Dynamics in payment processing for OTC derivatives trades

By Vinod Jain, managing consultant, HeadstrongCaeson Potter, technical manager, Headstrong This paper seeks to highlight and address the various dynamics in payment processing for over the counter (OTC) derivatives trades. Introduction: Payment processing is a critical function within the lifecycle of OTC trades. The majority of trades in the $465 trillion OTC derivative trading market …

February 14, 2011 | Headstrong

By Vinod Jain, managing consultant, Headstrong
Caeson Potter, technical manager, Headstrong

This paper seeks to highlight and address the various dynamics in payment processing for over the counter (OTC) derivatives trades.


Payment processing is a critical function within the lifecycle of OTC trades. The majority of trades in the $465 trillion OTC derivative trading market are cash-settled. Too often settlement breaks in OTC trades occur as a direct result of mismatching cash flows between the receiving and paying entities on a bilateral agreement. A settlement break directly impacts books and records of a firm. In the new era of post regulation, with a mix of OTC cleared and non-cleared trades, as well as the increase in the number of bilateral contracts using cash as collateral, payment processing will emerge as one of the key operational areas for process efficiency.

However, if both parties establish an agreement on the payment amount to be settled, then they are ensured fixed trade economic details. Thus, a settled payment exchange between the two parties guarantees that both are capable of meeting their trade obligations.

Current payment process for OTC trades:

A payment transaction occurs during an OTC trade’s lifecycle process for the exchange of regular periodic cash flow, coupon payment, upfront payment, termination and innovation fees, credit events; rate reset fees, margin, collateral movement (including interest on collateral), claims and charges. Similar to the OTC trade confirmation process, every payment between the two counterparties is agreed, confirmed and matched before the payment value date. The bilateral netting process reduces the number of cash movements and lowers the cost of payment processing. To achieve the benefits of netting, a single payment instruction is linked to multiple underlying trade details. Firms’ internal systems record the payment history for OTC trades.

In addition, to store the golden and copper record of a credit default swap trade, the Depository Trust & Clearing Corporation Trade Information Warehouse (DTCC TIW) also processes payments for credit derivatives trades via a link with CLS Bank for settlements. Also the new DTCC cash flow matching system for equity derivatives will streamline the payment notices affirmation and confirmation process for OTC equity derivatives. Both initiatives support the industry drive towards standardization and transparency.

The fact that settlement matching and exception payment processing is still the least automated function in an OTC life cycle process highlights the multiple issues that exist within the OTC settlement function. Processing structured and collateralized debt securities has proved challenging ever since their inception in the market. Some of the payment processing issues facing firms include:

• Non standardization of collateralized-based asset types which, with their unique life cycle events, create payment processing inaccuracies
• Late and inaccurate notifications of payment reset rates for CMO’s, CLO’s and ABS Asset Types
• Higher payment processing failure rates due to a steep decline in the value of the assets
• Numerous post-value date adjustments, causing higher risk rates with lower efficiency returns
• Reversal of additional or initial payment due to change in reset rates

Account setup

To streamline regular payment processes, firms maintain standard payment instruction details for each currency, counterparty, account and payment type. This information is exchanged between counterparties on a regular basis usually by fax or email. Firms employ dedicated teams to set up new accounts for counterparties as well as to maintain all static data. When information is incorrect and/or must be changed, the manual process causes delays. A time delay occurs in verification of the changes and updates across all relevant systems, as well as across multiple payment processing platforms. There is no centralized platform or standard messaging to update the standard settlement instruction between the dealers, buy-side firms and custodian.

Payment notices

Payment notices are sent out by firms giving details of the upcoming payment and the various trade elements which are used in the calculation. The payment notice highlights the currency, value date, amount, payer, receiver, account details, rate, period, trade identifiers and trade details used in the calculation. Though payment notices are typically auto-generated from internal proprietary systems, the communication with counterparty is still manual, through telephone, fax and email. The verification of payment notices is also manual and time consuming from the receiver of the payment notices side. Without uniformed payment notice templates available to communicate the details, there becomes a need for multiple interpretations. The variation of the payment notices for each asset class adds more spice to this process.

Life cycle events

A consistent challenge exists to maintain a single copy of an OTC trade across its life cycle. An event in the life cycle involves a cash movement between two counterparties. A correct identification of the life cycle event ensures correct payment calculation. There is no industry data available to identify the number of payments across each payment type. Any change in the benchmark floating rate triggers a control point to validate the payment. Every incoming or outgoing payment due before the value date is sent to the Treasury unit for funding. The Treasury group in an organization ensures that the required amount is made available in the Nostro account for outgoing payments and earns interest on the additional funds by investing in the overnight market.

Payments related to collateral movement and initial margin

Cash is the most preferred asset used as collateral against a counterparty risk. Initial margin is typically referred to as a good faith deposit or a cushion payment to cover initial day market movement and can be requested intra-day on volatile market days. Thresholds and minimum transfer amounts are other parameters used to identify whether payment transactions should be made. Thresholds allow counterparties to take a certain amount of unsecured credit risk equal to the threshold without requiring collateral to cover the additional risk. Though cash by nature is fungible, collateral management process demands that independent amount, initial margin and variation margin can be tracked to each customer. The recent financial crisis, regulations and industry initiatives have ensured that this traceability is necessary for the financial system.

The effect of incorrect payments

The majority of firms have write-off policies to protect against failed transactions, which can occur for multiple reasons. Amounts to be written off can include back valuation charges, interest compensation, loss on funding and overdraft charges. Such charges directly impact the firms’ P&L. Depending on the trade situation an incorrect payment can be back-valued. When payments are back-valued, there are two outcomes:

• The paying party pays the back valuation charges and the receiving party receives the payment on a specified good value date
• The paying party chooses to make a late payment in which the payment is delivered to the receiver with a new value date and the paying party pays the late payment fees

Then, there is also the manual process involved with the reversal of incorrect payments and the cumbersome reconciliation process that must take place to re-receive and or re-send a payment. While incorrect payments vary based on the particular product specification, and in general represent only a small fraction of all payments made, the losses associated with incorrect payments can be substantial. A missed or incorrect payment may lead to complete portfolio reconciliation. There are no industry wide guidelines for OTC products. Thus each institution has set its own policies and guidelines for processing interest compensation claims.

The effect of central clearing

Clearinghouses mediate every buy and sell of member firms. The member firm pays membership fees and posts collateral for every trade cleared at a clearinghouse. With the Dodd-Frank Act mandating more centrally cleared trades, there will be increased transparency (mark-to-market pricing) all of which can be monitored. Cash flow and collateral reports for OTC trades from clearing houses are still evolving. Firms using clearing members should demand added transparency on their collateral and payment flows. In addition the clearing members’ demand for fees to clear the trade should be negotiated. The back loading of the trades from the traditional OTC cleared world should include updating of the payment process and instructions.


Reconciliation of payments for OTC derivatives poses some of the greatest business challenges due to their definite economic impact. Un-reconciled payments directly increase firms’ liability. Firms monitor their Nostro accounts closely to make sure that no unidentified counterparty cash is left sitting in them. The reconciliation process is extremely manual and labor intensive, consisting of excel spreadsheets and novated agreements between counterparties. Reconciliation methodologies are usually proprietary to firms and reconciliation break accounting is manual.

Industry initiatives such as trade netting and portfolio compression are used to reduce the number of trades and payments to be processed. The number of breaks reconciled within two days has increased across asset classes.


Payment settlement matching is one of the least automated functions in the OTC trade lifecycle function. Payment processing for certain trade events should not be automated due to trade complexity, counterparty complexity or the nature of the payment. With the renewed focus on risk management, counterparty exposure calculation is one of the prime functions in credit risk management including payments in transit, failed payments, past due and currently unsettled payments with the counterparty. A non-payment incident immediately triggers the risk management team to re-evaluate the counterparty exposure risk. Settlement functions are performed in a low cost centre. However, increasing value additional services in payment processing for OTC derivatives either through process efficiency or automation still remains the major factor.



Banks have real opportunity in FX hedging for SMEs

Other | Banking Banks have real opportunity in FX hedging for SMEs

GFT are finalists in two categories for the Cloud Excellence Awards 2022

Other | Banking GFT are finalists in two categories for the Cloud Excellence Awards 2022

LexisNexis® Risk Solutions
How Does NXTsoft OmniConnect Work for Partners?

Video | Banking How Does NXTsoft OmniConnect Work for Partners?

Castlepoint Systems pioneers world-first regulation technology solution

Case Study | Banking Castlepoint Systems pioneers world-first regulation technology solution