Derivatives and Information Technology
A successful IT solution provides a powerful service offering to help navigate the myriad aspects of derivative transactions processing. Derivatives software systems are the most complex in the capital markets area.
Continued innovation in IT and the increased risk involved in derivatives have led the market to employ the best technology available to help manage the day-to-day challenges of managing derivatives. This complete guide covers the derivative definition and contracts definition in nutshell.
Ongoing changes in the regulatory landscape are driving increased transparency, efficiency, and security in derivatives markets.
From the technical perspective, a financial derivatives contract is an agreement between two corporations (counterparties) to exchange cash (cash flows) or assets such as securities and commodities (known as obligations), which are driven by terms specified in a contract for a specific duration (known as the contract terms).
Contract terms vary by the type of product that the contract represents. The exchange of cash flows may or may not happen, the number of flows may vary, flows may be unidirectional or bidirectional (one or both parties may pay), or flows may even be triggered by an external event.
The actual value of the contract and cash flow may vary over the contract terms and may depend on various market parameters. This is a precise definition of a system’s personnel. From a technical point of view, then, the key elements of a derivatives contract are the following:
Contract (defines all terms)
Recall that if Party 1 to a listed and cleared contract is a buy-side firm (client), then Party 2 is a clearing firm (member of a clearinghouse). In an OTC bilateral contract, both parties could be any two market participants.
Typically, one would be a buy-side firm and the other would be a sell-side firm (dealer). All transactions take place between the two entities directly without any intermediary.
In other cases, contracts can be made between two sell-sides (dealers) or between clearing firm and clearinghouse.
The objectives of this blog are to
define the derivatives contract from technology’s perspective
discuss how information technology (IT) is addressing the challenges in managing derivatives
outline the importance of IT strategy and its alignment with organization strategy
understand the requirements of successful IT organization structure, team, and talent
Derivatives IT Platform
A derivatives IT platform (DIP) is a collection of software systems that support derivatives business activities, including front-to-back processing of all types of contracts, trading, and risk management. The present blog uses platform and systems as synonyms for DIP.
The Role of IT and Its Challenges
Increased use of derivatives has caused the market to grow exponentially over the last two decades. Starting with spreadsheets, derivatives management has evolved into highly complex systems.
Over the same interval, contracts have become increasingly standardized and operations have become increasingly automated to reduce business and operational risk and manage volume. While many complex contracts in OTC markets resist automation and create operational challenges, market regulations are pushing OTC markets toward standardization.
The role of an IT platform is to support managing the contract from its origination to its termination, including the obligations during the term of the contract and also operations and events that impact the contract.
Derivatives IT systems are necessarily complex due to a large number of contract types and the complex structure behind most contracts.
Order management. Derivatives order management involves pre-trade compliance, documentation, and multilevel approvals. The challenge is to provide all the required controls for operations risk mitigation without impeding the efficient and swift processing of orders.
Well-designed IT systems can provide a flexible workflow and efficient end-to-end process automation while satisfying auditing requirements and controls.
Trading. Derivatives trading is mostly electronic, except for some OTC bilateral trading. To achieve STP, a derivatives management platform must be electronically connected to trading platforms.
This connection also prevents manual trade capture and operational failures. Other aspects that heavily rely on systems are quick to market reach and best execution.
In addition, systems provide for the implementation of trade compliance rules and trading limit controls, which are part of the risk management process.
Pricing and structuring. The derivatives pricing and structuring process use standard and custom analytical models. Well-designed systems support industry standard models with the ability to customize and add new methods.
Processing. Derivatives processing includes allocations, trade confirmations, settlement processing, reconciliations, and other activities. The transaction processing employs various technical communication methods and protocols such as FIX, FpML, and SWIFT.
Integration systems using communication protocols enable firms to achieve efficient transaction processing with the least number of failures possible, which is critical to lower operational costs and potential losses.
Position or life-cycle management. Derivative contracts are long-lived and liable to be affected by various internal and external events. Contracts are subject to regular valuation and analysis.
These activities employ complex mathematical models, mostly involving the processing of large data—in some cases, in real time. These functions require a well-designed and technologically advanced platform.
Risk management. Risk analysis is another business activity that employs complex mathematical models using voluminous data.
It involves activities such as real-time calculation of risk analytics, scenario analysis, stress testing, end-of-day risk reporting, and the monitoring and control of real-time limits. Again, these functions require a well-designed and technologically advanced platform.
Settlements. Timely and accurate settlements are essential to avoid unexpected losses and reputational damage to the firm. In today’s market, the settlement of cash and securities, including the approvals of work-flow and operational risk control, is fully automated. Participants are connected to financial institutions through SWIFT infrastructure.
Accounting. Derivatives accounting is one of the most complex tasks because of the varying nature of derivative cash flows and accounting standards. Adherence to accounting rules is critical to avoid fines and reputational damage.
Systems enable automation of complex accounting rules, thereby avoiding blogging errors and marking cash flows of both simple and complex derivatives, which ultimately results in properly classified ledger entries.
Workflows and STP. It is critical for firms to automate most of their processing and STP. To achieve the highest level of STP, firms must automate operations, including order origination, trade processing, final settlement, event processing, and well-defined workflow. Only advanced technology platforms can provide this level of automation.
Collateral management. Timely and accurate exposure and margin calculation are essential for efficient collateral management, which is the most important business function of counterparty risk management.
It also requires collateral optimization, dispute management, inventory management, workflows, and other functions. All of these activities are extremely cumbersome to do manually and only automated systems can accomplish them adequately.
Trading limits and control. As part of the risk control process (market risk, credit risk, compliance risk), trading limits are set and controlled from various dimensions such as exposure, national, and other risk measures. Systems provide various tools to monitor and control trading, even in real time.
Market access and integration. For successful automation and efficient trading, firms must connect to various market players such as data providers, execution venues, servicing platforms, and internal upstream and downstream systems.
There are many different systems involved, and integrating these systems is critical for reliable and uninterrupted communication. Today’s advanced systems with integration models provide secure, fast, and reliable communication.
Reliability and scalability. Systems must be highly reliable and scalable to support constantly changing markets and to avoid unexpected costs from operational failures. In addition, derivatives analysis involves large volumes of data only reliable and scalable systems can accommodate.
Security and transparency. The 2008 financial crisis has highlighted the need for regulations supporting transparency, safety, and security to protect overall financial systems. Given the size of market activity, an industry-wide adaptation of advanced technology is the only solution.
Information Technology Strategy and Road Map
An efficient IT platform is essential for the success of any derivatives business, whether it is a small buy-side firm or a large sell-side firm.
It provides an effective foundation for the execution of business strategy, serving current IT demands while preserving the capacity to grow with the changing needs of the business.
Essential organization elements required to develop an ideal platform are pertinent IT strategy, visionary leadership, successful execution, and a motivated team.
A well-defined and vigorously executed strategy exists behind every successful business. IT strategy is an integral part of the overall strategy of any organization in the derivatives sector.
A firm’s IT strategy must be precisely aligned with its business strategy. In many firms, the challenge is the lack of alignment between IT and the business. To develop and execute a successful IT strategy, firms must create an environment that brings the business management (the visionaries) and IT leaders together.
Business and IT management must jettison the pernicious notion that IT is part of the back office or is a supporting tool. They must embrace IT as a mission-critical pillar of business strategy.
IT must assume a proactive role in identifying areas for improvement and aligning requirements with what is practically possible. IT must generate and persuasively present new ideas to help realize new business opportunities, galvanizing the IT organization into an innovative environment rather than merely plodding along as a service organization. For all this to happen, the IT organization must be driven by people with strategic business vision.
Developing an excellent strategy is futile unless it is actualized by proper execution. Firms must adopt a well-defined IT engagement model in addition to allocating eligible and sufficient resources to it.
An IT engagement model is the system of governance that ensures the delivery of IT solutions to realize the IT strategy and the organization strategy it serves. This model clearly defines the following key ideas to accommodate the alignment between the IT and organization strategy:
Define the relationship between IT and business management
Define the working model of IT and business in developing IT solutions
Define the decision-making process
The IT roadmap is the operative plan for implementing the IT strategy. Every firm, small or large, must develop an IT roadmap as part of its IT strategy detailing short-term, medium-term, and long-term goals. An IT roadmap provides details of steps, the timeline, deliverables, and the budget required to meet business goals.
To develop an effective roadmap, a firm must gather and synthesize input from its strategic decision makers—at a minimum, its senior management, including its CEO, CIO/CTO, COO, and CFO.
A well-defined IT strategy with a roadmap helps business in the following ways:
It enables leaders to envision the future growth of the business, market changes, regulatory environment, and resulting IT needs.
It ensures that IT expenses are thoroughly budgeted.
It improves the productivity of the IT organization and supports enterprise-wide goals.
Firms whose IT strategy and roadmap are poorly articulated and implemented sooner or later end up with incomplete IT services, dysfunctional IT organizations, unpredictable costs, and failed operational risk controls.
The following list identifies key points to be considered and goals to be addressed while developing your IT strategy and roadmap and in building your IT platform:
Comprehensive trading functionality, supporting a listed and wide variety of OTC contracts
Automated contract lifecycle management promoting full STP
Portfolio management tools for supporting multi-asset class contracts, sophisticated pricing and valuation models, P&L, and risk analysis
Real-time risk analysis capabilities to support market risk, credit risk, and compliance
Enterprise risk management and reporting capabilities to provide a consolidated view of firm-wide risk management, compliance, and control
Flexible workflow management and auditing tools
Fast, secure, and reliable connectivity with external systems of execution, post-trade processing, and settlements
Support for a global, multi-entity, or multibranch organization structure
Unified platform or array of tightly integrated systems, providing seamless contract flow and integration with other internal systems
Open, modular, and scalable architecture
The preceding list contains just a few key goals, which will be explored in detail in subsequent blogs. Each firm must build its own exhaustive list of IT organization goals to match its overall business needs.
There is, however, no standard IT organization structure. While many firms choose a traditional hierarchical structure with multilevel middle management, other firms prefer a relatively flat structure with fewer middle managers. Hierarchical and flat structures have their respective advantages and disadvantages.
The universal key to successful IT organization is its strategy and teams. Building an IT organization to serve the derivatives business is a particularly challenging task, largely due to the need to assemble experienced teams with the perfect blend of technology and domain expertise.
Only management teams with a vision and motivation can build IT teams with such talent and balance.
Over time, there has been good progress in building such teams because of the standardization of market practices and attractive compensation. Today, the systems for managing listed markets business are mature, whereas the system for managing OTC business continues to evolve.
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Functional Groups and Talent
Most organizations that use derivatives are big. For an IT organization to be successful, its component teams must understand and serve the overall business of the firm and its derivatives operations. In turn, any team within an IT organization is composed of various groups characterized by their skills and roles.
Management and IT strategy. This group includes the senior management at the IT division level as well as at the organizational level. Typically, IT strategy is developed in conjunction with business unit management. This group sets the goals of the IT organization and manages the execution process.
Design and architecture. Large IT organizations generally maintain a separate group that is responsible for high-level design and architecture application. At a minimum, certain team members must be designated to specialize in these functions. The right architecture and design are critical for the success of applications.
Business analysis. To redress lack of domain expertise, most teams employ analysts who understand the business and are capable of communicating with technical teams. They are commonly part of application development teams.
Application development. An application team consists of project managers (mostly middle level), architects, technical leads, and developers. This team is responsible for developing and implementing software applications. In developing derivatives-related applications, this team plays a major role in delivering effective solutions.
Infrastructure and systems support. Availability of IT infrastructure is mandatory for any financial institution to operate their business. Support groups focus on all aspects of systems and infrastructure to ensure business continuity. Typically, support activities include application support, database support, and infrastructure support.
Product specialists or consultants. These are subject matter experts (SMEs). In the case of new projects or vendor product implementation, firms tend to hire SMEs to help in the application development process.
Although most firms try to employ SMEs in their core development teams, acquiring and keeping such talent is a chronic challenge because of a shortage of talent.
Testing and validation. Testing teams are also known as quality assurance (QA) teams. Their core responsibility is to test the applications before they are deployed for use by the business.
This team must have a good understanding of the derivative business. Since there is a lack of talent in this area, testing activities are usually performed by business users or analysts.
Core Derivative Skills
In addition to all the IT and management skills universally required across the IT landscape, derivatives IT teams must possess special domain expertise to build a platform that meets strategic goals. Certain team members, such as analysts and testers, must have in-depth business and products knowledge.
They typically hold special certifications such as Chartered Financial Analyst (CFA), Financial Risk Manager (FRM), and Professional Risk Manager (PRM). Minimum required expertise and skills include the following, which have been covered in the preceding parts of this blog:
Nature of contract. Details of various types of derivative instruments and important characteristics of each contract, including the difference between various types of contracts and their characteristics.
Contract life cycle. A complete understanding of the life cycles of each category: listed, cleared, and bilateral. Clear knowledge of each phase from the start of the contract origination to expiry.
Operations and events. Different types of events and operations of each type of contract, and how those events affect the contract.
P&L analytics. A clear understanding of the various components of profit-and-loss analysis of contracts. Knowledge of elements such as valuation, mark-to-market, realized and unrealized gains and losses, computing trade, and portfolio level P&L are required.
Cash flows. A clear understanding of each type of contract, its corresponding cash flow, the types of each cash flow, and the premises of cash-flow calculations such as the bases of payment calculations and payment schedules. Furthermore, fundamental accounting rules and accounting treatment of different types of cash flows.
Risk analytics. An understanding of various risk measures and how they are connected to different types of contracts, including the bases of their use and calculations.
Market data. The knowledge of various market data elements used in derivatives and how they are used in computing cash flows, P&L, and risk measures.
Systems integration. The use and context of upstream systems that supply data and downstream systems that consume derivatives data.
IT Platforms and Systems
The objective of the present blog is to discuss the various systems employed by buy-side and sell-side firms and to introduce derivatives IT platforms. This blog begins by defining the IT platform: its characteristics, data, and various systems. It goes on to discuss buy-side systems typically incorporated in a functional platform.
Buy-side systems include investment management, order management, trading, portfolio management, trade processing, risk management, and other back-office systems.
Finally, a hypothetical sell-side IT platform is presented with a brief description of each system and its function. No single pattern of IT systems characterizes sell-side firms because they provide many different types of services.
Most of the platform architecture models discussed in this blog are based on the general functional needs of firms rather than the provision of specific solutions.
As technology and business processes mature, however, firms are adopting uniform-architecture models at a high level. Developing and operating an IT platform is a challenging task for most firms. It is essential for all personnel—from executives to interns—to understand their firm’s IT platform and its systems.
The objectives of this blog are to
discuss the characteristics and components of derivatives IT platforms list and study the various systems incorporated in a buy-side IT platform discuss the sell-side IT platform and its functions
Managing derivatives is a very complex and broad business area. Servicing derivatives end to end requires that multiple software systems and external systems—such as affirmation platforms and banking systems—all work in concert.
A derivatives IT platform (DIP) is a collection of software systems that are used to service derivatives contracts, including the most complex tasks such as trading, risk management, and front-to-back processing of listed as well as OTC contracts.
Essentially, the term IT infrastructure is used to refer to both software systems and the underlying hardware, or sometimes just hardware such as servers, desktops, cloud, or grid computing environments.
Advances in the hardware field have been exponential in the last decade. Demands such as computing power, operating cost, security, leverage, and network capabilities have been addressed with today’s advanced hardware.
Because hardware is not within the scope of this blog, this blog uses the term IT platform instead of IT infrastructure.
The term IT platform covers a lot of ground in consideration of the many software applications in use today in the financial industry—, especially in the derivatives area. At the enterprise level, IT platforms are built to service the full spectrum of investment activities, including securities and other assets along with derivatives.
For the sake of simplicity, however, this blog confines itself to the derivatives IT platform, ignoring other portions of an enterprise IT platform.
Although systems servicing listed markets have matured, systems servicing OTC markets are still evolving. Certain OTC instruments and operations are being standardized and OTC systems are converging with listed market systems, trending toward a unified platform servicing all derivatives.
The ideal DIP is an integrated cross-asset solution, supporting business processes from pre-trade analytics, trading, and position management; to collateral and margin management, risk management, and compliance; right through to settlement and clearing, accounting, treasury management, and reporting.
Specific requirements vary with the nature of a firm’s business. For example, insurance firms are typically focused on hedging, which is the governing theme of their platforms.
Whatever its theme, a proven IT platform infrastructure is essential to optimize the transparency of a firm’s positions and risk, address regulatory requirements, utilize tools for analysis, and provide a holistic view of overall operations.
Throughout this part of the blog, the term IT platform (in short, platform) is synonymous with DIP. The system refers to an independent software application; module refers to a part of the system.
Throughout this section, the system is used to refer to each independent business function. In practice, some functions, such as order management and trading, could be implemented as modules of a larger system.
A growing number of firms are turning toward a unified or single platform, addressing business needs end-to-end. However, some small size firms are leaning more toward hosted solutions or outsourcing. This blog discusses a unified platform that consists of in-house applications, vendor products, or a combination of both.
The layers of a platform include the following
The IT infrastructure layer represents hardware such as servers, storage, and networks, whether hosted within the organization or at external data centers.
The data layer represents numerous databases that hold derivatives-related data used by various systems across business lines.
The middleware layer represents the software components that allow various systems to access data seamlessly.
The systems layer represents various independent or interdependent systems, each composed of several functional modules.
Historically, systems of different types of technologies coexisted and cooperated using several integration models. Some of these models are real-time; others are batch-oriented.
Today’s integration technology and models achieve seamless integration between systems from multiple vendors, even those running on different operating environments, such as Unix, Windows, and Linux.
Heterogeneous Systems In practice, IT platforms are built using different technologies running on different infrastructures containing various products supplied by several different vendors. All components must work together seamlessly to form an IT platform.
Once market participants enter into a derivatives contract, their responsibilities remain essentially the same regardless of whether they are on the buy side or the sell side. They need to manage the contract in a similar way, although their purpose and risk management strategies may vary.
The sell-side differs in certain aspects because of its volume and business objectives. In most cases, sell-side firms enter into a contract to offset risk, but their obligations remain and they need to manage the contract until the end of the term.
Most functions related to derivatives are applicable to both buy-side and sell-side firms. The focus of the following section is on the operations of buy-side platforms rather than on the business itself.
Recall that buy-side firms include institutions such as asset managers, pension funds, hedge funds, insurers, and corporations from regional to global companies, across all industries.
The primary purpose of derivatives is to hedge risk; the secondary purpose is to earn profits from speculation and leverage. Because buy-side, risk-taking transaction volume is limited, the buy-side profile is very different from that of the sell-side profile.
A buy-side derivatives contract is typically associated with some asset position of the firm or is a part of a specific risk management strategy. However, some hedge funds may involve in derivatives speculation heavily.
An integrated cross-asset platform incorporates all functional layers, from trading activities in the front office, through risk management and control in the middle office, to processing and accounting in the back office.
The various systems of the buy-side platform are slowly converging to a single system or a couple of systems integrated seamlessly. The drivers of this convergence are the need for seamless workflow and straight-through processing (STP), transparency, and enterprise-level risk management.
This convergence has become easy because of the seamless integration of different systems through the use of standard protocols, matured integration models, and advanced technology architecture.
Many vendors are competing to deliver single-platform solutions that meet the needs of the buy side from end to end. In most cases today, a deal is captured only at one point and flows through various systems serving different business functions.
IT platform sizes and operations vary by volume of derivative transactions.
Investment or Asset Management System
The purpose of an investment management group is to develop and implement effective investment management strategies while quantifying and controlling risk. Investment portfolios may hold simple securities, complex structured products, real estate, derivatives, and many other assets.
Typically, an investment portfolio holds assets such as equities, fixed income, credit, FX, commodities, swaps, and exotic asset classes. Derivative instruments are used in investment strategies for risk control, profit generation, or both—depending on their function in a given portfolio.
The core function of an asset or investment management system is to help asset managers in developing and executing trading and hedging strategies across multiple asset classes by providing portfolio analytics, risk analytics, position management, and other tools that help investment managers in the decision-making process.
Firms holding a wide range of assets typically employ multiple systems, each to deal with different type of assets managed by different groups of investment managers. In practice, derivatives are often held in different portfolios and managed separately.
In such cases, all positions are combined periodically to test hedge effectiveness, compute risk, and perform scenario analysis and stress tests to study the impact on profit and loss (P&L).
This may happen in certain downstream systems referred to as enterprise risk and reporting systems. Derivatives portfolio management topics are discussed in later sections.
Another term in use is portfolio management, where portfolio refers to a group of assets of the firm, including derivatives. The group that manages assets is known as a portfolio management group, an investment management group, or asset management group. Key definitions include the following:
Asset management. Investment management of collective investments on behalf of many clients (investors).
Investment management. Professional asset management of various financial and nonfinancial assets— such as securities, commodities, and real estate—in order to meet specified investment goals of investors. Investors include institutions such as insurance companies, pension funds, corporations, fund managers, and private investors.
Wealth management. Investment services for high net-worth clients. In addition to investment management, it typically includes financial advisory, insurance, legal, or other services.
Managers. People who are responsible for decision making are variously known as a portfolio manager, investment manager, fund manager, investment advisor, or money manager.
Hedging derivative. When the change in fair value or cash flow of an investment and that of the hedging derivatives offset each other, no change results to the overall value.
This offset is not assured, for the value of the investment and derivative may change independently. Positions are evaluated periodically to check whether a hedge is still effective.
In an ideal platform, the derivatives trade request (derivatives order) goes through the order management system before it is executed. The next section details this step.
Derivatives Order Management System
A derivatives order management system (OMS) is primarily an order-tracking system that manages (receives) orders from initial request (capture) to final execution. In the process, an order may go through certain validations and approvals. In a regulated firm, this is an important process.
Order origination and approval may involve documentation and trade compliance checks. The task of the OMS is to track and keep the complete audit trail before an order is sent for execution.
The key functions of a derivatives OMS are to do the following:
automate workflow to track and process an order from origination to execution, facilitating the recording and tracking of multi-level approvals and document management (all paper trails). The OMS helps to avoid errors and promote STP and compliance.
support pre-trade compliance through various validations and checks
provide access to underlying positions and other information
support listed and most common OTC derivative contracts
support multiple origination points and allocation across multiple investment portfolios
provide flexible role definition and configuration of workflow
support the processing of large volumes of orders
provide security, controls, increased transparency, reporting, audit trail, and to comply with regulatory
Since the order management process is simple, it is often part of the asset management system, the trading system, or some other system. In addition, OMS is often used to refer to a broader functionality including trading and risk management, because most vendors combine these functionalities into a single system.
However, large firms may have a separate system just to deal with the order management process. These functions are discussed here separately for the sake of clarity.
Most derivative trades are executed via an execution broker. Some large firms may even access exchange markets directly. Recall that the executed order is referred to as a trade. Approved orders are passed on to the trading desk (trader) for the execution. Systems used by traders are known as trading systems.
Traders (buy-side) reach markets either through an electronic channel or through other traditional channels such as a phone. The several types of electronic channels that a trader can use to reach sell-side firms or exchanges include the following:
Client interface provided by sell-side firms (dealer-provided ETPs). It is an online interface over the Internet or through a desktop application.
Independent third-party trading systems that provide access to multiple ETPs, such as electronic communication networks (ECNs) and swap execution facilities (SEFs)
in-house or proprietary applications that connect to ETPs (mostly using APIs provided by ETPs or protocols such as FIX)
exchange client interface in case of listed product trading directly on the exchange, provided by exchanges
SEF client interface to reach to OTC and cleared markets
Trading systems provide connectivity to these channels and accommodate communication. In addition, trading systems provide many other features, including the capabilities to do the following:
access market data, news, and analysis from various sources
access markets, including exchanges, OTC markets (ETPs, broker-dealer platforms), and global markets
conduct pre-trade analysis, scenarios analysis (what-if analysis), stress testing, and other forms of risk analysis
calculate real-time P&L, real-time risk analytics on both pre- and post-trade bases to reflect ongoing trading activity, real-time calculation of positions, cash flow, and other numbers define, execute, and manage sophisticated trading strategies, support rollovers, rollbacks, splits, and close-out trades automate pre-trade and post-trade compliance.
And control provides user-friendly and customizable user interfaces support the trading of a wide variety of derivatives, including swaps, options, futures, and other derivative instruments covering various asset classes such as interest rates, equities.
FX and commodities support standard and custom analytical models for pricing, valuation, and risk analytics calculate and suggest automatic hedges as required.
Based on risk factors and strategy, systems my suggest trades to balance the hedge capture trades in various ways, including manual entry, electronic protocols, and file imports. Traders use multiple systems in parallel for their trading activities. Most trading systems are a combination of vendor and internal systems and ETPs.
In listed markets, trading systems are more advanced, providing features such as complex strategy setups, basket trading, and access to in-depth markets. In the OTC market, cleared products trade on SEFs and bilaterals using single-dealer and asset-class specific platforms.
SEFs provide desktop interfaces to buy-side and sell-side firms. SEFs are mostly simple trading front-ends, providing features such as access to dealers, limit checking, market data, and blotter, as defined below:
Trading strategy. Most trading strategies involve multiple trades in combination. It is necessary for traders to execute these trades together as a group to avoid any unwanted risks introduced by market movements.
Blotter. A screen that lists all trader’s trades from all different sources (the trading activity of the day)
Trading floor. Synonym for front office (also known as. trading room, trading desk, dealing room, or simply floor)
Derivatives Portfolio Management
A derivatives portfolio management system (DPMS) is the centerpiece of derivatives IT platform. Managing a derivatives portfolio is typically much more complex than any other asset type. Derivative positions are long-lived and liable to risks that need active risk management.
Of course, all investment positions are subject to risk, but derivatives may carry much larger risks as discussed in earlier blogs. During their term, derivatives are also subject to certain events that need to be processed. When OTC exotics are added, the process becomes much more complex.
As the market landscape changes, products and processes are being standardized and market participants are getting better at managing complex derivatives and adapting to robust risk management techniques and standardized operational procedures.
A portfolio management system is also known as a position management system or simply a position system. The portfolio management comprehends a broad set of functions. The core functions of DPMS are real-time pricing, position keeping, trade processing, risk management, reporting, and the generation of accounting entries.
Because this blog divides platforms conceptually into multiple systems, some functions in this blog are treated separately that might be more properly considered as part of a DPMS. This blog as a whole covers most DPMS functions.
The core functions of a DPMS include
pricing and valuation
market data management
real-time position keeping
settlement and deliverables
STP, life-cycle management, processing, and workflow
multi-asset class contract support
And integration with upstream, downstream, and external systems security, compliance, and audit control support for multi-entity global organization structures. In the following section, minor functions are classified into several groups, some of which overlap one another and are in practice combined into a single feature.
Portfolio analysis includes portfolio performance analysis (P&L analysis), risk analysis, composition, simulation, optimization, and other portfolio management activities. Portfolio analysis tasks and features include but are not limited to the following:
calculation of P&L at different levels, such as trade, position, trader, and desk, including flash P&L, P&L variance, and carry components study of impacts on P&L using various methods such as stress testing and scenario testing
P&L calculation by components including realized, unrealized, interest income, fees, and commissions for multiple periods or for a specific historical date all calculations in real-time or intraday on-demand basis at both summary and granular levels tools such as interactive simulations, stress testing, scenario testing, and possible hedge suggestions flexible P&L reporting by period—daily, weekly, month-to-date, year-to-date, relative-to-tenor.
Analysis tools allowing slicing and dicing of portfolios to study risk exposures by different portfolios detailed portfolio performance reports at various levels, such as individual business lines, to help assess business performance, with the ability to drill down from portfolio to trade level.
Also includes detailed performance analysis based on factors such as interest rate and volatility movements, FX, time decay, and change in positions.
features to navigate through the portfolio and study analytics by tenor, product, trader, portfolio, currency, and so forth
P&L scenario analysis with parameters such as time, market parameters, the scope of deals, and so on
pre-trade analysis such as studying the impact of trade on P&L and risk before trading
support for standard market models as well as complex models with the ability to customize
cash-management reports such as cash-flow projection
Some of the key terms in the preceding entries are defined in the following box.
Profit & Loss (P&L or PnL) the change in the value of a position or portfolio. In the case of a portfolio, the P&L is reckoned over a specified period of time. Typically, the P&L is computed daily as a representation of the gain or loss relative to the preceding day.
P&L Attribution the daily P&L and, as such, the root cause for the change in P&L. It is also known as the P&L Explained.
Portfolio vs. blog Although blog and portfolio are often used interchangeably, a blog refers to a small set of positions of a specific trader or desk, whereas a portfolio is a broad set of positions. Simulation the process of evaluating the impact on a portfolio of adding simulated trades or positions.
Scenario Analysis the process of analyzing a portfolio by shifting one or more market factors such as interest, volatility, and spot rate. It is also known as a what-if analysis.
Orders are executed over different channels and desks. After the execution, all trades are transferred to DPMS for further processing and life-cycle management. The ways for loading trades into a system include the following:
manual deal entry (keyed)
automated import from the source system
direct transmission from external execution platforms such as ETPs via supporting protocols such as FIX
Trade capture is the initial step of trade processing, triggering trade validation (pre-trade and post-trade) and further processing.
Pricing, Valuation, and Structuring
Derivative contracts are complicated instruments, and their pricing and valuation rely on complex analytical models. Derivatives trading also involves structuring complex trading strategies. Systems provide the following tools:
pricing of trades before trading—including simple and complex contracts and strategies
valuation (mark-to-market or mark-to-model) of current positions tools to structure (design and value) simple and complex strategies, including multi-leg structures
Real-Time Position Management
Position management functions include the valuation of positions, P&L, and risk analytics in real time as market data change and as traders execute trades. They include the abilities to aggregate by legal entity, product type, business line, geography, or any other deal-level attribute.
Position management is also known as position keeping.
Risk Management and Analytics
Risk management is the most critical task and includes portfolio-level operations and overall firm-level aggregated risk management.
Portfolio-level risk analysis includes intraday and end-of-day risk measure calculations. During trading hours, a portfolio’s exposure changes as the market moves. Traders periodically monitor risk factors, apply different scenarios, and perform what-if analyses.
Traders monitor risk at the portfolio level, desk level, and position level, reaching to the source. In addition, they also study the impact of potential new trades.
Periodic (end-of-day) risk analytics are monitored by traders as well as desk heads and risk managers (the risk management team). These numbers are fed into an enterprise-risk scenario.
The core functions of the portfolio risk management process include the following:
calculation of various risk measures at different levels— such as trader, desk, and portfolio—on demand as well as periodically ability to drill down through risk numbers by the blog for a given desk down to the source position and to view the risk as being bucketed in a variety of ways
support of a comprehensive list of contract types, including complex OTC contracts
support of scenario analysis with factors such as the shifting of a single factor or of multiple market factors simultaneously
valuation of hedge effectiveness (hedge effectiveness analysis)
Lifecycle Management and STP
Lifecycle management includes the contract origination, post-trade processing, event handling, and all other tasks from the front office to back office until the contract expiration. The core functions include the following:
Automated trade capture from multiple sources and execution of pre-trade validations post-trade processing from validation to live contract real-time, straight-through processing of all steps from beginning to end flexible, event-driven, roles-based, and customizable work-flows for four-eye verification.
With secure and robust processing combined with controls and audit trail processing of events that occur throughout the contract term such as credit events, corporate actions, amendments, and novation consent processing periodic payment calculations.
Deliverables, settlement netting, reconciliation, and so on connectivity with a servicing organization such as affirmation platforms and portfolio reconciliation for post-trade processing and portfolio optimization
Support exists for daily and periodic operations such as rate-fixing (rate resets), cash flow generation, contract expiration, daily and monthly report generation, among other housekeeping activities. Typically, these activities are scheduled to run on a daily basis.
Multi-Asset Class Support
The ideal DPMS supports a broad range of derivatives, including all listed and most common OTC contracts. In addition, a DPMS must provide the flexibility and ease to add new contract types appropriate to various asset classes.
Many firms organize their business into different groups separated by asset classes or markets. To accord with their business team structure, firms may use several different systems to manage derivative contracts.
In such cases, all these positions are consolidated into a single central database (system) for tasks such as risk analysis, P&L analysis, and reporting. This database is typically known as the derivatives trade repository or warehouse.
The reporting feature includes the generation of such reports as the following:
front office reports such as daily trading activity, risk, and P&L reports
operations reports such as daily business activity, reconciliation, and exception reports
P&L reports—daily, weekly, monthly, quarterly, and annual P&L reports aggregated at different levels
position reports with an overall picture of any outstanding hedges, including valuation
cash flow reports—immediate and projected
performance and compliance reports such as hedge effectiveness reports
enterprise risk reports such as market risk, credit risk, VaR, capital adequacy, and other exposure reports intraday P&L, risk, position, and other snapshot reports on all aggregation levels, from an individual position to an entire portfolio or firm
Global or Multi-Entity Structure
Most large organizations are global with multi-entity organization structures. Systems must support management of portfolios in hierarchical structures, multiple business units, operations, and P&L centers spread across multiple geographical regions and time zones.
Derivative transactions involve several types of legal agreements such as give-up agreements, netting agreements, ISDA master agreements, and collateral agreements (including CSAs and CSDs). Systems must provide a digital document repository to store all relevant legal agreement terms and conditions in a searchable and easily accessible format.
DPMS systems are integrated with upstream, downstream, and external systems using standard messaging protocols: FTP, electronic communication protocols (FIX, FpML, and SWIFT), emails, and others.
Real-time communication is critical for efficient STP and to reduce operational risks. Systems must support most communication models in order to seamlessly integrate internal and external systems.
Derivatives Accounting System
All cash flows generated from derivatives transactions must be reported to a firm’s accounting system for corporate-level log keeping. Essentially, a derivatives accounting sub-ledger system generates sub-ledger entries that eventually feed into a general ledger (GL).
These entries are generated periodically or on an on-demand basis. Accounting entries that have been generated are validated before being loaded into a general ledger.
The key functions of derivatives accounting are the following generation of accounting entries (GL entries) for all economic events impacting the economics of contracts real-time (intraday) and end-of-day, end-of-period processing abilities ability.
To add simple and complex accounting classification rules to comply with accounting standards support for multi-currencies, multi-entities, and most contract types support for hedge accounting with various methods to comply with regulatory requirements (FASB133, IAS 39, IFRS9), known as hedge effectiveness analysis
financial reporting for decision makers, senior management, and business managers
security and reliable access, control, and audit trails
Derivatives accounting functions are generally combined with the core derivatives system (DPMS).
Enterprise Risk Management and Reporting
Enterprise risk management (ERM) is a firm-wide or group-wide risk management function supporting the analysis of credit and market risk exposures.
ERM functions include the following
market risk management
credit risk management
liquidity risk management
operational risk management
settlement risk management
capital requirements reporting
limits and control
compliance monitor and control
enterprise reporting and auditing
The following sections describe the technical aspects of the functions listed above. Most of these functions are generally implemented as independent systems—for instance, market risk management systems, credit risk management systems, and compliance systems.
Risk management activity focuses on every level of transaction processing from pre-trade analysis through the deal capture and from confirmation through the settlement in order to control the operational risk.
Market Risk Management Systems
Market risk management systems (MRMSs) capture trade valuations of all portfolios and calculate various market risk measures, such as value at risk (VaR), at different levels.
The key features of MRMS include the following:
calculation of VaR using various analytical models—such as historical, Monte Carlo, and parametric—at different levels
calculation of various risk measures such as Delta, duration, convexity, risk decomposition, and hedge recommendations in real time and on demand
scenario analysis functions such as simulations, advanced what-if analysis, and P&L decomposition
portfolio stress testing with custom scenarios and backtesting functions
real-time and historical market data management
Credit Risk Management System
Credit risk management systems (CRMSs) provide comprehensive calculation and control of credit exposures at various levels, including the enterprise level. Exposure details include mark-to-market exposure, potential future exposure (PFE), gross exposure, net exposure, and collateral values.
In most cases, calculation of economic and regulatory capital requirements is included in a CRMS.
The key features of a CRMS are the following:
calculation of exposure and various credit risk analytics at different levels real-time or periodic computation of exposures at various levels such as counterparty, entity, currency, instrument, portfolio.
And country risks production of various enterprise-level reports including regulatory reports such as economic and regulatory capital—Risk Weighted Assets (RWAs)—per Basel II or III (as applicable), VaR, and other measures as required
CRMS may also include limits-management abilities based on credit exposures and other factors. Limits management is explained in the “Limits Monitoring and Control” section below.
Operational risk arises from all operations across an organization, and enterprise-level operational risk controls are implemented in almost all systems. Operational risk control functions include the following:
implementation of four-eye rules for critical transaction operations such as trade blogging, payments, and deliverables processing
capture of audit data in each system for all most all user operations
capture of system access data for each user
planning and building of reliable and high-availability systems to avoid system failures
provision of robust workflows to reduce processing failures and handle exceptions efficiently
implementation of a high-availability and robust technology solution to reduce or eliminate IT infrastructure failures
implementation of compliance monitoring procedures and dashboards
Compliance Monitoring and Audit
A compliance monitoring system is a central enterprise-level system used to monitor adherence to compliance rules and other characteristics such as concentration, diversification, and various statistical measures.
When it is not practical to build such systems because the process is too complex and fluid for automation, teams perform the monitoring and audit activities, collecting data from various systems for various types of audit.
Settlement risk exposure is usually calculated at various levels—such as counterparty, region, and currency—and reported daily to appropriate internal teams.
Enterprise reporting provides various reports for senior management of the firm, internal audit, and external regulatory agencies. These reports include P&L reports, VaR, and capital requirements.
Banking blog vs. Trading blog Banking blog refers to the portfolio of long-term positions of the firm, whereas trading blog refers to short-term positions taking place in mostly a single trading day.
Limits Monitoring and Control
The limits management system (LMS) plays a critical role in controlling risk by monitoring and limiting the trading activities. As part of the risk management process, various limits are set to control trading activity.
Limits are based on such factors as credit exposure and such market risk measures as notional, duration, VaR, maturity, delta, specific trader, desk, and compliance rules.
These limits are set at different levels and monitored in real time or periodically. In recent years, systems have evolved to the point of monitoring these limits in real time and alerting or even stopping the trade.
Thus, the LMS plays an important role in the risk control process. LMSs are also known as trade control or compliance monitoring systems.
LMSs do the following
provide the ability to set limits using a number of elements such as various risk factors, exposure at different levels, aggregated notional at different levels, types of instruments, contract term, currencies, credit ratings, business lines, traders, desks, and the combination of multiple factors
allow periodic, on-demand, and real-time limits calculation and reporting
provide tools to analyze current exposures and limits with drill-down ability
provide enterprise-level reports to efficiently utilize limits across the organization
Although the LMS concept is new and not many firms have one, limits have long been set and reviewed by management using generated reports.
Collateral Management System
A collateral management system is a critical process in mitigating credit risk. Collateral management includes margin management of listed and cleared contracts and collateral from the counterparty in OTC contracts.
The term margin management is often used in listed markets, while collateral management is used in OTC markets. Although functionally their overall objectives are the same, their underlying methods may vary.
Traditionally, firms use different systems for these two functions. In recent years, however, these two functions are increasingly being combined in a single system or module. Listed market margin management is a mature and well-defined process, whereas collateral in the OTC market is an evolving and complex process.
Key functions of a collateral management system include the following:
managing legal agreements among the firm, FCM, and counterparties (including give-up agreements, master agreements, CSAs, CSDs, netting agreements.
Managing all data elements such as thresholds, ratings, counterparties, initial margins, independent amounts, haircuts, minimum transfer amounts, and rounding tolerances supporting listed product margining as well as the collateral of simple and complex OTC contracts providing workflows for all operations—margin call creation, counterparty margin call processing, reconciliation, dispute management, and other operations
performing collateral valuations, margin calculations, and margin calls generation
processing counterparty and FCM margin calls and validating, allocating, approving, and delivering collateral operations
managing collateral positions including securities and multi-currency cash (held and pledged)
managing interest, coupons, and dividends of collateral held and pledged
providing collateral eligibility calculations to process margin calls
supporting collateral substitution and corporate action processing
supporting handling of collateral valuation disputes and resolutions
providing reconciliation and dispute resolution workflows
providing collateral optimization features through producing
efficient margin requirements, lowering collateral funding
costs, and leveraging collateral securities and cash
providing various reports such as daily collateral and margin movements, projections, reconciliation reports, and inventory
Collateral Types Besides securities and cash, other collateral types such as guarantees and letters of credit are also used in the derivatives market. Nonetheless, cash and securities are the most common collateral types.
Compliance Monitoring and Control
The key function of compliance is to provide oversight of all investment activities while complying with regulatory requirements and internal policies and procedures.
In the derivatives environment, the oversight includes monitoring derivative trading programs through trade and post-trade rules, concentration and diversification, operations, and adherence to procedures. In addition, functions include periodic review of risk management policies and operations.
Most compliance and control functions are built into order management, portfolio management, and other systems where applicable. All systems maintain and supply audit data to the compliance team periodically or on demand. The compliance team may also run reports against the firm’s central trade repository for audit and investigation purposes.
Data Warehouse or Contract Repository
Firms maintain central data warehouses that hold all derivative positions (along with other securities, in most cases) for all departments and systems. Alternative terms for such a central database are a data repository, trade repository, positions repository, and position warehouse.
All systems feed their daily trades and other related transactions to a central warehouse and keep the database up to date. Usually, a load runs at the end of every business day.
Data warehouses are typically used for the following functions:
collection and storage of all derivative trades and transactions (including nonderivatives in the case of larger-scope warehouses)
collection and storage of P&L and risk analytics
reporting at various levels, including the enterprise level
servicing the requests of internal and external auditors and regulators
ad hoc query and analysis using business intelligence (BI) tools
storage of trades in a common format enabling sharing with other systems in the organization
Payment and Settlement Systems
Holding derivative positions results in two-way transactions between counterparties, such as obligation payments and receivables and various types of fee and collateral transfers.
The transactions typically involve either cash or securities movement. The payment and settlement (P&S) system receive instructions to process these transactions on a daily basis from the derivatives management system. It receives immediate settlements as well as future settlements as early as two to ninety days in advance.
The key functions of P&S system are the following
manage settlements with presettlement validation work-flow, rule-based netting, and audit control
process all outgoing and incoming cash and security transactions
reconcile all transactions
generate various reports such as cash-flow and security projections, daily transaction reports, reconciliation reports, inventory reports, and others communicate with custodian banks using appropriate protocols
A P&S system may process derivative transactions along with other transactions from investment management and other business activities of the firm. Reconciliation the process of comparing and confirming actual versus expected transaction details. All financial transactions are reconciled as they settle.
The corporate treasury is responsible for a firm’s finances. Treasury management systems provide comprehensive financial functions such as planning, funding, portfolio management, financial risk management, stakeholder reporting, and hedging.
Derivatives management is part of the financial risk management function of the treasury. Typically, treasury portfolios hold a corporation’s debt, investments, and derivatives. The key functions related to treasury portfolio management include the following:
valuation of all portfolio positions including debt, cash, and derivatives
calculation of various risk analytics with the ability to drill down to the source of risk
provision of scenario testing and other tools for portfolio analysis and investment planning
generation of various reports tailored to the different groups within the organization
all other standard portfolio analysis features
Sell-Side (Dealer) Platform
Sell-side firms are part of the foundation of financial markets and play many different roles. They are heavy technology houses. All of their operations are technology intensive and run multiple business lines operating in parallel.
While some business lines are totally independent, others merge into either the middle or back office. Each business line may use one or more systems either as independent systems or as one integrated platform. Their variety makes generalizing about these systems hazardous.
There is no standard or universal paradigm describing how sell-side firms structure and operate their IT organizations. In consequence, this section presents a hypothetical or logical platform covering mainly derivatives business lines.
The sell-side business is competitive, and firms compete with each other to provide the best services as a function of how well built their systems and how advanced their technologies are. This race motivates sell-side firms to build their own systems rather using general vendor products.
The major objectives and challenges of a sell-side technology platform are the following:
Effective risk management tools. Being a risk taker, the sell-side must effectively monitor and manage various risks such as market risk, credit risk, and operational risk.
Custom analytics. To stay competitive, sell-side firms develop custom analytical models for pricing, structuring, and valuation of simple as well as complex instruments.
STP and automation. Automation of contract life-cycle management and transaction processing reduces the cost of operations while increasing profitability and controlling operational risk.
Trading controls. A sell-side firm must employ monitoring and tight control of trading activities to stay within limits set to protect the firm’s interest rather than that of a specific trader or desk.
Compliance and audit. Because sell-side firms are subject to strict regulatory oversight and requirements, they need to develop and implement strict monitoring, compliance, reporting, and control policies.
Scalability. To stay competitive, sell-side firms must continually innovate and deliver new scalable products and services to accommodate the growing needs of market participants.
Service standards. High service standards must be maintained to satisfy and retain current customers.
The portfolio management, risk management, and operations functions of sell-side firms are fundamentally the same as those of buy-side firms. The differences in their respective risk management techniques and tools stem from the differences in their business objectives.
Most sell-side activities are segregated by product desks and markets. Systems are built to suit these business units. For instance, a large sell-side firm may have totally independent system groups for each asset class, such as FX, interest rate products, and credit products.
A sell-side firm generally holds large portfolios managed by independent divisions, each focused on a specific market segment. For instance, the FX department's main focus is on FX products, including spot products and derivatives.
Likewise, equities, rates, and commodities may remain independent. However, all are aggregated at a higher level for firm-wide risk management reporting and other purposes.
In addition, sell-side firms may run many other business lines such as clearing services, custody services, and prime brokerage. Each line generally uses its own independent set of systems. Sell-side IT departments are typically very large and consist of many smaller teams delivering independent systems.
The remainder of this blog outlines the functions of these various systems considered hypothetically in order to present a broad-stroke picture of the sell side.
Sales and Customer Relationship Management
Sales and customer relationship management (CRM) are the core processes of the front-office sales department. Of the many tools used in the sales process, two systems are significant for traders: the order management system (OMS) and the customer relationship management system (CRMS).
Beyond logging raw customer information, firms develop and incorporate many creative features in their CRM to enable the growth and expansion of their business by analyzing customers’ needs and behavior and targeting their products and services appropriately.
Order Management System
A sales team receives orders from clients and routes them to the appropriate desk or trading venue. They track orders, executions, and allocations using an order management system (OMS). A sell-side OMS provides many features enabling sales traders to attain the shortest possible response time, maintain a competitive edge, and promote business growth.
Order Routing System
An order routing system (ORS) is essentially a routing system that sends an order to a selected destination for execution. Since sell sides maintain connectivity to many execution venues, ORSs aid in the automation of message flow. It is nonetheless possible for an OMS to connect directly to executing venues without ORS.
Research and Analysis
Research and analysis comprehend a large array of tasks that combine to produce analysis and reports on relevant topics. Each firm organizes its data and research in ways best adapted to its particular business.
Some firms leverage advanced technology to aid their research and analysis tasks; others use technology primarily for information storage.
Most sell-side firms operate various desks dealing with different classes of products and develop proprietary models for pricing, valuation, structuring, and risk management. Because each product line relies on in-depth specialist knowledge, each trading desk tends to develop and maintain independent trading systems.
Sell-side trading systems are comprehensive and advanced, supporting standard and custom trading algorithms. They are tightly integrated with middle-office systems to provide STP.
Market Connectivity Systems
Most sell-side firms have access to most of the market, including local exchanges, global exchanges, electronic platforms, and other dealer systems. They operate a large array of systems connecting to all these venues, mostly one for each venue. These systems are also known as gateways, such as exchange gateways and ECN gateways.
Client Connectivity Systems
Most sell-side firms provide direct access to their clients through connectivity systems or through dealer trading platforms that use standard protocols, APIs, or online applications. These systems connect clients to internal trading systems or desks directly.
Post-trade processing at sell sides involves dealing with large volumes and is critical for ensuring timely settlements and customer satisfaction. Sell-side firms typically employ trade-processing systems and dedicated teams for processing transactions in different markets.
Derivatives Portfolio Management Systems
Because sell-side firms hold large portfolios, they maintain multiple systems serving different desks, with all positions being consolidated in a central repository for enterprise-level risk management and reporting tasks.
The functions of DPMSs explained in the buy-side section of this blog apply generally to the sell side, although they vary in details.
Enterprise Risk Management
As noted in the buy-side section, an enterprise risk management (ERM) is a broad set of tasks implemented using several systems and parts from various systems.
The high-level functions of the ERM are the same on both sides, but sell-side firms face much larger risks than buy sides and employ different proprietary techniques to mitigate their risk. Note that the buy side and sell side carry different risk profiles.
Back Office Systems
The back office typically runs a payment and settlement (P&S) system, an accounting system, and other systems used for corporate governance.
Collateral Management Systems
Although overall collateral management functions are similar on the buy-side and sell-side, sell-side firms may employ multiple systems for collateral management. Since they deal with multiple clearinghouses and a large number of end-clients, their systems and operations are large and complex.
Many other systems in sell-side firms serve various business lines such as clearing services, market making, custodial services, and prime brokerage. Most of these business lines stand independently and use dedicated systems for their business activity.