If the financial crisis has brought home one lesson, it is that apparently healthy markets can collapse in no time.
The flash crash on May 6 may not have been a real crash, but it caused real losses, and reinforced that message, just as investors began to feel that the worst might, perhaps, be over.
With this lesson in mind, it seems strange that some derivatives traders are still relying on risk management systems that are updated only daily – something many believe is way out of date in a volatile market increasingly driven by high frequency trading.
Or, as Nils-Robert Persson, chairman of software firm Cinnober, puts it: “Clearing systems and risk management software haven’t sold terribly well in the last 10 years.”
That is changing. Technology providers agree that there is a new approach to risk management throughout the industry, in which real time is becoming a reality. More firms than ever acknowledge that they need to monitor their risk exposures as fast as they create them.
A new opportunity
One of the first companies into this breach was Sweden’s Cinnober Financial Technology. Originally, it built trading systems for exchanges. When several clients asked for customised clearing solutions, Cinnober realised it had almost all the components for a clearing system.
The resulting product, Tradexpress Real Time Clearing, was released in April 2009. A year later, it won its first customer for the system, and four more have ordered “very large” proof-of-concept studies.
Cinnober believes it has the “most modern clearing system globally”, and that the market for these solutions is much larger than it had anticipated. “The largest investment banks have a huge interest in clearing technology,” Persson says. “They even move faster than clearing houses.”
Interestingly, when asked who gave the impetus for the new solutions, Persson replies: “High frequency traders were among those that approached us, as they wanted to calculate their risk in real time. While they were running their own processes, they were looking for a second party to provide real time risk management so they could check if their systems were running correctly or spinning out of control.”
The OTC story
Tech providers to the OTC markets have a similar story to tell. Being so vast, the OTC business has become a victim of its own success, which tore open the gap between front and back offices.
“The OTC markets had been growing so fast that banks are only now figuring out how to deal with that growth. Frankly, the infrastructure wasn’t capable of scaling up to the extent that the market has grown,” says Rohan Douglas, CEO of New Jersey-based Quantifi, which provides valuation models, risk management software and consulting services for the credit and fixed income markets.
“Banks used to accumulate huge backlogs of unsettled trades as their infrastructure couldn’t cope with the speed of the trades,” Douglas recalls. “This was already beginning to change pre-crisis, but regulatory pressure has certainly helped. Another factor that has helped is the increased standardisation of OTC trades. While a lot of OTC trades still have unique characteristics and there are still gaps in that area, standardisation has made progress and has gone a long way to make processing and settling easier and faster.”
From Quantifi’s perspective, most activity is now happening in the interbank market, where big firms want to electronically trade, clear and settle credit and interest rate products as fast as possible. The next step will be connecting these processes to the clearing houses. In a third step, there will be a roll-out to investors, who will get the same trade data and execution.
“This is where we see our biggest future market – connecting the systems on all three levels,” Douglas enthuses.
Rather than risk management being something people were happy to leave to the end of the day or the next morning, there is now growing demand for risk analysis even before trades are made.
“The speed gap between the front and back office is most definitely closing,” says Ed Gouldstone, hedge fund product manager at Linedata in London. “Back in the day, the back office didn’t even look at a day’s trades until the next morning, but that process has now sped up and the data can be audited at any given time.”
At the same time, the view on the portfolio is becoming more holistic, as institutions want to immediately gauge the total risk of positions as the market and their portfolio changes during the day.
“The goal is real time updates as the market changes and new trades are done. In practice, more complex products which take longer to value and limited market data for less liquid products restrict what can be done,” says Douglas.
Whether a firm needs real time risk management also depends on its strategy. Active hedgers need fast updates, while buy-and-hold institutions can simply ride out volatility and don’t want to be informed of every tick change.
One of the most formidable challenges systems providers face is the sheer quantity of data and number of data streams.
Paris-based Linedata has been offering a real time portfolio management tool to its clients for five or six years, driven by the need to bring the various spreadsheets and data feeds into one portal. Of Linedata’s 700 clients, around 300 are hedge funds.
“Hedge funds and investment firms are high volume consumers of data. With thousands of ticks streaming into their systems, the volume of data they need puts a big strain on their IT infrastructure, so stability is key and the question how best to make use of the infrastructure and the incoming data,” explains Gouldstone. “Another key focus is to know the exposure across the portfolio, so they need solutions that update positions tick-for-tick. With a portfolio of 40,000 positions, that can be quite a challenge.”
What users want
Asked what clients need today, software providers highlight several areas they are working on.
Valuations and the ability to customise are high on the agenda, as well as being able to process huge quantities of information. “A primary need is to get good data and more frequent data, which is especially important as the OTC market isn’t as liquid as the exchange-based market,” says Douglas.
But there are also new demands that have moved centre stage, as firms become more keenly aware of certain risks.
One of these is counterparty risk. While this has always been a concern for banks and brokers, now even investors are on the watch for banks or other institutions that might fail.
“With the markets as volatile as they currently are, customers also want to know where their
Another peril that has made global headlines is rogue traders.
“Our clients currently request to be able to manage the
SunGard entered the real time risk management market around five years ago with Stream Instant Control.
But it doesn’t have to be human mischief creating trouble. The sheer complexity and speed of trading create new demands on IT systems.
“We’ve noticed increased client requests to monitor give-up acceptance,” says Rousseaux. “They need to keep track of positions acquired via several brokers and our system Stream Instant Control automatically consolidates all orders, regardless who executed them. This prevents traders taking too big positions and moving out of their limits. A strong demand also comes from firms that grant clearing to their DMA customers, as they need to monitor their total risk acquired that way.”
Speaking the same language
Other challenges arise from inconsistencies within the same firm. Historically, many traders used their own pricing models which did not necessarily match the way the firm marked or processed trades in the middle office.
Several tech firms have tackled this issue, bringing front and middle office on to the same page. Quantifi, for example, has integrated models that Douglas says “are accurate enough for the front office traders and for risk management and trade processing”. This is intended to give consistency in valuation through the whole trade process.
Calypso Technology’s front-to-back office system is based on using one system for all three levels of the firm, ensuring that they can all view a trade simultaneously.
“In many cases, the front office have their own pricing modules and pricing environments to price trades. The middle office might not have the same data and pricing. Since we provide one system, everybody in the bank uses the same modules and there is no reconciliation necessary,” explains Naveed Ahmad, business analyst at Calypso in London.
Other clients want functional integration and simplification. “In the last six months,” says Rousseaux, “our customers are specifically asking to combine different functionalities that we used to offer via different software solutions. The need is to bring together all the data streams and bring them on one platform.”
Increasingly, he says, clients need to combine different figures and models when calculating value at risk. So they need to see what their risk is across portfolios and asset classes, taking into account both standard models like Span or Tims and their own risk ratios and standards.
Speed, simplicity and a narrower focus on the essentials are demands that Ahmad highlights: “I think clients increasingly realise that they don’t need all-singing, all-dancing systems that brew their coffees in the morning. They are willing to give up shiny extra functionalities they don’t actually need in favour of faster, more responsive systems offering functions that they really need.”
Regulators force the pace
The markets of the past may not have been riderless, but many jockeys were more concerned with keeping up with the field than exercising a great deal of informed control over their businesses.
Now, everyone feels the regulators’ push towards transparency. As Persson puts it: “Now the regulator demands that market participants have to know exactly where their risk is at any given time. And clearly, not knowing that can no longer be acceptable.”
The authorities’ demands go even deeper than that, Gouldstone (pictured) points out, such as being able to tell by how much positions were over the limit and for how long. Such data retrieval allows regulators to engage in forensic analysis at levels previously undreamed of.
Much greater detail is not the only challenge. As SunGard’s Rousseaux explains: “Audits to the regulators will no longer be at the end of the trading day, but will have to be done on an ad-hoc basis when the regulator requests them.”
In the US, the Securities and Exchange Commission has even decreed that brokers with direct market access must calculate their risk in real time. “This is a new demand caused by a new requirement that wasn’t around two years ago,” comments Persson.
The real time adjustment is not just affecting trading firms, but exchanges and clearing houses too. “Markets that don’t have modern infrastructure need to know that all positions in the market are covered with collateral, thus ultimately ensuring market stability,” Persson says.
This impetus will gain force as regulators try to push more OTC trades into clearing houses. With higher volume, says Persson, “real time risk management for the clearing houses becomes crucial, or you just gather systemic risk there and do nothing to manage it.”
More demand might be created by further regulatory requirements, which are due to be passed in the EU and will be fleshed out in the US over the next two years.
Changes could be dramatic – or even traumatic – on the OTC side, even though the exact shape and implementation of recent and future regulation is still very much in the air. However, tech providers agree that the big trend is clear. There is a strong push towards transparency, more electronic execution, clearing of OTC trades and more transparent access to market data.
“Some changes are less driven by the banks themselves but more forced upon them by regulation. New regulation aims to bring more transparency and competition which is not necessarily something that the banks wholeheartedly welcome, especially on the execution level and with regards to market data,” says Douglas.
Tech is no barrier to clearing
One of the arguments the industry has used in consultations with regulators is the huge demands some of the legal provisions could place on firms’ software and hardware resources.
To resist more clearing, some industry figures have claimed that it’s “technically impossible”.
Tech providers beg to differ. “To those we say, it is impossible when you’re using technology of the ’70s and ’80s, but there was a lot of progress, and those solutions are no longer a problem. We, for one, have the technology,” Persson insists.
The real source of resistance is elsewhere, he believes: “Some of these changes might cut into firms’ profits. There are strata of the industry, especially in middle management, where technological change is resisted to protect bonuses. To these, more efficient markets and processes can look threatening.”
Of course, costs are always a hot issue. Efficient systems don’t come cheap. “Expenditure seems to be the main obstacle for investors such as hedge funds that have just started out and maybe have €20m under management,” Gouldstone explains. “They have to pay for their infrastructure from their management fees at the start and some struggle to afford it. Conversely, the established players in the market have more financial freedom and are keen to get updates.”
But tech firms say that once clients have been won over, they come to fully stand behind the new procedures and possibilities. “This is a conversation I’m having more and more often with our customers,” Gouldstone says. “They tell me that they’ve really started to appreciate the value of having real time data. Increasingly, they can justify the necessary spending to have that real time view.”
Only the beginning
Tighter regulation, more complex trading and new awareness of risks have been some of the effects of the financial crisis on the real time risk management market, both in terms of client demands and what tech providers offer.
Risk models and the way processor capacity is used are more efficient than ever. Calculations that used to take hours and were conducted many hours after the fact can now be done in seconds and on an ad-hoc basis.
In short, the changes have been dramatic, which is likely to continue as risk management overall has evolved from ‘nice to have’ to a business-critical core function.
“Senior management would like to see the risk positions in real time across a wide set of products and geographies to allow for quick and accurate decision making,” claims Ahmad.
Closing the speed gap between trading systems and clearing systems fully might not necessarily be essential – or could be superseded by the need for transparency through all offices, from front to back.
“It might not move towards the back office keeping tabs on the front office any time soon. For these people, the priority is to have access to the same kind of data and look at the same exposure as the front office for auditing and transparency reasons,” says Gouldstone.
But some market participants feel that the present drive towards faster real time management and pre-trade risk management is only the beginning. Or that the two horses will eventually not chase each other, but run in tandem.
“There is no reason for a trade to take three days to be settled,” believes Persson. “I feel the development will be towards immediate settlement, collateralisation and payment. But this is likely not a point we will reach in one year, but 10 years.”