the leading banks signing up to the International Swaps & Derivatives Association’s (Isda) novation protocol, which will lead to improved practices and the cutting of outstanding confirmations. We look forward to a swift implementation - even with this close scrutiny over the summer months, the Bank for International Settlements (BIS) reported that the notional amount of credit default swaps (CDS) increased by 60% in June 2005.

Yet the surge in popularity is not restricted to credit derivatives - BIS statistics show that there has been a marked increase in activity throughout the equity and commodity markets; volumes grew by nearly a fifth in June 2005 alone, and this certainly correlates with our experiences with clients.

The main focus of the market regulators has so far been on the more vanilla credit market, and rightly so. This has generated much progress, but there is now an increasing need for the market to turn its focus to the manual processes that remain in the trading of complex structured products, such as equity and commodity derivatives.

In order to provide an all-encompassing solution to the confirmations problem the buy and sell-side need to co-operate. The sell-side is fully aware of the need for change, and the volume of trades at the buy-side has now reached a level where there is an active interest in reducing the number of unconfirmed trades. This impetus has been spurred on by comments from the Federal Reserve and the Counterparty Risk Management Group (CRMG). The buy-side has not traditionally implemented large-scale automation throughout its OTC derivatives settlement process, but there is now interest to the point of making capital expenditure to connect to systems.

Matching service providers are also looking at ways to increase traffic over their systems, and have become more proactive in addressing the needs of market participants. However, the various initiatives ongoing in the market are yet to reach a level of co-operation whereby suitable standards and procedures are in place to ensure a reliable framework for processing all OTC derivative instruments.

It is important that new solutions are multi asset-class and do not focus on an isolated instrument category. It may never be possible to fully automate trading in highly structured off-exchange derivatives, but a large part of the trade lifecycle can already be automated – with the right technology. With complex equity and commodity derivatives largely excluded from automation projects to date, there is a danger that the market will wait until problems are caused by the backlog of confirmations before taking action. As the use of OTC derivatives has increased, the volume of confirmations has increased beyond the capacity of both the buy and sell-side.

Both the buy and sell-side are struggling with enormous confirmation backlogs, and this causes a knock-on effect in the market. The sell-side players with the highest volumes must focus on the largest backlogs first, causing the smaller players (both buy and sell-side) to wait to have their backlogs resolved. The sell-side has the capacity to bolster its systems to handle the increase in volumes, but few buy-side firms have been able to achieve an acceptable level of automation to be able to cope with the growth in trades across asset classes.

For there to be efficient post-trade activity it is fundamental that there is an efficient reporting and workflow process in place. To reduce risk in such a fast-developing market it is important that appropriate processes are in place to facilitate the transactions at the buy-side.

The systems to address this problem need to be developed in partnership. For example, systems need to take into account that it is not possible to connect the buy-side to the same DTCC connection as the sell-side. Similarly, a standard Web interface is not practical for firms that complete more than a minimal number of trades per day. It is also important to appreciate that not all buy-side firms are able to allocate large budgets for expenditure on systems and staff. Appropriate and tailored back office processes need to be implemented to ensure that the smaller firms in the market and buy-side firms can manage risk effectively. It is also necessary for the sell-side and the larger participants to make adjustments to their systems to accommodate changes in the market.

None of us want to see the OTC derivatives market become the problem child of the securities industry, and the technology does exist that can prevent this outcome. The buy and sell side need to work together, and the industry must acknowledge there is more to this market than vanilla-style credit default swaps.