By Nina Mehta

Our latest look at the new players in the derivatives software market has uncovered three companies taking different routes to success. Calypso Technology is trying to sneak into the back-office business with a Java-based system run on-site at clients' offices for now, with full back-office outsourcing planned for the future. ADP, the payroll-processing giant, is using its girth to break into the back-office processing business aggressively. And Sentry Financial Systems has created a four-pronged third-party solution for proprietary collateral management.

Calypso Technology

Several things have occurred to make the back office fertile ground for Calypso Technology, a San Francisco-based software developer. First, the core technology infrastructure in financial institutions has aged over the last half-dozen years—and especially more recently as tech efforts were redirected toward Y2K issues and the euro. Back-office systems therefore got short shrift and are about to become woefully inadequate to cope with the expected increase in volumes over the next few years. In addition, the Internet has made it possible for institutions to provide real-time, portal-based services to wholesale clients.

Calypso's plan: to make the back office its lair. Launched two years ago by Charles Marston, former president of Infinity before its merger with SunGard, the 11-person firm takes a back-to-front approach to business functionality, focusing on trade processing, position-keeping and accounting across a range of instruments. Its Java-based software system, available to financial institutions to run on-site, handles foreign exchange, money markets, bonds, repurchase agreements and fixed-income derivatives. Over the next few months, says Marston, Calypso's chairman and CEO, the company will enrich its currently limited functionality for futures and eventually move into equities. Further on, it may host its own software, giving clients the option of outsourcing their back-office processing.

So what's the draw of Calypso over ADP and other firms providing back-office functionality? It's newness and the decisions it's making today, says Marston.

It's an ironic advantage—having a clean slate. "The price of a track record is that you have to have been on the scene for a while, which means, of course, your software has been software for a while,” notes Marston. "It's going to be functionally rich because you have clients saying ‘I need this' and ‘I need that,' but most likely it was built using older design methods and technology, making it expensive and slow to adapt.”

	"Going forward, there will be electronic delivery of new products, made possible by the Internet and by having more information about clients.” Charles Marston

Calypso has no legacy systems to support, naturally, and has designed its systems to take advantage of the extensibility and adaptability of today's technology. Its system uses a component-based multitier architecture, which includes a relational database for persistence, an event layer for the real-time distribution of events within the system, and separate engines providing the requisite business functionality—electronic ticketing, liquidations, P/L and so forth. A thin-layer user interface sits on top. The system is also scalable, so if accounting, for instance, becomes nettlesome and trades take too long to process, a bank could run the accounting engine on a larger machine or run multiple copies on several machines.

All tech journeys begin with a single client, and Calypso is now engaged in a front-to-back implementation of its system on the derivatives trading desk of a commercial bank's capital markets unit. The company's target clients in the months ahead: mid-sized to large commercial and investment banks in North America and Europe.

Peering into the future, Marston expects to see a good deal of product innovation over the next few years. In the past, banks had salespeople, traders and a traditional delivery mechanism for financial products. "Going forward,” he speculates, "there will be electronic delivery of new products, made possible by the Internet and by having more information about clients, based on a more complete knowledge of their trading activities, their business, their positions and so on. Customer service will grow in significance, and banks will rely on technology—well-designed systems deployed on the Internet—to provide it.”

As the financial industry finds new ways to innovate, the back office will clearly become more important. "A firm like ours will participate in and even enable more of the changes,” predicts Marston. "Our product is in anticipation of these changes—this has driven the decisions we've made so far, the design of our products and the markets we've focused on.”

ADP, of course, isn't quite a new kid on the tech block. A triple-A-rated corporate with $5.5 billion in annual sales and 37,000-plus employees, it has a worldwide reputation in payroll and data processing. Its brokerage division is the company's second-largest business unit, accounting for about 25 percent of revenues. Over the last half-dozen years, the firm has narrowed its priorities and shed its market data business. It's now committed to ramping up its range of product processing on the back end in order to capture more business.

Its strategy, in a nutshell: to better service its clients by handling more of their global transaction processing. "It makes more sense for financial institutions to reduce costs by outsourcing the processing of standardized products,” says Clarke Gray, senior vice president in the brokerage division. "This reduces costs for the institution and provides economies of scale for the high-volume standardized transactions that can be processed more effectively on a service-bureau basis.”

Six or seven years ago, ADP's brokerage division focused on processing equity transactions for U.S. broker-dealers. In 1995, it acquired Wilco International to improve its international fixed-income and securities processing capabilities, then Information Catalysts Inc. a year later for its fixed-income processing products—at the same time, expanding into the global banking market. Last May, ADP added OMR Systems to its slate, taking over its processing capabilities for foreign exchange, money markets, commodities and over-the-counter derivatives.

The latest goal is to wrap all this settlement functionality into a single platform that will provide a unified transaction processing and settlement engine across markets and asset classes. The platform should provide clients with an integrated account and master security data, an interface for all transactional activity, and consolidated books and record-keeping. The system uses a rules-based middleware transaction manager to connect to clients' front-end systems and transmit transactions into the processing and settlement engine. The first phase of this product integration process was completed at the end of last year, and a demo version is available.

	"It makes more sense for financial institutions to reduce costs by outsourcing the processing of standardized products.” Clarke Gray

ADP says it can handle all but the most sophisticated low-volume products, such as triple barrier options and lookbacks, designed to meet specific client needs. "Until the processing for one-off instruments becomes commoditized, it's not for us,” notes Gray. "But we can now take 95 percent of a firm's transaction volume across all asset classes, process it centrally and provide consolidate books and records, settlements, and management reporting. This solves the systems integration problem that global banks encounter across multiple systems and geographic locations.”

The master plan, however, isn't to gobble up the entire back office of banks and broker-dealers. ADP is counting on handling the transaction processing, while clients retain their own operations staff to perform reconciliations, manage settlement exceptions and interface with customers.

The primary resistance to ADP's global processing system involves the service-bureau arrangement, since banks' internal technology departments are often loathe to relinquish control of the transaction processing function. But as outsourcing becomes a more acceptable solution, that hurdle will likely blow over. The economy of scale ADP presents, along with the reduction in operational risk, is huge. "Clients typically come to us to process trades when they want to improve service levels, they have problems with regulatory requirements, their costs are out of control, or they want to consolidate their back office and management reporting,” points out Gray.

Last month, ADP processed 1.7 million equities transactions a day. It handles more than 15 percent of the stock-exchange and OTC equity volume daily, along with a good portion of the Internet volume for many on-line brokers. "We have the necessary redundancies, backups and controls in our systems,” declares Gray confidently. "Given the volume, there are stringent martial law requirements about how things get done here.”

Collateral management doesn't sound like a sexy business—and maybe it isn't. But it's becoming increasingly important. Sentry Financial Systems, for one, is betting that the trend will continue.

David Wechter, a principal at Mt. Laurel, N.J.-based Sentry Financial Systems, worked at the CME Depository Trust Co. in the mid-1990s. Sponsored by the Chicago Mercantile Exchange, the industry project offered collateral management for market professionals. When it stopped operations in late 1997, Wechter conducted market research to see if banks would be open to third-party solutions for their proprietary collateral management. They were. Wechter partnered with Yaron Avitov from SunGard Capital Markets and Eli Shoham, signed on Fuji Capital Markets Corp. as the new firm's initial sponsor, and in 1998 rolled out Sentry, a global collateral management system.

Collateral management has clearly matured over the last five years, along with the industry's view of collateral. "The majors have been managing collateral for years,” says Wechter, "but it's becoming more of a market standard in trading relationships—to better manage credit and, in some cases, to better manage capital, given the capital-relief benefits offered for using collateral.” The CME DTC and similar ventures raised the visibility of operational and legal issues surrounding collateral, along with the option of using collateral in trading operations. Recent volatilities in Asia Pacific and the turbulence at Long-Term Capital Management and other highly leveraged firms also raised concerns about credit risk and the incumbent realities associated with the lack of collateral.

	"Collateral management is becoming more of a market standard in trading relationships — to better manage credit and capital.” David Wechter

Sentry had the benefit, says Wechter, of being designed "with basically a white sheet of paper.” The company's founders talked to firms with no collateral programs and those with some of the largest collateralized portfolios on the Street, and ultimately created a four-pronged collateral management product. The prongs: the integration of exposures across instruments; the integration of collateral (in the form of a collateral inventory system); the integration of a rule set, which is essentially the agreement structures themselves; and the integration of a work-flow environment, which enforces the organization's policies for managing margin calls and settlement issues. The system, based on COM objects technology, can be deployed in different environments and integrated into a bank's proprietary applications.

Banks, of course, have alternatives. They could build a collateral management system on their own or go to another vendor. What Sentry Financial brings to the table, notes Wechter, is its industry and technology experience and its integrated, single-platform solution. It's crucial, he says, for a bank's collateral management facility to be integrated into the margin call process and for cash management to be integrated into the collateral management product as well. The idea is for a company's margin calls and related data to be accessed with just a couple of mouse clicks. "That's uncommon in other collateral management systems,” he points out. "Most companies have disparate solutions and bring them together with paper or people, or through ad hoc interfaces.”

Luckily for Sentry Financial, the nature of collateralization is such that once a bank launches a collateral program, there's a snowball effect. "If three firms start asking their 25 counterparties to do collateralization, what's the effect on those 25 counterparties?” asks Wechter. "Now they have no choice, because they have those agreements in place. They have, effectively, begun their collateral program, and they're going to seek out additional clients to collateralize for sources of funds.” Another advance on the collateral front, he says, is that some institutions are now looking for cross-product opportunities—taking collateral benefits in one business line, for instance, and using that collateral portfolio to offset obligations in another business line.

Sentry Financial currently licenses its software to banks. In the next few months, the firm will unveil a web browser-based collateral management option that should provide opportunities for Internet and intranet services from both Sentry Financial and its clients.