Although investment managers and pension funds previously largely ignored derivatives, recent events in the market are causing them to look at them again. Futures, options and swaps can provide useful instruments to either gain or hedge exposures to help meet performance targets or to manage risks. But derivatives can be complex instruments that must be handled carefully. Firms have to decide whether they want to trade and manage derivatives in a system integrated with their equities and fixed income platforms, or whether they require a separate specialised system.
“Because equity markets have been falling over the last three years, the buy side community has changed its investment strategies towards more complex products,” says Hervé Vinciguerra, chairman of Paris-based trading and risk management system supplier Sophis. Furthermore, institutional investors are demanding a safer investment process with more accurate risk control. “That is why derivatives trading volumes have increased so much,” he says.
The changing nature of the markets has also led to an increase in alternative investment strategies which can often include derivatives such as convertible bonds, says Clare Porter, vice president for the Panorama trading and risk management system at New York-based SunGard Trading and Risk Systems. She also points out that the growth of fund products that incorporate optionality or guarantees brings with it the need to hedge these characteristics using derivatives.
European firms are also using derivatives to diversify their portfolios and gain exposures to foreign markets, says Tom Driscoll, vice president for sales and marketing at Massachusetts-based trading and middle office systems supplier Charles River Development (CRD). This is similar to firms in Asia, but different from those in the US where there is more use of derivatives for speculative trading, he says.
What this means is risk management for the buy side is becoming very similar to that of the sell side, with buy side firms requiring improved technological risk tools, says Vinciguerra. Although Sophis originally targeted the sell side with an equity derivatives system, it has recently created a buy side version of its system called Value that supports a variety of asset classes, including derivatives. Customers so far include France’s CDC Ixis Asset Management and London-based hedge fund Astin Capital, with a number of other asset managers and pensions funds currently testing the system, says Vinciguerra.
Porter agrees that if firms start to use derivatives in a serious way they need proper systems to do so. “New products are often supported by spreadsheets initially, but this is not scalable and exposes the organisation to operational risk from the corruption of spreadsheets, lack of integration of the new products with the firm’s_overall positions, and a lack of controls,” she says.
Although there are specialised derivatives trading and middle office systems available, there are a number of advantages to handling derivatives in the same system the firm uses for other instruments. An obvious reason is cost, not only of the initial application, but of maintenance and support. Another reason is that it is easier to apply consistent pricing tools across asset classes and to aggregate the risks of all positions for managing exposures on a portfolio basis if they are all in the same system to start with. “A big advantage of a system that integrates asset classes is that it brings control, auditing, compliance and exposure management all under one roof,” says Driscoll.
CRD provides a system that not only supports a wide range of asset classes, but also integrates a number of functions, including pre-trade compliance checking, order routing and execution and portfolio management. “The system was designed from day one to handle all asset classes, and it is often used to support derivatives in the context of a broader investment strategy,” says Driscoll. Of CRD’s 90 buy side customers, which include Henderson Global Investors and asset manager Schroders, both based in London and Dresdner RCM Global Investors, around 20 are now using it for derivatives as well as other instruments. A recent survey of customers revealed six are now aggressively trading interest rate swaps with the system, says Driscoll.
CRD’s first product was its ComplianceMaster compliance application, and it subsequently built its trading application on top of this. Driscoll believes that this is a strength because “derivatives can represent a substantial portion of compliance risk because of the exposures associated with them,” and therefore it is important the compliance module can handle the complexity of the instruments.
Sophis’s Value system also includes a real-time compliance management system, with functions for pre- and post-trade compliance checking. Other features of Value include market and credit risk management, benchmarking and performance measurement and back office functionality.
One thing that the software suppliers generally agree on is that systems must be flexible to be able to support the range of derivatives that a firm might want to trade. “Firms will often be trading a few of many types of derivatives,” says Porter. Among the buy side users of SunGard’s Panorama system are Luxembourg-based asset manager Dexia, Capitalgest, the asset management arm of Italy’s Banca Lombarda e Piemontese, and Paris-based hedge fund Systeia Capital Management. Firms must be able to easily define new instruments in the system and have them supported throughout the processing and position management of transactions.
Vinciguerra says that this flexibility needs to extend beyond the simple ability to add new instruments, but should also apply to the ability of the systems to scale up or down according to the size of the firm, and to support its trading strategies. “Since the size and activity of buy side companies varies widely, fund managers need solutions that must be simple, flexible and scalable,” he says.
Given the complexity of many derivatives instruments, they often require sophisticated pricing models. Although at one time such models were the preserve of quantitative analysts within sell side firms, in recent years pricing models for the major derivatives products have been standardised and commoditised and there is now a range of suppliers that offer libraries of these models as add-ins to spreadsheets or trading and risk management systems. CRD admits that derivatives analytics is not its strength, so it has incorporated the model libraries from New York-based specialist Unisys/TechHackers. SunGard recently acquired convertible bonds pricing specialist Monis, based in London, and incorporates its models into its Panorama system. Other model suppliers include London-based MB Risk Management, New York-based Savvysoft and California-based Financial Engineering Associates.
A recent solution to the problems of the cost of sophisticated software for derivatives and its demands in terms of skilled operating, maintenance and support staff, is to rent applications online. Over the last few years, a number of new and established software suppliers have begun to make their applications available via the Internet for a monthly rental fee in a model known as application service provision (ASP). Imagine Software and Egar Technologies, based in New York, and London-based Reech Capital all offer ASPs that support derivatives pricing, trading and risk management. In the case of Imagine, its installed system usually costs over £1m and is mostly bought by large sell side firms. However, in 2001, it launched an ASP version that costs around £1,500 a month and targeted at buy side firms. Nearly 100 firms are already using the service, says Ray Krastins, director of ASP sales and marketing at Imagine. An additional benefit of this approach is the ability to outsource the administration of the security master and corporate actions, he says.
Other suppliers that offer systems that support derivatives trading include London-based Misys Asset Management Systems, New Jersey-based Princeton Financial Systems, Copenhagen-based SimCorp, Connecticut-based SS&C Technologies, and Stockholm-based Trema.

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