Vendors Set Up Shop To Serve Complex Swap Systems Market

The phenomenal growth of interest rate and currency swaps has created a mini-boom for companies offering systems to structure, evaluate, and manage these complex transactions.

Although the swaps market is huge, it is still in its infancy when it comes to systems development. Unfortunately for some houses, it's been common for a bank or brokerage firm to set up its swaps desk before investing in software and hardware to manage these operations.

In the early 1980s, when margins contained room for error, management left the mysteries of computers and newfangled financial instruments to the whiz kids with MBAs. But as more players entered the swap business, returns declined and the proverbial window of opportunity remained open for a few hours instead of a few days.

"Systems weren't so important when the market was small," says Patrick de Saint-Aignan, a Morgan Stanley managing director and chairman of the International Swap Dealers Association, "but a tremendous amount of technology is now required." It is essential, he says, that swap houses devote their resources to developing risk management systems.

Some players have developed systems in-house, but a majority have relied on vendors to provide either the front or back end. For instance, Manufacturers Hanover Corp. installed CCF Inc.'s TUFFS system in New York to process swaps from the bank's offices worldwide, while its risk management system was built internally.

Although most large firms have the expertise to develop a system in-house, the departure of key personnel often leads to maintenance and expansion problems. One London house was recently put in the embarrassing position of having to survey banks and brokerage firms to find out with whom it had done swaps.

At another firm, the calendar on a PC-based swaps book crashed six months after the system's designer left.

Whether swap software is used by traders, managers, or back-office personnel, it must contain a calendar for the world's major trading centers and several methods of discounting cash flows to present value.

The calendar allows a trader to instantly determine whether any one of hundreds of payment dates over the life of a swap falls on a holiday in the country where the payment will be made or received.

Most swap packages allow traders and managers to select from several different formulas to discount cash flows to present value. This is necessary because there is no industry standard for mark-to-market.

To be a viable competitor in the swap software market, a vendor's system must accommodate a variety of financial instruments, including futures, options, FRAs, swaptions, caps, collars and floors -- to name a few.

Customers are demanding a portfolio approach covering a broad range of instruments for several reasons. When a firm acts as principal in a swap, it will often use another instrument to hedge. Any inventory or risk management system for swaps must also accommodate hedges for these transactions.

In their search for wider spreads, banks and brokerage firms have been shunning plain vanilla swaps in favor of more exotic deals that combine swaps with other off-balance sheet instruments.

The recent joint proposal by the Federal Reserve Board and the Bank of England addressing off-balance sheet risk isn't limited to swaps. When new capital adequacy requirements are instituted, banks will need systems that aggregate all off-balance sheet instruments.

In addition to horizontal integration across markets, users want a system that links the front and back office. The ability to interface with internal databases and real-time market information is also considered necessary, although users don't always take advantage of these features.

Until the industry adopts daily mark-to-market and active secondary trading emerges, swap dealers can't justify the cost of real-time price feeds. Several vendors carry swap quotes on contributor pages and the International Swap Dealers Association recently began distributing floating interest rates on the Reuter Monitor service.

A number of the swap software packages available today originated as homegrown applications developed for major players.

Devon Systems International of New York introduced its Exposure Management Software for currency options and has since expanded into other off-balance sheet instruments, including swaps. With sophisticated analysis and an endless number of management reports, EMS ranks among the most comprehensive packages, but it requires skilled operators.

Investment Support Systems of Bloomfield, NJ also got its start in futures and options before adding swaps to its Futrak risk management system. ISS is currently preparing a new release of its swap module that will include currency swaps and swaptions in addition to the interest rate swaps, caps, floors, and collars covered by its existing product.

By contrast, Softbridge Microsystems of London and New York set up shop to serve the Eurobond market and has since broadened its product line to include interest rate swaps and cross-currency contracts.

Last month, Softbridge unveiled its Swaps portfolio package, which allows swaps to be written to books and aggregate cash flows to be analyzed. The system incorporates hedges in U.S. Treasuries, futures, and FRAs and evaluates net cash flows using zero coupon techniques.

The two products designed exclusively for swaps are the TUFFS system offered by CCF and Swap Services International's Swapware program.

TUFFS grew out of a system designed for Union Bank of Switzerland by Ultimate Data Systems of New York, which was acquired by CCF in 1985. The centerpiece of TUFFS is its back-office software that integrates off-balance sheet instruments into a consolidated reporting structure. Initially aimed at the back office, TUFFS now includes a trader analytics module.

The Swapware package offered by Swap Services allows a trader to structure and price transactions, simulate risk exposure, and maintain records. A companion package known as Swapbook takes a portfolio approach.

Although vendors try to gloss it over, a battle is being fought in the swap software market between suppliers committed to minicomputers -- primarily DEC VAXs -- and those betting that PCs will be powerful enough to handle portfolios of several thousand contracts.

On the side of minicomputers are CCF and Devon Systems, while Investment Support Systems, Softbridge Microsystems, and Swap Services International favor PCs.

"It's beyond the capacity of a PC to do more than 50 swaps in real-time," insists Kevin Sculley, vice president of software products at CCF. But Boris Antl, founder of Swap Services International, maintains that PCs can accommodate thousands of deals, each with hundreds of cash flows.

The situation is not all black and white, however, because Devon Systems offers its software in single-access PC and IBM mainframe configurations in addition to running on VAXs. And PC-based vendors such as Softbridge Microsystems and Swap Services will port to VAXs if that's what the customer wants.

Right now, PCs dominate the front end, where they are used to determine the profitability of a swap under a variety of interest rate and currency scenarios.

Vendors of PC-based systems say they can also be used by the back office and management to instantaneously mark-to-market 1,000 swaps or more. But some banks and brokerage firms managing substantial books -- 2,000 swaps and up -- have invested $750,000 or more in systems that run on minicomputers.

Naturally, these firms steadfastly maintain that PCs lack the power necessary to meet their needs. "It takes a bloody big computer to revaluate 5,000 swaps at a time," says the operations manager of a bank swaps group that uses VAXs.