Hedge Funds Diversify Away from Single Prime After Financial Turmoil Leads to Collapse of Major Brokers

Why It's Important: With the demise of Bear Stearns in March 2008 and the bankruptcy of Lehman Brothers this past September, hedge funds that had prime brokerage relationships with these firms were exposed to significant counterparty risk. Some hedge funds that primed with Lehman had their assets frozen as part of the European bankruptcy proceedings against Lehman, driving some to liquidate securities to meet redemption calls from investors and even forcing some out of business. "There are people who either had long assets on deposit and can't get them back or, worse, Lehman borrowed the assets and lent them out," explains Larry Tabb, founder and CEO of TABB Group.

Where the Industry Is Now: Most hedge funds with more than $250 million in assets have relationships with two to four primes, which are picked for their trading expertise in certain asset classes (e.g., FX or derivatives) or geographies, such as Europe or Asia. For smaller hedge funds, however, diversifying can be difficult because the large prime brokers have minimum-asset requirements and other constraints to weed out the smaller players. Smaller hedge funds, with $10 to $15 million in AUM, typically launch with a single prime broker that may provide trading systems, margin accounts, stock loans and clearing.

Focus in 2008: Hedge funds will move to diversify their prime brokerage relationships to protect their investors' assets. "It boils down to diversification," says Michael Levas, chief investment officer at Olympian Capital Management in Fort Lauderdale, Fla., who selected RBC Capital Markets as a prime broker because it has a triple-A rating and also has a second prime broker on tap in case he needs it. To offer smaller hedge funds the opportunity to diversify broker relationships, mini-primes (e.g., Cuttone & Co.) that partner with the larger prime brokers on the back end for stock loan and clearing services are emerging.

Industry Leaders: Prime brokers Goldman Sachs, Morgan Stanley and J.P. Morgan (which bought No. 3 prime broker Bear Stearns) will continue to be the three strongest players, along with Credit Suisse, which onboarded a lot of hedge fund clients after the Lehman bankruptcy. Barclays Capital (which acquired Lehman's North American trading business) will pick up where Lehman left off, and Bank of America will jump back in via its purchase of Merrill Lynch. However, global custodians -- The Bank of New York Mellon, Northern Trust and State Street Bank, as well as Citi and J.P. Morgan Chase -- also will emerge as strong players. "In the changing landscape, global custodians will have a bigger role to play in the context of prime brokerage because securities held on deposit at a global custodian cannot be rehypothecated [i.e., lent out]," explains Terry Ransford, SVP, director of trading and technology, Northern Trust Securities.

Technology Providers: Hedge funds will need software to capture daily data from each prime broker, reconcile their positions with each firm and monitor their risk. "You can't get the risk analysis done unless you have all the data from the primes," says Mark Coriaty, director of professional services at Eze Castle Integration.

Some of the third-party providers in the space include Nirvana Solutions, Sophis, Imagine Software, Paladyne Systems and FTEN. "We're multiprime out of the box," says Philippe Stefan, head of global business development at Sophis, which is used by large hedge funds to confirm and reconcile positions with multiple prime brokers.

Price Tag: Transitioning from a single-prime to a multiple-prime environment is labor-intensive and brings more complexity and operational costs --involving systems, IT staff, risk monitoring and compliance. "There are some software costs that could add a couple hundred thousand dollars in expenses per year just to manage this," says Donato Cuttone, founder and senior managing director at Cuttone & Co.

Politics Not Pancreas the Reason for Jobs' Macworld Exit

The news that Steve Jobs would not deliver the keynote at this year's Macworld Expo in San Francisco next month was hardly a surprise to those of us covering this company. Rumors had been swirling for weeks that Jobs wouldn't attend and when Macworld officials wouldn't confirm his attendance, so close to the event itself, rumors only grew louder.

Also not a surprise: swirling rumors that Jobs was pulling out of the conference, the last Macworld, because of health concerns.

I can tell you that sources inside the company tell me that Jobs' decision was more about politics than his pancreas. Sources tell me that if Jobs for some reason was unable to perform any of his responsibilities as CEO because of health reasons, which would include the Macworld keynote, I should "rest assured that the board would let me know."

So I'm inclined to believe it. Especially as I look at the history of Macworld and Apple's relationship to it.




Apple has been trying to separate itself from Macworld for some time, preferring instead to host its own "special events" a few times a year. There used to be Macworld New York, Boston, Tokyo and other expos around the world. But over the years they have been scaled back significantly as Apple has been able to appeal directly to its customers via the iTunes website and its 250 retail stores which host more than 3.5 million visitors every week.

The fact is, Apple hosting its own events gives the company complete and total control over its own message. More and more companies are leaving traditional trade shows in favor of enjoying the total spotlight at their own events. I've reported recently that some big names are either dramatically reducing, or exiting all together, the massive Consumer Electronics Show in Las Vegas next month.

Apple's decision seems to follow that trend. Shares [AAPL 90.75 5.40 (+6.33%) ] took a hit on the Steve Jobs news, which make sense in the bizarro world of sell-first-ask-questions-later dominating Wall Street nowadays. Which once again is too bad. Steve Jobs is fine. It's Macworld the expo that's on its last legs.

Risk Management Is Wall Street’s Top Priority for 2009

Why It's Important: Poor risk management practices have been blamed for the credit crisis and ensuing global financial meltdown. Financial institutions and regulators suggest that risk previously was simply reported, rather than managed, and inaccurately assessed, causing banks to post billions of dollars in losses in 2008.

Where the Industry Is Now: "We've been seeing a rush to risk and risk management as a way to get out of this [financial crisis]," says JR Regan, senior executive responsible for global strategy, risk, compliance and security solutions at BearingPoint. Overall there has been an increased focus on enterprise risk management, he adds. "It used to be that financial risk was the granddaddy and everything else wasn't so important. Now firms want to see the sum of all the risks and how that impacts business."

Despite the trend toward enterprise risk management, many companies are still far from achieving it. "Every company should quantify the likelihood of what can go wrong and the risk it is taking," says Philippe Stephan, head of global business development at risk management software provider Sophis. "In practice this is very hard to do, but it is what people should aim for."

Meanwhile Alexandr Sokol, CEO of financial software developer CompatibL, points out that firms have now recognized the importance of credit risk. "Among the different types of risk, market and operational risk were always there, but credit risk seemed a low likely contingency," he says. "But after the events of the last few months it went from hypothetical to something very real, as people lost money when Lehman Brothers defaulted." Top management has also upped its interest in risk, Sokol says. "The key focus is to upgrade risk calculations. It's critical for a business to survive."

As for technology, it has "always been ahead of what people were willing to spend," asserts Sophis' Stephan. "It has been available to address a lot of risks people were not managing, such as OTC pricing. The technology has been around for a number of years. But are people using the tools to manage risk? No."

Focus in 2009: Risk management is expected to be the key industry focus for the next few years, with the spotlight on risk infrastructures. Traditionally disjointed risk and finance functions will be brought together, suggests S. Ramakrishnan, CEO of Reveleus and Mantas products for Oracle Financial Services Software. Firms will benefit from the CFO's strong connection to risk oversight, he adds.

Analysts agree that the biggest challenge firms face in managing risk is at the operating level. Risk managers will be given much more importance by a firm's top managers than in the past, when the pursuit of alpha typically came at the expense of risk mitigation. As such, firms will have to develop adequate risk platforms to provide the CRO and management team with the right information to assess risk across the environment, TABB Group CEO and founder Larry Tabb says. And the CRO and management team will have to have the power to override individual desks or develop a strategy in which the CRO can overlay a hedge without the desk stepping in.

Industry Leaders: Although some analysts question whether its risk management practices differ significantly from other firms', Goldman Sachs was the only bulge-bracket firm to turn a profit amid the 2007 subprime crisis.

Technology Providers: SunGard, Oracle Financial Services, Sophis, Calypso, Misys, OpenLink, Risk Metrics Group and a number of other, smaller players.

Price Tag: For compliance risk, a platform could require investment of more than $1 million to get started, but much larger investments are not uncommon, particularly when the bank has many lines of business. "For market, credit, operational or liquidity risk, the costs rise with the size and degree of sophistication of the bank's business," says Eric Bass, senior managing director, SMART Business Consulting. "A very large, well-known U.S. bank (with retail, wholesale and investment banking businesses) spent over $120 million building a custom credit risk management system."

Collateral Automation to Be A Trend in 2009

Why It's Important: "The importance of the collateral management function in managing counterparty credit exposure is now more obvious than it was a year ago," says Celent analyst Isabel Schauerte. "Growth in collateral agreements reflects increased reliance on this function -- especially when the growth in the derivatives market has brought new counterparties with questionable credentials to the market. And the credit crisis has brought the issue of counterparty credit risk into sharp focus."

Where the Industry Is Now: Where collateral management was once a staid, boring world of simply holding on to collateral until a contract comes to its natural fruition, the credit crisis, the collapses of Bear Stearns and Lehman, and the volatile markets have injected a large dose of excitement -- if not downright fear and panic -- into the former drudgery of collateral management. To automate collateral programs, Excel spreadsheets or tactical databases have been sufficient at smaller firms; larger, more mature participants in the market have developed custom in-house collateral systems.

Focus in 2009: Fourteen broker-dealers, including Credit Suisse and Goldman Sachs, are working to build an automated margin messaging system that will be made available next year. And buy-side firms are considering purchasing software that monitors collateral alongside collateral agreement terms and conditions.

The J.P. Morgan collateral management team is building a new global platform for collateral management. According to Kelly Mathieson, managing director, global clearance and collateral management executive, treasury and securities services, at the firm, "We will turn our attention to the more functional layer that provides eligibility, allocation optimization, the onboarding experience for our clients and further enhancements toward creating a virtual global long box" -- in other words, a real-time view of collateral positions from anywhere in the world. "This is genuinely a transformational moment for the collateral management industry."

There is a widespread desire for a single, integrated platform that allows for straight-through processing of collateral management activities, according to Celent's Schauerte. "By consolidating the multiple activities of the collateral management function into one system, a reduction of errors and inefficiencies can be achieved," she says. This platform should enable the reception of global data across transactions, positions, movements and external data flows, and support multiple message and file formats, Schauerte adds. It also should have connectivity to a central asset price database. "Market participants are interested in increasing the transparency of post-trading pricing," she says. "A central database could be established, containing information on asset values that could be accessed by all market participants."

Schauerte also sees a trend toward an automated workflow approach to collateral management. "Timing, deadline controls and monitoring can ensure that margin calls proceed according to the collateral agreement and potential errors and omissions are largely eliminated," she says. "This workflow should integrate smoothly into the post-trade process automated workflow."

Industry Leaders: Credit Suisse, Goldman Sachs, J.P. Morgan and Morgan Stanley are leading several technology initiatives as founding members of the Collateral Framework Group.

Technology Providers: AcadiaSoft, Algorithmics, Allustra (acquired by Omgeo), Murex, Misys, Lombard Risk, Sophis and SunGard provide software for collateral practitioners. TriOptima offers a reconciliation tool.

Price Tag: J.P. Morgan's new global platform will cost millions of dollars; less comprehensive software tools run in the hundreds of thousands of dollars.

Consolidation, Client Reporting to Lead 2009 Wealth Management Projects

Why It's Important: Wealth management has been more profitable than many areas of financial services, and this trend should continue: Wealthy individuals seek experts in uncertain times, and a recent PNC survey of 1,263 Americans with at least $500,000 in investable assets found that 65 percent still like stocks as an investment. In addition, baby boomers are setting up retirement income cash flows and transferring wealth to children, and high-net-worth individuals are migrating, along with their brokers, from large brokerages to smaller firms less damaged by the subprime mess.

Where the Industry Is Now: While TowerGroup estimates that wealth management technology spending budgets will drop 5 to 6 percent in 2009, firms continue to invest in wealth management technology. "Some of the bigger IT projects going on in the investment industry are wealth management-related," says Tom Secaur, managing director of consultancy Citisoft. "They're a combination of vendor-based implementations, projects that involve huge builds of software and multiyear initiatives that cater to a globally expanding business." In June Merrill Lynch opened wealth management offices in Russia and Turkey, and expanded teams in Europe. In November Citi announced a new wealth management service in Malaysia.

Small and midsize firms are investing in infrastructure as they watch the New York wirehouses struggle. In fact technology has leveled the playing field, says Galan Daukas, EVP of Washington Trust. While previously only the largest investment management firms could offer diversification through specialized teams of analysts and portfolio managers, today "Technology has enabled investment managers in small, independent firms to access the best investment ideas worldwide," explains Daukas, who says his firm uses Smartleaf's Concord overlay management technology to work with third-party managers, mutual funds, fixed-income and exchange- traded funds, and proprietary models from one platform.

The firm has also bought new CRM software (Unapen's ClientLogix). "By making investments while many of our competitors are distracted or otherwise engaged, we'll be able to grow our market share," Daukas says.

Smaller firms, however, have already begun belt-tightening. "We're doing all we can to consolidate resources," relates Robert Brandenburg, senior equity trader at Lotsoff Capital Management. Lotsoff recently dropped one of its two order management systems, saving $150,000 a year, and improved automation with a reconciliation tool from CheckFree APL.

Focus in 2009: Investment in new wealth management technology will slow as a result of the market downturn. Rationalization (read: consolidation) of wealth management platforms is expected. "The target is to support a single platform," says Doug McGann, a partner with Milestone, a management consulting firm that focuses on the financial services industry.

Client reporting is one area of wealth management technology investment that may remain strong in 2009. Surveys have shown that client communication is one of the top three things clients look for in a wealth management organization, according to Citisoft's Secaur.

Industry Leaders: Its purchase of Merrill put Bank of America in a leadership position in wealth management. Goldman Sachs, Morgan Stanley, Credit Suisse, UBS and Wells Fargo/Wachovia also are in the top bracket in terms of assets under management. Citi/Smith Barney has been retrenching along with the rest of the firm.

Technology Providers: Advent, NorthStar, SunGard and Thomson offer wealth management workstations. Smartleaf offers overlay management software, and Unapen and Salesforce provide wealth management CRM solutions. CorrectNet and Assette provide client reporting tools. CheckFree APL offers reconciliation software.

Price Tag: Large-scale global projects can cost upward of $20 million. Rationalization projects theoretically should save money, although there typically are training and integration costs.

Canadian Banking System Could Provide Insight Into Future Regulatory Planning

As the industry looks toward 2009 and tries to put the not-so-sweet memories of 2008 behind it, everyone is debating how a regulatory framework should be set up to avoid another crash like this in the future.

But no matter how well we prepare for the next subprime mortgage crisis, credit crisis, or savings and loan scandal, regulations are always designed to protect against the last crisis. And, no doubt, we will have a new type of crisis 10 or 20 years from now, and everyone will act surprised and ask, "How could this happen?"

The answer is actually pretty simple. Our memories of painful things -- negative events such as market crashes, personal loss or even being rejected by a high-school crush -- are suppressed, and time seems to soften our memories of how bad things actually were. It's human nature to forget the bad and remember the good.

Right now everyone is risk-averse: Risk is bad, and poor risk management is causing a lot of pain. But as 2008 memories fade, banks will begin to take more risks again. At first a little risk will be acceptable. When it doesn't blow up in the bankers' faces, then a little more risk will be OK. Before the bankers know it, a whole lot of risk will be rationalized as being tolerable, until "something completely unforeseen" happens, such as thousands of people who have no income defaulting en masse on mortgages that never should have been offered in the first place. Who'd have thought?

Right now everyone is waiting to see the new regulatory framework that will monitor the financial markets. But we needn't look far or come up with radical new regulations. Our neighbors to the north seem to have found a good balance.

Canada's banking model has weathered the storm. Canadian banks are more tightly regulated, more liquid and less highly leveraged. There is no subprime mess in Canada, as lending rules are stricter. No banks are on shaky ground. In fact the World Economic Forum rated Canadian banks as the soundest in the world. As such, Canadian banks are eyeing weakened U.S. banks as possible acquisition targets. And while IT spending growth globally will be slightly negative -- double-digit negative in the U.S. -- financial services IT spending in Canada is the only market projected to experience IT growth in 2009, according to Financial Insights.

Is Canada's banking structure the answer? Some say it's too restrictive, which is probably true. But since every other country got it wrong when it comes to regulating financial services over the past decade, maybe we should look to the sole survivors of the credit crisis and learn something from them.

Low Latency Spending Moves Full Speed Ahead

Why It's Important: In the past, Wall Street's reliance on technology to reduce latency was focused mainly on algorithms and the trading of equities. While algorithmic trading of equities remains the most sensitive to data latency, other asset classes -- such as foreign exchange and certain types of derivatives, especially exchange-traded options -- are also moving more and more toward algorithmic trading and are increasingly sensitive to latency.

"Low latency is critically important in the options market, and in the coming years it will only become more so," writes Kevin McPartland, senior analyst, TABB Group, in his report "Low-Latency Options Trading: Unraveling the True Meaning of Speed." "Latency is already being reduced at each stage of the trading process but at increments and levels of priority that vary by firm."

Why is it so important in the options market? "Options is the epicenter of market data, with 2 billion messages a day," McPartland tells WS&T. "There are a lot of people executing high-speed options strategies." With the Options Price Reporting Authority (OPRA) recommending that market participants have the capacity to handle nearly 2 million messages a second (10 billion a day) by January 2009, simply handling all of that data is going to require firms to use technology that reduces latency in all parts of the process.

Where the Industry Is Now: Technologies that enable lower latency -- such as the newest quad-core chip sets, complex event processing (CEP), field-programmable gate arrays (FPGAs) and hardware acceleration -- have been used to speed the trading process. But with the industry's increased focus on reducing risk in 2009 through intraday or even real-time risk calculations, certain latency-reducing technologies will find their way into the risk management organization. This will be especially true if financial firms look to integrate real-time risk monitoring with the trading desks because risk management calculations tend to require large amounts of "compute farms," says Peter Lankford, director at STAC Research. "The latency on the compute farms has a big impact on understanding the firm's positions during the day. The speed of the processing and analysis and latency within grids can be a big deal."

Focus in 2009: A lot of the low-hanging fruit has been picked when it comes to data latency, so firms are looking for new ways to decrease latency. Hardware acceleration is gaining traction, and in the current climate of reduced budgets, firms are looking for efficiency gains that save money and also reduce latency, such as "collapsing the stack" (reducing the hops between systems to streamline processing) and improving resource efficiency in the data center, says Lankford. "Reducing latency sometimes goes hand in hand with better efficiency," he says. For instance, FPGAs are a low-power technology that can greatly reduce latency.

Industry Leaders: All of the brokers have some trading operations and algorithms that are latency-sensitive. They have all spent time and resources over the past few years aimed at reducing data latency. This trend will continue into 2009 and beyond, as for "any firm that is positioned as a trading firm, milliseconds will matter," says Robert Iati, partner, TABB Group.

Technology Providers: CEP providers include Aleri, BEA Software, Vhayu, Coral8, Streambase, Kx, Progress Apama, Oracle Fusion and KnowNow. Hardware acceleration vendors include graphics processing units (GPUs) providers AMD ATI and NVIDIA, among others.

Price Tag: Considering that TABB Group estimates that "if an agency-broker's electronic trading platform is five milli-seconds behind the competition, it could cost the firm up to $4 million," most firms will be willing to make investments in latency-reducing technology. The ultimate price tag varies, depending on the size of the firm.

Wall Street & Technology’s 2009 Capital Markets Outlook

After a rough year, Wall Street is looking to put 2008 behind it. In 2009 CIOs will be working with smaller budgets but will face many of the same challenges they have had in years past. At the top of the priority list will be improving risk management technology, providing technology support for compliance with new regulations, and improving collateral management technology. Wall Street & Technology's 2009 Capital Markets Outlook offers some insights for the coming year.

What phrase would best capture 2008 on Wall Street? Train wreck? Implosion? Both seem appropriate to describe the year that brought us the mortgage, CDO and CDS meltdowns; Bear Stearns' collapse; Lehman's bankruptcy; panic in the global financial markets; and a seemingly endless succession of layoffs (150,000 U.S. financial sector jobs lost between September and early December alone, according to Reuters). It's no wonder everyone thinks 2009 can't get here fast enough.

But when the new year does arrive, much uncertainty will remain. CIOs will certainly be asked to do more with less. And we can expect the turmoil will force Wall Street firms to invest in a few key technology areas.

Many firms will take a hard look at their risk operations and policies as they recover from their past CDO and CDS indiscretions, and many will realize the need to invest in new risk management technology. Further, it is inevitable that at least a few new regulations will hit the Street in 2009, making investment in new compliance tools necessary. And as firms struggle to get a grip on counterparty risk, collateral management automation projects will become a priority.

When it comes to staffing and IT budgeting, in efforts to cut costs without axing employees, platform consolidation and technology rationalization will become the norm. "Right now management attention is focused on rationalizing infrastructure, whereas in the past four to five years it's been about figuring out how to grow the business and not being left behind competitors," notes David Easthope, senior analyst at Celent. And for the thousands who are unfortunate enough to lose their jobs, social networking technology should continue to shine as Wall Streeters look for new positions.

The surge of wealth management technology initiatives seen in 2008 will probably ebb as firms learn to leverage their new platforms. Yet TowerGroup predicts that wealth management spending will be one of the few bright spots in financial services IT spending, pointing to client reporting software as an area of likely investment.

Wall Street & Technology's Penny Crosman, Melanie Rodier, Ivy Schmerken and Greg MacSweeney contributed to the 2009 Capital Markets Outlook.