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WHITEPAPERBUY-SIDE SYSTEM REQUIREMENTS

By Avadhut Naik, Head of Solutions, Quantifi and Sol Steinberg, Founding Principal, OTC Partners

Post-Crisis Reform Radically Reshapes Financial Markets

In the last few years, the financial markets have undergone dramatic change. While some of this is down to natural evolution, much of the change can be directly attributed to new rules introduced in the wake of the 2007 crisis. Regulators, legislators and central bank governors have been determined to avert another bubble bursting or an unexpected event that could threaten markets.

Lawmakers have targeted key financial practices for reform, radically altering the expectations and behavior of industry participants. The combination of the Dodd-Frank Act, European Markets Infrastructure Regulation (EMIR), MiFID ll and Basel lll signify the biggest regulatory change in decades. These reforms have resulted in major change to how financial products are traded, settled, collateralized and reported, resulting in deep and ongoing structural changes to the markets.

Impact on Buy-Side Firms

There is no doubt that these new rules are directly impacting buy-side firms - be they asset managers, hedge funds, insurance companies or pension funds. But while the changes have certainly brought challenges, they have also brought opportunities. Firms that can proactively evaluate structural and operational dislocations in the marketplace and tailor business models to leverage the opportunities while addressing the challenges will be in the best position to stand apart from their competitors. Revised business models call for revisions to supporting processes and systems. Buy-side firms should look to re-architect their processes and technology infrastructure with a goal to strengthen risk control and oversight, enhance transparency and improve efficiency of front-to-back office control functions.

Sell-Side Exits Bring New Buy-Side Business Opportunities

While the market reforms have impacted all players, it is the sell-side (liquidity creators) institutions that have borne the regulatory brunt much more than buy-side (consumers) institutions, thanks to the central position they hold in the global financial system. The worldwide reach of the sell-side, their size and interconnectedness to other institutions make their survival critical to the survival of the entire system, hence regulations are designed to protect the financial markets from the systemic risk stemming from these institutions.

One set of regulations is focused outright on preventing banks from engaging in high-risk businesses. The Volcker Rule bans proprietary trading and prohibits a banking entity from owning interest in a hedge fund or private equity fund that might engage in proprietary trading. This has a potential negative impact on liquidity and the loss of a significant source of revenue. However, buy-side firms that understand the Volcker Rule, and can design new ‘Volcker compliant’ vehicles will be well positioned to minimize its impact.

Another set of regulations is focused on imposing higher regulatory capital charges on banks, especially for high-risk products. At a macro level, Basel III mandates that banks should progressively reach a minimum solvency ratio of 7 percent by 2019. At a more granular level, the capital required to hold certain high-risk products is prohibitively high.

One of the consequences of the regulatory focus on sell-side institutions is the breakdown in the clear demarcation of functions between the sell-side and buy-side institutions. Sell-side firms are withdrawing from businesses they traditionally dominated. Buy-side institutions like hedge funds, large asset managers and private equity firms are stepping into this vacuum left by banks exiting these businesses.

By their very nature, strategies in these businesses and the asset classes involved require a more sophisticated set of models and analytics than what is supported by legacy buy-side model libraries and risk management systems.

Quest for Higher Yield Driving Demand for Buy-Side Analytics

The quest for higher yield in a low interest environment is another reason for hedge funds and asset managers to seek out alternative investments that promise higher returns. For example, the buy-side is showing a renewed interest in structured credit products as the low risk tranches of these products are offering a higher risk weighted return in the current environment. Naturally, these investments involve a higher amount of risk, which needs to be actively monitored and managed.

This has also resulted in a demand on the buy-side for best-of-breed analytics and next-generation technology frameworks to support more complex products, capabilities they have traditionally lacked.

A Clear Mandate: OTC Derivatives Must Be Cleared Through CCPs

Regulation has also hit the OTC derivatives market. Most market participants are now required to clear standard derivatives using centralized (clearing) counterparties (CCPs). Clearing derivative contracts over CCPs involves the posting of initial and variation margin. Buy-side firms which previously have not invested in sophisticated collateral management, collateral optimization and margin calculation capabilities are now having to do so.

In addition, there is the proposed requirement, whose implementation deadline regulators have extended by 9 months, that counterparties of a non-cleared bilateral trade must also exchange initial and variation margins. While these regulations are targeted at reducing the systemic risk in the financial system, they have the side effect of increasing transaction costs for derivatives, since collateral required for satisfying additional margin requirements has to be funded.

To be consistently profitable, firms will need to carefully choose execution platforms based on an independent comparison of costs of funding margins over the life of trades. These regulation-imposed changes in

• Basel III mandated that banks should progressively reach a minimum solvency ratio of 7percent by 2019. Prior to Basel III, the minimum requirement was 2 percent, although mostbanks held more in reserve than that. A 2009 Basel III impacts study estimated that large banksactually had an average solvency rate of 11.1 percent, but definitions of regulatory capital andrisk weighted assets have changed since then. Using the current definitions, the 2009 studywould have found large banks had an average solvency ratio of 5.7 percent, meaning banks inthe 2009 study would have been short 600 billion Euros under Basel III rules.

• As a consequence of Basel III, banks will likely experience increased pressure on their returnon equity due to higher capital and liquidity costs. Banks are expected to feel pressure onmargins across all segments and they will likely look for operational efficiencies and maketactical or strategic changes. Changes might include adjusting lending rates, shifting to highervalue clients, or focusing on less risky segments of the portfolio.

Higher Capital Charge on Risky Assets - Basel III

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The credit crisis, and the regulatory response it spawned have fundamentally reshaped financial markets. While the changes have brought about challenges, they have also ushered in opportunities.

market practices call for more sophisticated analytics as well as better operational capabilities. Sophisticated models ensure profitability by factoring in all the costs of executing trades including value adjustments for counterparty risk, costs of funding margins (initial and variation) as well as costs of capital. Better operational capabilities ensure consistent analysis across the organization (Front Office through Back Office) in a timely fashion.

Improved Front-to-Back Office Technology Transforms Margin Challenges into Opportunities

In a world where collateral requirements are reaching prohibitive levels, it is paramount for buy-side firms to be able to anticipate, source, deliver and reconcile funding requirements in real-time. Capital is too much of a precious resource to be wasted away on over-

estimated margin calls. To avoid squandering capital, some of the leading buy-side firms are implementing new improved front-to-back technology to gain a significant edge over the competition. Risk analytics, collateral optimization and faster trading processes are giving these firms a distinct advantage. In addition, there is a middle majority of firms well aware of the looming threat of lagging behind that are actively implementing similar capabilities in their systems - but in a less organized and less systematic way.

The more the buy-side can accurately comprehend risk, the better it will be at maximizing capital - potentially taking the unused portion and funding more profitable trades. In the past, managing margin requirements was a reactive task, performed at the end of the trading cycle, and done within administrative and back office operations, usually manually. Today, the buy-side is turning to new technology to give them a complete, front-to-back view of their global collateral assets to allow them to assess multiple sourcing and funding options in real time.

• In July of 2012, the Commodity Futures Trading Commission proposed its first clearing mandate forswaps under Dodd-Frank. The first swaps proposed for mandated clearing included four classes ofinterest rate swaps and two classes of index credit default swaps.

• In 2013, five years after the financial crisis, the OTC swaps market saw the introduction of trade reporting and mandatory clearing. Deadlines for mandatory clearing for dealers and clients weresuccessfully met, without any noticeable drop in volumes or migration of swaps trading to futures.Both CME and LCH SwapClear processed large volumes of swaps transactions through automateddaily processing, for which parties involved posted initial margin and variation margin.

• The move to central clearing of swaps is a phased-in transformation. Following the first phase, whichmandated central clearing for dealers, major swaps participants and active funds, a second phaseadded hedge funds, asset managers and regional banks. Central clearing of swaps representeda big shift for the buy-side community, as many asset managers did not post initial margin in thebilateral world, so they had to prepare their infrastructure to handle both the process change and the calculations required for margin obligations.

• Second phase participants - the buy-side - have been given a reprieve before they must comply with reforms. Under concerns from market participants over how countries were implementing the rules,regulators extended the timeline for both initial margin and variation margin by nine months and addeda phase-in period for variation margin. Initial margin must be phased in from September 1 2016 to September 1 2020, while variation margin must be phased in from September 1 2016 to March 1 2017.

Central Clearing of OTC Derivatives

Technology Trends That Can Provide a Competitive Edge

• Move towards single technology solution, foranalytics, trade capture and enterprise risk control,with coupling between front, middle and back officefunctions

• Straight-through-Processing that starts from tradeexecution all the way through to central clearing

• Independent margin calculation and swaps portfoliopricing tools

• Reconciliation tools that can account for margincall discrepancies, either at the CCP or clearingintermediary level or both

• Transaction Cost Analysis (TCA) tools that canincorporate data from the trading process as well asintegrating back office data into the trading process

Given a collateral-centric swaps workflow involves numerous challenges and encompasses ever-changing technology demands, the leading investment managers are examining integrated front-to-back systems that can provide a complete solution for all of their analytics, trading and risk requirements, both for today and in the future. In addition, a sizable number of firms are using the platforms that their clearing brokers provide and that integrate seamlessly with their middle and back office functions. This allows them to report aggregate risk exposure in addition to developing P&L accounting systems in a Straight-through-Processing (STP) workflow that copies the entire front-to-back process. Working alongside are the necessary risk analytics systems and Transaction Cost Analysis (TCA) tools.

The goal is to optimize and streamline the entire workflow, to ensure greater trade transparency and enterprise-wide reporting. Each function largely depends on the other: the pre-trade function relies on asset and ancillary services; trading depends on pre-trade functionality; the back office depends on STP from the middle office.

The ideal workflow creates a closed loop on risk and valuation data, as well as strategic information relating to TCA. Funding can only be optimized, latency reduced, trade costs cut, and Best Execution mandates be met when this high level of workflow visibility and seamless connectivity is achieved.

Systems RethinkMarket and regulatory changes are forcing firms to re-think their business operating models. Increased complexity and uncertainty have motivated forward-looking firms to avoid stop-gap measures and replace legacy systems with a new generation of holistic trading and risk management software that supports front, middle and back office requirements across all assets. Business models cannot be altered in isolation. Supporting processes and systems also need to be aligned with the evolving business models.

Over the past few years there have been considerable improvements in the technology available to deploy and integrate financial software, boost usability and speed of processing, and improve flexibility, be it the increase in computation power, simplicity of data management, the advent of cloud computing, or more powerful APIs for easier integration. Any systems rethink needs to be done with a view to benefit from these improvements. The technology should be designed to improve front office, risk and financial control functions by ensuring consistent risk management analytics and reporting are shared across all business environments.

Key Considerations for Buy-Side SystemsIn today’s fast paced environment buy-side firms require technology that can work faster, perform better and scale with their business. The rapid pace of innovation in technology presents a whole new range of possibilities for how this technology can be leveraged. Buy-side firms that make good choices and manage their technology will be in a significantly better position in terms of operating costs, their ability to measure and manage risk, and to understand profitability across the

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Leading investment managers are examining integrated front-to-back systems that can provide a complete solution for all of their analytics, trading and risk.

organisation. Any major redesign of systems should be based on a thorough analysis of the firm’s immediate and future strategy as well as leveraging the best technology available.

Cross-asset and multi-strategy support

Opportunities created by banks exiting markets for asset classes deemed risky by the regulators and quest for higher returns in a low interest environment are forcing buy-side firms to actively consider a broad range of strategies and asset classes. Sophisticated firms need to have the flexibility to implement multiple strategies across different asset classes. To achieve this, the systems they use need to be geared to support multiple strategies spanning multiple asset classes.

Integrated analytics, trading and risk platform across a heterogeneous portfolio

Traditionally, in buy-side institutions front office and middle office users have leaned towards using specialized systems that suit their functions but do not necessarily integrate well with each other. Portfolio managers and traders in the front office have used tools providing strong analytics and pre-trade analysis to make portfolio composition and trading decisions. Middle office and operations teams have preferred systems that are light on analytics but offer a secure, auditable and versioned platform for portfolio and risk management functions.

In the developing environment, lower yields coupled

Quest for Yield

Advances in TechnologyRegulations

Redesigned SystemsShould...

• Dodd Frank (Volker rule)• Basel III• Dodd Frank (Clearing

Mandate)

• Increased computing power• Cloud platforms• Distributed databases• In-memory analytics• Support for mobile device

• Support multiple strategiesacross a broad range of assets

• Facilitate operational efficiency• Be integrated across

heterogeneous portfolios• Enforce prudent risk

management and control

• Investors seeking higher yield in a low risk environment

The diagram below outlines some of the key drivers behind buy-side firms demanding best-of-breed analytics coupled with new technology.

with higher transaction costs are squeezing returns. Pre-trade analysis has to consider the cost of funding collateral required to post margins and the cost of funding regulatory capital when evaluating the profitability of a strategy. This calls for a very high level of integration between front office and middle office systems across all asset classes.

Robust risk management and control

Pre-crisis risk management was primarily focused on market risk. Yet, even that did not adequately take into consideration extreme scenarios, fat-tails etc. The ensuing regulation requires more stringent market risk management with greater focus on stress-testing of extreme scenarios. Equal emphasis has also been placed on other risks like counterparty credit, liquidity and operational risks. Any systems being considered should have capabilities to measure, monitor and manage these risks at an enterprise level across multi-asset portfolios.

Operational efficiency

In an environment where opportunities are limited and transaction costs high, operational efficiency becomes key to the success of any organization. Systems that facilitate optimum action in a timely manner by integration, flexible workflows, and ease of communication will be key to competitive advantage.

Business intelligence and transparent reporting infrastructure

Data warehouses and reporting engines that facilitate aggregation and analysis of data and analytics is key to any systems infrastructure. Reporting engines need to be able to aggregate data across all asset classes and present an integrated view of risk and P&L. Reporting capabilities need to be flexible to serve the needs of portfolio, risk managers, investors and regulators. Ideally the system should also allow for integration with a third party business intelligence or data visualization tools available.

Delivered on state of the art technology platform

Market participants are turning to a new generation of technology to allow them to meet increasingly demanding business requirements while improving flexibility and reducing costs. Distributed NoSQL databases provide a scalable and cost-effective

alternative to expensive relational databases for data intensive workloads. Cloud platforms such as Amazon AWS and Microsoft Azure offer many advantages (e.g. flexible provisioning, competitive pricing, built-in redundancy) for solutions that support cloud deployment. Modern multi-core, vector-enabled CPU’s are much more powerful than the previous generation, however pricing and risk libraries must be designed to take advantage of these new features. The low cost of memory has enabled new in-memory analytic technologies to be developed that support analysis of massive data sets in near real-time. Mobile (touch-based) device support is increasingly a requirement but requires the adoption of new development frameworks and design patterns.

Low total cost of ownership (TCO)

Sufficient consideration needs to be given to the total cost of ownership of the system. Any analysis of costs has to take into consideration licensing costs, implementation costs, operating and support costs, as well as disaster recovery costs.

Conclusion

The credit crisis and the regulatory response it spawned have fundamentally reshaped financial markets for buy-side firms, however, while the changes have brought about challenges, they have also ushered in opportunities. The key to success will be the speed with which firms are able to understand the changing marketplace and adapt their business models to align with these changes.

Changing business models need to be supported by corresponding changes to business processes and systems. The next generation of buy-side systems will need to:

1. Support multiple strategies across broad range ofassets

2. Be integrated across heterogeneous portfolios3. Enforce prudent risk management and control4. Facilitate operational efficiency5. Provide timely business intelligence and transparent

reporting infrastructure6. Be delivered on state of the art technology platform7. Deliver all this for a low total cost of ownership

About Quantifi

Quantifi is a specialist provider of analytics, trading, and risk management solutions. Our award-winning suite of integrated pre and post-trade solutions allows market participants to better value, trade and risk manage their exposures and responds more effectively to changing market conditions.

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