Solving buy-side trading challenges with effective analytics

By Jordan Hu | 16 April 2018

Nowadays, people find themselves living in very turbulent times, with political and economic instability all over the world, ranging from the impending Brexit to the escalation of trade tensions. As the financial sector is a litmus test to all world events, financial professionals must always be equipped with the right tools to evaluate risks and conduct sophisticated analyses under any circumstances.

Over the past few years, super low rates, lack of market liquidity, and the drying up of trading volume have reduced profitability for many buy-side firms. These challenges make it harder for portfolio managers to apply their existing trading strategies to collect alpha.

 

Stagnant derivative market

The challenges facing buy-side firms are especially apparent in the derivative trading arena. Derivatives play a major role in investment strategies for buy-side firms, as they are used to expand trading strategies for maximizing alpha, managing risk, funding gap management, and creating a synthetic access to certain asset classes.

After the 2008 credit meltdown, regulators pushed for transparency in derivative trading. Most sell-side firms now provide Swap Execution Facility (SEF) platforms for buy-side firms to execute their derivative trades, such that more than 50% of traditional over-the-counter interest rate plain vanilla derivative trades have migrated to these platforms, and more than 75% of credit default swaps take place electronically as well.

Although derivative trades are moving to SEF platforms, their trading volume has been

lagging behind due to various reasons, such as regulatory ambiguity and separate liquidity pools. For example, Europe’s MiFID II requires that research which was previously given at no cost to investors must now be paid for. The rule is directed towards the European Union, but it does not clearly state whether such research provided by banks in the United States falls into this regulation.

 

Ever-increasing regulation

The buy-side and the derivative markets have encountered more challenges in the past few months, with MiFID II bringing increased compliance expenses. The directive introduces heavy fixed fees for trading venues, such that smaller brokers find it harder to meet post-trade compliance requirements, leading to some dropping out and others consolidating, which decreases competition in the market.

 

What buy-side portfolio managers need

Resolving these issues is the key to improving trading volume on SEF platforms, but it will require new approaches, such as introducing new trading protocols and new instruments.

New approaches will inevitably lead to changes in the derivatives field and bring new challenges, especially to buy-side firms. Besides executing derivative trades and generating alpha for all their trading strategies, as mandated by their funds, buy-side firms will have to adjust to the changing market. In order to meet these challenges, solid pre-trade analytics and risk management solutions are a must. The ideal solution for the buy-side should have the following features:

- Be fully calibrated with market conventions, such that the valuations are fully tied out with dealers’ valuations

- Conduct its own EOD closing process, such that all closes are marked in the correct time points, and data are gathered from reliable sources

- Have high quality historical time series data as its key element

- Incorporate many arbitrage trading strategies, such that portfolio managers can easily construct their strategies and conduct relative value analysis, such as regression or correlation analysis, to identify trading opportunities

- Allow portfolio managers to set up trade alerts to manage large sizes of trading strategies, improving their trading efficiency.

 

The importance of real-time P&L and risk management

The increasing market volatility is changing the landscape of portfolio risk management. Clients are demanding a more sophisticated intraday real-time portfolio management system for both P&L and risk, so that they can be more efficient in managing their portfolio risk. Most firms do have a back-office system to manage EOD P&L and risk management, but lack true intraday P&L and risk management. This is particularly true for Global Macro funds, as they have complex portfolios covering various market sectors and regions.

 

Real-time portfolio management

Portfolio management should be a real-time system, such that trade straight-through-protocol (STP), trade lifecycle management, and trade valuations are all real-time. This framework enables portfolio managers to get state-of-the-art real-time P&L and risk assessment. In addition, solutions should:

- Provide real-time P&L and risk management through multi-tier architecture, in which all calculations are done in the back-end server, reducing the CPU burden in the front-end

- Allow portfolio managers and risk managers to leverage the front-end GUI to navigate the portfolio

- Have a multiple layered portfolio hierarchy, such that trading strategies can be grouped in the same folder for each P&L and risk management.

 

Real-time risk management

Portfolio managers need solutions that calculate more than just traditional dV01 risk, which is outdated. The calculations should also include:

- Bucket risk, basis risk, Vol bucket risk, and SABR skew risk in the risk engine, such that they can see detailed breakdowns of their risk profile

- Factor-based historical Value-at-Risk (VaR), such that not only is traditional historical VaR calculated, P&L is also explained from book to strategy level. This feature enables portfolio managers to trust the VaR number and understand where the P&L comes from.

 

Factor-based historical VaR

Risk management solutions require factor-based historical VaR and P&L explained to help validate the accuracy of historical P&L distribution. P&L factors explain each position’s daily P&L into various market factors, allowing portfolio managers to track each trading strategy performance to improve the portfolio risk reward ratio. More importantly, the time series of historical factor-based P&L enables truly transparent and auditable VaR calculations, avoiding conventional black-box VaR risk management.

Another advantage of factor-based VaR is that portfolio managers can apply the market factors for scenario analysis, as each asset class has its own unique characteristics. The traditional scenario analysis may not be able to shock the market data to produce meaningful results. With factor-based VaR calculations, portfolio managers can customize their scenario analysis with much broader coverage of market factors, such as future basis, cross currency basis, LIBOR/OIS basis, and LCH/CME basis etc.

 

Effective implementation

If buy-side firms are to meet and overcome the latest market challenges, they need to utilize effective analytics and portfolio management solutions as described above. However, building such solutions in-house is costly and time-consuming. Therefore, firms should leverage outside solution providers, which will give them the benefits of saving time and reducing the cost of development.

 

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