www.capitalobjects.com
Enterprise JavaBeans For derivatives

New Internet exchanges are popping up almost every day, and virtually every derivatives dealer has grand plans for Internet trading in the future, if not the present.

New York-based Capital Objects hopes to capitalize on the boom by providing the technological building blocks for start-up derivatives exchanges. It doesn't provide a full-fledged, plug-and-play web application; instead, it provides a platform that customers adapt to their particular needs. Right now, Capital Objects has two main types of clients: startup B2B derivatives exchanges, and dealers expanding their Internet functionality with clients.

In a broad sense, companies like Ariba offer similar services to fledgling B2B exchanges. But no one offers building blocks specifically geared to the derivatives markets. The key to Capital Objects' business model: most derivatives trading sites have similar—if not identical—functionality. "They all have some way in which a client can select a trade,” says Kautilya Raval, CEO of Capital Objects. "There's always some form of buyer-seller matching, there's always some form of auction, there's functionality like instant messaging and e-mail processing, and there is always some sort of risk management or position-keeping service offered. We've created a platform that supports all of those things.”

Capital Objects' platform is based on big chunks of Enterprise JavaBeans that can be adapted, customized and reused by the customer. Capital Objects chose to use EJB rather than a straightforward Java solution because, while Java is quite flexible compared with, say, C++, it doesn't lend itself to error checking, and there's little functionality embedded in the language itself. EJBs are far more robust. Companies like Capital Objects use them to deploy a site with "application servers” that perform specific functions, like caching or messaging—and their customers can simply plug these components into their own application, rather than write the code themselves. "We take over a lot of the low-level, core development that a robust system requires,” says Raval.

The fact that Capital Objects works exclusively in EJB is a major advantage, Raval believes, because there's no need to fuss with any sort of legacy code, and EJB is clearly the wave of the future. "Most applications require something called ‘clustering,' which allows them to do a hot backup,” he says. "If one server goes down, the other server gets picked up dynamically. The only way you can fully exploit clustering is if you have everything native in EJB. There are going to be a growing number of features like that, because newer features will only work with EJB code.”

Capital Objects' biggest advantage, says Raval, is its simplicity. "We take a customer that may be looking at an 18-month development cycle, and reduce it to six months, or even less, before they get an alpha version of their site up.” Moreover, because the platform is written in EJBs, it can communicate easily with other EJB-based vendor products, such as real-time data feeds and news services. And Capital Objects also sells its source code, providing even more flexibility for customers.

One customer that recently implemented the Capital Objects platform was ePrimus, a credit derivatives market-maker that wanted to provide its services over the Internet. The customer wasn't interested in an auction system, but rather one that allowed it to control the sorts of products it offered its clients—and that allowed it to manage its own risk as well. Capital Objects supplied the web infrastructure, data model, pricing and front-to-back trade management code for the system.

"They were selling credit protection, so they were holding default swaps on their books,” says Raval. "There was a big risk management component to that, because they weren't off-loading it. The default swaps just kept growing and growing in their portfolio.” Capital Objects provided a real-time risk engine in which, as a trade was made or market data were adjusted, the system re-computed the company's exposures to various criteria, like sector concentration, rating concentration and country concentration, and determined what protection it could continue to offer. "There was a nice real-time component to that,” says Raval.

www.kiodex.com
Kiodex Pulls Off a Coup

In the e-derivatives markets, alliances are everything. No company understands that simple truth better than Kiodex, a software vendor specializing in Internet-based commodities trading and risk management solutions. In September, the New York Mercantile Exchange announced that it has chosen Kiodex's Trade Engine to match and clear orders for the Enymex system, scheduled to launch early next year. Enymex is an Internet-based electronic trading, clearing and risk management platform for over-the-counter energy and metals products that, among other things, will allow customers to cross-margin their OTC and Nymex futures positions.

The deal is a major triumph for Kiodex, formed in March by former Goldman Sachs commodity derivatives mavens Martin Chavez and Raj Mahajan. Nymex's imprimatur lends the fledgling company something not easily gotten in these explosive early days of electronic trading: quick credibility. After just six months of existence, the Nymex deal has put Kiodex on the map.

Kiodex offers two main products: Trading Engine, the automated, HTML-based order-matching system for Internet commodities markets; and Risk Workbench, a web-based risk management application providing pricing and risk analytics. The company also provides risk management consulting services, and advises up-and-coming commodities exchanges on how to build liquidity.

Its target clients include oil, natural gas and electricity exchanges, as well as emerging business-to-business markets such as paper, chemicals, steel, telecommunications, bandwidth and semiconductors.

Kiodex believes there's a ripe market for its various wares. "When we were at Goldman, it became clear that our counterparts had very little of the technology needed to value each trade and instrument,” says Mahajan. "Many relied exclusively on spreadsheets, and could never be sure what the fair market price was for each deal. They also had very little sense of what it takes to manage risk effectively. In highly volatile markets, like electricity and gas, prices can triple in the course of an hour. Electricity prices can go from $20 to $1,000 in a few hours. We felt it was important for end-users to have the proper tools to price and understand their risk.”

Selling those tools will be far easier thanks to the Nymex deal. Kiodex will use Trade Engine as a platform to market Risk Workbench, with the ultimate goal of providing customers full pricing and risk management functionality. "For every trade that goes through Enymex, the trader will get a teaser—a minimal analytic like a mark-to-market report to get a sense of what Workbench can do,” says Mahajan. "We view that as our principal source of marketing. And we have an exclusive opportunity there.”

It's an opportunity made greater by the relative dearth of sophisticated commodities risk management software, says Mahajan. Most systems "are good at physical position management, which tells you where, when and what kind of crude oil you should be delivering, what's in your inventory, and so on,” he says. "But they're little more than a repository for trades. They don't provide you with the high-end analytics.”

Risk Workbench, which follows the application service provider model, offers an array of pricing and risk analytics for a variety of commodity derivatives products. It provides end-of-day sensitivity reports (that is, the Greeks), mark-to-market and value-at-risk calculations, real-time risk and position reporting, various visualization tools and quarterly FAS 133 statements.

www.visiblemarkets.com
Mortgage-backed and Corporate Bonds, eBay-Style

College reunions are great venues for hollow talk about past and future business endeavors. When the liquor wears off, the deal-making usually dies too.

But at a 1999 MIT reunion, two old buddies—Brian Robertson, a senior executive who helped develop Amazon's toy business; and Samuel Choi, a Lehman Brothers mortgage derivatives trader—hatched an idea so compelling they decided to give it a whirl.

Visible Markets Inc. was the result: a Boston-based bond trading web site specializing in sophisticated little pieces of mortgage-backed and corporate paper. The browser-based platform—soon backed by such prominent firms as eSpeed and State Street Bank— launched its first trades last June. It has since signed up more than 140 institutions as active users.

Visible Markets decided not to attack super-liquid instruments like U.S. Treasuries, which are already served by electronic trading platforms, or the whole-loan or high-yield markets, which are so security-specific they lack much fungibility. Instead, the company has taken on mortgage-backed securities, collateralized mortgage obligations, asset-backed securities, investment-grade corporate bonds and all the various tranches these securities get broken down into—a niche not yet well served on the Internet.

"We wanted to find instruments with enough definable features to trade, but not ones that would put us in direct competition with TradeWeb or eSpeed,” says Charles Smart, vice president of analytics at Visible Markets and former head of mortgage trading at Nomura Securities International. "We're the only people up and running in this space.”

"We wanted to find instruments with enough definable features to trade, but ones that would not put us in direct competition with TradeWeb or eSpeed.” —Charles Smart

While Robertson hails from Amazon, Visible Markets borrows heavily from another e-commerce titan: eBay. Visible Markets is a pure financial auction site—and it's quite flexible. Users can list their desired sales price methodology in many ways—as a spread to U.S. Treasuries, for example, or as a price with a hedge ratio, or as a discount margin to some other security. The bond analytics to help decide upon a fair offer and hedge ratio are supported by a strategic alliance with Applied Financial Technology, a leading supplier of prepayment and interest rate models. Users can also set either a public or private minimum reserve price, and can define their own time window for receiving acceptable bids.

Once an auction has started, all clients who have ever expressed an interest in the security in question receive an immediate e-mail alert. Moreover, participants can anonymously upload their portfolios to the system, and receive an e-mail whenever a Visible Market client expresses an interest in buying or selling one of their securities.

As an auction progresses, an e-mail alert updates both seller and interested buyers at every change. If bidding gets active at the end of an auction, the system automatically grants a time extension until all participants have been quiet for at least 30 seconds. When the auction finally closes, if a deal involves a spread to Treasuries the system automatically grabs a Treasury price from the mid-market of a GovPX screen.

To protect anonymity, Visible Markets—clearing through National Financial Services LLC, a Fidelity Investments subsidiary—stands as the counterparty to all trades. While it's thus necessary for participating customers to have a credit line for Visible Markets, Smart claims that the company's deep pockets has not typically made this a problem. The firm is a registered broker-dealer and a member of the National Association of Securities Dealers.

There are other e-commerce flourishes, too. When customers make a deal, the system prompts them in an Amazon-esque way with a message to the effect of, "If you liked the bond you just bought, you might love the following bonds.” Moreover, customers can search for bonds with given attributes and, once located in another user's portfolio, can start a reverse auction to try to buy them. The owner of the instrument in question receives an e-mail alert that there's a buying interest in a given security and that a reverse auction has begun.

There is even a fully anonymous chat feature built into the system, and behind the platform real brokers calling people in the market to make sure they notice attractively priced paper that is up for auction. "We did not take a ‘Build it and they will come' attitude,” says Smart. "We recognize the value of occasionally making a phone call and making sure auctions are well attended and successful.” Although Smart declines to say how many auctions end in a consummated deal, he does say the percentage of auctions that result in a trade has been steadily on the rise.

Visible Markets charges nothing to set up an auction or post an interest. Instead, it collects a small commission when a deal is consummated. Its customers include banks, hedge funds, corporate pension funds and university endowments, making the system cross-matching in nature. "A dealer might be dealing with another dealer over the system or dealing with a University endowment,” says Smart. "Or two buy-side firms might trade directly against each other. No one ever knows who's on the other side of a deal.”

Such an auction platform appears to function well since the mortgage-backed and corporate bond markets generally trade on a spread to the more liquid Treasury and swap markets, and yet bonds reside in a diverse range of portfolios. Instant execution is not needed as much as increased transparency and liquidity.

"In the old days, when you won a bid-wanted request, you really had nowhere to go with it,” explains Smart. "You certainly couldn't call out to other dealers and flip it out. Now, when you buy a piece of paper, you at least know that if you change your mind about it, there is an anonymous platform to offer it back out to the market again. I think this should encourage people to position these securities a bit more than they otherwise would.”