Settlement risk—one of the most deadly in the risk menagerie—is the risk that occurs between the time a transaction is agreed upon and settlement. It is a “silent killer” because traders and risk managers may continue transacting business and calculating their risk under the mistaken assumption that certain trades have been settled.

Over-the-counter derivatives are especially vulnerable to settlement risk, because unlike their exchange-traded cousins, the OTC contracts differ in maturity and other details. All this has attracted the attention of regulators such as the Bank for International Settlements (BIS), which last year issued a report noting that active dealers of OTC derivatives reported backlogs of hundreds of unmatched trades, with a significant portion having been left outstanding for 90 days or more. According to the report, discrepancies were found in 5 percent–10 percent of the confirmations, with some reports even as high as 30 percent–50 percent.

Spurred by possible regulatory scrutiny, Chase Manhattan and two other major broker-dealers agreed last year to use matching technology designed and built by Canada’s SNS Technology specifically for OTC derivatives trades. The matching service, which was expected to go live early this year as Londex, will compete with Swift’s version of the matching service, expected to launch in September 1999 through the London Clearing House. While 14 additional institutions have expressed interest in Londex, Chase officials are urgently pushing greater industry participation, since they contend that neither the status quo nor Swift’s version will appease the regulators.

“This has become an issue in the derivatives industry because of the large number of outstanding confirmations between dealers, and the fact that volumes have reached levels never seen before,” says Neil Wright, executive vice president in charge of risk technology at Chase. “We have signed a contract with Londex, but the product will need greater industry participation if it is to work. From our perspective, Londex offered a flexible product and appears be quick to the market.”

“Matching for these products is a big problem. We don’t yet have a standard that is flexible enough.” Patrick Poncelet Swift

Because OTC instruments are usually highly customized, often with multiple embedded options, matching trade information can be problematic. Messaging fields for each trade can be different in a number of respects. “It is up to the members of Londex to decide which fields are included in the matching,” Wright explains. “Fourteen major players, including European and U.S. firms, have expressed interest in being founding members of Londex.”

Swift’s Accord product, using message field number 362, has been able to match vanilla OTC derivatives such as forward rate agreements successfully, but the system doesn’t work as well for exotics such as collars, which contain both a cap and a floor, admits Patrick Poncelet, head of business development at Swift. “Matching for these products is a big problem. We don’t yet have a standard that is flexible enough. The problem is that you need the same fields for matching between two dealers, and that limits the flexibility to match other trades.”

What’s more, Swift officials admit, they have been relatively slow in delivering a messaging template solution for exotic OTC derivatives. They contend, however, that spending more time getting feedback from end-users will prevent the problems that undermined the failed SwapClear project they worked on two years ago with the Chicago Mercantile Exchange. In addition, they point out that Swift’s existing Accord technology can handle vanilla OTC derivatives, which make up 60 percent of the traffic.

Still, Wright says banks such as Chase want the Londex service as an alternative to Swift. “Londex could be an end-all solution. Regulators will put pressure on banks to deal with the service,” he says. “This would involve investment in technology, but this should be prioritized. Londex can probably work with any technology in the back office.”

Merrill Lynch licensed SciFinance 1.0, developed by Austin, Texas-based SciComp, for use in quickly generating sophisticated programming language for structuring and pricing options without having to program a system. The software will help decrease turnaround time for developing prototypes of derivatives models for Merrill Lynch’s global equity-linked products department.

Merrill Lynch licensed SciFinance in December 1998 and will deploy the technology globally according to a three-year contract, with options to renew for up to 12 years. The licensing agreement follows another deal signed by SciComp with the Amsterdam, Netherlands-based investment firm MeesPierson. MeesPierson officials said they bought the option-pricing technology to customize models for the company’s exchange and OTC equity derivatives trading business.

MeesPierson hopes the technology will be faster than other option-pricing methods, including Monte Carlo, says Monique Donders, who heads MeesPierson’s derivatives department. “We plan to use the technology to construct models to price a whole range of instruments, including vanilla and complex products. We will use the models for both pricing and hedging.” Of particular interest to MeesPierson was the ability to use discrete time instead of continuous time; to price barrier options with stochastic volatility; and to set interest rate volatility parameters.

Because the SciFinance software generates models based on the option’s specifications, it eliminates the need for programming. The software, which is priced starting at $100,000 per year, produces finite difference codes, which often run faster and are more accurate than traditional methods, according to Elaine Kant, founder and president of SciComp. In addition to offering speed, Kant claims, the software is less burdensome on computer memory. She adds that a bank could develop a consistent set of models with only a half page of code. The technology will also restrict access to certain models, ensuring that traders use the most appropriate pricing mechanisms.

Infinity extended its recently launched credit assessment tool called Market Simulator by adding NetSuite, a set of customized Java applications for scheduling, reporting and Internet-based distributions. Market Simulator incorporates several standard risk measurement methodologies—Value-at-risk and stress testing—and was codeveloped by TrueRisk as a single integrated framework.

Users will be able to customize reports distributed automatically at any point in time and construct or access reports from a remote computer that does not use Market Simulator. The Infinity NetSuite is integrated with the Infinity 7 suite of applications, and is an add-on product to Infinity’s Market Simulator. “By having a Java interface to the full power of Market Simulator, users can benefit from the ease-of-use, portability and rich networking capabilities of Java, combined with state-of-the-art risk measurement techniques,” says Dan Rissin, a principal at TrueRisk.

New Products
Company	Vendor	Product	Use
Calpine Corp.	TransEnergy	Manager Version 5	Allows users to manage energy commodity transactions.
EnTrade BV	TransEnergy	Manager Version 5	Allows users to manage gas commodity trading.
Merrill Lynch	SciComp	SciFinance 1.0	Generates code to value and hedge equity derivative instruments.
Dai-Ichi Kangyo Bank	FNX	Sierra System’s FX Options Module	A front-to-back-office trading system.

New Products
Vendor	Product	Function
Spheresoft	Real-Time Highlighter	Highlights changes in Excel figures in real time.
	Modeler	Demonstrates paradigm shifts.
	Chronion	An open library for time-series data and analytics.
	Constellatia	A framework for developing web-based client-server applications.
Inventure/Saladin	Ranger/Energy Server	Provides data mining and distribution through Ranger for energy-related data held in EnergyServer.
Infinity	NetSuite	Customizable Java applications for Market Simulator.
Algorithmics	Algo Suite 3.1	An update to integrated risk management system.
Sava Risk Management	PowerSuite Version 2.0	Enhances diversity of pricing for energy options, improved analytical speed and user interfaces.
Barra	Cosmos System Global Manager version 2.3	Offers European Monetary Union capability and the addition of new asset types and emerging-market currencies.
Mint Technologies	Special Software Solution	Links back-office systems with coninuous linked settlements for settling European currency transactions.
Decisioneering	CB Predictor	An Excel add-on that incorporates statistical forecasting tools into a spreadsheet format.

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