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Citi Prime Finance’s 2011 IT Trends & Benchmarks Survey
Once these new offerings, capable of handling the increasing
complexity of investment instruments such as credit default
swaps and bank debt, were more widely available, this drove
the more established software providers in the long-only asset
management space to broaden their functionality and / or
instrument coverage to remain competitive. Trading platforms
being offered today by traditional providers such as Charles
River, Eze Castle and Bloomberg’s AIM are signifcantly more
multi-asset and fexible as a result of their need to remain
competitive with emerging hedge fund-focused platforms.
The resulting availability of vendor packages to service the
industry meant that it was no longer a differentiator for hedge
funds to develop their own portfolio management tools; this was
now a commoditized function. In some cases, it still made sense
for funds to internally develop trading software, especially for
more technically based strategies, but by-and-large, a host of
order- and execution-management solutions became available
over the past decade, making that function highly commoditized
as well.
When the liquidity crisis of 2008 hit, many of the largest funds,
who had built extensive core infrastructures from scratch (and
hadn’t commercialized them) were left with a high support
cost base, and much less asset-based revenue to support those
costs. The lesson learned for newer funds launching was that
they should take advantage of the host of commoditized vendor
and/or service provider portfolio management and trading
solutions, which are easier to scale up or down as assets under
management change with the business cycle.
Wave 2 Customizations Drive Collateral
Management & Financing Enhancements
The years preceding the liquidity crisis of 2008 saw a massive
increase in the usage of derivatives by hedge funds of various
sizes and strategies, for purposes of alternative fnancing, yield
enhancement, risk hedging and market access. The Bank of
International Settlements (BIS) shows that the total notional
principal outstanding in over-the-counter (OTC) markets rose
from $220 trillion in June 2004 to $684 trillion by June 2008,
in part spurred by increased hedge fund interest.
As the use of derivatives soared, prime brokers began expanding
their core equities-related businesses into the fxed income arena
wheretheycouldbetteraccommodatecredit-relatedstrategiesand
derivative trades. This occurred just as hedge funds were reaping
the beneft of Wave 1 commoditization, wherein they had more
broadly available multi-asset trade and portfolio management
platforms and better insight into their own portfolios.
The result was a shift in the prime brokerage model. Whereas
previously, hedge funds would have a single prime brokerage
relationship or at most, a single prime brokerage relationship
per fund, they now began to open multiple prime brokerage
accounts for each fund. This allowed the hedge fund to create
competition in their margin fnancing rates across their various
primes, place trades with specifc organizations to achieve
position offsets and minimize risk exposures, and to access
multiple derivative credit lines. As a result, the fund was no
longer able to rely on their prime broker to get a holistic view on
their margin requirements and collateral. Instead, they needed
to aggregate this information across multiple providers.
Few, if any, systems had been developed for the buy-side at this
point in time to help them assess their risk and, subsequently,
their margin obligations; track their collateral use; or assess their
fnancing rates across a portfolio of prime brokers. Nearly all
the systems available in the market had been created for large,
sell-side frms and these platforms were primarily single asset.
Another divergence between specialized hedge fund needs and
existing system offerings had emerged. This situation helped
drive Wave 2 of hedge fund IT investment as illustrated in Chart 9.
By late 2004 / early 2005, several leading hedge funds in
the credit space leveraging OTC derivatives had noticed an
opportunity to turn their multiple prime broker relationships
into a differentiated advantage. This was achieved by creating
collateralmanagement platforms able toevaluate theuseof their
credit lines, their overall derivatives exposures and exposure
per prime broker, and to track and assess their margin calls
and determine whether their fnancing rate would be cheaper if
they offered up bonds as margin collateral as opposed to simply
collecting repo fnancing on these instruments.
A wave of customizations took place, the result of which was
that market leaders were able to “optimize” their collateral
management. Firms who had customized industrial sell-side
platforms to be more nimble, focused and multi-asset were
able to point toward basis point savings, broader uptake of
credit lines and more strategic use of their cash and collateral
as real points of differentiation. This was a particularly good
selling point with the rising class of institutional investors who
were often unfamiliar with the more credit-related strategies
and who were unsure about the operational complexities of
“When we are looking to address a function, our frst question
is, ‘Can we buy this product?’ If so, we prefer a perpetual
license model vs. a lease model so that we don’t get locked
in to an annuity payment.”
– CTO of a U.S.-based fund, managing between
$3 billion and $5 billion USD