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Magazine Issues » June 2010

DERIVATIVES PROCESSING: is real-time really real?

Regulators and investors are demanding more 'real-time' treatment of post-trade derivatives data to make reporting and risk management more accurate. Are such real-time ambitions actually achievable, or even desirable, asks Nicholas Pratt?

The phrase ‘real-time’ has become much overused in financial technology. The computing world has always had a tendency to misappropriate everyday terms – just talk to any architect currently looking for a job only to find that the 50 ‘architect’ vacancies advertised in the newspaper require an in-depth understanding of computer mainframes rather than seven years at university learning how to make sure buildings do not fall down.

At the same time, traders and front-office staff have always wanted the fastest systems and, with the advent of electronic processes, execution algorithms and high-frequency trading, the competition to have the fastest trading system and software is almost as competitive an area as who makes the most money.

Consequently, the phrase ‘real-time’ trading has been thrown liberally around the capital markets, even though it does not always mean what it suggests, particularly when it relates to some of the more obscure derivatives. “In many ways the industry has misunderstood what is meant by real-time,” says Tim Dodd, head of product management at Front Arena – a trading solution developed by SunGard.

For certain instruments, such as market-making derivatives, where the market data is released on a constant stream, real-time functionality that enables traders to revalue their portfolios with immediate effect, it is very applicable, says Dodd. For other instruments, such as interest rate derivatives, the availability of market data is not as timely. Even in the most liquid of currencies or markets, the market data is only updated every 15 minutes.

“The most expensive and sophisticated software and technology will not alter the simple fact that the market data is too slow to be used in a ‘real-time’ context and that to invest in real-time technology for trading in a market where data is only updated every 15 minutes is a clear waste of resources,” says Dodd. “It is important that traders realise there are some factors – such as the delivery of market data – that are beyond the control of technology vendors. A trading system that works in real-time across all asset classes is not a realistic demand.”

Real-time revaluation
Now the demand for ‘real-time’ technology is moving beyond execution and pricing towards the post-trade world of valuations, risk reporting, portfolio analysis, accounting and other middle- and back-office processes. Some of these processes, such as basic positioning where a portfolio managers’ market position is updated after every trade, is relatively straightforward, but trying to value derivatives contracts on a real-time basis is far more challenging.

“Achieving any kind of real-time revaluation is very difficult prospect,” says Christopher Kallmeyer, vice president of software development at Financial Software Systems. “It is all about the various factors that could change the value of the portfolio so the more complex the portfolio, the more factors there are and the more it needs to be revalued.”

It is an issue for all the prime brokers and asset servicing companies, says Kallmeyer, because they are trying to deliver the best possible services and tools to their investment management clients. “If they could get real-time valuations alongside real-time positions, then that would be ideal for some. But others may say that having your P&L updated five times a second is faster than can possibly be consumed by users, meaning that they cannot do anything with it – so there are limitations.”

The need for real-time derivatives processes on the post-trade side and for the benefit of reporting staff and counterparty risk managers, not just traders and portfolio analysts, has come about because of the general improvements in the market’s infrastructure and the pressure there has been from the regulators to have things done in a more timely fashion – including confirmations and matching, not just execution.

This regulatory demand has been across all asset cases. In May of this year the US regulator, the Securities and Exchange Commission, called for a central database and audit trail of real-time trading activity following a day of upheaval on its markets back on May 6. As of yet no real explanation has been found for this upheaval other than that some transaction may have been incorrectly entered by fat-fingered traders, but the real concern is that electronic and high-speed trading is in danger of getting out of control.

On the derivatives side, the concern is more to do with the complex and convoluted structure of the transactions and whether or not both counterparties in the bilateral contracts are keeping track of the changing value of the underlying assets. Consequently there is the demand for so-called real-time services for not only execution and positioning but also risk and reporting, clearing and settlement and other middle- and back-office processes.

But obstacles still remain – not least in terms of trade confirmations. “Many highly structured derivatives were taking more than five days to be confirmed,” says Neil Wright, product manager for derivatives servicing at State Street. Progress has been made for more standardised OTC derivatives which are now confirmed electronically through industry utilities like MarketServ. “The more complex derivatives may never be confirmed on a same day basis but if we can get them all to within five days and electronically matched trades on a same-day basis, then that would be a great help in terms of having a consistent set of data to use for all other post-trade services.”

The development of common messaging technology, such as financial protocol mark-up language (FpML) has also helped to develop a complete front-to-back office view of trades but there are still a number of investment managers that are not using it, says Wright. “The larger investment managers have technology platforms that can transmit these trade details to their asset servicers in a timely fashion and in an electronic format but once you get below that level and into the world of faxes, it becomes a much harder task.” 

Given the challenging nature of developing real-time, post-trade services for derivatives and the tendency for the market to overplay the use of ‘real-time’, can investment managers afford to take a slightly more casual approach to this area? Not according to Gert Raeves, senior vice president of strategic business development at data management firm GoldenSource, who believes that recent events have shown that it is a fit-for-purpose argument. “The whole Landesbanki case has showed that fund managers should not be bringing these type of instruments into their portfolios unless they have these type of processes set up and the right framework to manage it all.”

Misleading term
Raeves does, however, agree that ‘real-time’ is a misleading term. “Event-driven is a better term.” Rather than the execution-driven pricing changes that so occupy the front-office traders, the back and middle office should be looking at credit events 201 a fall in ratings or other macroeconomic factors. And rather than the speed at which the data is delivered, managers should be concerned about its consistency and integrity.

“It is about data quality and making sure that the data is not unfiltered and raw and is from the same set of data that is used for front office,” says Raeves. “The market needs to be assured that the data used in the back and middle office is consistent with the data used in the front office and vice versa. The golden copy concept is well used in the back office but not in the front office.”

As with SunGard’s Dodd, Raeves contends that the greatest challenge is not in the technology available and the services provided by various vendors, but in the availability of the market data. “Unfortunately some of it simply does not exist and there is a lack of consensus on valuations, meaning there is often no such thing as an observable price but just two different counterparty’s opinions.”

Nevertheless, technology still has a part to play, particularly in terms of risk management and the ability to recalculate portfolios every few seconds which, if not quite real time, is certainly more immediate than an end-of-day batch approach to recalculation. “The technologies are getting better,” says Carrick Pierce, president of Derivix, which provides software for portfolio risk visualisation and analysis.

Pierce cites the growing use of cloud computing, which enables firms to consume web-based hardware and software on a pay-as-you-go basis rather than having it installed in-house. “Formerly you were restricted by the technology and its availability. Unless you had access to an army of servers you could not expect to do any better than end-of-day risk analysis. But now there is a real trend to do this analysis in as real time as you are able to afford. I think this is a good thing for the industry. As the technology improves, real-time risk management will be more widespread and it will be a situation where, if you can do it, you will do it.”

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