Synthetic Financing: Target Operating Models and Technology Challenges

1 July 2015

A survey of 56 market participants carried out by swaps technology provider 4sight and consultancy The Field Effect has revealed that 32% of participants are currently booking Synthetic Financing transactions such as Total Return Swaps and Portfolio Swaps. A further 18% plan to in the near future. Firms surveyed included a range of tier one and tier two investment banks and asset managers.

The survey was carried out as part of research for a whitepaper and webinar discussing market trends leading to an increase in Synthetic Financing, technology challenges and how to define a target operating model in light of increasing volumes and the complexity of synthetic trades.

The paper, entitled “Synthetic Finance: Target Operating Models and Technology Challenges” also discusses the emergence of holistic models incorporating physical and synthetic financing, liquidity and collateral management and balance sheet and capital deployment. 

Increased Synthetic Finance Volumes

The results highlight the growing importance of Synthetic Financing. A synthetic finance trade replicates the payoff characteristics of an underlying instrument using a derivative.

Market data suggests that Synthetic Financing is becoming more prevalent as a service provided by prime brokers to hedge fund clients and in inter-dealer trading. Risk Magazine recently reported that Barclays has experienced double-digit growth in its Synthetic Finance business in the past 3 years. According to Hedge Funds Review, JP Morgan has also more than doubled its synthetic balances in the past 12 months.

A number of buy side and sell side trends are driving this growth including:

  • Hedge Fund assets under management are increasing after a post crisis dip in 2008 and have surpassed pre-crisis levels
  • More funds are becoming UCITS registered in order to access flows of retail and institutional investor capital. However, UCITS funds are only permitted to short sell using synthetic financing transaction types.
  • Basel III is creating added cost pressures for the sell side including increased capital charges, liquidity costs, leverage restrictions and balance sheet scarcity
  • Synthetic trades provide efficiencies from a balance sheet, liquidity and capital point of view and reduce some of the cost impact for prime brokers

Technology Requirements are Changing

The growth in the market is resulting in a number of new entrants emerging to provide synthetic prime brokerage services to hedge funds. This is leading firms to define their target operating models and review technology solutions.

Existing synthetics providers are also now finding that technology provision no longer meets requirements in light of increasing volumes and complexity.

The survey found that:

  • 28% of participants had no technology systems in place for synthetic finance but they plan to install
  • 19% had a technology system in place but it was not yet mature
  • 8% had systems in place that were both mature and cost effective
  • 84% of respondents rated their current technology systems as average, poor or very poor
  • Only 16% rated their technology systems as good or excellent.

Finally, market participants with a more mature operating model are now integrating physical and synthetic financing with liquidity and collateral management and breaking down siloes between desks and business lines. This enables a more holistic view of the deployment of capital, liquidity and balance sheet across the firm and its clients in order to hit high return on equity targets in the more demanding operating environment.

“The survey highlights the lack of effective technology provision for an increasing volume of synthetic finance swaps trading”, comments Martin Seagroatt, 4sight’s director of marketing and product innovation and co-author of the paper.

“These types of swaps can be complex to process, often including multiple underlying instruments and thousands of trade events. Technology solutions that can provide efficient, automated processing of synthetic financing trades with low manual intervention and high STP are now a key component in running a profitable swaps business.

Firms should seek to implement a holistic target operating model that optimises the deployment of scarce resources and maximises synergies across product types. This approach looks to increase return on capital and balance sheet while reducing funding consumption and provides a deeper analysis of client profitability across all business lines.”

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