1209 WST Digital Issue

D e c e m b e r 2 0 0 9

Business Innovation Powered By Technology

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16 Software as a Service Stilllooking to control costs and maximize productivity, more and more Wall Streetfirms will consider renting softwareapplications rather than buying them.

17 Cloud Computing Nearly half ofWall Street IT executives surveyed bySIFMA identified cloud computing asthe No. 1 disruptive technology.

18 High-Frequency TradingResponding to charges of unfair access,regulators will closely scrutinize high-frequency trading, which drives as muchas two-thirds of equities executions.

19 Dark Pools In the push for trans-parency, the SEC likely will enact rules toshed light on dark pools, changing theway the anonymous venues operate.

20 Hedge Fund AutomationTo meet investors’ demands for moretransparency while complying with regulators’ calls for real-time reporting,hedge funds are automating processes.

21 Risk Modeling With no guaranteeof future bailouts, and with regulatorsturning up oversight, financial firmsmust improve their risk managementmodels, processes and technology.

22 Business Intelligence Areassuch as portfolio and risk managementcan benefit from the insight provided bybusiness intelligence tools. But it startson a foundation of data management.

23 OTC Derivatives ClearingCongress is working on OTC deriva-tives reform to rein in systemic risk. Butthere still is no consensus on exactlyhow central clearing would work.

24 Regulatory Reporting With awave of new regulations in the works,firms must establish an effective datamanagement and reporting infrastruc-ture in order to avoid costly penalties.

25 Social Networking Companiesin every industry are embracing socialnetworking to improve communicationamong employees and clients. But willthere be a return on the investment?

Even as many financial firms realized near-record profits in 2009,the economy continued to limp along, job losses mounted andbanks failed in increasing numbers. So what will 2010 have in storefor Wall Street CIOs? Wall Street & Technology examines the top 10trends that will shape the capital markets in the coming year. p.15

Wall Street&Technology

Wall Street & Technology’s 2009 Reader Advisory BoardJohn A. Bottega, Chief Data Officer, Federal Reserve Bank of New York

Joseph Ferra, Chief Wireless Officer, Fidelity Investments

John Galante, SVP & CTO, J.P. Morgan Worldwide Securities Services

Joe Gawronski, President, Rosenblatt Securities

Scott Ignall, CTO, Lightspeed Trading

Robert Palatnick, Managing Director/ Technology, DTCC

Steve Rapp, SVP & CIO,AGI Management Partners

Steve Rubinow, EVP & co-CIO,NYSE Euronext

Prashant Sarode, VP, Corporate & Investment Banking Technology, Wachovia

Derek Stein, Chief Technology Officer, Barclays Global Investors

Tim Theriault, President, Corporate &Institutional Services, Northern Trust

Timothy M. Tully Jr., SVP & COO, BNY Mellon Wealth Management

Cover Story: Capital Markets Outlook 2010

2 D e c e m b e r 2 0 0 9 w a l l s t r e e t a n d t e c h . c o m

26 Special ReportTechnology InnovationCME Group leveraged a pioneering rolein electronic trading and cutting-edgetechnology to transform the 111-year-oldChicago Mercantile Exchange into theworld’s largest derivatives exchange. For its efforts the firm has earned the top spot in the InformationWeek 500,WS&T sibling brand InformationWeek’sannual ranking of the most innovativebusiness technology organizations.

11 Close-Up Paul Wilmott,7city LearningFinancial risk modelersdon’t care if their models work and riskmanagement at capitalmarkets firms is no better today than it was before the financial crisis, saysPaul Wilmott, researcher, consultant andlecturer in quantitative finance.

13 Technology EconomicsUnderstanding the economics of financialservices technology and determining theactual value of technology investmentsrequires balancing quantitative and qualitative analysis, asserts ContributingEditor Howard Rubin, founder of researchand advisory firm Rubin Worldwide.

28 Industry Voice Though cost basis reporting requirementshave gone largely unnoticed by brokeragesand mutual funds amid the financial crisis,the legislation will alter the relationshipbetween client and firm, and Wall Streethas little time left to prepare for compli-ance, notes Scivantage’s Cameron Routh.

31 Perspectives According to Special Contributing EditorLarry Tabb, prognosticating about 2010is much like shaking a Magic 8-Ball:“Reply hazy, try again.” Nonetheless, “allsigns point to yes” that a few trends willdominate Wall Street in 2010.

From the Editor 5

Upfront 6

Product Watch 30

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Financial Services in 2010:Top Business and Technology TrendsAs we approach the new year, financial services firms need an economically viablesolution for competing in today’s market. Join Financial Insight - IDC’s David Potterton,VP of global research, as he shares his insight on the top business and technologytrends for financial services in 2010. Join this live, one-hour webcast to learn how tointegrate new functionality into online financial applications to deliver personalizedreports and improve customer satisfaction; recruit and retain customers by offeringvisually compelling Web experiences; and reduce development efforts by using standards-based, reusable solutions and open source BIRT technology.Thursday, Dec. 3, 2009, 2 p.m. ESTwallstreetandtech.com/2010-trends

Driving Innovation in Tough Times Managing IT during a bull market is relatively easy. Managing a technology organization through the worst financial crisis in a generation is a different story. Wall Street & Technology’s 2009 Gold Book recognizes seven IT leaders who have drivenexceptional technology innovation during the past year — whilesimultaneously reducing costs and navigating the toughest financial market in history. The honorees are Rob Goldstein,BlackRock; Steve Rubinow, NYSE Euronext; Joseph Squeri,

Goldman Sachs; Steve Rapp, AGI Management Partners; David Reilly, Morgan Stanley;Joseph Ferra, Fidelity Investments; and Richard Hagan, TradeKing.wallstreetandtech.com/gold-book-2009

Goldman’s Blankfein ‘Doing God’s Work’In an attempt to heal its image, Goldman Sachs has been givingnewspaper writers access to its top executives. But as WS&TExecutive Editor Penny Crosman notes in a recent blog post, theseexecutives are neither charming nor in touch with reality. The mostalarming sound bite may have come from Goldman chairman and CEO Lloyd Blankfein,who reportedly told The Times of London that he’s just a banker “doing God’s work.”wallstreetandtech.com/blog/blankfein

Wealth Management — An Integrated Desktop WorkflowAs the economy shows continuing signs of recovery, wealth management firms arelooking to provide their financial advisers with better tools and improved processes sothey can connect with their best prospects, increase the value of their interactions withexisting clients and improve productivity. In this free, one-hour webcast, learn how anintegrated desktop can help advisers better acquire, manage and serve their clients —while growing the value of assets under management. wallstreetandtech.com/integrated-desktop

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Wall Street&Technology


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ESPITE THE RETURN to near-record profitability at manyfinancial services firms, most executives would probably prefer toput 2009 behind them and start fresh in 2010. After all, isn’t thatwhat the New Year is all about — turning the page on the prior yearand looking forward to something better?

The problem is that the economy is sending mixed signals. In2009 we knew what to expect — job losses, a painfully weak economy and more bankfailures. As the industry looks to 2010, however, record banking profits are likely to beaccompanied by job losses, a painfully weak economy and more bank failures.

So how do CIOs finalize 2010 strategic IT plans when some economists are predict-ing a return to growth and other experts warn that a jobless recovery and sluggish busi-ness spending will postpone a serious rebound until 2011? I certainly don’t know what toexpect — except that most 2010 budgets will be based on less-than-certain assumptions.

While the editors at Wall Street & Technologyaren’t brave (or foolish) enough to try to predictwhich way the economy will move next year, we areconfident (perhaps foolishly) enough in our tech-nology predictions to publish our 2010 CapitalMarkets Outlook. This year’s Outlook highlights10 topics that will demand the attention of CIOs nextyear. There are four topics for 2010 — risk manage-ment, regulation, credit derivatives clearing andsocial networking — that we also deemed prioritiesfor 2009. Two topics — risk management and OTCderivatives — also made our list in 2008. In fact riskmanagement has been one of the priorities we havehighlighted since 2005, though most agree that a lotof work still needs to be done (see: credit crisis).

One of the largest unknowns heading into 2010is what will happen with regulatory reform. Six ofthe 2010 Outlook’s 10 topics — high-frequency

trading, dark pools, hedge fund automation, risk modeling, OTC derivatives clearingand regulatory reporting — are waiting for some sort of regulatory clarification. Untilthe final regulations take shape, firms will operate with a wait-and-see approach.

Even when the regulations are finalized, however, 2010 budgets and planning stillwill depend on a stable global financial market. I’m not sure if the bull market will con-tinue through 2010 or if the recovery will continue to be jobless. But I would be will-ing to bet that at this time next year we’ll still be discussing how firms can improve riskmanagement procedures and technology. Place your bets, anyone?

Best Guess

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ALTHOUGH THE CLIMATE CHANGE bill that would

set the stage for a massive carbon credit trad-

ing market in the U.S. has yet to pass the

Senate (its backers hope to get it passed before

a U.N. climate summit in Copenhagen in December), the

possibility that it will pass has Wall Street firms participat-

ing in and studying existing programs, hiring experts, and

educating customers about the potential new market.

The latest bill, sponsored by Senators Barbara Boxer (D-

Calif.) and John Kerry (D-Mass.), seeks to cut carbon emis-

sions in the U.S. by 2020 from 2005 levels. It does not yet

specify how carbon credits would be allocated.

Nonetheless, at a mid-October debate among potential

market participants and energy market experts on carbon

emissions trading, it became clear that

many are preparing for a U.S. cap-and-

trade scheme. “Customers are allocat-

ing resources to understand carbon

credit trading and how to implement

it,” said Michael Cosgrove, managing

director/head of commodities and energy

brokerage, North America, at inter-

dealer broker GFI, which plans to

build out an electronic trading

platform to accommodate the

many players expected to partici-

pate in carbon emissions trading.

Steve Schleimer, director of energy

and environmental market regulation at

Barclays Capital, said customers have been asking

for information on the timing of carbon emissions

programs as well as on voluntary efforts. “In the last six

months, companies have been taking a pre-compliance view,”

he related. “They’re looking at what they can do now to

hedge their exposure.”

Added Elliott Piggott, managing director of Trayport, the

electronic trading technology vendor that sponsored the

debate, “There has been a steady stream of entrants from the

U.S. into the European markets to learn about carbon credit

trading. These firms are building up information and getting

themselves in position” for the new market.

Setting LimitsSo what have firms learned from existing carbon trading

programs, such as the European Union’s Emission Trading

Scheme and the United States’ Regional Greenhouse Gas

Initiative (RGGI)? According to Barclays’ Schleimer, the RGGI

shows a need to set realistic and effective emissions-reduc-

tion goals. “RGGI was a good stab at cap-and-trade, but one

problem is [that] they set their caps in 2003,” he noted.

“Since then there’s been significant reduction in emissions,

and because of economic factors, many of the power genera-

tors have switched to natural gas,” which emits less carbon

than coal-fired plants. Consequently the power companies

aren’t approaching the cap of 140 million tons a year.

The European Union scheme initially also provided for too-

liberal allowances for carbon emissions, noted Praveen Kumar,

faculty fellow at the University of Houston. A key

to success in the proposed U.S. program, he

stressed, will be “having the political spine

to set the right origin point.”

Veronique Bugnion, managing director

of trading analytics and research at Point

Carbon, pointed out that carbon emission

caps won’t significantly affect U.S. polluters

until at least 2014, giving the markets time

to develop. “In 2012 [when the proposed

U.S. cap-and-trade rules would take effect]

we see a market that’s not hard to comply

with,” she said. “In Europe it took all of

Phase One for people to learn how to trade.

Those that need offsets [e.g., power companies] will

[need to] know how to trade; those that receive

credits they don’t need will need help

learning how to trade. In 2014 the

caps will start biting, and prices for

carbon credits will go up.”

Bugnion did point to a signifi-

cant contribution pioneered by the

RGGI: the use of auctions for selling

carbon emissions. According to Bugnion,

the auction model is now a successful option in several

emissions-reduction programs.

But not every aspect of existing programs has been as

successful. One problem evident in the European system is

that approval of offset programs takes too long and too

many ideas have been rejected, suggested Trayport’s Piggott.

According to Keiron Allen, marketing and communications

director for European carbon credit exchange BlueNext, it’s

not clear what offset initiatives will count under the cap-and-

trade program in the U.S. “There’s debate around this,” he

said. “It’s a bit fuzzy.” ✧ —Penny Crosman

Gearing Up for Carbon Trading

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CURRENSEE CEO Dave

Lemont describes his new

forex social trading site,

which emerged from beta

mode into live status in late October,

as Facebook meets Quicken in foreign

exchange. The site, currensee.com,

provides social trading tools, trading

through online brokerages and aggre-

gated information about forex markets.

Currensee is not for voyeurs or pre-

tend investors, Lemont stresses, noting

that the site is restricted to people who

have an active foreign exchange trading

account and who link that account to the

Currensee site. Then users can “friend”

other users Facebook-style and let them

see their trades and comments, as well

as view their friends’ trading activity

and ideas. Users are encouraged to give

their actual names to keep it real.

According to Lemont, more than 40

forex brokers already have relationships

with Currensee, and the site is eager to

add more. “Brokerages are not builders

of social networks,” he says. “We’ll

never be a broker, but a deci-

sion-making tool.”

Why are Currensee users

— about 1,000 people joined

the site by invitation during

its beta mode — willing to

share their live trade data?

“In foreign exchange the mar-

ket is so gigantic — $3.2 tril-

lion worth of trading takes

place a day — that two

traders sharing their strate-

gies won’t move the euro,”

Lemont notes. Collaborators,

he adds, share ideas through

live chats and messages.

Currensee aggregates the trades of

its users to create graphs illustrating

overall market trends, such as the

percentage of traders who are long vs.

short in the U.S. dollar and historical

volatility indicators. It also provides

news from Thomson Reuters, economic

event information from Econoday and

“social widgets” such as Bloomberg TV.

The site is free; so far, Currensee only

makes money by setting up FX accounts

for visitors who don’t already have one

and receiving an introducing broker fee

when those customers execute trades.

But Lemont expects the site to grow

along with the boom in the forex mar-

kets. “Foreign exchange is recession-

proof,” he contends. “If the economy

goes down, there will always be a way

to profit from currency pairs.” ✧ —P.C.

PITY THE MISUNDERSTOOD Wall Streetquant. More than four out of five quants feel theirsupervisors have the same or less understanding ofthe job of a quant than they did a year ago, accord-

ing to a survey of 400 quants and risk professionals released atthe beginning of November.

The survey asked respondents about the relationshipbetween quants and their managers. Results included the fol-lowing findings:

• 64 percent of quants feel that their supervisors either donot at all understand or only somewhat understand the job ofa quant.

• 86 percent of quants feel their supervisors’ level ofunderstanding of the job of a quant is the same or worse thanit was a year ago.

• 70 percent of quants feel that the level of understand-ing of the role of quants within their institutions has decreasedor has not changed at all from a year ago.

The survey, which was conducted by London-based 7cityLearning, a global financial services training company, sampled a random selection of alumni from 7city’s Certificatein Quantitative Finance. Respondents work mainly for globalfinancial institutions in the areas of quantitative finance andrisk management.

Perceived failures by quants and risk managers have beenpointed to by many economists as one of the principal reasonsthe global financial crisis escalated so precipitously. Dr. PaulWilmott, course director for the CQF, finds the survey resultsto be especially troubling, not least because the start of theglobal financial crisis took place 12 to 18 months ago.

“These numbers are alarming,” said Wilmott in a releaseannouncing the study’s findings. “They indicate that even withthe events of the past year, financial institutions are still nottaking the importance of financial education seriously, espe-cially as it pertains to improving relationships and understand-ing between quants and their managers.” ✧ —P.C.

Lonely Forex Traders Get Company

Wall Street’s Quants Feel Misunderstood

Trends & Analysis

Thanks to Currensee’s new social network for foreignexchange traders, “Trading alone is a thing of thepast,” according to a video posted on YouTube.


ARK POOLS ARE becoming less dark. NYSEEuronext has begun to enable broker-dealers toreport dark pool trades to a central TradeReporting Facility that will post the venues’ daily

trading activity at NYSE.com.Goldman Sachs Execution & Clearing, Barclays Capital,

Getco, Knight Equity Markets and UBS Investment Bank vol-unteered to begin reporting their respective venues’ activity tothe facility beginning in November. According to NYSEEuronext, other firms also have indicated an interest in theexchange’s transparency initiative and are establishing the nec-essary technology to begin participating in the program.

The initiative appears to be a response to regulators’ con-cerns about dark pools. In an October speech, James A.Brigagliano, co-acting director, Division of Trading andMarkets, at the SEC, said, “Although [dark pools] report theirtrades in the public trade stream [through FINRA], the publicreports merely indicate that the trade was OTC and do notidentify the trading center that reported the trade.” This “makesit difficult for the public to assess ATS trading and to identify theATSs that are most active in a particular stock,” he explained.

Noting that “In recent years dark pools have increased theirpercentage of total U.S.-listed trading volume to approximately8.5 percent,” Brigagliano added that one of the SEC’s three mainconcerns about dark pools is “inadequate post-trade transparen-cy, rendering it difficult for the public to assess dark pool tradingand to identify pools that are most active in particular stocks.”

He continued, “The Commission has long been an advo-cate of post-trade transparency and has encouraged the mar-kets to enhance the information made available to the publicregarding transactions effected on exchanges and in the OTCmarket. As the Commission has stated in the past, transparen-cy allows all market participants to assess overall supply anddemand. Transparency substantially counteracts the effects offragmentation that necessarily characterize a decentralizedmarket structure, without forcing all executions into one mar-ket. In addition transparency can reduce the information gapbetween investors with differing degrees of sophistication.Broad public disclosure of market information is necessary toassure the efficient pricing of securities, to maximize thedepth and liquidity of the securities markets, and to provideinvestors with the opportunity to receive the best possibleexecution of their orders.”

Meanwhile Brigagliano expressed concern that requiringthe alternative trading systems (ATSs) to disclose trades in a

way that identifies which dark pool did what would upset largeinvestors by providing too much information about the partiesto a transaction. But in an October press release, several darkpool executives expressed support for the NYSE’s new darkpool reporting facility.

Industry Support“We’re looking forward to the launch of NYSE Euronext’sATS transparency initiative,” said Greg Tusar, head of elec-tronic trading in the Americas at Goldman Sachs, which runsthe most active dark pool in the U.S. “By publishing tradingvolume on its Web site, NYSE Euronext has spearheaded anindustry-driven solution which provides a public source forevaluating broker-dealer ATS volumes.”

According to Frank Troise, head of equities electronicproduct at Barclays Capital, “This initiative is an importantstep toward the standardization of trade volume reportingacross ATS venues. Industry participants will be able to makemore informed order placement decisions and therebyimprove their execution quality.”

Jon Ross, head of Getco Execution Services, said, “Weneed to maintain the right balance between vibrant publicprice discovery and individual execution preference. This ini-tiative is an important first step in collecting the data critical toanalyzing and preserving that balance.”

Charlie Susi, head of direct execution for the Americas atUBS Investment Bank, added, “The way the industry has adver-tised non-displayed volumes and crossing rates has been highlyinconsistent, which makes it very difficult for clients to get aclear picture of liquidity. This initiative is something we’repleased to see, because it will establish better objectivity and clar-ity. We encourage all of our peers to join us in participating.”

According to NYSE Euronext, the daily trading activity vol-ume published by its central facility will be based on tradereports that will be single-counted and matched only. ✧ —P.C.

NYSE Shines LightOn Dark Pools

Trends & Analysis


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INRA’s actions against Scottradeprovide a warning to all onlinebrokerages: If you don’t provideautomated surveillance of account

activity, you too may be punished.FINRA fined Scottrade $600,000 at the

end of October for failing to establish andimplement an adequate anti-money launder-ing program as required by the Bank SecrecyAct and FINRA rules. FINRA requires bro-kerage firms to establish and implement AMLpolicies, procedures and internal controls rea-sonably designed to detect and cause thereporting of any suspicious transactions thatcould be related to possible violations of lawsor regulations — regardless of whether thosetransactions are associated with suspiciousmovement of funds into or out of accounts.

“Each firm’s AML program must be tai-lored to its business model, including the tech-nological environment in which the firm oper-ates,” said Susan L. Merrill, FINRA EVP andchief of enforcement, in a statement. “Despitethe large volume of online trading at Scottrade,the firm failed to establish any systematic orautomated surveillance until 2005. Then, theautomated system the firm implementedremained inadequate because it focused only

on suspicious trading that was accompanied bysuspicious money movement.”

Specifically FINRA found that betweenApril 2003 and April 2008, Scottrade failedto establish and implement an adequateAML program tailored to its business model,which consists primarily of providing cus-tomers with an online platform to trade secu-rities. In 2003 Scottrade handled about49,000 customer trades per day, and its vol-ume grew to about 150,000 daily trades by2007. According to FINRA, among the risksinherent to Scottrade’s brokerage model andsubstantial trading volume are an increasedrisk of identity theft, account intrusions, andthe use of customer accounts to laundermoney using securities or other financialinstruments or to violate securities laws.

FINRA has advised firms that their AMLprograms should consider factors such astheir size, location, business activities, thetypes of accounts they maintain and the typesof transactions in which their customersengage. FINRA also has instructed onlinefirms such as Scottrade to consider conduct-ing computerized surveillance of accountactivity to detect suspicious transactions.

According to FINRA, from April 2003through January 2005 Scottrade used a man-ual system that relied almost exclusively oninternal personnel to monitor accounts forsuspicious money movement or securitiestransactions and refer that activity to thefirm’s risk management department for fur-ther review. FINRA found that the sheervolume of online trading, along withScottrade’s reliance on inadequate internalresources, rendered the lack of an automat-ed system to detect suspicious activity unrea-sonable. FINRA also found that Scottrade’sAML procedures failed to provide adequatewritten guidance to its employees as to howto review transactions and failed to provideadequate written guidance to its AML ana-lysts for detecting and investigating suspi-cious trading. ✧ —P.C.

Scottrade Slapped With $600,000 Fine

F WALL STREET regulator

FINRA is working to

become more profi-

cient at fighting fraud,

said FINRA CEO Rick Ketchum during

SIFMA’s annual meeting in October.

“We have enhanced our examination

programs, procedures and training ...

to help us better detect conduct that

could be indicative of fraud,” he said.

Efforts cited by Ketchum include

gathering more information prior to

each exam regarding a firm’s owner-

ship and affiliate relationships; identi-

fying indications of problematic behav-

ior concerning the opening of invest-

ment advisory accounts at a broker-

dealer; examining the relationship

between broker-dealers and feeder

funds or master funds that utilize feed-

er funds; and examining for material

misstatements in financial reporting,

unusual money movement, and appar-

ent red flags involving a firm’s auditor

and off-balance sheet items.

In addition FINRA established in

March an Office of the Whistleblower

to handle high-risk tips, and in October

created an Office of Fraud Detection

and Market Intelligence, which will

review incoming fraud allegations.

FINRA also is examining social net-

working tools, Ketchum said. “Social

networking sites such as Facebook or

LinkedIn provide new ways to connect,

inform and interact with customers,”

he said. “They also raise new regulato-

ry challenges. For example, ... they may

not allow you to archive and maintain

the communications.” FINRA formed a

Social Networking Task Force to look at

“how regulation can embrace techno-

logical advancements in ways that

improve the flow of information

between firms and their customers

without compromising investor protec-

tion,” Ketchum added. ✧ —P.C.

FINRA to LookAt Facebook

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Trends & Analysis

N INTERNATIONAL GROUP of regulators isurging financial firms to improve their risk manage-ment infrastructure. The Senior Supervisors Group,which comprises senior financial supervisors from

seven countries (the U.S., Canada, France, Germany, Japan,Switzerland and the U.K.), issued a report in October on the riskmanagement lessons to be learned from the 2008 banking crisis.

The report reviews the funding and liquidity issues thatcaused the recent crisis and explores areas of risk managementpractice in need of improvement across the financial servicesindustry. In a section on IT infrastructure, the group calledattention to the need for better data integration and for firms tobe able to boost processing capacity during times of stress.

“Firms are constrained in their ability to effectively aggre-gate and monitor exposures across counterparties, businesses,risk strands and other dimensions because of ineffective infor-mation technology and supporting infrastructure,” the reportstates. “Many firms ... said they are making considerable invest-ments in risk management infrastructure. Many projects, how-ever, are in the planning stages or in the infancy of execution,with significant work remaining. One challenge to improvingrisk management systems has been poor integration resultingfrom multiple mergers and acquisitions. One firm suggestedthat acquisitions over the years have produced an environmentin which static data are largely disaggregated. Another firm

echoed this view, reporting that certain products and lines ofbusiness have not been included in data aggregation and analy-sis processes. A third firm reported that having two systems forthe same business results in duplication of processes.”

On the issue of IT scalability, the report says, “Another criti-cal infrastructure concern during recent market events was theability of firms to process record-high volumes of product trans-actions during periods of market stress. Transactions in equities,foreign exchange, government securities and other instrumentsspiked sharply during the market disruption, taxing some firms’systems. Proactive firms are responding to this challenge byadding capacity to key system platforms to ensure that they canprocess volumes well in excess of previous peak levels.” ✧ —P.C.

Regulators Blame Risk Woes on PoorData Integration

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STANDARDIZED OTC deriv-atives should trade on regulatedexchanges and clear centrally,according to the CFA Institute.

The global association of investmentprofessionals cosigned a letter toCongressional leaders containing recom-mendations on the Over-the-CounterDerivatives Markets Act of 2009.

The recommendations for derivativesreform originated from the Investors’Working Group, a panel of industry andmarket experts created by the CFAInstitute and the Council of InstitutionalInvestors to study and report on financialregulatory reform from the viewpoint of

investors. The IWG issued a July 2009report on the need to improve regulationof OTC derivatives.

Although OTC derivatives are legiti-mate vehicles for managing financial risk,they spread throughout the economy,causing great financial harm in the currentcrisis, according to IWG, which pointedout that the global OTC derivatives mar-ket is enormous (US$592 trillion innotional amount as of December 2008) yetwas exempted from virtually all federaloversight and regulation by theCommodity Futures Modernization Act of2000. Problems plaguing the OTC deriva-tives market include lack of transparency

and price discovery, excessive leverage,rampant speculation, and lack of adequateprudential controls, the group concluded.

In addition to recommending on-exchange trading and central clearing,IWG said OTC derivatives trading shouldbe strictly limited and subject to robustfederal regulation. The SEC and theCFTC should have primary regulatoryresponsibility for derivatives trading, IWGurged, adding that the U.S. should leadglobal efforts to strengthen and harmonizederivatives regulation. ✧ —Ivy Schmerken

The IWG report can be downloaded attinyurl.com/iwg-report.

OTC Derivatives Should Move On-Exchange

Trends & Analysis

1 0 D e c e m b e r 2 0 0 9 w a l l s t r e e t a n d t e c h . c o m


According to Paul Wilmott, a researcher, con-sultant and lecturer in quantitative finance, riskmanagement on Wall Street today is no better

than it was before the financial crisis. Founder and proprietorof the quant magazine Wilmott and cofounder and coursedirector for the Certificate in Quantitative Finance at 7cityLearning, he says financial risk modelers don’t care whethertheir models work. But it would be foolish to paraphraseWilmott, who has strong opinions about the Street’s risk man-agement practices, a sharp wit and a way with words. So here’sa lightly edited version of his exclusive interview with WS&TExecutive Editor Penny Crosman, in which he discusses howto fix the financial services industry’s risk problems.

Nothing HasChanged

WS&T: How are you?Wilmott: Tired. I’ve got a crazy Dutch film crew followingme around; everything’s a bit manic, and I’m exhausted.

WS&T: Concerns about risk management have been grow-ing on Wall Street post-crisis and pre-regulation. How mightWall Street firms change the way they perform risk manage-

ment? Are there new metrics, models or methods that will beor should be considered? For instance, some say Value at Riskis no longer relevant as a measurement of risk. Wilmott: There are plenty of good models out there, it’sjust that nobody’s incented to use them. If you used thewrong model to design airplanes, you’d kill passengers andend up in prison. But do the people using financial risk

models care what happens? Of course they don’t.

WS&T: So there should be a direct link between the riskmodelers and ... Wilmott: Prison, I agree. There are people who think weshould go after these people. There should certainly be morelawsuits going around. Someone I know moved to a new bank

recently. He was doing a risk management procedure and thetraders came up to him to say, “You’re telling me the risk is toobig — can you just fudge the figures and make it smaller?”Nothing has changed. I don’t know why anybody thinks it has.

That’s why no one with half a brain has ever liked VaR,because it can be used to hide risk. I’ve been talking for yearsabout how people hide risk rather than hedge, because that

“People hide risk rather than hedge because that allows them totrade bigger and bigger, and if they’re lucky they get a big bonus.”

>>>

Paul Wilmott, Cofounder and Course Director,

Certificate in Quantitative Finance,7city Learning


allows them to trade bigger and bigger, and if they’re luckythey get a big bonus. If they’re not lucky, nothing happens tothem. The more sophisticated your tool, the greater potentialfor pretending there’s no risk.

WS&T: Do you think Value at Risk should be thrown away? Wilmott: No. VaR is fine for day-to-day activities. Butthere are lots of other things people should be doing. Forexample, worst-case scenarios. I don’t believe in trying torefine the probability of crashes happening. People are sur-prised that crashes are happening every few years thataccording to theory are only supposed to happen once every10,000 years. Who cares whether it’s once every few years,once every six years or once every 7.3 years? What mattersis taking steps that will protect you when there’s a crash,because there will be one.

Did you expect anything was going to change because ofthe subprime crisis? People say that’s the end of everything —quantitative analytics is dead, CDOs are dead. I say it will bebusiness as usual, and faster than you think. Nothing’s chang-ing. People deserve everything they’re going to get in thenext crisis because they’re not complaining enough [now].But there are really good models out there.

WS&T: Such as? Wilmott: The trick is to not have models that are too sophisti-cated. Don’t get too caught up in the details of the mathematics.

One of the main culprits in all this has been the master’sin financial engineering courses. They’re sold by universitiesto 22-year-olds who have no experience in life and banking.Professors who never worked a day in their life in the realworld are teaching all of these poor, unsuspecting fools whoare paying $80,000 a year for the degree because they knowthey can get a job in a bank and they’ll be making millions.They’re happy to pay $80,000. I’m not happy because I knowthe education they’re getting is substandard, to say the least.It may be fantastically mathematical, but it’s got nothing to dowith finance in the real world.

So there are swarms of these people out there — manytens of thousands of people have come out of these degreeprograms and are put in charge of derivatives, valuation andrisk management, and they’ve never seen the real world. Thisis where I plug the Certificate in Quantitative Finance. [Ed.note: Visit cqf.com for more information.] CQF is the onlyfinancial engineering course in the world that hasn’t had torewrite any lecture notes because of the recent crisis. We’vebeen warning about these things since we started in 2003.

WS&T: Have the graduates of your course performed betterthan the average quant?

Wilmott: Sadly, we haven’t reached the critical mass wheremy CQF alumni could save the planet. Had we started theCQF five years earlier, then we would have saved the world.But we haven’t. Maybe we’ll stop the next crisis.

WS&T: Do you focus on common-sense thinking in your courses?Wilmott: Everything we do is real-world. Everything ispractical, based on data, common sense. When did commonsense disappear from the planet? We try to knock some com-mon sense back into these people. We try to instill confidencethat they can do their own modeling and think for them-selves. Another one of my pet peeves is how sheep-like peo-

ple who work in banks are. They copy each other so much.We teach skeptical thinking — to question assumptions, tofigure out if the model is wrong.

WS&T: What about the data itself? One of the problems withthe subprime mortgage mess was that for many years prior,housing prices hadn’t dropped and U.S. homeowners had ahistory of paying their mortgages and being unwilling toforeclose. So if someone was analyzing the past four years ofhistorical data, they wouldn’t have any indicator of trouble. Wilmott: Why are they using the last four years’ worth of data?

WS&T: How far back do they need to go? No historical infor-mation really tells you what’s going to happen in the future. Wilmott: I’ve owned some properties — I bought my firsthouse when I was 25 — and in my experience, there’s a one-in-three chance of losing money from property. You do have to goback a few years, but not a long time, to see falling house prices.When you go through bubble after bubble after bubble inevery single walk of life, what a lack of imagination a person hasto have to think house prices never fall. I have to hit myself inthe head with a hammer to get into that frame of mind.

WS&T: But are models like that used in financial firms? Wilmott: 2010 I hope will be the year in which people final-ly start taking moral hazard seriously. People have an incentiveto say house prices will keep on rising if it means they can dothe trade. But you’re also right that there are people whobelieve in all of these models and the idea that house pricesdon’t go down. I’m incredibly blessed or cursed by alwaysquestioning everything. You have to do constant rethinking. ✧

“The more sophisticated yourtool, the greater potential for pretending there’s no risk.”

PROFESSOR in a medical school once told me thata key lesson for his students was to get them to notjust perform their diagnoses based on the data theyhad for a case but to “look at the patient,” too.

This important message is one that should be applied to manyareas in which the foundation for interpreting a situation, arriv-ing at key insights and developing intelligent foresight is basedon a combination of quantitative and qualitative information.

For example, such a balanced outlook is essential for assess-ing the interaction of technology with the global economy,national competitiveness and policy, and company perform-ance. This balance is critical to the use and interpretation ofindustry technology data and benchmarks.

Although technology spending represents approximately 5percent of revenue and 7 percent of operating expense across allbusiness sectors worldwide and is as high as 10 percent to 12percent of net revenue and 16 percent to 18 percent of non-interest expense for the world’s most technology-intense finan-cial services institutions, its dynamics — the interactions oftechnology investment and the creation of value — are unchart-ed. They haven’t been calibrated and are misunderstood.

We can learn a lot by looking at both the “numbers” (keymeasures relating to technology investment patterns andexpense) and the “patient” (the performance and strategic plansof the business itself). Such a multidimensional context is essen-tial for companies to consider as they look inward to under-stand and evolve their technology strategies and look outwardto benchmark and compare themselves to peers and attempt todiscern applicable best practices from other sectors.

The importance ofthis approach is clearagainst the backdrop ofthe global “technologyeconomy.” At the mostmacro of analytic levels,the global technology economy is huge. As a reference point ofinitial calibration, 2008 global technology spending was approxi-mately $4.2 trillion dollars. This is the equivalent of $701 for eachperson on the planet, or the equivalent of one personal computer(or 3.5 iPhones) per year for every inhabitant of the planet. If the$4.2 trillion dollars of 2008 technology spending was treated as agross domestic product (GDP), it would rank behind only theUnited States, Japan and China (in 2008 terms) as the fourth-largest economy of the 186 tracked by the World Bank.

The Financial Services Technology EconomyAnd the technology economy of the financial services sector isthe largest of any of the non-governmental sectors. With perhaps$40 billion of IT spending among just the top 5 largest financialservices institutions in the world, this alone would rank above theGDP of 108 nations. In terms of technology “intensity” — ameasure of technology spend in the context of revenue and oper-ating expense simultaneously — the financial services sector is atthe top of the charts: four times that of construction and engi-neering, three times that of consumer products, twice that ofpharmaceuticals, and one and a half times that of media, which isthe No. 2 sector in terms of total technology spend.

At this early stage of knowledge in the field, it is highly like-


Examining The Patient

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Introducing: Technology Economics in Financial ServicesThe financial services industryspends billions of dollars on tech-nology each year, but very fewexecutives actually know whatreturn they are achieving on theirIT investments. Technology economics can help companiesaccurately determine the value of

technology so they can use it to drive measurable change andcontinuously enhance perform-ance. Each month Howard Rubin— the founder of Rubin World-wide, a professor emeritus ofcomputer science at HunterCollege of the City University

of New York, an MIT Center forInformation Systems Researchaffiliate, a Gartner senior adviserand a former Nolan Nortonresearch fellow — will explorehow the discipline of technologyeconomics can help firms gain acompetitive advantage.

Howard A. Rubin, Contributing Editor

ly that those companies that can understand the workings oftechnology economics and take charge of their own internaltechnology economy microclimates today (and get it right) bymastering the balance of expense and value before such learn-ings are documented and taught in the standard business schoolcurricula will be in the best position to leverage technology forextreme competitive advantage.

And in no sector is this “taking charge” more critical andevident than in financial services, which is the most technolo-gy-intense sector worldwide. This is not only true because ofthe absolute dollar amount of technology spending; it also istrue because of the high stakes associated with effective tech-nology investment. Technology economics in financial servicesis about more than just the commonly used taxonomy of “Runthe Bank” and “Build the Bank” expense and investment — itis about leveraging technology to grow revenue, protect rev-enue, reduce cost, avoid cost and manage risk.Perhaps the old RTB-BTB terms should bethrown away because they mask the linkagebetween technology and the “patient.”

Similarly the most commonly usedbenchmarks of technology investment — ITspending as a percentage of revenue and ITspending as a percentage of operatingexpense — obfuscate some of the most criti-cal dynamics that companies need to under-stand and manage. For example, widely usedhigh-level financial services industry datashows that for banking and financial servicesthe average IT spending as a percentage ofrevenue for 2008 was 6.9 percent with anaverage spend per employee of $24,391.

But within financial services, the mosttechnology-intense business segment, invest-ment banking, is characterized by spendinglevels of 10 percent of net revenue or more,with IT spending per employee averaging close to $60,000 peryear and peaking at $120,000. At the other end of the microcli-mate spectrum in financial services, retail and “card” business-es typically spend less than 5 percent of net revenue on technol-ogy with spending levels of $18,000 per employee.

Benchmarks in ContextAgain, by looking at the “patient” and going beyond the num-bers, the basic “technology economy” phenomenon evidencedby this data is simply that, in the context of IT, not all financialservices are created equal. So not only are these benchmarkshard to interpret because of the vagaries of revenue trends andhead count, to be useful they must be interpreted in the contextof the movement of business and markets.

Static measures of IT spending in the context of revenue

and operating expense just can’t stand on their own. The prob-lem is with the denominator. “Revenue” is unstable and nottightly coupled in the short term to IT spending. “Operatingexpense,” or “non-interest expense,” has similar inherentproblems as a denominator. While IT spending hopefully hasa more direct impact on business process costs throughautomation-driven cost reduction and cost avoidance, suchchanges in profile are more typically a lagging effect of ITspending with those intended consequences. Therefore, froma technology economy vantage point, you need to switch froma snapshot view to a dynamic view to consider how these met-rics interact and change over time.

For top-performing financial services companies, IT spend asa percentage of net revenue typically declines as “Grow andProtect Revenue” strategies yield results, while IT spend as apercentage of non-interest expense declines. The latter is a result

of the impact of technology as a lever for automating processesand driving down operational costs. Therefore, over time it islikely that IT becomes an increasingly larger component of thecost of business operations because automation is driving operat-ing costs down at a faster rate than IT spending is increasing.

Effectively using benchmarks of IT spending clearlyinvolves looking at the numbers as they move through time inalignment (or misalignment) with business strategy. Usingthese numbers effectively also requires an understanding of thetechnology economic microclimates of business with whichthey are associated. It also demands having insight into the timelags associated with getting results from technology invest-ments. But more important, it is essential that one looks at thenumbers in the context of the “patient” to discern patterns andcompletely understand the overall health. ✧

2008 Average IT Spend Per EmployeeWhile banking and finance spends more on technology per employee than anyother business sector, tech expenditures within financial services vary widely.

Source: Gartner IT Key Metrics Data 2009

0 $5,000 $10,000 $15,000 $20,000

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Information Technology

Hospitality and Travel

Utilities

Energy

$24,391

$17,153

$13,444

$13,359

$10,498

$10,356

$4,441


URING the first few months of 2009, many financial services executivesbelieved that it would be a lost year — most expected the markets to continue to tumble, or at best tread water, and anticipated more bank failures, job losses and pain. 2010 couldn’t get here fast enough.

In the end, 2009 surprised everyone. Since March thefinancial markets have been on one of the strongest bull runsin history. Many financial firms have returned to profitability,and some are reporting near-record profits. Still, the globaleconomy is only limping along, job losses continue to mountacross financial services and almost every other sector, andbanks continue to fail (more banks failed in 2009 than in 2008).

So 2009’s mixed bag leaves many in the industry scratch-ing their heads when it comes to predicting what will happenin 2010. The uncertainty likely will limit increases in tech-nology spending, though budgets shouldn’t be as tight asthey have been. New regulations designed to protectinvestors and secure the economy are just starting to takeshape and surely will be front-page news for most of thecoming year. And hiring likely will remain slow, except for incertain specialties, such as risk management, quantitativeanalytics and the trading of multiple asset classes.

So at the top of most CIOs’ 2010 priority lists will be deal-ing with regulatory reform and improving risk management,as well as efficiency initiatives. Wall Street & Technology’sCapital Markets Outlook 2010 offers some valuable insightinto these goals and other priorities for the coming year.

As companies keep a tight lid on costs and the technologiesmature, the use of hosted software and cloud computing will

continue to increase on the Street next year. Hosted softwarecan provide cost savings and enable faster time to market thanin-house deployed technology. And cloud computing is gain-ing acceptance as providers increase security and many largefinancial institutions create private, internal clouds.

In the front office the use of dark pools and high-fre-quency trading (HFT) will continue to attract attention,and regulators will explore further the value they provide tothe market. Although HFT and dark pools are not newmarket innovations, politicians and regulators have focusedon them as they seek to restore investor confidence.

Investors, meanwhile, aren’t waiting for regulators —they’re demanding more transparency from asset managersand hedge funds now. Similarly, investors are demandingimproved risk management procedures. And in order to attractand retain investors, many hedge funds are automating report-ing processes and increasing transparency into operations.

These trends, along with an increased use of businessintelligence, changes in the clearing of OTC derivatives andthe adoption of social networking technologies, will shapemany banks’ 2010 technology strategies and spending. >>

Wall Street & Technology’s Penny Crosman, Ivy Schmerkenand Greg MacSweeney developed the 2010 Outlook.

D


Why It’s Important: A small revolution has taken placeover the past two years in the way capital markets firms,especially buy-side firms, buy and use software. Ratherthan purchase and install programs, they’ve grownincreasingly willing to rent applications from the softwarevendor or a third party and to let someone else host andsupport it for a monthly subscription fee; users log in andaccess the software over the Internet. This is variouslycalled “software as a service” (SaaS), “hosted software” orthe “application service provider model” (although somesay “ASP” is an old-school ’90s term), and it changes thegame for internal IT departments. A major force behindthis trend is Marc Benioff, chairman and CEO ofSalesforce.com, whose hosted customer relationship man-

agement software is used by 63,200 companies, includingCowen and Company, Daiwa Securities, E-Trade andForex Capital Markets. The upside of SaaS is that IT staffshould be able to spend less time supporting these plat-forms; on the other hand, they represent one more reasonto keep IT spending and staffing levels low.

Where the Industry Is Now: Wall Street firms are usingASP models now “for certain components of their busi-ness, especially around reconciliation, trade processing,trade settlement and collateral management,” accordingto Paul Migliore, CEO of consultancy Citisoft. For suchmiddle- and back-office functions, it makes sense to farmout the technology platform yet still do the actual pro-cessing work in-house, he says.

Even the largest Wall Street powerhouses are turningto hosted software for non-core functions. MorganStanley, for example, uses SaaS for e-mail archiving andcertain human resources and sales applications.

Focus in 2010: Buy-side firms will continue to makeheavy use of hosted software in 2010, according toMigliore. “In the last year, assets under managementhave dropped dramatically because of the depression inthe marketplace,” he points out. “With the increasedpressure on margins, there’s a much bigger pressure onoperational efficiency, especially in the middle and backoffice, which leads to more discussions around outsourc-ing and application service provider models, as well asFSP models — full-service providers,” Migliore says,referring to outsourcing models — for instance, a firmcontracting State Street to do all its accounting.

Sell-side firms also have plans for software as a service.Morgan Stanley, for instance, plans to grow its use ofSaaS. “SaaS for a while was still slideware,” notes DavidReilly, CIO of enterprise infrastructure at Morgan. “Nowit is real.” But Reilly’s not planning to put hosted softwareeverywhere. “There’s always going to be a need for pro-prietary software that we feel is a competitive differentia-tor or that we need to provide a service to a particularclient,” he explains.

Industry Leaders: Morgan Stanley was one of the firstWall Street firms to go public with its use of Salesforce,the hosted CRM pioneer, and has since escalated its useof hosted software.

Technology Providers: Hosted (SaaS or ASP) software isavailable from Calypso, Fidessa, Sky Road/Marketceteraand Codestreet for trading; SR Labs (market data feedhandler); Thomson Reuters (market data); Eze Castle/NetAge and Navatar for customer relationship manage-ment; Wall Street Systems for treasury management; andSunGard for a variety of applications. This is by no meansa comprehensive list — it includes merely some of the soft-ware companies we’ve spoken to this year that offer host-ed versions of their products.

Price Tag: Varies tremendously by type of application andsize of installment. The enterprise edition of SalesforceCRM is $125 per user per month. ✧


CAPITAL MARKETS

OUTLOOK

2010

Still-tight budgets and small IT staffs will drive Wall Street firms’preference for renting software rather than buying it. By Penny Crosman

Sound Bite: “There’s always going to be a need for proprietary software that we

feel is a competitive differentiator.”—David Reilly, Morgan Stanley

Software as a Service

No Slowdown for SaaSCHALLENGE


CAPITAL MARKETS

OUTLOOK

2010 Cloud Computing

Securing The CloudsWhy It’s Important: Cloud computing — loosely defined assoftware, hardware, storage and/or networking as a service —is building serious momentum, on Wall Street and everywhereelse. Claus Mortensen, IDC’s principal for emerging technolo-gies advisory services, predicted earlier this year that IT cloudservices will form 25 percent of all incremental global ITspending growth by 2012. Merrill Lynch analysts estimate thatby 2011 the cloud computing market will reach $160 billion,including $95 billion in business and productivity applications.In a survey of Wall Street IT executives conducted by SIFMAand IBM in June, the number of respondents predicting thatcloud computing would force significant business change morethan doubled from 21 percent in 2008 to 46 percent in 2009,making it the top disruptive technology (ahead of even opera-tional risk modeling and mobile technologies).

Where the Industry Is Now: Large financial services firms areusing public clouds (such as Amazon’s or Google’s) for applica-tion testing and for basic applications, such as customer rela-tionship management. But they have been reluctant to storesensitive data in a cloud. “If you use Amazon, you share its cloudwith many different companies,” points out Madge Meyer,EVP of State Street. “Security is still a challenge every day forall companies.” Smaller firms, with fewer internal IT resources,use cloud computing for CRM and beyond.

As with hosted applications, the primary business driver forcloud computing is cost cutting. “IT departments are alwayslooking for ways to save money and costs, and cloud comput-ing services are a way to potentially save money,” says MikeBarba, manager, information risk management, at SMARTBusiness Advisory and Consulting. “If you use the cloud, youdon’t have to purchase all the hardware and licenses requiredto do a project, [and] you don’t have to maintain a lab. You cansimply purchase a number of months’ worth of hardware timefrom Amazon. So the cost savings can be dramatic.”

Barba warns, however, that there may be a hidden cost tocloud computing, especially if using public clouds. “A lot oftimes information security concerns are overblown, in thatoften cloud service providers do things better than an ITdepartment in a small to medium-size company; they haveeconomies of scale to help them,” he notes. But, “From a lit-

igation perspective, what happens if sensitive data in a cloudis compromised?” Barba asks.

Many cloud services contracts stipulate that data protec-tion is the customer’s responsibility — even though the cloudprovider manages the data and the client often has no controlover it. Wall Street firms need to carefully examine such con-tracts and be certain they’ll be able to comply with data pri-vacy and security rules even as the cloud provider makeschanges, such as moving data from one facility to another.Further, IT staff need to manage this relationship, which canbe a job in and of itself, Barba says. “The provider is ... notgoing to think clearly for you or think from the business per-spective,” he says. “It’s a changing role for IT — you needbusiness and IT knowledge, and you need to be very flexible.”

Focus in 2010: Public cloud providers such as Google andAmazon are beefing up cloud security. The Cloud SecurityAlliance (cloudsecurityalliance.org), a group of informationsecurity professionals, is working on a set of best practicesand an information security standard for cloud providers.Cisco recently bought cloud security company ScanSafe,which it will use to help the networking giant figure out howto make its cloud offerings more secure.

Large firms, such as Merrill Lynch, Morgan Stanley andState Street, are building internal clouds within their own datacenters and firewalls. State Street’s Meyer calls this “capacityon demand.” “When you need it, it’s there,” she says.

Industry Leaders: Morgan Stanley, Merrill Lynch, State Street.

Technology Providers: Amazon, Google, IBM.

Price Tag: Varies by type of service and size of institution (e.g.,how much storage, how many application users). Amazon’s feeschedule ranges from 10 cents to $2.88 per hour. ✧

The obstacle to large financialfirms’ use of public clouds has been security, butindustry groups and vendors are working to fix this.And internal clouds, protected within a firm’s ownfirewalls, are under construction. By Penny Crosman

Sound Bite: “What happens if the serviceprovider has a problem — whose fault is it?”—Mike Barba, SMART Business Advisory and Consulting

CHALLENGE

Why It’s Important: High-frequency trading firms — mainlyproprietary trading firms and hedge funds — are responsiblefor as much as two-thirds of U.S. equities daily trading volumeand are the major source of liquidity for retail and institution-al investors, according to many experts. Critics contend thatHFT firms that colocate their black-box trading strategies at ornear exchange data centers have unfair access to execution ven-ues and can front-run slower traders. Concerns over flashorders and unfettered sponsored access, or “naked access,”have prompted the SEC to review these strategies, but any rulechanges could dramatically impact market liquidity.

Where the Industry Is Now: Low-latency automated tradinghas exploded among electronic market makers and statisticalarbitrage players seeking to eke out small profits by capturingthe spread across multiple execution venues. According toLarry Ryan, HP’s chief technology officer for worldwide finan-cial services, automated high-frequency trading is responsiblefor 50 percent to 70 percent of equities trading volume.

To accelerate trading,HFT firms typically co-locate the servers thathouse these strategies in a data center at or near the major equity venues.“Everyone is trying to takelatency out of their sys-tems — the trading ven-

ues, the ECNs, the exchanges are trying to trade fasterbecause the broker-dealers are directing order flow based onthe [venues’] response times,” explains Ryan.

Focus in 2010: Regulation will be the focus as Sen. TedKaufman (D-Del.) has called for a broad review of marketstructure by the SEC. The regulator already has proposed aban on flash orders and is examining high-frequency tradingas well as sponsored access, colocation and dark pools. Riskmanagement gateways on the exchange side or plug-in riskcontrols on the broker infrastructure will come into play as

tools to rein in naked access. Meanwhile, HFT shops willfocus on expanding their strategies to markets in Europeand Asia and moving into other asset classes.

Industry Leaders: The big HFT players are electronicmarket makers, including Getco, Tradebot, Citadel andQuantLab, and hedge fund managers such as D.E. Shaw,SAC Global Advisors and Renaissance Technologies.Proprietary trading desks of Goldman Sachs, MorganStanley and Deutsche Bank also engage in HFT. LimeBrokerage is a key provider of colocation services and mar-ket data to hundreds of low-latency trading firms. Clearingbroker Wedbush Morgan is a major provider of sponsoredaccess to HFT shops and reportedly clears trades for Getco.

Technology Providers: HFT depends on advanced tradingtechnology, high-performance computing systems, colocationand low-latency networks. “HFT firms need low-latency mar-ket data, usually direct feeds, connectivity to the executionvenues, smart order routing technology and a FIX engine,”comments Sang Lee, managing partner at Aite Group. Someof the top providers of these technologies include FTEN,Quanthouse and Lime Brokerage, which offer infrastructureto HFT firms including market data and connectivity to exe-cution venues, according to Lee. Colocation/proximity serviceproviders include British Telecom and Savvis, along with7Ticks, Equinix, and Switch and Data.

Alpha generation platforms such as Alphacet are designed tohelp quants develop strategies quickly, and Marketceteralaunched an open source software platform for building auto-mated trading systems. Complex event processing (CEP)engines speed processing of real-time streaming data. And firmsalso need low-latency messaging middleware, tick databasesand feed handlers from providers such as 29West and Tervela.

Price Tag: HFT technology is expensive, but analysts say thebarriers to entry have fallen. TABB Group senior analyst KevinMcPartland estimates that entry costs are a few hundred thou-sand dollars. But as HFT firms scale up, the costs escalate. ✧


CAPITAL MARKETS

OUTLOOK

2010

Regulators are scrutinizing high-frequency trading, which accountsfor as much as two-thirds of equities executions. Charges of unfair access likelywill continue to drive the HFT controversy in 2010. By Ivy Schmerken

Sound Bite: “High-frequencytrading is simply the leading

edge where trading in thecapital markets is going.”

—Graham Miller, Marketcetera

High-Frequency Trading

High-Frequency Hot ButtonCHALLENGE


CAPITAL MARKETS

OUTLOOK

2010 Dark Pools

Why It’s Important: Dark pools provide liquidity and helpinstitutional investors trade large blocks of securities anony-mously, which is valuable to asset managers who are worriedabout exposing their large orders and moving the market aheadof their trades. But politicians and regulators have focused ondark pools (along with high-frequency trading and flash orders)as they look to restore investor confidence in the U.S. markets.“The SEC is under a lot of pressure, rightly or wrongly, torestore confidence in the U.S. markets,” says CheyenneMorgan, analyst with TABB Group. “At the very least, it is agood reason for the different participants in the industry to gettogether and discuss what is best for the markets.” Most partic-ipants expect dark pools, through either regulation or voluntaryreporting, to increase transparency for investors in 2010.

Where the Industry Is Now: Since dark pools do not reporttrades “to the tape,” as other, traditional trading venues arerequired to do, it is hard to get an accurate estimate of theirinfluence on the market. “We can’t accurately gauge the mar-ket,” says Sang Lee, cofounder and managing partner at AiteGroup. “We estimate the size [i.e., trade volume] of the darkpool market at about 12 percent. Brokers think that darkpools hold 20 percent of the market. Some venues overreportvolume, some underreport and some don’t report at all.”

The opaqueness of the dark pool market is one reasonpoliticians are examining the way dark liquidity providersoperate. During an October Senate hearing on dark pools andother market structure issues, market participants debated thevalue of dark pools. One theme emerged: More transparencyis required. Peter Driscoll, senior trader at Northern Trust andchairman of the Securities Traders Association, said he wasconcerned about the ways orders are routed through theopaque venues and believes that it is important for the SEC toinvestigate dark pools. “We are sending orders to dark pools,and it is our right to know how they are handled. Transparencyin the order-handling process is extremely important.”

But too much transparency would hurt many investors,warned Dan Mathison, managing director of Advanced

Execution Services at Credit Suisse, which runs its own darkliquidity network. “Dark pools are beneficial for investors,”he said at the hearing. “Those who would compel dark poolsto display orders would be helping [high-frequency] traders.”

Focus in 2010: Much of the work to regulate dark pools willseek to balance the needs of investors. Regulators will try todetermine how much transparency is needed to make sure allinvestors — institutional and retail — are treated fairly, with-out providing too much transparency, which would renderdark pools useless (by providing information to traders whomay front-run the market). “There will be more scrutiny,”says Dave Csiki, managing director at INDATA, a providerof buy-side trade order management, compliance and port-folio accounting software. “Our clients say that dark poolsare valuable and provide liquidity. More oversight might behealthy, as long as it doesn’t stifle innovation.”

Dark pool competitors, such as exchanges and brokers, thatmust display trades also are lobbying for more transparency asthey look to even the playing field or gain a competitive advan-tage in the hypercompetitive U.S. equity markets. “The dis-played pools view the dark pools as a threat,” says Aite’s Lee.

Even ITG, which runs its own dark pool, POSIT, wantsmore openness. “We support efforts to improve transparen-cy, as long as [they are] applied fairly across the markets,”CEO Bob Gastro said at the Senate hearing.

Industry Leaders/Technology Providers: Some of the lead-ing dark pools, according to TABB Group’s 2009LiquidityMatrix, are Crossfinder (Credit Suisse), KnightLink (Knight Capital), SigmaX (Goldman Sachs), Liquidnet,MSPool (Morgan Stanley), Millennium (NYFIX), Getco,LeveL, Barclays and Instinet.

Price Tag: Most brokers help asset managers connect to darkpools, and since trading in dark pools can help reduce marketimpact, the cost savings for asset managers can be significant. ✧

Sound Bite: “Everything we are talkingabout hinges on regulations over the next sixto 18 months. I will be shocked if we don’tsee more regulation.” —Sang Lee, Aite Group

Transparent GoalsDark pools provide

a valuable venue for block trades. But new regulations may change howparticipants interact with anonymoustrading venues. By Greg MacSweeney

CHALLENGE

Why It’s Important: When Lehman Brothers failed andAIG was on the brink of collapse in September 2008, the systemic risk associated with a collectively over-leveragedfinancial industry was painfully apparent. Add in the BernardMadoff Ponzi scheme, and investors and regulators sudden-ly realized that maybe transparency is important after all.

Where the Industry Is Now: Investors are demandingtransparency from hedge funds, which can provide the nec-essary information only by automating processes.Fortunately, the industry is past the era when many fundswere run on spreadsheets. “We are well beyond the spread-sheet-only days,” says Dave Csiki, managing partner atINDATA, a provider of buy-side trade order management,compliance and portfolio accounting software. “We are see-ing a lot of transparency demands from investors, and real-time reporting is very popular.”

Hedge funds, rocked by volatile markets and record

redemption rates, have risen to the challenge. “There hasalways been a need for transparency, but when a fund isbeating the market, investors don’t ask [questions],” saysNael Farsakh, solutions partner at EMC Consulting. “Thathas changed. We never used to hear hedge funds talk abouttransparency and compliance, but now they are making surethey have the right infrastructure in place.”

In addition to investor demands for transparency, regu-lators are looking to avert another global financial crisis byidentifying risks before it’s too late. The only way to pro-

vide the necessary level of reporting and transparency is todeploy systems that can track and report assets’ values.

Focus in 2010: “Most proposed legislation is focused onmonitoring systemic risk before it occurs,” says Keith Bliss,SVP at Cuttone & Co., an introducing broker. “The only wayhedge funds are going to be able to handle the regulatorydemands is through automation.” New regulations may notbe finalized until mid- or late-2010, but hedge funds can’tafford to wait to automate processes.

“The minimally accepted requirements by investors forportfolio analytics and risk management have gone up dra-matically,” reports Mike Rosen, managing director and prin-cipal at Concept Capital, a mini-prime broker. “And NAV[net asset value] ‘light’ isn’t going to cut it anymore. Thetrend is going to be daily NAV, and it will be a check box inthe due diligence questions” that institutional investorsrequire hedge funds to complete, he adds.

An independent third party, such as a prime broker, andtechnology solutions from proven vendors can help hedgefunds meet the due diligence requirements. “We are seeingmore investors coming in and doing due diligence on ourclients and technology,” says Nigel Kneafsey, CEO ofOptions IT, an infrastructure service provider to the hedgefund industry. “Running a hedge fund on a fully in-house-built system is not going to be acceptable going forward.”

Industry Leaders: Introducing brokers, such as Cuttone &Co., Merlin Securities, Concept Capital and ShorelineTrading Group, all provide services and technology to hedgefunds that can help meet current demands for transparencyand reporting from investors and future regulatory require-ments. Larger prime brokers offer similar services.

Technology Providers: Most introducing brokers and primebrokers offer automation technology along with their servic-es. Technology providers that cater to hedge funds also haveemerged recently. “A few years ago all you could find werefront-office solutions,” says INDATA’s Csiki. “Today thereare custody and back-office functions available as well.”

Price Tag: There are too many variables to pin down a cost.Depending on the level of sophistication and size of the hedgefund, and whether it is running its own technology or relyingon a prime broker’s functionality, prices vary widely. ✧


CAPITAL MARKETS

OUTLOOK

2010

Institutional investors are already demanding more transparencyfrom hedge funds. Not to be outdone,regulators are readying new rules forhedge fund reporting. By Greg MacSweeney

Sound Bite: “One of the first things aninvestor asks is what systems a hedge fund

has in place. Running on Excel doesn’t cut itanymore.” —Scott Alintoff, SunGard VPM

Hedge Fund Automation

A Clear UnderstandingCHALLENGE


CAPITAL MARKETS

OUTLOOK

2010 Risk Modeling

No Country for Old Models

Why It’s Important: If another failure on the scale ofLehman occurs, bailouts may not be so readily available, andWall Street firms will have to be able to inform regulators oftheir exposures across asset classes and geographies. NassimTaleb, author of “The Black Swan,” testified this fall beforeCongress: “There are many variations of Value at Risk [thecommonly used method for projecting the losses an institu-tion could suffer on a given day] out there, and for me, theyare all equally defective.” Even methods meant to improvethe standard VaR, such as “expected shortfall” or “condition-al VaR,” are insufficient, he said, because past losses do notpredict future losses. “Stress testing is also suspicious becauseof the subjective nature of a ‘reasonable stress’ number.”

Adds Irene Aldridge, managing partner and quantitativeportfolio manager at Able Alpha Trading, a proprietary trad-ing and investment consulting company, “The major problemwith VaR is it underestimates the tail risk.” VaR has beenextended in many ways to reflect liquidity risk and take intoaccount operational risk and basic stop losses, but if there’s anextreme change in price, VaR is thrown off, she says. VaRneeds to be supplemented with other risk management efforts,such as considering worst-case scenarios, experts agree.

Where the Industry Is Now: Many firms are jumping rightback into high-risk products — for instance, by selling secu-ritized insurance policies (referred to by some as “collateral-ized death obligations”) to investors and hedge funds. But atthe same time capital markets firms are installing more riskmitigation technology and rethinking risk-modeling tools. Asthe cost of high-speed computing has dropped, risk modelinghas become almost commoditized and fewer humans areneeded to run them, says Aldridge. “You can price complexderivatives in a matter of microseconds, whereas 10 years agoit took several days.” Nonetheless, Aldridge adds, because ofthe expense, “On Wall Street we’ve seen significant resistanceto applying technology toward minimizing risk.”

Focus in 2010: Wall Street needs to put more-sophisticatedmodels in place next year, argues John Lietchy, associate pro-

fessor of marketing and statistics, Pennsylvania StateUniversity. “Firms can benefit from more-sophisticated timeseries models of correlation structures and dependencestructures between marketplaces,” he contends, adding thatVaR models often don’t account for the extreme correlationsthat occur during a market crisis or a disruption.

But Paul Wilmott, a researcher, consultant and lecturer inquantitative finance, cautions against too much model sophis-tication. “The more sophis-ticated your tool, thegreater potential for pre-tending there’s no risk,” hesays. More important is tohave risk managers ques-tion existing models andapply real-world knowledgeto them, Wilmott asserts.

Able Alpha Trading’s Aldridge says she expects to see riskmanagement advances in the areas of portfolio manage-ment, high-frequency trading and the risk ratings of loans.

Industry Leaders: Aldridge says Citi is doing a “phenomenaljob” of leveraging risk management technology, and much ofthe credit goes to Shakil Ahmed, the firm’s cohead of electronictrading. At the same time, Aldridge notes, Citi has dramaticallycut technology costs by using the R programming language,whose source code is available for free, to create risk models.

Technology Providers: The R Project for StatisticalComputing, The MathWorks (Matlabs), Numerix andQuantifi all provide modeling solutions that can be applied torisk assessments; RiskMetrics Group and SunGard are amongthe providers of risk management applications.

Price Tag: Varies tremendously. Companies are starting to use free, open source tools, and many perform calcula-tions on an Excel spreadsheet. But the high-performancehardware, programmer time and quant time needed toeffectively address risk are expensive. ✧

Congress and taxpayers agree: Financial firms cannot continue tomake large, risky bets and expect a government bailout. Survival in 2010 will hingeon more-effective risk management models, processes and technology. By Penny Crosman

Sound Bite: “No onewith half a brain has everliked VaR because it canbe used to hide risk.”—Paul Wilmott, 7city Learning

CHALLENGE

Why It’s Important: The need for business intelligence tools— which can help firms understand counterparty exposuresand operations risks and eliminate points of failure, as well asmonitor performance and identify business opportunities —came to light amid the collapses of several broker-dealers lastfall. “The idea that you can have a valuations process that’sdiscrete or distinct from a risk management process or evendistinct from an operations process is being thrown out thewindow,” says Stephen Bruel, research director, securities andcapital markets, TowerGroup. “If operations are behind, ifyou haven’t done a reconciliation with the counterparty, howdo you know what transactions you need to collateralize?”

Where the Industry Is Now: Although quants and researchanalysts make heavy use of reports and analytics, businessintelligence is largely absent from areas such as operations,risk assessment, investment performance and customer serv-ice. Most firms have multiple, disparate customer databases,operations data sources, collateral management databases andtrading data stores that make it impossible to optimize BItools, which require a solid data foundation or at least cleanand consistent data sources. Some capital markets firms areworking to integrate data stores to facilitate BI-style dash-boards and reports. Large enterprise data management proj-ects that were begun at many large Wall Street companiesseveral years ago but abandoned when IT budgets and staffswere dramatically cut may see new life in 2010.

Business intelligence is also emerging in wealth manage-ment. For example, wealth management firm Janiczek & Co.recently chose hosted BI software from Mydials to monitorand manage portfolio management, relationship manage-

ment, service management, sales management and businessmanagement results. “You get what you inspect, not whatyou expect,” says Joseph Janiczek, the firm’s founder andchairman. Some wealth management firms are seeking toprovide more-accessible and -sophisticated client reports,according to Craig O’Neill, SVP of Odyssey Financial, aprovider of wealth and asset management software.

Focus in 2010: Some of the new rules Congress and regula-tors come up with likely will require business intelligencecapabilities. For instance, regulators are certain to requirefirms to repeat the recent stress tests, according toTowerGroup’s Bruel. “Broker-dealers are going to have to runinternal stress tests for things like liquidity and report theirfindings back to the regulators,” he says. Such activities shoulddrive the purchasing of data management software and tech-nology that provide more-efficient access to information, suchas in-memory databases. Further, complex event processingsoftware will make its way into the back and middle offices tohelp firms address risk and valuations, Bruel adds.

At BNY Mellon, 2010 plans include making the new busi-ness intelligence software easier to use and delivering more-intuitive charts and reports — for instance, showing salespeopleat-a-glance wins versus goals or showing regional CEOs whichopportunities require decisions in the next month.

Industry Leaders: Bank of New York Mellon recentlycompleted a number of customer data integration projectsto build business intelligence reports (using Oracle soft-ware) for institutional sales groups. State Street is engagedin an ambitious enterprise data management initiative.

Technology Providers: IBM, Oracle, Sybase, SAP,Microsoft, Actuate, Mydials.

Price Tag: Open source (read: free) and inexpensive businessintelligence tools are available, but the underlying data integration or data cleanup projects tend to run in the millions of dollars. ✧


CAPITAL MARKETS

OUTLOOK

2010

Business intelligence tools can deliver decision-making insight toareas on Wall Street that sorely need it, such as portfolio and risk management. Thecatch? Data has to be clean, accurate and organized (if not integrated), which meansshelved enterprise data management projects may be resurrected. By Penny Crosman

Sound Bite: “If we have trouble with datamanagement in individual silos, what’s going

to happen at the enterprise level?”—Stephen Bruel, TowerGroup

Business Intelligence

Intelligent DesignCHALLENGE


CAPITAL MARKETS

OUTLOOK

2010 OTC Derivatives Clearing

Why It’s Important: “Central clearing is all about reducingsystemic risk,” says Kevin McPartland, senior analyst at TABBGroup, explaining that central clearing of OTC derivativeswould reduce the counterparty risk in bilateral transactionsbetween dealers. Adds Joe Trentacosta, board member of theInternational Securities Association for Institutional TradeCommunication (ISITC), “Margin [would be] posted to a cen-tral exchange versus directly with a counterparty.” Centralclearing also would enable added efficiencies, such as a reduc-tion in margin requirements and cross-margining of listed andOTC derivatives, as well as bring transparency to pricing.

Where the Industry Is Now: Major futures exchanges(InterContinental Exchange, Eurex and CME) have rolled outcentral counterparty (CCP) facilities in the U.S. and Europefor plain vanilla credit default swaps and CDS indices. CMEeven scrapped its CMDX electronic trading initiative withCitadel to focus on clearing. NYSE Liffe and London-basedclearing house LCH.Clearnet, however, shut down their CDSclearing business in September. Experts predict that CCPs willclear plain vanilla derivatives but that exotics will continue tobe cleared bilaterally. “All of this requires the brokers to bederivatives clearing members. That is still in its very infantstage,” says ISITC’s Trentacosta. Buy-side firms also are figur-ing out how central clearing will work. “They don’t like a sin-gle entity seeing all of their positions,” Trentacosta explains.

Focus in 2010: A key focus will be on finalizing derivativesreform bills. Another will be securing buy-side support andpushing firms to submit trades through the derivatives clear-ing members. But in order for central clearing to gain trac-tion, exchanges need software to provide pre-clearing checksand reconciliation mechanisms. “The exchanges don’t havethe infrastructure, and clearly the clearing members are notready to invest hundreds of millions to do it,” says GerardRaffe, SVP of product management at Calypso Technology,which is working with Eurex and two other major exchangeson a central clearing initiative. “Exchanges will need systems

to calculate net present value, value at risk, margin and inter-est payments on long-term swap contracts.”

Industry Leaders: Ventures from global futures exchanges arethe major players in OTC derivatives clearing — specificallyICE Trust, CME Clearing House and Eurex Clearing. NasdaqOMX entered the CCP space with International Derivatives

Clearing Group (IDCG), partly owned by BNY Mellon, toclear interest rate swaps, and CME and Eurex also are target-ing interest rate swaps. Meanwhile SwapClear, owned byLCH.Clearnet, currently controls 50 percent of the interestrate swaps market. Another key player is DTCC Deriv/Serv, amatching facility for credit derivatives trades. DTCC’s TradeInformation Warehouse is a top contender to become the cen-tral repository for OTC derivatives trades, and TriOptima wona bid to develop a repository for interest rate derivatives.

Technology Providers: Many vendors offer reconciliationproducts and other post-trade systems to address workflow,including Calypso, TriOptima, Omgeo and SmartStream, aswell as Summit Systems and Murex in the risk space.

Price Tag: There are no estimates for the cost of building anOTC derivatives clearing infrastructure. But experts saysoftware packages from the vendors range from $50,000 to$100,000. Still, “The buy side needs to know what the clear-ing members are going to charge for the business,” saysISITC’s Trentacosta. “[If] they don’t know how much it’sgoing to cost, it’s hard for the buy side to gauge [how muchit should invest in solutions].” ✧

Sound Bite: “The big question is what doesthe word ‘standardized’ mean to you. Two ...dealers may arrive at two different decisions onwhat standard derivatives are.” —Tim Lind, Omgeo

Clearing UpDerivativesReform

Congress is working on legislation for OTCderivatives reform, but there stillis no agreement on mandatoryclearing of standardized instruments or on how exoticinstruments will be handled.

By Ivy Schmerken

CHALLENGE

Why It’s Important: Regulators are demanding increasedaccess to firms’ data because of the near global financial melt-down precipitated by subprime mortgages and the derivativesactivities of AIG, which weren’t exposed to reporting require-ments. “Investors and market participants are all looking fortransparency,” comments Milton Miyashiro, head of regula-tory compliance for evaluations at Thomson Reuters. “Thereforms are designed to bring stability to the markets that havebeen running away through innovation.” Firms will need to be

able to provide access to data that is trustworthy, relevant andhigh quality, otherwise they could face penalties from regula-tors, including being held to excessive capital reserve levelsthat are detrimental to the business, suggest experts.

Where the Industry Is Now: Every regulator has some reformor new requirement that it wants to implement. The SEC islooking at the rating agencies and dark pools, as well as othermarket structure issues; the U.S. Treasury is looking at OTCderivatives transaction reporting, dark pool reporting,registration of hedge funds and private equity firms, and report-ing of bank executives’ compensation. Meanwhile FINRA islooking to create post-secondary trade reporting for mortgage-backed and asset-backed securities. And in 2009 banks dealtwith the Financial Accounting Standards Board’s FASB 157,which forced them to report the fair market value of CDOs andother complex debt securities on their balance sheets.

Focus in 2010: “Firms will invest in infrastructure andextractor tools to strengthen their data quality and all theirdifferent information systems and reporting systems to

come up with clear and accurate data,” says Miyashiro, whopoints out that, “Basel II is going live, ... so you’re playingwith live ammunition.” Compliance with Basel II, accordingto Miyashiro, will require the top 20 U.S. banks to scoretheir own assets and to aggregate their historical data todetermine their risk-based capital models.

OTC derivatives reform also will require banks toreport their trades to some form of repository. And asindustry consolidation continues, banks involved in merg-ers and acquisitions — such as J.P. Morgan (WaMu), Bankof America (Countrywide) and Wells Fargo (Wachovia) —will need to integrate and consolidate enterprise systems,licensing agreements, data farms and servers.

Industry Leaders: The too-big-to-fail banks (i.e., Citigroup,Bank of America, Goldman Sachs, J.P. Morgan, MorganStanley, Wells Fargo) that went through rigorous stress test-ing to assess their risk with the U.S. Treasury departmentalready understand the scope of regulatory demands and theunderlying reporting requirements and capabilities.

Technology Providers: The main players in the data man-agement space are GoldenSource and Asset Control, whileSybase, Oracle and SAP are leading database solutionsproviders. “The products are out there, yet firms have beenreluctant to hand their critical data over to a third party,”says Kevin McPartland, senior analyst at TABB Group.Instead, “They’ll [develop] enterprise solutions, and thedata will sit on their site.”

Companies such as Informatica provide frameworks forenterprise data integration. Messaging standards also willbe required for data reporting. “FpML is a logical thoughtthere for [derivatives] reporting,” notes McPartland.Others point to XBRL, an XML-based standard that theSEC has implemented for financial reporting.

Price Tag: No one is willing to estimate the cost of developingan effective data management and reporting infrastructure,but experts agree that the investment is substantial. “These arenot trivial dollars,” says Thomson Reuters’ Miyashiro. ✧


CAPITAL MARKETS

OUTLOOK

2010

With a plethora of proposed regulations in the pipeline, financialservices firms are facing more-strenuous audits and data-reporting requirementsthat could result in penalties if firms get them wrong. By Ivy Schmerken

Sound Bite: “Nowadays the investment return[on data management and reporting] is not

delivered in just dollars and cents but also thenumber of prison years you avoid by getting

it right.” —Arvind Parthasarathi, Informatica

Regulatory Reporting

Data On-DemandCHALLENGE


CAPITAL MARKETS

OUTLOOK

2010 Social Networking

Why It’s Important: Almost every industry has seen theinfluence of social networking, and capital markets is nodifferent. Traders use social networks to share tradinginformation (such as which ECN is having problems),investors use them to share tips and companies are creatinginternal social networks to increase employee productivity.“Social networking is going to be here for the long term,and it is important to stay engaged there,” says StephenEhrlich, CEO of Lightspeed Financial, which runsLightspeed Spotlight, a social network for active tradingcustomers of Lightspeed Trading.

Where the Industry Is Now: In the past few years, financialfirms of all stripes — exchanges, brokers, industry associationsand vendors — have experimented with social networking.Many use the technology internally for collaboration.SWIFT, the global financial transaction consortium, launchedSWIFTcommunity.net in 2007 and has almost 12,000 users.And most financial organizations have some sort of presenceon Twitter — CME Group’s Twitter feed has more than766,000 followers. A few independent sites, such as EliteTrader, offer participants a place to exchange information andconnect with like-minded users. Similar to Lightspeed,Charles Schwab hosts a proprietary active trader social net-work for clients. TradeKing has one of the most robust socialnetworks in the industry, with 175,000 account holders.

On most proprietary social networks, customers canshare ideas and even criticize the provider. “Many compa-nies are fearful of how social networking allows customersto speak their minds openly,” says Lightspeed’s Ehrlich.“Sometimes you don’t like what they have to say about you,but the criticism is often the most valuable information.”

Focus in 2010: The big question to this point has beenwhether social networking provides an ROI, and it probablywon’t be answered for some time. “There is no money to bemade at this point,” says Marc DeCastro, research managerat advisory firm Financial Insights. “Firms are still trying tofigure out if social networking is about marketing, clientsupport, customer support or something else.”

So why should a financial services organization invest in

social networking? For starters, it is considered a sign thatthe company has modern technology. “Millennials arecompletely comfortable interacting with a financial institu-tion online or through a social network,” DeCastro says.“Banks in particular will look to refresh their platformswith social networking types of interactions, as well as Web2.0 tools. That is what is going to attract and retain clients.”

Engagement, however, still can be a concern for firms thatinvest in social networking. SWIFTcommunity.net, for exam-ple, saw only 1,300 people log on in October 2009, with just 93comments in total, reports Andrew Carrier, head of marketingcommunications and banking at SWIFT. “We have a lot ofusers, but engagement is a challenge,” he concedes. “Socialnetworking is not about having a place for SWIFT to push out

its stories; it’s about having a place where the community canengage. We didn’t build it for us — it’s built for the users.”

Industry Leaders: TradeKing, Lightspeed, Charles Schwab,E-Trade, Scottrade, Elite Trader and SWIFT, to name a few.

Technology Providers: Some companies build their ownsocial networks, but others rely on technology fromproviders such as Small World Labs, Elgg.org, KickApps,Groupsite and CrowdVine.

Price Tag: Varies depending on the commitment. Forinstance, after developing a platform based on technologyfrom Small World Labs, Lightspeed added a full-timeemployee dedicated to maintaining its social network. ✧

Social networking is changing the way consumers, investors and traders interact and share information. But all companies are struggling to showhow the technology is actually adding tothe bottom line. By Greg MacSweeney

Sound Bite: “The millennials who use socialnetworks will turn into the prime customers in the future. But how long does a firm waitaround?” —Marc DeCastro, Financial Insights

CHALLENGE

Social Networking Is Here to Stay


The Chicago Mercantile Exchange is a 111-year-old enti-ty that in recent years acquired the Chicago Board of Tradeand the New York Mercantile Exchange. In doing so, CMEparlayed a pioneering role in electronic trading — it intro-duced Globex, the first electronic futures trading platform, in1992 — and its once mundane-looking clearing operation

into its top spot among derivative exchanges. “They were theupstart, underdog futures exchange 15 years ago, and nowthey own the world,” says Larry Tabb, CEO of financial mar-ket research and advisory firm TABB Group.

And now they own the top spot in the 2009InformationWeek 500, Wall Street & Technology sibling brandInformationWeek’s annual ranking of the most innovative business technology organizations.

The company’s success hinges on a technology team, 800-strong and led by CIO Kevin Kometer, that must live on theedge of emerging technology — and even drive it, cajolingvendors such as Dell and Hewlett-Packard, AMD and Intel,and Cisco to build what might not look like mass-marketproducts yet. “We’re almost playing matchmaker,” says JohnHart, CME’s managing director of technology engineering,about its relationship with vendors. Three years ago, for exam-ple, CME started work with Verizon and Tellabs to create a

Living onTechnologyBy Chris Murphy, InformationWeek

As the operator of theChicago Mercantile

and other exchanges,CME Group’s

competitive advantageincreasingly is built on

technology innovation.

WO TYRANTS lord over the business technology team at CME Group, and theyexplain most of what you need to know about the exchange operator’s Type A,Saturday-working, never-satisfied culture. One is volume. The other is speed.

CME Group operates the Chicago Mercantile Exchange, the world’s largestderivatives exchange. In the past five years, CME’s trading volume has grownmore than 300 percent a year — from 30 million orders a month in 2004 to

6.5 billion in October 2008, when the financial crisis hit its peak. In that same span, the aver-age time for a quote or order to come into and back from CME’s data center was collapsedfrom 180 milliseconds to less than 6 milliseconds. A blink takes about 300 milliseconds.

Despite the economic challenges, this year’sInformationWeek 500 companies had the vision andguts to keep trying new ideas. And 25 financial servicesfirms made the list. View all 500 business technologyinnovators at informationweek.com/500.

T

Technology Innovation


Technology Innovation

metro area Ethernet network that was more point-to-point,not looped, to get far more speed. That went live last year.

Yet until 2008 one of CME’s most precious systems, the corefutures trading platform that matches buyers and sellers, was farfrom leading-edge — it was ultrareliable but shackled to a lega-cy system of 1 million lines of code, written for proprietary SunSolaris servers. New features required long and costly testing,and hardware refreshes cost tens of millions of dollars.

So the IT team rewrote its core futures trading systems —which handled contracts worth $1.2 quadrillion of notionalvalue in 2008 — in Java in six months and started migratingthem to commodity Linux servers in January. The results: Ata leaner 295,000 lines of code, the new platform cut responselatency by 67 percent (by 5 milliseconds), and cut mainte-nance and capital expenses by 90 percent.

Platform for GrowthThe company hopes to use its electronic platforms to seizenew trading markets, including carbon credits through itsGreen Exchange joint venture and, in reaction to the finan-cial crisis last fall, credit default swaps through its proposedCMDX partnership with hedge fund Citadel InvestmentGroup. CME also is proving itself to be a partner of choicefor foreign exchanges, from Brazil to Malaysia, that arelooking to trade their products through Globex to reachmore global investors.

Rick Redding, CME’s managing director of products andservices, notes that with an acquisition or partnership, ITteams are pulled in from the very earliest stages to assess if theeconomics work. But if it’s an organic project that leveragesCME’s platform, IT’s called in fairly late in the game. It’s justa given that the infrastructure is in place to expand, he relates.“The IT team spends a lot of time in their cycle leveragingahead of our needs,” Redding explains.

And that’s the way it has to be when a big spike in volumeis 18 times an average day’s volume. CME maintains enoughcapacity to handle two times the last known peak.

According to Kometer, every Saturday that’s not Christmasinvolves some significant testing, which can’t be done on trad-ing days. It’s common to have 100 people in the data center ona Saturday, he says, lighting up the production environment totest systems. Testing’s often coordinated with trading cus-tomers — the hedge funds, banks and brokers — that need totry out their own trading systems’ interaction with any newCME software. A blazing-fast matching engine inside CME’sdata center doesn’t help if customers don’t see better perform-ance in their systems, which increasingly rely on automatedtrading. “We have to work with our customers to make suretheir technology is evolving with ours,” Kometer says.

It won’t get any less intense. CME, which runs about

4,000 Red Hat Linux-based servers today across data centersin Chicago and New York, is adding a 260,000-square-footdata center in the Chicago suburbs.

CME’s tech-driven capabilities put it in the midst of ahuge business opportunity, in part driven by the financialproblems of the past year, says Joe Panfil, CME’s managingdirector of enterprise technology. Companies are increasing-ly doing real-time risk assessments of their counterparties’ability to pay up, rather than waiting until day’s end, herelates, explaining that that plays to CME’s strength in speed.Political and regulatory pressure could drive some derivativestraded over-the-counter today onto regulated exchanges orclearinghouses such as CME. NYMEX’s clearing of OTCenergy contracts spiked after the collapse of Enron, Reddingnotes, as people looked for more assurance that the other sideof a trade could pay. “It’s times like that [when] people lookfor unique solutions to make the system better,” he says.

Challenges AheadCME faces challenges ahead, too. While it dominates manyfutures products markets, TABB Group’s Tabb notes that equitytrading has fragmented among exchanges, and CME faces morecompetition from established exchanges and from banks andbrokers setting up their own exchanges for emerging products.

One thing not discussed here is reliability, which mightseem odd given the pressure for the exchange to never fail.When the financial crisis was at its worst last fall and volumessoared, CME never buckled — nor did any rival exchanges.Imagine the chaos if they had.

So alongside volume and speed, reliability must be anoth-er of those tyrants, right? Sort of. It’s a bit like reminding achampion marathoner to breathe while kicking the last mile.

“You don’t even talk about it, because it’s got to be there,”Panfil says. “Then, the focus gets back to speed and capacity.” ✧

“We have towork with ourcustomers tomake sure theirtechnology isevolving withours.”Kevin Kometer, CIO, CME Group


Mutual Funds and Cost Basis Compliance

N OCT. 3, 2008, President Bush signed intolaw the Emergency Economic StabilizationAct, which contains a provision that will requirebrokerage firms and mutual fund companies totrack and report adjusted cost basis informationto investors and the IRS. Due to the economic

issues gripping the financial services industry, the basis report-ing regulations went largely unnoticed. However, the legisla-tion is significant, and little time exists for firms to properlyprepare to comply with the reporting requirements.

With just over a year before reporting equities becomesrequired, brokerages should be well into the planning stagesfor purchasing and implementing a cost basis system. Manyfirms, however, have failed to begin planning, let alone com-mence the lengthy process of selecting, testing and imple-menting systems. This procrastination by the fund industrymay have a dramatic impact on business operations andinvestor satisfaction over the long term.

Security-specific rules and the current state of cost basisofferings create unique, often challenging problems formutual fund companies. Fortunately for investment manage-ment firms, the legislation does not impact pure mutual fundproviders until January 2012. (Those firms with brokeragearms will be required to cover equities beginning in 2011.)

Historically, mutual fund providers have used AverageCost as the default lot relief method (LRM). The new legis-lation requires that shareholders be allowed to select theLRM of their choice. This process can be very difficult forfirms to resolve and undoubtedly will change the nature ofthe relationship between firms and shareholders. Satisfyingthis requirement means opening a communication channelwith the shareholders. If executed poorly, the result is a con-fusing and unsatisfying experience for the client and a time-consuming and costly exercise for the firm. Those firms thatfocus solely on achieving the bare minimum necessary to bein compliance with the new legislation are likely to fail in theoverall execution of cost basis implementation.

Brokerages and fund companies have four options avail-able for automatically adjusting cost basis: retrofit a legacysystem that currently maintains some form of cost basis track-ing, develop a new in-house system from the ground up, rely

on the back-office provider or transfer agent to implement asolution, or contract with a dedicated cost basis vendor toprovide comprehensive tracking and reporting services.

For large firms, which frequently develop systems in-house, retrofitting a legacy system may seem reasonable atfirst. But attempting to support complex cost basis issues witha system that was not designed specifically to support costbasis can yield poor results. The final system is likely to becostly to build, costly to maintain or both.

Custom-build projects are notoriously expensive. But thegreater issue at this point, even for deep-pocket firms, is time.A custom-build project may take two to four years to com-plete requirements, development and testing.

Many transfer agents offer some form of a cost basis solu-tion. Transfer agent solutions, however, often provide minimalfunctionality and limit the availability of data for other applica-tions. Further, the systems tend to not be entirely automated,leading to reconciliation headaches (and costs) for a firm’soperations team. Generally the transfer agent cost basis offer-ing will suffice for small firms, but will not be adequate for larg-er, more innovative firms. Cost basis vendors typically offer themost robust solutions but may, at first glance, appear to bemore expensive, as transfer agents may bury the expense of costbasis systems in the overall relationship billing.

A Changing Client Relationship The impact of mandatory basis reporting is not limited to tech-nology acquisition. The very nature of the relationship betweenfirm and client must evolve. Investors will be allowed to use anylot relief method they desire. This necessitates a new, more open

O As SVP, strategic products, Cameron Routhis responsible for the overall leadershipand management of Scivantage’s strategicproduct initiatives and oversaw the devel-opment of Maxit, the firm’s cost basisapplication. Routh cofounded GainsKeeper,an early cost basis vendor, in 1999 andpreviously worked for PaineWebber (UBS),Fidelity Investments and AIG.

Cameron Routh, SVP, Strategic Products, Scivantage

About the Author


communication channel. Failure to provide an intuitive, accessi-ble method for indicating accounting methods will lead to asurge in support costs related to assisting confused customers.

The customer support angle is particularly compelling.While most of the focus has been on compliance — and forgood reason — firms have not fully considered the impact oncustomer support. With the spotlight now on cost basis,shareholders are likely to ask more tax questions about everyposition in their portfolios, including non-reportable lots.

Vanguard has already begun to think beyond complianceto identify the various ways basis reporting will impact thefirm. “Even though a firm is not obligated to provide assis-tance on pre-effective shares, it will lead to an increase in sup-port traffic,” suggests Charles Portale, Vanguard productmanager, Retail Investor Group. “The manner in which eachfirm handles these inquiries could have a significant impacton the customer experience.”

He Who Hesitates Is LostAnother issue facing firms is the scarcity of resources, both inter-nally and externally. As the deadline for reporting approaches,competition for qualified resources will increasingly drive updevelopment costs. By implementing ahead of the last-minutesurge, firms will have the best opportunity to manage cost.

Finally, firms that delay implementation of a comprehen-sive system will be at a competitive disadvantage to firms thatare more proactive. Many fund companies will assume thattheir cost basis offering will be measured against other fund-only firms, which share the 2012 tracking deadline. It isimportant to note, however, that clients will begin receivingadjusted cost basis data from their brokerages in 2011. Thismeans customers will receive tax reporting assistance, in the

form of adjusted cost, from their brokerage but not their fundcompany. At a minimum, this will lead to client confusion anda spike in help desk traffic; but in some cases, it could alsoresult in dissatisfaction leading to a shift in assets.

Furthermore, many large fund firms also have a brokerage(e.g., Vanguard and Fidelity Investments). Likewise, manylarge brokerages are also players in the mutual fund space(e.g., Charles Schwab). Although no information is availableabout specific firms’ development efforts, it is reasonable toassume that some, if not all, of these firms will integratemutual funds into the cost basis solutions that they imple-ment for the 2011 securities reporting deadline.

The potential for lost market share should not be trivial-ized. Those companies that introduce cost basis systems nextyear will not only get ahead of the legislation, they will beperceived as innovators within the industry and potentially berewarded with in-flows from firms that are slow to respond.

Firms that identify the regulations as an opportunity tooffer innovative, value-added cost basis tools and online datapresentation to their clients will differentiate themselves andbecome the clear front-runners as clients become morefocused on the need for cost basis information. Choosing afully featured, innovative cost basis system sends a strongmessage to the industry that your firm is committed not justto meet the requirements of government regulations, but todo so while exceeding the expectations of your clients and theability of your competitors.

One last point to consider in evaluating cost basis optionsis that cost basis is volatile. Tax rules change, new asset class-es are developed, the demand for basis in other productsevolves and new ideas for related tools continue to emerge. Ifa firm hasn’t already demonstrated a solid track record of costbasis innovation, it is unlikely to innovate in the future. Makethe wrong selection and the functionality a firm buys todaycould be all it is provided with three or four years later.

And don’t overlook the chance to have a positive impacton your customers. Investors have always struggled with taxreporting. Mandatory reporting or not, providing adjustedcost basis to shareholders improves the overall investmentexperience and increases customer loyalty. The sooner yourfirm implements a cost basis solution, the sooner it will reapthe benefits of an improved customer experience. ✧

Complex CalculationsMany fund shops do not feel a sense of urgency toimplement a cost basis reporting solution prior to the mandatory deadline. But this is a risky decision.Accurately calculating adjusted cost basis is no smalltask. Cost basis tracking systems for mutual fundsneed to account for the following complexities:

• Wash Sales• Dividend Reinvestments• Multiple Lot Relief Methods• Holding Period (short-term vs. long-term)• Sales Loads• Fund Reclassifications • Method of Acquisition (purchase, inheritance, gift)• TOA Out (firms will be required to include cost

basis information)• TOA In (firms will be required to reconcile any

missing information)• Corporate Actions• Bifurcation of Tax Lots (two-bucket system)

The fund industry’s procrastina-tion in implementing cost basisreporting systems may have adramatic impact on investor satisfaction over the long term.

IDELITY INVESTMENTS launched a newonline platform for trading international stocks and exchanging foreigncurrencies. A significantexpansion of the firm’s

international investing capabilities, thenew stock-trading platform — aimedat retail investors, broker-dealers andfinancial advisers — includes access tomore than 1,200 available mutualfunds and 250 ETFs with internationalsecurities exposure.

The new platform provides retailinvestors, and broker-dealer and adviserclients with automated and direct accessto a broad set of global markets and for-eign currencies, third-party research,

news, and real-time market data and quotes for foreign currencyand international equities, according to Fidelity. It also offers

streamlined processing and recordkeep-ing of international equities and foreigncurrencies, the company says.

Retail investors will be able totrade in 12 foreign markets (Australia,Belgium, Canada, France, Germany,Hong Kong, Italy, Japan, Netherlands,Norway, Portugal and the UnitedKingdom) and exchange eight curren-cies, all from their existing brokerageaccounts, enabling them to view all oftheir equity investments and currencypositions in one place. ✧www.fidelity.com

800-343-3548

Cadis Translates For Asset Managers

Innovative Technologies & Services

Fidelity’s new online global trading platform enablesretail investors to trade in 12 foreign markets.

OCAL-LANGUAGE support can be a challengefor global asset managers’ middle offices, accordingto Cadis, which says fund managers require morethan a low-level translation of double-byte lan-guages, as one character is often incompatible for

multiple processes and asset classes. Buy-side firms in Asia, forexample, often run middle offices in the local language; withoutsuitable translations, managers must resort to cost- and time-intensive workarounds, the vendor points out.

Cadis says its software supports deep translations that encompassindividual terms and labels in the language and definitions that the

user understands.The London-basedfirm adds that its software enablesusers to source mul-tiple golden copiesfor local operationswhile working fromthe same master data as their globalcounterparts.

Cadis users can receive, store, display, create and modify datain all languages supported by their underlying infrastructure,enabling user-specific, rather than generic, translations. Cadis’local-language support also encompasses downstream models,applications and processes. ✧www.cadisedm.com +44 (0) 207-033-8894

A Hosted FeedHandler for High-Frequency Traders

R LABS LAUNCHED a hosted version of its low-

latency, multi-asset-class feed handler for all

major markets in North America, Europe and

Asia. SR Labs has partnered with Options IT, a

provider of “infrastructure as a service,” to provide the

market data and technology infrastructure to house the

data feed handler.

The hosted feed handler will provide high-frequency

trading shops with a market data solution designed

specifically to integrate market data into high-performance

trading applications and optimized for models deployed

in exchange colocation facilities, according to the New

York-based trading technology provider.

“High-frequency trading is increasingly being adopted

by trading desks large and small, and the appetite for new

and better technologies is at an all-time high,” said

Srinivasan Ramiah, CEO of SR Labs, in a release. “Our new

hosted offering provides high-frequency traders a one-

stop solution for a fully managed, ultralow-latency market

data offering, thus giving our clients a competitive edge

by reducing costs and accelerating entry to market.” ✧

www.srtechlabs.com 917-478-1243

F

LS

Fidelity Launches Global Online Trading Platform


Larry Tabb, Special Contributing Editor

ROGNOSTICATING ABOUT 2010 is much likeshaking a Magic 8-Ball: “Reply hazy, try again.” Whiletransparency is currently increasing, 2009 was a year ofextremes. We started ’09 as a panic gripped the world.

An unprecedented housing-led recession exacerbated by recklesscredit dissemination and wanton loan syndication threw theeconomy into global recession. Our banks were hobbled; andwhile the TARP and the CBOE volatility index (VIX) reachedtheir apex, the Dow shattered its nadir: “Outlook not so good.”

Then in March the outlook changed. Fiscal stimulus wasprovided, central banks reduced short-term lending rates tonear zero and, though the economy was still hobbled, marketsbegan to turn. The yield curve steepened, the VIX came down,global markets rallied and even the lesser-performing globalindices grew by more than 40 percent. While not all of thebanks prospered, the more solvent are “without a doubt” turn-ing in stellar results, and “signs point to yes” that we are in moreof a boom rather than the bust realized by the general economy.

So are we coming out of recession, or are we being dragged

back into the mire? I wish I could answer that with certainty.Economists can’t, and neither can our Magic 8-Ball: “Cannot pre-dict now.” But I’m an optimist. I believe that the banks will regaintheir footing, investors will come out of their holes and the finan-cial markets will move forward, albeit with a bit of trepidation.

2010 will be a growth year as ’09 performance is lookingspectacular. Firms will both reinvest in their infrastructures andreposition themselves in the wake of the regulatory realign-ment that surely will come (“You may rely on it”).

Washington and Brussels will dominate the 2010 agenda (“It isdecidedly so”). Legislators and regulators are taking a deeper lookat market structure than we have seen in decades, revisiting every-thing from information dissemination to order routing, dark pools,flash trading, colocation and high-frequency trading. In addition toexamining the exchange-traded world, regulators are analyzing

the OTC markets as well, looking at exchangemigration, product valua-tion, central clearing,margin enhancement andenhanced capital reserves for non-vanilla products.

While the exact regulatory changes are uncertain at thistime (“Ask again later”), many will require greater reporting,analysis and oversight dependent on more-extensive data man-agement, risk management and real-time reporting as well as amore extensive data-collection, event-processing and reportinginfrastructure (“It is certain”).

Electronic trading solutions also will continue to be frontand center (“Yes — definitely”). This will include both theextension of liquidity-provisioning infrastructure as well asinvestor-enabled tools such as algorithms and direct marketaccess. Very popular in the U.S./European equity markets andthe U.S. exchange-traded derivative markets, these tools arebeginning to be rolled out across more asset classes, includingFX and fixed income, and to geographies from Latin Americato the Far East (“Outlook good”).

This trend follows both Moore’s and Metcalfe’s laws aboutprice/performance of technology and networking. And no matter how legislators and regulators clamp down on high-frequency trading, their efforts will be thwarted, as banningtechnology advancement, intelligence and the profitability ofbeing first will be all but impossible.

While the above trends are immutable, the next few will beeconomically driven (“Concentrate and ask again”). As theeconomy picks up, hedge funds will be recapitalized as investorswill not want to miss the alpha party. The IPO and issuancemarkets also will accelerate, driving demand for research, ana-lytics, and authoring and presentation tools. In addition, if themarket continues its upswing, we will see individuals eventuallycome back into the market. But before individuals flood back,there will be much carnage as advisers will be changed, portfo-lios realigned and brokers fired. This will launch a new wave ofretail brokerage/wealth management investment.

While 2009 was a year of opaqueness with little or no fore-sight, 2010 is still a question mark. Will we come out of thesechallenges and stay out, or will we stay hunkered in our bunkerfor another year? Will this be a year of growth or retreat?Unfortunately the Magic 8-Ball says, “Still hazy, try again.” ✧

Firms will both reinvest intheir infrastructures and repo-sition themselves in the wakeof the regulatory realignment.


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1209 WST Digital Issue