Trading in off-exchange derivatives has long been the domain of specialist brokers – an intricate world of bespoke contracts, non-standard risk and valuation models, blighted by suboptimal settlement operations.
However, a new breed of technology promises to deliver a unified process and accountability in stark contrast to the challenges of legacy processes, opening the asset class to broader investment opportunities through lower settlement risk and higher margins.
Going off-piste - a rewarding but challenging route
Like off-piste skiing, trading over-the-counter or OTC instruments requires skill, independence and flexibility. The market structure of the multi-lateral Exchange-traded world doesn’t suit all types of derivative business and instruments, so the bespoke and bi-lateral nature of trades agreed and conducted off-exchange satisfies a specific demand for more freestyle liquidity – specific terms, maturity and risk profile - and those offering it venture off the packed powder of the exchange slopes to write business that’s inherently more rewarding, but without the safety offered by their groomed and gated runs.
Aside from the financial risks and rewards of uncleared, volatile and heavily geared contracts however, the players in this part of the market endure the unnecessary challenge of manually intensive operations – non-standard contracts, fragmented process and high rates of settlement failure - which add cost and risk to an already-challenging asset class.
Recent studies conclude that for OTC Derivatives alone, streamlining post-trade processes could remove a total of $8 billion of unnecessary operating costs and operational losses. With such losses stemming from operational risks, this is a major consideration for all market participants.
Furthermore, attempts to bring transparency and lower systemic risk through regulation, bring with them an ever-increasing reporting and reconciliation burden which compounds to threaten the viability of these assets in themselves in the longer term.
Black-run rewards with on-piste control
Imagine taking the best attributes of the existing OTC world, and increasing profitability and compliance by lowering the frictional cost of operations and financing.
Well that’s exactly what is happening. By leveraging smart contracts, and ISDA’s Common Domain Model – an industry-standard protocol that maps out the lifecycle of post-trade derivatives – a new breed of technology offerings is emerging.
Based on proven, finance-grade digital ledger software, service providers are already laying down the trail markers… offering the industry the choice to bring their products onto a platform that removes the frictional cost of failures whilst giving the lateral freedom to write customer-specific terms. A unique combination of contracts and workflow that are smart enough to enable flexibility alongside automation. Allowing attributes to be shared and matched with each consumer and counterpart of the trade simultaneously, removing the constant internal reconciliatory burden and providing an immutable golden-record throughout the post-trade lifecycle.
Beginning with trade inception and agreement between counterparts, the digital workflow enables matching, confirmation, settlement and regulatory reporting. All steps are contractually binding, with the agreements on-ledger providing both proof and legal certainty to all parties. Payments and changes of terms are subsequently handled automatically and seamlessly as the instrument negotiates its normal post-trade lifecycle through to maturity.
Such technologies are simple, secure and scalable, interoperable with existing systems through open APIs, and available now.
So to its users and their customers, this new technology offers operational efficiency without removing flexibility and choice - Fewer white-outs, avalanches and crevasses, but with freestyle rewards … the excitement of a black-run, but with the certainty of a clearly-marked piste.
