Geoff Cole, director business consulting at Sapient looks at the technologies, market infrastructure, and governance structures buy-side firms should be implementing to be derivative ready.A recent poll that we undertook found that although the majority of buy-side firms expect their derivatives usage (gross notional and trade volumes) to substantially rise over the next three years or so, many are not yet fully prepared for the changes to come. One of the main reasons is that the traditional mutual fund houses in particular with their decades of history in trading cash equities and bonds have not yet made the full cultural shift needed to pro-actively adapt to handle increased complexity and changing market structure. What really needs to take place is a major overhaul of operations. Firms not only need to invest in education and training of their staff but also may need to bring in external talent and experience. Equally as important is the revamping of derivative usage governance models and dedication of project teams to focus on the six, 12 or 18 months program of work that is required to optimize the organisation to fully support the full range of derivative activities. This includes the operational assessment and approval processes for new derivative instrument types, legal agreements and regulatory requirements as well as client services.
Fundamentally, derivatives can be broken down into building blocks of three main instrument types: futures, options and interest rate swaps, and everything else is just a permutation of that. There are two facets to preparation for dealing with increased derivatives activity in investment portfolios. One is internally focused whereby asset managers are looking at developing an enterprise view of the operating model across all geographies, product areas and asset classes. This is to ensure that there is the right level of common support services. We are not just talking about the trade lifecycle but also areas such as legal agreement management and regulatory interpretation.
The second part deals with investment in modern data architectures that can dovetail with accounting systems and break long-standing dependencies overnight cycles or custodian data feeds for relevant risk and portfolio analytics. The data architecture also needs a level of flexibility that will allow any new derivatives instrument types to be modeled and implemented within front, middle and back office systems. We see derivatives as building blocks of instruments and would recommend systems that have the same view because we think this is critical towards optimizing the data and technology architecture to support broader derivative usage across all investment products.
Other important factors to consider are the trading and increased usage of new derivative instruments within client portfolios. This requires a thoughtful or diligent rethink of the client experience. It is important to create a positive experience especially when new derivative instrument types are considered to be used within existing strategies or in portfolios or when new products are about to be launched. This involves offering both education as well as creating a long lead time to ensure that clients at all levels feel comfortable with the direction of the portfolio and investment strategy.
In terms of the technology itself, there are different options. There are some systems in the marketplace that have come from a sell-side heritage and are very strong in risk analytics as well as real-time views on the exposures and sensitivities of various derivative instruments. However, there aren’t many vendor packages that have the requisite level of flexibility and variety that is needed today by front-office investment teams which is why customized tools remain popular. This is particularly true in the areas of portfolio management and decision support where the screens, tools and the method of interacting with portfolios inclusive of derivatives needs to be tightly coupled to the way the portfolio manager and investment teams run the investment process.
Although in some cases, we are seeing the use of third-party service providers offering these custom tools to support in-house capabilities, asset managers will continue to view their investment process as their competitive advantage. They are looking to leverage their own strengths in investments and reach in front office talent.
There is, however, more interest in third party providers for the middle and back office. Asset managers are looking across the various service providers to see which respective risk, decision support, performance and attribution calculation engines they can plug into. We are also seeing things like initial margin calculators and portfolio margin calculators being made available by some of the future commission merchants (FCMs) and clearinghouses as well as different ideas for utilities.
Another important aspect is the need for improved governance. The range of committees, working groups and structures that should be involved in supporting the implementation and usage of new derivative instrument types are often overlooked. We do see this as an area of opportunity for compressing the product launch time cycle and optimizing elements of the process. The ideal governance structure should include enterprise-wide committees with a mandate for oversight, monitoring and guidance for long-term derivatives usage and risk management across all investment products, across all geographies, and across asset class silos.
* Hear more from Geoff on this topic via our recent podcast.
