master new instrument adoption

Eight approaches to master new instrument adoption and avoid chaos

Many of us have experienced delays and challenges when trying to master new instrument adoption into a current treasury or investment operating model. Even trying to onboard typical flow instrument types like ETDs or CFDs can be problematic and often end up on a backlog or in the parking lot. Problems found in the set-up process can show many underlying complex causes.

Five common causes of new instrument adoption failure include:

  1. Lack of existing ‘standard’ instrument configuration within current operating systems and service providers including accounting ledgers.
  2. To many customised workarounds to support downstream operating model processes. Often this leads to manual human efforts to support, with increased operating risk
  3. Challenges with data integration across internal and external providers and processes. The instrument type data representation and IBOR requirements can differ across systems and providers
  4. Global and local regulatory requirements for trade reporting. An arbitrage effect can happen across different jurisdictions and authority requirements
  5. Running out of budget to continue with the project. Continued delays and resource spend, and vendor costs can spiral out of control

Onboarding a new instrument is a ‘bellwether’ measurement to indicate how well the firm’s current operating model stacks up’.

The process often shines a spotlight on any failure points across the complete operating value chain including system and service providers, resources, accounting, and governance including regulatory impacts.

A common cause of frustration and delay can be valuation readiness, this can include curve construction, volatility surfaces, underlying model methodology and timings. In recent times and the past decade, I have experienced strong providers with solid derivatives valuation libraries but lacking supporting model documentation and methodology transparency. Clients often refer to this ‘as black box syndrome’. Simply put, either too complex or the firm is unable to provide suitable written methodologies and explanations.

Model methodology and valuation curve construction inputs require regular documented validation and testing by the firm to demonstrate ‘fit for purpose’ model frameworks and documentation to the authorities, auditors, and internal control units.

Going back a decade to 2012, when I led Citi’s fund services derivatives product team, volatility and variance swaps were considered exotic and growing in client demand. There was contractual issues and often wrong prices between parties. The structure of the instrument was difficult for the vendors to standardise and model in the pioneering early days. Volatility swaps and variance swaps allow investors to buy or sell volatility in the form of a swap, in which one party pays the fixed implied volatility and receives the realised volatility during the life of the trade.

From a valuation perspective, volatility swaps were problematic, Volatility swaps are different from traditional swaps because they are a payoff-based instrument. Traditional swaps include an exchange of cash flows, which may be based on fixed or varying rates. Volatility swaps, on the other hand, are based on a ‘greek’. Difficult to price and measure, the market declined and migrated away from volatility swaps towards variance swaps. Pioneering new instruments and markets are often complex to navigate and slow to standardise.

Fast forward to the present day, digital assets and tokenization adoption is creating a participant mindset shift from ‘innovation to transformation’. Improved transparency and guarantee of settlement plus potential automation of lifecycle events could deliver more liquidity, speed, and vast benefits.

However, the current lack of a coordinated global or local legal regulatory digital asset framework and timelines provides real industry adoption challenges and could introduce fragmented non-standard operating frameworks. I keep referring clients to ‘credit risk’ and how this might evolve within digital assets and payment process adoption.

Onboarding new instrument types for investment firms typically involves several steps to ensure a smooth and compliant integration.

Master new instrument adoption with these eight approaches

  1. Research and Due Diligence: Begin by conducting thorough research on the new instrument types you wish to onboard. Understand their characteristics, market dynamics, risk profiles, and regulatory requirements. Assess how these instruments align with your investment strategy and risk appetite.
  2. Internal Assessment: Evaluate your firm’s infrastructure, systems, and operational capabilities to determine if they can support the new instrument types. Assess the impact on your investment process, risk management framework, compliance procedures, and reporting capabilities. Identify any gaps or enhancements required to accommodate the new instruments.
  3. Regulatory Compliance: Financial instruments are subject to extensive regulatory oversight. Ensure compliance with relevant regulations, such as those imposed by financial regulatory authorities or exchanges. Understand the legal and documentation requirements, reporting obligations, capital adequacy rules, and any necessary licenses or registrations.
  4. Risk Management Framework: Enhance your risk management framework to incorporate the new instrument types. Review and update risk policies, limits, and controls to account for the specific risks associated with these instruments. Consider factors like market risk, credit risk, liquidity risk, and operational risks.
  5. Operational Infrastructure: Assess your operational capabilities to support the new instruments. Determine if your existing systems, order management platforms, trade execution tools, and reporting systems can handle the additional complexity. Consider any required modifications or upgrades to facilitate instrument processing.
  6. Staff Training and Education: Provide comprehensive training to your investment and operations teams on the new derivative instrument types. Ensure they have a solid understanding of the instruments, their valuation methodologies, associated risks, and trading strategies.
  7. Testing and Pilot Phase: Before fully integrating the new derivative instruments into your investment process, consider conducting a testing phase or pilot program.
  8. Execution and Monitoring: Once you are confident in your readiness, begin executing trades in the new instrument types. Monitor their performance, risk characteristics, and compliance on an ongoing basis and adjust.

Summary of Key Points

Onboarding a new asset type is a massive undertaking. You are trying to combine complex processes, high speed processing, high process risks and complex external touch points. Despite the brilliance of your internal people – bring in third parties who can bring a simple perspective : what worked elsewhere – and what didn’t. Avoid the bear traps everyone else falls into and pick a proven route to efficiency, and master new instrument adoption in your firm.

Ask me!

We’ve done a ton of these projects for firms like yours – we tore our hair out some time ago so that you don’t need to. Get in touch and find out how we can fast-track your firm’s new asset adoption!