As financial institutions intensify their use of derivatives, the equally complex computer systems designed to help manage banks' market risks are coming under greater scrutiny from industry executives and regulators.
Banks continue to hold and trade more derivative instruments, the customized investment products built by Wall Street's "rocket scientists," who are more likely to have backgrounds in computer science or advanced mathematics than in finance.
The growth of derivatives, which get their name from the fact that their value derives from an underlying security or group of securities, has sparked a boomlet of technology companies seeking to help banks and investment houses better understand and price their increasingly enigmatic portfolios.
Banks today mainly use exchange-traded futures and options, as well as the more exotic over-the-counter derivatives, to hedge their traditional investment portfolios. But the recent Barings Bank and Orange County debacles point to the fact that without sophisticated risk management systems in place, derivatives can quickly swamp a financial institution.
As a result, experts say, financial services firms worldwide will spend about $2 billion this year on risk management technology systems that are either developed internally by banks or licensed from independent software firms.
Some of the largest vendors of systems used by derivatives traders are Cats Software Inc., Infinity Financial Technology Inc., Sungard Data Systems Inc., and Kamakura Corp.
In addition, there are dozens of smaller companies that sell packages of miniprograms, called macros, that derivatives traders incorporate into their spreadsheet software in order to quickly perform complex calculations.
Part of this trend has been that over the past few years a number of respected bank risk managers have seized the opportunity to jump into the software business.
One recent and noteworthy example is Till M. Guldimann, who until last June headed up J.P. Morgan's highly respected Global Research Group and was largely responsible for the introduction last year of Morgan's unique market risk methodology and data base - called RiskMetrics - that the money-center bank publishes for use by its derivatives trading clients.
Mr. Guldimann, who last month joined Infinity Financial as an executive vice president and member of the Mountain View, Calif.-based company's board of directors, said that financial institutions historically have invested more heavily in developing risk management systems internally, while "the external (software) market is extremely fragmented and focuses on individual businesses."
These software firms have provided distinct risk measurement systems for measuring market risk of investment products like bonds, asset-backed securities, and foreign exchange trading.
But this line-of-business orientation makes it much harder for banks to get a unified view of its overall risk position, Mr. Guldimann said. "Building a firm-wide risk management system, combining business-specific products from many entrepreneurial software firms, feels like herding a bunch of cats. It's an almost impossible task unless you have a very strong data and analytics backbone and strategy."
Donald R. van Deventer, president of Los Angeles-based Kamakura, said the state of the third-party derivatives software business today is similar to the explosion of asset/liability management systems firms in the mid- 1980s.
"The advent of the personal computer made it possible for two people in a garage to write asset/liability software," said Mr. van Deventer, who like Mr. Guldimann, is a risk measurement pioneer who helped build systems at BankAmerica Corp. and First Interstate Bancorp before founding Kamakura in 1990. "Now that same technology can be applied towards creating derivatives math software."
The problem with this new product glut, he noted, is that banks aren't deploying these tools consistently in their trading rooms, and serious snafus can result. "There hasn't yet been a big mistake with the improper use of a good mathematics tool, but it can and will happen eventually."
Mr. Guldimann and Mr. van Deventer are both advocates of what has become known as firm-wide risk management, where banks incorporate the leading- edge valuation methodologies found in today's derivatives risk systems to help gauge the volatility of a bank's entire balance sheet.
For example, with Mr. Guldimann's help, Infinity Financial is developing software "tool kits" for building this new generation of all-encompassing systems, and Mr. van Deventer said Kamakura's derivatives analysis software is available as part of an overall bank profitability measurement system sold by Santa Monica, Calif.-based Treasury Services Corp.
Regulators are also moving to this unified view, as they try to move banks away from risk management systems based on accrual accounting methods and toward more use of the mark-to-market valuation models found in derivatives analysis software.
At the same time, federal regulatory agencies are paying closer attention to the methods and technologies banks are using to manage derivatives risks.
"There has been a tendency at some institutions to use these systems as sort of a regulatory fig leaf," said one bank examiner who asked not to be named. "But now we're spending more time looking at how this software works and how it is being used."
"We are very encouraged by (regulators') willingness to push systems based on mark-to-market, because we think it's the only current approach to risk management," Mr. van Deventer said, adding that the Federal Reserve has invited his firm to present its risk management research.
While bankers and regulators have scrambled to catch up with the light- speed advances in the predictive mathematics and computer technology needed to crunch all the numbers surrounding the management of derivatives, the learning curve is still steep.
"It's like a high-jump contest, with the regulators starting by setting the bar at only two feet," Mr. van Deventer said. "But now that the capabilities of the jumpers are better, the bar is going to go way up."