FSA Spotlight on OTC Derivatives

Financial services institutions who fail to effectively manage operational controls when executing and settling over-the-counter derivatives risk damaging investor confidence in the rapidly growing market.

That was the message from back and middle office software provider peterevans today (1 March), following the distribution of a letter of concern to practitioners from the Financial Services Authority (FSA) drawing attention to perceived failures in OTC settlement and confirmation of deals in some banks and financial services firms.

"This is a significant intervention from the FSA in a fast-growing field," said peterevans Managing Director Dr Mike Foley.

"The explosion of the OTC market – with over 50 per cent of all credit derivatives trades executed through London-based institutions – has seen market demand climb fast and is leaving some practitioners in a situation where they do not have adequate back office technology to ensure swift and effective transaction confirmation.

"This will undoubtedly give investors cause for concern. In such a fast-moving market, confirmation of settlement becomes central to satisfying an investor. Effective automated systems are key to managing settlement, and those institutions who have not implemented adequate controls are increasingly at risk of damaging investor confidence in the sector," he said.

He said the OTC market had demonstrated a high level of creativity and innovation in its short life span, and while the FSA warning should not be taken as a threat of ‘creeping regulation’ of practitioners, a sensible approach to back office functionality should be viewed as a tool to increase client confidence.

Credit derivatives now account for a total of over £2.5 billion – a staggering increase from £94 billion at the end of 1997, according to the British Bankers’ Association. Levels of post-trade automation have not kept pace with this growth for some City dealers.

"While it can be viewed as a challenge to get adequate levels of back office automation in place to fully exploit the benefits of the OTC market, the medium to long term benefits of exercising good levels of control are numerous – in addition to the investor confidence boost which comes from providing a timely service, institutions are able to demonstrate to regulators that they are adopting a realistic and best-practice approach," added Dr Foley.

Derivatives were identified as the fourth-highest risk area in terms of managing daily transactions according to a newly published survey by City of London think tank CSFI, behind concerns about too much ‘prescriptive regulation’, credit risk and corporate government risk.

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