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Rethinking Risk Management

Both the buy and sell sides are trying to give traders a consolidated picture of risk across products or asset classes. Each is taking a different approach.

It's no secret that talk of being able to trade multiple asset classes using one system is sweeping the buy-side community. Buy-side traders are not only excited about the benefits for trade executions, they are equally so for the resulting ramifications on risk management.

Being able to see a consolidated picture of a client's risk across all asset classes and holdings has long been a goal on Wall Street. Portfolio managers and their traders are responsible for cross-asset-class supervision of their clients' holdings; the need for information to come together electronically into one application - where it then can be subjected to risk management analytics - is essential.

This consolidation is currently difficult because "investment banks [the sell side] tend to be vertically aligned and product-focused within asset classes and geographies," says Larry Tabb, founder and CEO of Westborough, Mass.-based TABB Group. "Their customer base [the buy side], however, tends to be looking horizontally across products."

For large financial institutions with firmly entrenched product-centric silos, one solution is to add on a layer of integration to bring information out of those vertical silos and into a cross-asset-class application. At that point, traders can apply risk analytics to existing positions and perform pre-trade analytics, or examine portfolio-rebalancing scenarios.

Newly established financial institutions, however, have a chance to grow in a very different way than their predecessors. These smaller institutions, such as boutique hedge funds, can deploy new cross-asset-class platforms rather than add system after system as asset classes and strategies are added to their repertoire.

A New Beginning

Mike Williamson, head of technology with London-based KBC Alternative Investment Management (KBC-AIM), faced such a decision recently when the firm began to employ new trading strategies. Four years ago, KBC-AIM was spun off from KBC Financial Products - a sell-side, specialist broker-dealer. Initially, the hedge fund, which manages about $500,000, was focused on one strategy - convertible bond arbitrage. Its technology and infrastructure were provided by the parent bank, including a trading system that was in place at KBC Financial Products. Williamson declines to name the system vendor.

The setup worked fine, according to Williamson, until KBC-AIM began employing new strategies - in particular, the trading of credit derivatives and equity derivatives, along with some interest-rate derivatives for hedging. The existing system reached it limits, he says.

That system - which originally was constructed to support equity derivatives trading - had been customized internally and extended to support credit derivatives. "What we found - and I think this is probably the situation in a lot of banks - is that internally you get one system that is built in a siloed way; it's a particular system for a particular business unit," Williamson says. "Then it kind of gets pushed and pushed in new directions as business expands and people try to pile new kinds of trades into it," he continues. "We were trying to shove trades into our old existing system that it was never really designed to handle."

KBC-AIM decided to review the available vendor systems that supported cross-asset-class trading. Williamson was determined to find a system that could handle everything KBC-AIM's legacy system managed and was flexible enough to incorporate the firm's proprietary risk analytics. "We wanted to put in our own minute kinds of risk measures and unify risk across the equity and credit spectrum," he explains.

KBC-AIM ultimately chose Front Arena from Stockholm-based Front Capital Systems (a SunGard company). According to Williamson, the system was more targeted to the siloed landscape found throughout much of the financial services industry than other products the firm considered. "Institutional hedge funds of our size - trading portfolios that are completely cross-asset-class - are trying to do something that most banks historically haven't," he says.

Specifically, KBC-AIM constructs portfolios of relative-value trades that consist of different asset types. For example, a trader may have a mix of equity and credit derivatives on the same underlying company - a tactic called capital structure or relative-value arbitrage. If a trader is managing a portfolio of a company's credit products - either debt products, bonds or credit derivatives - and hedging those with equity derivatives, the trader needs a model of the relationship between the credit and equity products.

KBC-AIM's old system could not construct such a model, so traders were forced to manage their risk on Microsoft Excel spreadsheets. "The [Front] system allows us to go in and build our own model of the credit-equity relationship," Williamson says. "What we can now do is capture risk across all the asset classes on the system so the traders themselves, as well as senior management, have a much more complete picture of the risks that we are exposed to."

To gain a more complete picture of the risks it faces, another hedge fund, which declines to be named, is building its own system in-house, according to a trader who trades credit derivatives for the $22 billion hedge fund. "To be able to see the live P&L is something that more and more hedge funds in the capital-structure-type space are aiming for," he notes. "The goal is to be able to see the relationship between trades, such as credit versus equity versus bonds versus options." The trader adds that it's easier to pull this information together for equities than credit derivatives, which are accompanied by 15-page legal documents that create bottlenecks in many of the back offices that trade them.

To reach the end goal, many of the markets have to become more transparent, the hedge fund trader adds. He points out that MarketAxess and TradeWeb have taken positive steps in helping to make the fixed-income - and now credit derivatives - markets more transparent.

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