From allocations to average pricing: Getting the complete picture of the trade lifecycle

Key Takeaways

• Trade allocations and give-ups considered major risks
• FIA and DMIST standards aim to improve average pricing
• Firms must adopt a more holistic approach

Electronic trading has been a welcome development with traders across the asset class spectrum embracing the liquidity, speed, and cost efficiency. However, as with any technological advancement, there are the inevitable unintended consequences. In this case, it has revolved around trade allocations and average pricing.

A recent report by Acuiti in conjunction with OSTTRA — Futureproofing Derivatives Post-trade: Building Operational Resilience Across the Market — found that the two key areas of risk in the system are allocations and give-ups, whereby orders are executed at one brokerage firm and given to another for clearing.

Both were cited as major causes of the pandemic-fuelled disruption in 2020 by the majority of the senior market participants canvassed from 57 major sell-side firms and asset managers across the globe. Industry data revealed record volumes in March 2020 led to 15 times more contracts not being cleared on trade date because of manual processing in the top day clearing of trades. Similar frictions also emerged in 2022, in the wake of the Russian invasion of Ukraine and related market volatility.

Problems with workflow meant that the trade was cleared in the eyes of the central counterparty (CCP) but not from the perspective of the executing broker or asset manager. This left unallocated exposure, although clients were oblivious to any issues.

Industry reaction

The result was industry soul-searching and the creation of the Derivatives Market Institute for Standards (DMIST) as an independent standards body to foster greater efficiency, resiliency, and competitiveness in financial markets. Its first initiative, along with the Futures Industry Association, was to publish the Timeliness of Trade Give-Ups and Allocations standard in 2023.

The standard aims to improve the delivery and processing of allocation instructions by establishing the so called 30/30/30-minute timeframes. Clients, executing brokers and clearing brokers are obliged to submit and process allocation instructions within 30 minutes of the trade being confirmed or instructions received. A set of metrics was also defined to allow participants to measure progress.

Opinions have been mixed. While most of the Acuiti respondents welcomed the standard, many remain worried over issues such as data quality and enforcement. They also voiced concerns about the potential impact of periods of extreme volatility. Normal conditions were one thing, but the view was that the system would struggle in tumultuous times. This is particularly the case for firms operating across multiple time zones because Asia and Europe close down for the day ahead of the US.

The Acuiti report also notes the proposed industry standard needs complete buy-in from asset managers and owners. Otherwise, it says it will struggle to fulfill its promise of timely allocations and risk reduction.

Getting average pricing right

The other hot topic highlighted in the Acuiti report was accurate average prices, which are a perquisite for timely give-ups and allocations. Market participants complained about the lack of standardization, inconsistency, and manual processes. In response, the FIA and DMIST launched a separate consultation last year followed by a final rule in June that sets out industry-wide agreed guidance on the minimum standards for average pricing.

The objective is to have standardized rules and automated functionality, which will help drive consistency and improve the current allocation and timing issues associated with average price order workflows. This entails automating the process from order entry through clearing, using a broker’s middleware system to interact with clearing. In addition, the number of allocations in the system for CCP average pricing can be significantly lowered by consolidating all fills into one allocation group.

The standard includes a 16-point functionality framework that covers three main components. The general standards category, for example, comprises an average pricing functionality to be made available for all products and CCP systems to support a minimum decimal precision of seven and a maximum of 10. Meanwhile, the grouping section covers minimum product criteria and lists the transactions that should be excluded. In addition, it encourages CCPs to consider offering an alternative to traditional average pricing that uses notional value. Last but not least is cash residuals, which specifies that the CCP should not only automatically calculate and monitor the cash residual but also include the figure in end-of-day reports.

A holistic approach

Despite the progress being made, there are technological gaps that need to be addressed to successfully comply with these new standards. It is early days, and the majority are either investing or planning to partner with product firms that have developed the required functionality. Whichever choice firms take, they should not be adopting a piecemeal approach but a front-to-back product suite that can run around the clock and process large trade volumes at high straight-through processing rates. This not only simplifies workflows but also enhances performance and feeds the real-time status of a trade’s clearance back upstream into the risk system so that traders have transparency to the status of their trades.

In summary, minimizing operational risk and meeting regulatory deadlines with data flowing seamlessly throughout the trade lifecycle, offering real-time insights into net positions, margins, risk, analytics, and commissions, is an achievable goal for the industry with agreed industry standards and modern technology.