Technology: Unravelling the tech trends

Software vendors have had difficulty selling their pricing models to top-tier investment banks and have targeted second-tier or regional investment banks instead. But greater product sophistication could mean this is about to change, while vendor consolidation and buy-side demand is reshaping the whole market. Shamillia Sivathambu reports

Technology vendors have found it increasingly difficult to sell derivatives pricing and risk management software to large investment banks due to the latter's reliance on home-grown systems. Top investment banks maintain large quant teams and extensive in-house risk software capabilities; their reputations depend on how competitively they can price and risk-manage derivatives, thereby justifying their heavy expenditure on in-house models, explains Emmanuel Fruchard, director of fixed income and credit professional services at Paris-based risk technology company Sophis. But some software vendors argue that this trend is changing.

Greg Dowling, London-based global head of FX options, structured interest rate derivatives and structured equity derivatives IT at HSBC Investment Bank, says that, in the past, top-tier investment banks developed everything in-house because they wanted total control over their ability to respond to demand. "But vendors' systems are now more sophisticated and there is also greater integration. We are getting to a point where the choices between internal and external systems are not as stark," Dowling says.

"As business continues to grow, many top-tier investment banks will need a 'backbone', which is where integrating external software into proprietary systems plays a role," says Vall Herard, New York-based senior vice-president of product marketing at risk technology company Numerix.

Traditional capabilities have reached their potential and sell-side firms now need better models, adds Charles Marston, chairman and chief executive officer at Calypso Technology, the San Francisco-based risk technology firm. As long as the industry remains creative and innovative, there will be a need to update software systems, he says.

In-house systems tend to evolve according to a bank's sales and profit margins. If sales are low, it is unlikely that banks will spend more money on upgrades. This is not the case when employing the use of external vendors, who are constantly developing their systems in order to compete with other vendors, he explains.

Pricing issues

But not everyone is convinced that the take-up of external software will be all-encompassing amongst the large sell-side institutions. According to Fruchard, while large investment banks and market makers will move towards adopting external data support and risk management software, they will not make the same shift when it comes to pricing models.

A case in point is the recent adoption of Sophis' Risque software by RBC Capital Markets (RBC), the investment banking affiliate of Royal Bank of Canada and the sixth-largest financial institution in the US by assets. Through this deal, which was announced early last month, RBC expanded its implementation of Sophis' Risque software, a cross-asset and front-to-back-office solution that enables investment banks to implement straight-through processing all along their trading activity, for its equity and structured derivatives products to consolidate middle-and back-office functions onto a single platform. This deal marks the first installation of Risque in North America.

"The objective of installing Risque is to increase our efficiencies and risk controls," says New York-based Peter Sanchez, global head of operations for capital markets and securities at RBC. But RBC retains its use of proprietary pricing systems and uses an application programming interface (API) to integrate this with the Risque software.

Among the large sell-side firms, the trend will be to use a mix of both internal and external pricing models, Fruchard notes. Most large banks will use external pricing systems for their flow business while relying on internal valuation models to price more complex structures. When they do buy external pricing models for complex structures it tends to be for benchmarking purposes, he adds. HSBC's Dowling says: " We tend to develop our own pricing models to value the more esoteric derivatives,"

But Eugene Collins, head of UK sales at London-based technology vendor SunGard Reech, notes that in the past six months his company, which offers FastVal, an independent valuation engine powered by a web-based application services provision (ASP) valuation model, has seen an increasing number of top-tier investment banks request third-party pricing tools for their sales desks. "They want an independent pricing tool that they can pass on to the end investor," Collins says.

Using SunGard's suite of pricing analytics (Real), which is powered by Reech Adep, a proprietary cash-flow description language, both the investor and the bank can "speak in the same language," he adds. Sold as an add-on feature to the bank, the tool sits as a simplified front-end spreadsheet on the investor's desktop and allows them to understand a product's cash flow and maturity risk. Banks are also buying independent pricing models for the ongoing valuation of their counterparties, as those models are more transparent and cheaper to maintain, Collins adds.

A broad base

But a move towards greater consolidation among vendors and the demand for broad-based software solutions is encouraging investment banks and smaller regional banks to turn to external vendors for their trade processing, risk management and price valuation needs.

Cost and internal support constraints mean smaller regional banks tend to subscribe to just one or two vendors that can offer solutions across a variety of asset classes. Larger banks, on the other hand, can afford to be selective and use multiple systems from more than one vendor.

Dowling says HSBC uses a mix of in-house technology and vendor systems to solve niche problems. "Very often, we pick and choose the components we want to use." HSBC uses Summit for its interest-rate capabilities and Sophis Risque for equity derivatives processing. "Summit and Sophis tend to be specialists in these systems," he says.

Market makers can afford to run multiple systems, and therefore selecting the "best of breed" is feasible for this group of users, Fruchard explains. In this situation, it is the vendor's job to provide innovative add-ons or toolkit features that enhance functionality, he adds.

To cater for both tiers of investment banks, technology vendors are tending to creating more general application systems as opposed to niche models. "The industry is more interested in general solutions. Complex systems impose constraints," Marston says. Banks want general application systems because they are easily integrated into in-house models, says Giacomo Elena, director of derivatives and structured products at Banca Aletti in Milan. Banca Aletti uses Sophis Risque for its equity derivatives trade processing, which is integrated into its proprietary pricing models.

Last April, Calypso launched Calypso XSP, its exotic structured products trading solution that enables structuring and processing of deals with cash flow indexed to underlyings spanning any combination of interest rates, foreign exchange, equity, bond or commodity prices and indexes. The system was built to be general, Marston says. Scalable architecture simplifies the future evolution and add-on features can be integrated easily, he adds.

Its partnership with New York-based Numerix, announced last February, integrates Numerix's pricing analytics into Calypso XSP to offer customers the opportunity to use market vetted analytics as part of Calypso's complete solution, Marston says. This gives banks the option to plug in their own pricing model or to use Numerix.

Integrated solutions that span asset classes are becoming an industry trend. "We are unconcerned about competition from smaller vendors, which might have niche solutions," says Numerix's Herard. As users demand pricing across asset classes and solutions for hybrid products, niche players focusing solely on credit derivatives, for instance, will lose out, he adds.

But Doug Long, executive vice-president of New Jersey-based Principia Partners, provider of end-to-end processing solutions for structured finance and capital markets, has a different opinion. "Until the structured products market is mature, there will inevitably be niche systems."

Although Principia Partners provides solutions across a wide range of asset classes, its core competency is in developing different ways of arbitraging structured fixed income and credit derivatives. "There is no system in the world that can offer an all-encompassing solution for the top-tier banks," Long says. "It is unrealistic to expect one vendor to be the best in all areas," Dowling adds. This is why HSBC buys individual "components" from different vendors.

New client groups

While investment banks, and more recently asset managers and hedge funds, are the main users of such software systems, the market is witnessing a gradual take-up by private banks, building societies and savings banks that issue structured products.

There is a trend for distributors to adopt these systems, especially in Europe, where there is a market for retail structured products, Herard notes. "We are seeing distributors taking on risk even when they do not have their own investment banking arm," he adds. Numerix has relationships with several regional savings banks in Europe - namely Germany's Landesbanks - that sell structured products to retail investors. Their high risk ratings allow these banks to carry out back-to-back transactions without really taking on much risk. Their clean balance sheets are also encouraging them to jump in and buy off-the-shelf software, Herard explains.

According to Collins, SunGard sells a substantial amount of its Reech FastVal service, an OTC derivatives valuation service, to medium-term note (MTN) issuers. The majority of its MTN clients are based in the UK and Scandinavia and include names like the Yorkshire Building Society and Llyods. SunGard recently licensed three Icelandic MTN issuers, Islandsbanki, Kaupthing Bank and Landsbanki Islands, as new users of Reech FastVal.

The MTN community use SunGard's service as an independent source of valuation to price different contracts from different counterparties. The system is also used to evaluate the probability of early maturity on callable structures, Collins explains. "Building societies, private and retail banks also want to understand these products (MTNs). They (structured products) are no longer just the remit of investment banks," he adds.

The primary drivers behind buy-side institutions adopting such software for risk management and pricing functions are to acquire better profit margins while instituting their own system of internal best practices rather then having to rely on valuations by a number of counterparties. There is also increased regulatory pressure, following adherence to the IAS39 reporting requirements, which forces all derivatives onto the bank's balance sheet to ensure they are measured to fair value, Collins says.

Private bank Julius Baer does take positions on some structures and uses both internal and external systems to do this. "Due to our huge balance sheet, we do have proprietary books where we take on the hedging risk of some structures. But there are limitations, while we can take positions on fixed-income and range accrual products, we outsource the more complex structures to large investment banks," explains Zurich-based Andreas Vogelsanger, managing director, head of structured solutions at Julius Baer. The Swiss private bank uses systems from Wall Street, Front Arena and SuperDerivatives in addition to its proprietary software solutions.

Apart from new client segments, a new breed of third-party software is fast emerging within the industry. While hesitant to adopt external pricing models for hedging purposes, some banks are fast turning to software vendors for a broad-based solution to their data and risk integration woes and vendors are responding to the demand with a host of new products.

HSBC implements Yolus' multi-asset client reporting and risk management solutions because of its strength in the areas of cross-asset margining, consolidated client reporting, risk management and regulatory reporting. "Such systems have a lot of potential in the market. Most large investment banks use a variety of internal and external software so technologies that can integrate across systems can be very useful," Dowling says.

Misys has just instructed the first deployment of Eagleye, a rules-based risk management system that has the ability to monitor adherence to mandates, regulations, policies or any restriction and can be used to prevent large trader losses by monitoring trader limits. Unlike standard reporting engines, Eagleye allows integration across asset classes and on the fly risk management, explains a London-based spokesman at Misys.

In November 2005, Sophis teamed up with DataSynapse, provider of adaptive grid infrastructure software, to allow banks to manage on the fly data. Their data management system, GridServer, manages and responds to conflicts between different sources in the operating system in real time, a Sophis spokesman explains.

Aside from data integration software for the effective management of middle-to-back-office operations, some vendors are going a step further and developing processing systems to directly affect product marketing and distribution.

i-Deal, a New York-based financial services software company that delivers workflow solutions to the brokerage industry, launched ASP-based Ingenuity to streamline the entire new-issue process. Launched last summer, Ingenuity sits on the desktop and acts as a tool to help trading and sales desks to handle, market and distribute new structured product issues, explains London-based Paul Lucas, managing director of i-Deal in the UK.

"This is a centralised administration system that electronically interprets changes in the term sheet of new product issues. Traditionally, transcribing the deal from its mathematical model into the term sheet was done in long hand. Ingenuity narrows the room for errors and speeds up the process," Lucas adds. It connects issuing companies with equity markets and corporate debt, allowing the bank to control demand for the new product, he adds. A large number of investment banks have taken up this new software but Lucas also anticipates demand from private banks.

Obstacles

While technology vendors are taking steps to stay innovative and offer solutions that cater for existing client segments as well as new ones, hurdles remain. One of the main problems vendors face is in integrating external software with a client's proprietary systems. The issue is especially common at institutions that are just starting to venture into structured products, Calypso's Marston says. Their in-house capabilities are usually underdeveloped.

To overcome this, Calypso launched the Calypso University Training Programme, which aims to train implementation partners and clients. This programme is especially useful for smaller banks. Apart from familiarising them with the system, it also offers market insight and education of structured products, Marston adds.

While a web-based ASP solution tends to be the favoured application for smaller institutions as it allows system support to be outsourced and sticks to a pay-as-you-go formula, it poses problems when issuers want to launch bespoke products or increase trade numbers.

It is true that ASP models such as the one created by SunGard through FastVal create a level playing field across the structured products space by allowing all institutions to participate regardless of their in-house IT support, but vendors will increasingly need to create something bespoke for the distributor community, Herard says. Excel models are cheaper to run in the long run, especially if the bank plans to process larger volumes of trades and introduce more sophisticated products.

"If you are structuring these transactions you really need a solution that is robust, highly flexible, such as the ability to incorporate range-accrual technology for credit, and that gives you the ability to structure complex cross-asset transactions quickly. A cost-effective desktop solution that is deployable in Excel or in a portfolio management system makes it easier to deliver such capabilities because it gives users direct control over the structuring process," Herard says.

Cost is another issue, especially for smaller institutions that are new to structured products. TD Waterhouse, Canada's largest discount broker and a leading distributor of warrants and contracts for difference in the UK, avoids in-house or external valuation and risk management systems because the set-up costs are too high, says Richard Forsyth, senior manager for product development at the company.

Because structured products are not TD Waterhouse's core competency, justifying the additional IT cost would be difficult, he adds.