Cutter AdvantEdge
Issue 41, August 2006
Devilish Derivatives
There is no question that derivatives, and most especially credit default swaps ("CDS") , is one of the hottest topics, perhaps the hottest topic, for investment managers. As an example, consider The Technology Council™, a consortium of global managers facilitated by CutterAssociates™. The Council has 68 members, including all ten of the ten largest asset management firms in the world, with a total of nearly $22 trillion under management. Members of the Council choose the topics researched, and we consider their choices to be bellwethers of what is important to the industry. Council members chose derivatives-related topics as three out of the last eight; this has directed nearly half our research time over the last four years toward derivatives.
There is also no question why derivatives are such a major issue for IT. First, derivatives do not fit easily into the established systems structure, requiring additions, changes or enhancements in nearly every system from analytics to client reporting. Second, few, if any, of the current systems can properly process derivatives, forcing firms to install new core systems or, more commonly, to install derivatives-only systems and then to try to bring together the information on two disparate systems for analytics, trading, accounting and client reporting.
Third, the derivatives market, and especially the CDS market, has experienced explosive growth. According to the International Swaps and Derivatives Association, the CDS market has burgeoned from $631 billion in 2000 to over 17 trillion at the end of 2005, growing more than 25-fold in five years. This means that firms need to act much faster than they had to act for prior new instruments. Fourth, derivatives are difficult to understand. They are more complex in every aspect, from analytics to accounting to operations, and addressing a firm's needs for derivatives processing entails a very steep learning curve for IT.
The best solution to this problem would be to have the vendors of current core products - OMS, accounting, client reporting, and the like - enhance their products to properly handle derivatives. If this were to happen, then firms could continue to use their existing systems without disruption. However, our recent research indicates that, while many are trying, few of the OMS solutions and almost none of the other solutions can process derivatives correctly. Not only do vendors face many of the challenges listed above, but they are also saddled with systems architectures that are not amenable to absorbing the scope of changes required to handle these newer instruments.
A less attractive but still viable solution is to acquire one or more systems dedicated to handling derivatives and to run these systems in parallel with existing systems. This solution, of course, raises the problem of data integration. How can you get a total picture of your position and activity when your data is split between two systems? Those firms that had already installed data warehouses or data hubs already have a solution to this issue, although they will have to re-engineer their workflows to accommodate derivatives. It is also helpful if the firm already has centralized compliance checking, since this allows the installation of a new OMS for derivatives without impacting the firm's ability to check all trades for compliance.
At the moment, given the inability of traditional buy-side vendors to provide derivatives processing, buying specialized derivatives systems and running them in parallel with existing systems is the only viable solution for most medium and large firms. Smaller firms have the option of shoehorning derivatives information into their current systems, buttressed with manual processes and Excel spreadsheets, but this is not a scalable solution.
Where should you look for specialized systems? There are a few, off-the-shelf buy-side solutions, but there are many vendors of specialized derivatives systems to the sell-side. Please note, however, that you will face some obstacles here.
These systems were built for the sell-side and lack some basic capabilities needed by the buy-side. One of these is the concept of a portfolio. Since the sell-side operates using a common pool of capital, the concept of having holdings and cash dedicated to each of a number of portfolios is alien to them. For example, one vendor proudly stated that they could handle a portfolio construct by simple mapping client portfolios onto their system's "books," and shortly thereafter, when discussing a different topic, showed how easy it was to drag and drop assets from one book (one of your portfolios) to another book (a different portfolio!).
Furthermore these sell-side systems were built as stand-alone systems, and most lack the kind of integration features typically provided by buy-side vendors. This means that you will have to do a lot more work to integrate these systems into your current architecture.
In the future - unfortunately perhaps not the near future - the traditional buy-side vendors will enhance their systems to handle derivatives, and the need for parallel systems and their integration with your current systems will go away. For now, however, there are few great choices.