Driven by the need to stay competitive in the complex and volatile derivatives market, institutions such as Sanwa Bank are turning to sophisticated software to help them calculate the risk of arcane instruments ever more quickly.
A New York-based trading unit of Sanwa, the world's largest bank holding company, is installing a system from Infinity Technology Inc. that will tie together front and back offices. The software is expected to enable traders to price deals more quickly, taking advantage of market conditions, and to allow the bank to better manage the increasing number and complexity of instruments used to hedge customers' portfolios.
The software will also help the unit, Sanwa Financial Products, to do more of the "exotic" transactions, like structured deals, that are tailored to individual customers' needs and which tend to be the most profitable part of the derivatives market.
With the new system, "we'll be able to respond to customers more quickly," said Rahul Merchant, senior vice president and head of technology at Sanwa Financial Products, which was formed four years ago by Osaka-based Sanwa to specialize in derivatives trading in foreign exchange and fixed income products. "Deals that once took half an hour to price will take less than 30 seconds."
This is an increasingly complex task in a market where there are over 300 products. "We are providing interest rate and currency risk management to our customers, and how well we manage this in-house affects how well we can offer this to the end user," said Burton Hilton, who heads business development for interest rate and currency derivatives at Sanwa.
Sanwa Financial Products, which employs about 100, including 20 traders, works closely with customers to review their funding and investment strategies and to devise ways to meet the objectives.
Besides competitive pressures, institutions also are under pressure from bank regulators who are concerned about the effect of market volatility on derivatives portfolios. "There's a lot of investment (in risk management systems) going on as regulators seek to implement capital requirements that take into account a bank's internal risk management," said Robert Sullivan, lead partner in capital markets at Price Waterhouse.
Chase Manhattan Corp., Chemical Banking Corp., Smith Barney, ABN Amro Holding, and Bank of Montreal also are installing software from Infinity, based in Mountain View, Calif., to help do such things as calculate the effect of interest rate and currency fluctuations on customer portfolios.
Some companies, like J.P. Morgan, have built comprehensive risk management systems in-house, but most banks have turned to commercial software. The systems offered by vendors such as Infinity, Cats, and Renaissance focus on risk management product-by-product. And, Mr. Sullivan said, the such software is increasingly sophisticated.
The vendors in the field are "fairly young companies, and the concepts involved in risk management are still fairly new," he said.
The system that Sanwa is buying from Infinity, called Montage, includes a software "tool kit" that makes it relatively easy for the bank to develop applications, and a data warehouse. Montage is an object-oriented system, in which an programmed "object" can be used over and over again. Montage is designed to tie together the front office, where the trader makes a price for a deal; the middle office, "where we check the price before a deal is consummated, to make sure it's not insane," said Mr. Merchant; and the back office, where deals are posted.
Sanwa will continue to use its own front-end pricing systems, and will integrate its own analytic tools - options pricing models and proprietary algorithms to generate volatility curves, for example - with Infinity's.
"Other systems were a lot more proprietary in nature," said Mr. Merchant. "They didn't give us direct access to all the deal data in a very flexible way."
Its goal is to put out a prototype of the integrated system by the end of the year, and roll it out into production in the first quarter of next year.
Under the current system, structured deals must be booked manually into spreadsheets, a cumbersome process. In the new system, the transactions will be incorporated into the bank's data base. The system will be used first in the fixed income area. Over time it will be used in foreign exchange and commodities derivatives.
The tool kit approach "is not for the timid," said Debra L. Williams, a consultant at the Tower Group, a Cambridge, Mass., bank consulting firm. "You really have to be committed to putting in the time and energy to develop applications."
Typically such risk management systems cost upward of $250,000, Ms. Williams said.
When Mr. Merchant was hired by Sanwa last fall, he inherited a hodgepodge of systems used by traders and back office staff. The unit had different front-office and back-office systems, and different systems for foreign exchange trading and fixed income trading. Simple risk reports took six hours to run.
"Traders priced using one system, the back office used a different system to book," said Mr. Merchant, who worked for a year and a half at Lehman Brothers heading projects in equity-side risk management and in program trading before joining Sanwa. "Risk management was cumbersome and we could not run any scenarios quickly enough to get our traders the response they needed to effectively hedge their positions."
During Mr. Merchant's first three months on the job, he and his team focused on improving the unit's infrastructure. Sanwa was running a costly telecommunications network with private lines linking its offices in New York, London, and Hong Kong. One of Mr. Merchant's first tasks was to restructure telecommunications contracts, leading to savings of between 20% and 25%. Then the bank upgraded its computer hardware - moving to four processor Sparc Stations from Sun Microsystems Inc., and upgrading its operating system.
Once systems had been streamlined and upgraded, the bank could assess its risk management capabilities objectively. Risk reports now took only two hours to run, but they were not detailed enough. "We determined that the technology we had was not helping us, but hindering us," Mr. Merchant said.
Sanwa already was using Infinity's tool kit, but the bank was seven releases behind the latest version of the software. Infinity no longer supported the release that Sanwa was using, Mr. Merchant said. After evaluating several vendors, the bank decided to continue with Infinity, largely because it was the least proprietary and most flexible system.
New risk reports should take less than 30 minutes to run, but they will be far more detailed than current reports. By next year, the unit should be able to run reports that show which deal is the source of a given risk exposure. Currently the bank can look at which currency is the source of risk.
"We will be able to analyze the portfolio to any level of detail required," Mr. Merchant said.
With the new system, as soon as a deal is posted it will be visible to the front and middle office, in New York, London, and Hong Kong. Traders and risk managers will be better able to assess risk exposures. A year ago, Hong Kong and London had to fax tickets to New York, where they would be posted. Now the regional offices can post their own transactions.
With the new system, the trader will price the deal, the back office will post it, and the middle office will run a set of risk scenarios and updated risk reports. All this will be available to foreign offices as soon as a trade is booked.
Jeanne Brokaw is a freelance writer based in San Francisco.