Making a connection

Addressing both sophisticated multi-asset trading and physical asset optimisation – while complying with stringent new regulation – are challenges few software firms claim to have the entire solution to. Oliver Holtaway reports

Keeping abreast of ever-changing markets has always been a challenge for trading and risk management software providers. But today’s world of sophisticated cross-commodity trading, physical asset optimisation, and the extension of complex financial regulation to energy companies, is proving the toughest challenge yet.

The difficulty of bridging the divide between software that focuses on a company’s internal risk management and software that analyses and aggregates market information is the biggest single challenge for software companies today, says Robert Anderson, executive director of the Committee of Chief Risk Officers (CCRO). “Most seem to do one or the other. We need a product that will translate our exposure profile into financial risk,” he says.

In addition, software for physical risk management, needed by any energy company owning physical assets, is sorely lagging that for pure financial risk management. But the Sarbanes-Oxley Act compels energy companies to combine the analytical work they do regarding their physical exposures with a financial markets approach for regulators. This applies not only to the risks associated with the trading desk, but with risks incurred across the whole enterprise.

While a lot of software models simulate price and market risk, chief risk officers need something that will simulate the behaviour of assets and companies, Anderson says, in order to represent the financial consequences of physical risks and exposures.

Erol Hakanoglu, head of capital markets strategies at Goldman Sachs, says that from a customer’s perspective, the state of the market is not much better than it was five years ago. “The products may have shinier interfaces, but the underlying functionality is not much closer to customers’ needs,” he says. “Financial risk management software has improved – but software for the physical side is a no man’s land.”
Soli Forouzan, senior vice-president of product management and market strategy at SunGard Energy Systems, agrees that the current emphasis on transaction capture will give way to a new wave of risk management software that will capture the risks of asset ownership. “There are lots of different, specific operational risks associated with owning a power plant, gas pipeline or LNG terminal,” he says.

Market structure
But there are obstacles to development of such products. For a start, the very structure of the software market may be working against the needs of more sophisticated energy firms.

The traditional focus on the financial side of trading and risk management is much more profitable for software vendors, as a system designed for one company’s trading book can usually be sold on to another. Modelling physical risks is such a complicated and company-specific endeavour; however, it rarely makes economic sense for a software firm to devote resources to developing such products.

And the arrival of more banks and hedge funds into the energy sector is providing a further incentive for software vendors to sell more streamlined, off-the-shelf products. These financial institutions have a narrower set of needs than physical players, and are less willing to make substantial long-term investment in the kind of IT infrastructure required to run multifaceted software solutions. Instead, they often prefer to use cheaper, web-based services.

SunGard Kiodex is a good example of a software firm that has set its sights on the new breed of financial energy traders through the use of web-delivered services. SunGard Kiodex’s software solutions are delivered via Application Service Provider (ASP) – the only IT infrastructure required to use it is Internet Explorer. At first, the company targeted corporate hedgers, such as British Airways. But as more financial players entered the market, SunGard Kiodex slowly built up its functionality to handle trading books, and found that its model matched the needs of the new entrants.

“A utility company knows that it will have to manage its energy risk exposure for as long as it exists, so it is more willing to invest in long-term IT infrastructure,” explains SunGard Kiodex president Raj Mahajan. “But financial players don’t know if they will still be trading energy in three years’ time, so a web-based service is better suited to their needs.”

Mahajan says SunGard Kiodex will stay focused on hedge funds and more trading-oriented firms rather than traditional merchant utilities.
“There will be a continual demand for ASP services,” he claims. “Businesses have to ask themselves, what is the core competency, and what can I outsource? There are lots of companies who don’t need to be in the business of IT.”

It is also easier to be competitive in a market where customers are able to chop and change their risk management solutions. It can take over a year-and-a-half to implement a full, software-based risk management solution for a physical player. As a result, these companies tend to stick with their systems for at least three or four years before even considering an upgrade. During this time, their business is simply not available to vendors of end-to-end solutions.

Of course, software companies that tie their fortunes too closely to financial players’ presence in energy trading could be in for a nasty shock if the much-anticipated bursting of the hedge-fund bubble occurs – or if asset allocators simply decide that commodities are no longer an attractive asset class.

And conversely, customers of web-based systems run the risk of losing out if their service provider leaves the market.

“I like ASPs, but I know companies who bought ASP systems and then lost all their data when the company went bust,” says Brett Humphreys, managing director of New York consultancy Risk Capital Management. “There is an advantage to actually owning software – it won’t disappear if the company goes under.”

Big versus boutique
Another area likely to influence the future of risk management software development is whether niche players can survive. The market is polarising between larger players, such as SunGard and Openlink, which provide end-to-end solutions for the front, middle and back office; and smaller, ‘boutique’ players who provide specialist software for niche needs. As specialists, these niche players are arguably better placed to develop solutions to specific physical risks.

“There are people who build specialist tools for one market, and then there are firms like us, who offer a wider architecture that makes use of these speciality plug-ins,” says Jon Davies, vice-president of product management at KWI.

Davies claims that there is room for both the larger players and the specialists in the market, and predicts a proliferation of boutiques: “In the past, software vendors tried to offer everything, but as customers are getting bigger, and are trading across different commodities and markets, it is harder for a single vendor to cover all the bases.”

Most believe that the boutique firms can co-exist happily with the bigger players, but note that there has been a trend toward consolidation of late. In fact, Humphreys jokes that the best business model is to “start a small company, get a few successes under your belt and then get bought by SunGard.”

SunGard’s Forouzan acknowledges that there is a trend towards the software giants acquiring smaller firms: “Some of the smaller firms don’t have the scale to keep up,” he says.
“Boutiques can survive, but you have to have a really good product,” says Humphreys. “Good enough to be worth the integration pain.”

Openlink chief executive Coleman Fung says the smaller players keep his firm on its toes – but doesn’t believe that a boutique company will necessarily provide better service:
“Customers are looking for value solutions, but these companies are not always upfront about the total costs of implementation. It is often difficult to get these smaller products up and running.”

Innovation
Nevertheless, all the software giants accept that they must keep their system architecture open to specialist software plug-ins to stay competitive.
“I’ve never been to a client who didn’t have unique requirements for modelling and reporting,” says KWI’s Davies. “They can’t use a shrink-wrapped package: you have to provide flexibility.”

Thankfully for end users, it is slowly becoming easier to make different bits of software work together. Standardised data formats such as XML are useful in this regard, as is the work of industry associations.
And market participants still see plenty of scope for innovation in the software industry – which will in turn increase the competitiveness of the market.

According to Davies, the key will be providing decision-support tools that allow users to see the wood for the trees: “One of the problems in the energy markets is the sheer volume of data. Take UK power – you have prices every half hour, and you might need tens of thousands of scenarios around that data. How do you figure out which pieces of data are most important?”
Software systems need to allow customers to build these tools themselves, he adds.
Ultimately, customers accept that there are limits to how much software can do.

“Software vendors will never be able to provide everything that chief risk officers want,” says Anderson. “Keeping up with changing frameworks is the name of the game.”
As far as providing the foundation architecture is concerned, an informal straw poll of CCRO members identified SunGard’s suite of energy trading systems, Raft International’s raft credit, FEA’s @Energy software and Palisade’s @Risk as favoured platforms.

It is also a constant challenge for software companies to find software engineers with the background in energy – many left the industry after the collapse of Enron and are unlikely to return.

Erol Hakanoglu of Goldman Sachs doubts whether software vendors will be able to meet their customers’ needs on their own. Instead, he believes that investment banks with experience in energy trading and risk management will step in to act as intermediaries and create custom-made solutions – much as Goldman Sachs did for Norwegian oil company Statoil in 1997. “[These banks] have the expertise to form joint partnerships with software vendors,” he says. Crucially, these investment banks actually own physical assets within the energy industry.

Risk management software development faces some tough hurdles, and stringent regulation may mean that the in the future we will see more partnerships between software vendors with programming expertise, and investment banks with their understanding of physical markets and assets.