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Funds Increasingly Turn to Derivatives: But Lacking Technology, Rely on B/Ds, Utilities


As the use of derivatives in mutual funds continues to grow, so will buy-side firms' reliance on third parties to handle post-trade processing, along with the search for employees who truly understand these complex trading contracts, according to a report from Celent.

That's because buy-side companies simply haven't made automating derivative processing a priority.

"Asset managers are still really conservative," said David Easthope, an analyst with the Boston-based research and consulting firm. "Why throw a lot of budget dollars on technology that isn't really core technology?" he said. "The buy-side prefers older technology that is tried and tested."

As a result, Celent predicts that global spending on third-party technology to support automated derivative trade settlements will grow nearly 24% from a $187.8 million business today to a $232.5 million business by 2011. Although the growth of derivative use by buy-side companies is increasing about 5.5% per year, the sell-side firms will account for nearly two-thirds of that spending.

The use of derivatives is no flash-in-the-pan fad, either, said Chicago-based Morningstar Mutual Fund Analyst Lawrence Jones. "A lot has gone in to setting up these relationships," he said. In some markets, the value of derivatives is greater than the securities on which they are based. And while not all derivative tools are sustainable, some, such as the credit default swap and currency-risk derivatives, seem to have endless utility, he said.

Credit derivatives on domestic corporate bonds alone represent something close to a $10 trillion market-many multiples of the value of the bonds themselves, Jones said.

Today, funds rely heavily on broker/dealers and utilities, such as the Depository Trust & Clearing Corp. in New York, to settle trades in a timely, accurate manner.

"Broker/dealers have to get it done, and get it done right," said Andrew Weigel, president of Eclipse Software in Jersey City, N.J., which provides derivative platform software primarily to broker/dealer clients.

So far, it has worked well. After concerns that this quickly growing class still relied largely on manual processing conducted on paper, by telephone or via fax, and with mounting backlogs, 14 credit derivatives dealers convened in October 2005 to address the issue of automated trades.

Within a year, the processing backlog had been cut by 70%, and 80% of all derivative trades were being settled electronically.

But as the class continues to grow-the market for credit default swaps alone increased 206% between 2000 and 2006-so will the risk of buy-side companies relying on others, the report notes.

"If I get the trade wrong, the notional value is incorrect," Easthope explained. Celent estimates that the still highly manual processing of over-the-counter derivative trading process means that about 30% of trades include errors.

In 2006, the average credit derivative took brokers 12.9 days to confirm, while so-called, simple "vanilla swaps" took nine days, and the newest, more complex equity derivative contracts took 20.4, according to data from the International Swaps and Derivatives Association in New York.

If errors do exist, it can take even longer for managers to detect and correct them, thereby affecting the valuation of funds overall.

"How much of that can be pushed back to dealers?" Easthope asked. Sooner or later, as the use of derivatives continues to grow, buy-side companies will have to take on more control of the process in-house.

Patchwork solutions like in-house software models, paper and phone calls won't hold up. "It's like sticking your finger in a dam," Easthope said. "You have to decide whether you're going to add to headcount or add technology," he said.

But finding the people to handle those trades poses another problem. "There is a gap between where the industry is going to be and where the human resources pool is right now," Easthope said.

Buy-side companies will be looking for people who truly understand the way derivatives work and who understand programming. But so far, that hasn't happened, said Les Carter, a recruiter at Carter, Stone & Co. in New York. "Buy- side has always trusted the sell-side and banks to put on reliable trades," he said. And they have lived up to their promise.

Some companies, though, are slowly building derivative teams, Jones noted. T. Rowe Price and PIMCO are examples of companies with dedicated derivative traders and analysts, as well as accounting and analytics software.

Ultimately, increased competition among funds for intellectual capital brings the issue back to technology, Easthope said. "When human resources get very expensive, that's when technology gets more important," he said.

Still, that may take time. While derivatives are becoming more important at buy-side firms, they still don't represent a big enough portion of the portfolio yet, Weigel said.