These characteristics of OTC derivatives distinguish them from
exchange-traded derivatives that are transacted on a central
trading floor or through an electronic trading system and are
cleared and settled centrally through a clearinghouse, which acts as
central counterparty to all the contracts. The economic terms of
exchange-traded contracts, i.e. underlying assets, value, delivery
dates and strike prices (for options), and credit terms are stan-
dardized. This standardization and the creation of a central coun-
terparty make the contracts more liquid than OTC derivatives.
Transaction processing and settlement for OTC instruments
The operations function, which is responsible for transaction pro-
cessing and settlement, performs a key role in managing risk. It
minimizes credit, market and legal risks by ensuring that all trans-
actions are accurately recorded in internal systems, that the details
of trades are agreed as soon as possible after execution with the
counterparty and any disagreements resolved, and that the firm’s
settlement obligations are met when they fall due. Operations risk
is minimized by automating, as far as possible, all the process
from trade execution through to confirmation and settlement.
This reduces the errors due to manual intervention during confir-
mation and settlement of OTC derivatives transactions. While it is
possible to automate the processing of plain vanilla transactions,
more complex OTC transactions require significant manual inter-
vention at many stages of the processing.
Trade execution
Most OTC derivatives transactions are executed by telephone
although automated brokerage systems are used for certain foreign
exchange derivatives. Traders are responsible for
ensuring that trades fall within credit lines for the counterparty and
overall trading limits. While some institutions are beginning to
develop integrated credit management systems that provide online
Managing Operational Risk in Financial Markets
Transaction processing and settlement for OTC instruments
50
access showing the availability of credit lines for counterparties,
others need to apply to a credit or risk control function before exe-
cuting the trade in order to ensure that limits are not breached.
Although brokers are used in some transactions, they never act as
principals in OTC markets. They merely help locate and bring
together the counterparties willing to transact the business.
Data capture
After executing the trade, the details, including the date, time,
counterparty name, instrument, payment dates, etc. are recorded.
Trade data is either input directly into a front office processing
system by the traders and fed electronically to the operations area,
or recorded on tickets and passed to operations for manual entry
into the processing system.
Confirmation processing
After a trade has been executed, the counterparties confirm its
details to each other in order to produce an agreed record of the
transaction. There is increased use of the confirmation templates
developed by ISDA for standard trades. However, bespoke tem-
plates may be used for some more complicated products. The con-
firmation lists all the economic terms, e.g. the notional amount,
effective date, rates and payment dates, and legal terms of the
trade. When a firm receives a confirmation, it typically checks all
the terms against its own confirmation. Any discrepancy between
the two has to be reconciled and the confirmations reissued for
signature by both counterparties.
Confirmations are normally prepared by the back office staff who
are independent of the traders in the front office. Legal as well as
operational staff may be involved, particularly for more complex
products or if the firm does not already have a signed master
agreement with the counterparty.
4 Introduction to derivatives
Transaction processing and settlement for OTC instruments
51

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