 Lee Cutrone
Managing Director, Industry Relations
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Lee Cutrone, Managing Director, Industry Relations, Omgeo looks at how market and product evolution have led to great strides forward in automation
Without computerised traction control at the start line and without automatic braking systems around the circuit, Fernando Alfonso would not be sitting at the top of Formula One. Man without machine is nothing. Likewise, the innovative brains behind the most cutting edge instruments or complex trade ideas on today’s trading floors would be incapable of making their concepts become reality without the modern technological infrastructure that is built around them. Technology, from the front office through to the back office, must move in tandem with the market to enable the industry to be able to sustain growth and innovation.
The rise of complex financial instruments has done much to propel technology further up the business agendas of both buy-side and sell-side organisations. This has happened to such an extent that even the traditional division between the front and back office, in terms of their relative importance to the trade process, has been almost eradicated. Complex instruments, evolving investment vehicles, regulation and increased investor sophistication have caused the gap between the front and back office functions to narrow considerably. Market developments have meant that automation has become much more of a business process rather than a technology issue. Additionally, automation within the back office can now serve as a competitive advantage for some, demonstrating a dedication to efficiency and cost savings that is then passed on to clients.
On top of this, innovative trading styles and their reliance on the latest technology, such as algorithmic and quantitative trading strategies are pushing automation further up the agenda. These strategies are heavily reliant on technology and efficient processing is key.
Clearly, complex instruments are automation’s best friend, and development of exotic instruments such as credit derivatives has brought automation to the fore. The pressure from the Federal Reserve on the world’s biggest banks to reduce the credit derivative processing backlog by 30% helped to propel automation issues to the forefront of derivatives trading. It became a headline issue and trade processing was improved significantly.
As recently as March of this year, fourteen of the world’s largest banks outlined a new target of cutting the backlog of unconfirmed credit derivative trades by 70% in a letter to the Fed. This was a move welcomed by the Fed, even though the 70% promise relates to trades that are more than 30 days old. And in a twist that also proves that automation also breeds more automation, this move to reduce the backlog is part of a package of measures aimed at creating a largely electronic marketplace.
It is not just credit derivatives where strides have been made in trade processing. Automation in the processing of complex equity derivatives such as Contracts for Differences is improving significantly. Omgeo statistics support this, since the company began focusing on CFDs, volumes have gone from zero to 30,000 trades per month. Independent research backs this assertion up. The Z/Yen research claims that in 2005, processing costs for OTC equity options have fallen from $152 per trade to $135. However, if this is compared to the $4 processing cost of a vanilla equity trade then equity derivative processing still has a long way to go.
What makes the issue of derivatives processing even more pertinent is that high net worth investors are now beginning to enter the fray. Traditionally, CFDs have been products traded in the main by hedge funds and while this still remains the case, increasingly corporates are using products such as CFDs as a method of hedging forex or commodity risk. Moreover, in the last two years, retail investors have begun to want a piece of the action and as a result, retail volumes are climbing steadily. This has been driven both by increased investor sophistication as well as an evolving marketplace. For example, in the UK the introduction of SIPPS – self invested personal pensions - has allowed a wider scope of instruments to be incorporated into personal pension portfolios. Some estimates suggest that up to £30m a day is going into SIPPs. Investors are using them to access a variety of funds, stocks and complex investment vehicles such as CFDs.
Hedge funds, one of the biggest investors in exotic instruments, have also played a significant role in raising the importance of the back office. A recent report from Greenwich Associates on the fixed income prime brokerage market said that hedge funds accounted for 30% of volumes in credit derivatives, collateralised debt obligation, emerging market and high yield bond trading. As this market segment drives the creation of new strategies and increased complexity, greater automation is required to support the continuing development of front office activity.
What’s more, many hedge funds are continuing to leverage multiple prime broker relationships. Most commonly, this is done to prevent too much transparency into their trading strategies. In addition, by having relationships with several prime brokers, hedge funds can dilute the concentration of their risk and also stimulate competition amongst their primes. In this new paradigm of multiple relationships, automation has become even more important as a means of creating audit trails to keep track of trade details spread across many prime brokers.
With institutional investors increasing their asset allocation to hedge funds, trade processing and infrastructure capabilities have become a key competitive differentiator when vying for investor funds. Moreover, investors have also started to leverage technology to automate time intensive and skilled tasks. For example, the Dutch pension scheme for transport workers, Pensioenfonds Vervoer, whose portfolio is managed by Goldman Sachs Asset Management (“GSAM”) tasked an external technology vendor with creating a technology engine to ensure their portfolio remains on target. This resulted in the development of Alpha Engine, a technology solution that measures and monitors the effectiveness of investment decisions made by GSAM.
Automation has played a key role in the recent trend of self regulation advocated by regulators and governments for the hedge fund and private equity sectors. Regulators on both sides of the pond have opted for best practices via the threat of regulation rather than a full-fledged mandate. Most recently, the Bush administration announced that it felt no need for greater oversight of the rapidly growing hedge fund industry. Its recommended course of action after consultation with independent regulatory agencies was that the industry should ‘self-regulate’ through investors, hedge fund companies and investors adhering to a set of non-binding principles. The US Treasury Secretary attributed the necessity of these principles to the certain challenges that hedge funds pose, including the use of some over-the-counter derivatives, such as credit derivatives. “The guidelines should serve as a foundation to…guard against systemic risks”. This is an area, as referred to earlier, where technology has played a significant role in reducing operational, and therefore systemic risk that Mr Paulson was referring to.
Without technology, it could be argued that this self regulation would not be possible. Straight through processing and technology has assisted in the compliance of recommended best practices such as transparency and audit trails, and technology has played a key part to play in assisting market participates to comply with codes of conduct, therefore keeping the regulators at bay.
There is no doubt that the advent of OTC derivatives and the hedge fund industry’s voracious appetite for exotic instruments has led to significant strides in middle and back office technology. The notion of siloed front and back offices is old hat. Many say that as the market continues to innovate with increasingly complex instruments the front, middle and back office will continue to converge. While this is highly probable, it is unlikely that technology infrastructure will ever move at the same pace as the brains of the whiz kids developing highly complex new instruments on a continual basis. Complexity does breed automation, but technology can only support a concept once it has been borne.
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