The current Collateralized Debt Obligation (CDO) and asset backed commercial paper crisis, as well as the recent Societe Generale trading scandal, are pointed reminders to all investment management organizations: know what you own and know what you trade. Given the velocity of Wall Street-driven, new derivative types however, a firm’s ability to “know it all” is challenging at best. Industry processes that are not assimilating ongoing innovation in financial products through supporting technologies and standards are faltering. The list of concerns from investment management firms and performance measurement software vendors are increasing:

	Do legacy accounting systems assign accurate valuations, weights, flows and characteristics to certain derivative types?
	Do measurement and attribution systems have the ability to uncover characteristics within underlying securities in securitized packages that are important for valuation, attribution and risk measurement?
	How long can senior performance, attribution and risk measurement professionals sustain market pressure for deeper and more meaningful data analysis without significant change?

Technology advances are both solutions and obstacles when applied to these concerns. Certainly, technology is a major facilitator of the explosive growth in the finance industry’s activity and profits. However, recent market events have proven yet again that technology advances often outpace the ability of investment management organizations to integrate them. The resulting “technology lag” is proving disastrous for some and depressing for most.

Securitization and derivatives are the most glaring cases in point, underscoring how transparency and administration weaknesses can cause significant turmoil in the global economy. Certainly, the marketing and trading of securitized products, including derivatives, has improved markedly over the last five years. However, technology-driven accounting and administration, including performance and risk measurement of these instruments, has failed in many organizations. Legacy portfolio accounting and management platforms are providing data that is less than fully accurate, at best.

The current subprime saga clearly demonstrates that the technology of securitization and distribution has outstripped buyer understanding as well as the technology and process of accessing valuation and risk. The result reveals a lack of capabilities to look through the CDO to underlying securities as well as a failure to question the quality of credit provided to CDO’s investment banks.

Many of our clients are using legacy platforms to keep track of a host of new security types. Some firms have found ways to use transaction and security codes to “fool” the system into recognizing the valuation, performance, and risk characteristics of derivatives and securitized portfolio assets. From Cutter’s perspective, booking a derivative with several different transactions to achieve accurate reporting is not the best method for risk reporting. Other firms use employee-created spreadsheets and macros to analyze and report on the performance and risk of complex portfolios. This method has no standards for calculating the weights, impacts, or valuation of many derivative securities, especially the ever-increasing “over the counter” type.

Cutter Associates contends that these workarounds and “off line” adjustments are liabilities to the financial integrity of firms. It is time to invest in upgrading legacy systems and processes while continuing to develop and support more standard industry routines and calculations. Our clients appear to agree, with many requesting help in finding and evaluating new accounting, performance, and risk management systems to support derivatives and securitized offerings. In addition, there have been industry efforts over the last five years to strengthen derivative trading procedures:

	At least one global asset servicing organization is using the Financial products Markup Language (FpML) for derivative transactions to create a single dictionary of at least 10,000 distinct information fields for a derivative security. In tandem, the organization is completely regenerating a new middle and back-office accounting platform.
	The DTCC is another tangible example, developing a trade information warehouse that stores a copy of all DerivServ trades (approximately 80 percent of all credit default swaps.)
	The GIPS (Global Investment Performance Standards) administration executive committee is currently setting up committees to investigate expanding the standards to alternative assets and risk measurement.
	The hedge fund industry in the UK and the U.S. is creating voluntary standards for the valuation and transparency of hedge funds.

As a result, portfolio performance and risk measurement professionals are rightfully gaining in stature within their firms. These professionals depend on technology and process to pull together all portfolio data, validate the data accuracy, run software processes to compile and report, and then analyze the performance and risk attribution in a meaningful and impactful manner. To its credit, the CFA Institute has created an ethically-grounded knowledge certificate program for performance measurement professionals (CIPM).

CutterConsulting recommends that a firm’s senior management investigate the processes and the issues involved in producing performance and risk measurement reports and statistics. They should also be prepared to address areas where legacy software and process harms the reliability and integrity of the process.

Progressive investment management firms include senior management that strongly supports their performance and risk management professionals. Their goal is to create integrity-centric operation platforms and instill more process discipline such as in-depth questioning and analysis of data used in assessing portfolios. In times like this, as the tide goes out, it is best to reflect how best we keep our bathing suits on.