IT Derivatives Trading

by Robert Kirby

Derivatives - considered by many the cutting edge of finance - are financial instruments whose value (price) depends on other securities, such as bonds or Eurodollars. Enabling development of the derivatives industry has been one of the largest impacts that information technology (IT) has had on modern capital markets.

In 1965, for example, the cost to store one megabyte of data in RAM was about $100,000 (inflation adjusted). Today, storing that same megabyte costs about $20. The cost of the processor that can handle one million instructions per second (MIPS), meanwhile, has declined from about $1 million in 1965 to $1.50 today. This has revolutionized the quantity and quality of information available to traders.

Although the cost of computer hardware has been declining rapidly, total IT spending by financial institutions has increased. The software required to take advantage of accelerating processing power and storage requires substantial investment, and firms have ever-higher volumes of information to process.

Most products are expensive when first introduced, then decline in price as demand goes up. Eventually, they become commoditized for mass consumption. IT products are no exception. No business today would sit down to develop its own spreadsheet software when there are affordable third-party alternatives.

A decade ago, derivatives professionals had little choice but to build from scratch; no commercial packages existed. But as the industry has grown and demand has increased, buying off-the-shelf software components for derivatives trading has become the norm - except in Japan.

Derivatives trading in Japan began in the mid-1980s. Initially, Japanese banks bought trading systems from foreign software companies. At the height of the bubble economy, however, Japan's large systems integrators played up to the false belief that domestic banking requirements were so uniquely Japanese that only a custom-built solution would truly suffice. Several years, and hundreds of millions of dollars later, most of these mega-projects have achieved marginal success at best.

Coinciding with the trends toward client/server and open systems, Japanese financial institutions are now beginning to embrace new (foreign) technology. While this is a necessary condition for Japanese banks to remain competitive, it is not sufficient. How these technologies are implemented (and how the business will be reengineered) is the key.

Technology, like derivatives, is only as good as the person who uses it. According to Arnold Papp of Infinity Financial Technology, many Japanese banks in the past chose their technology partners on the basis of keiretsu ties. When the Japanese financial market was more regulated, and the major competitors were domestic, this was a viable approach. Now that Japanese banks see their real competitors as JP Morgan and Merrill Lynch, however, they are reconsidering their software needs.

The businesses of technology and finance have never been more intertwined. For Japan's financial institutions, staying at the leading edge requires making technology-driven rather than politically-driven choices. By focusing on adding value in a way that maximizes the advantages of their expertise and experience, they can make profits instead of trying to reinvent the technology wheel.

But for Japan's financial institutions, time is fast running out.

Robert Kirby is Japan Manager of investment consultant ProInCo Japan.

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