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March 18, 1996: Derivatives Engineering and Technology

Principia Debuts Its Derivatives System at Eight Home Loan Banks

Eight U.S. federal home loan banks have gone live with the Principia Analytics System, a new entry in the high-end Unix-based derivatives trading and risk management systems market. The regional home loan banks have been using Principia since last August for financial modeling, derivatives trading, market risk and credit risk management systems support.

Although the group of eight federal home loan banks banded together for their derivatives systems search, each individual bank was responsible for independently evaluating the systems being considered and for making their own final decisions. The eight worked together on selection in order to streamline the process and to take advantage of their collective negotiating power.

The Principia Analytics System was designed and built by a team of veteran derivatives traders and technologists that left New York-based Republic National Bank just over a year ago to form Principia Partners.

Theresa Adams, Principia's marketing manager, describes the system as a "complete front-to-back office solution" for derivatives trading and risk management. "It provides a complete set of tools for traders, sales and marketing staff, risk managers, credit officers as well as operations and accounting staff," she claims.

Each of the eight institutions has individually implemented their own Principia installation using a common set of architectural standards, based on Sun Microsystems Unix workstations running Informix as an underlying relational database engine.

At the Federal Home Loan Bank of Pittsburgh, end-users access Principia's back-end Sun server via Sun client workstations on their desktops or Microsoft Windows-based PCs equipped with X-terminal emulation software.

Group of Eight

The group of eight comprises the Virginia-based Office of Finance together with seven regional home loan banks in Atlanta, Boston, Cincinnati, Des Moines, Indianapolis, New York and Pittsburgh. The remaining federal home loan banks decided to search for their own derivatives systems independently of their peers.

"Principia distinguished themselves in two important respects, as far as we were concerned," says Sherrie Narayan, assistant product development manager at the Federal Home Loan Bank of Pittsburgh. "They were able to deliver nearly 100 per cent of the functionality we were looking for today, as opposed to having to work with us to build it into the system. Secondly, they really knew our business and understood our requirements."

The Principia system's derivatives credit risk analysis capabilities also set it apart from its competitors, adds Narayan. Most other vendors offered to build in such credit exposure management capabilities specifically for the federal home loan banks, she says, but Principia already had such functionality.

As well as its application modules, Principia offers its clients a proprietary database of historical derivatives prices. Users at the home loan banks can access this market data service via a dial-up modem link. Information from this centrally stored cache is then automatically downloaded and stored in the Principia system's underlying Informix relational database. The Pittsburgh home loan bank runs its end-of-day portfolio revaluations and market risk reports based on this information, says Narayan.

Principia's database includes standard derivatives data such as swap yield curves, swap spreads, credit ratings, securities rates and interest rate futures prices. It also contains some nonstandard derivatives information such as interest rate volatilities, according to Principia officials.

Federal Debt

The U.S.'s federal home loan banking system comprises 12 regional home loan banks and the Office of Finance, which acts as a focal point for the banks' debt issuance. The office issues structured notes and bonds, lending the resulting funds to mortgage providers such as savings and loans institutions. The system was set up in 1932 after a wave of bank failures.

Notes issued by the federal home loan banks are subsequently hedged in derivatives markets to insulate the system from adverse interest rate movements, as well as to lock in low-cost funding. The home loan banks are using Principia to model and manage their assets, including short-term loans that are periodically adjusted and rolled over to account for principal and rate changes.

"We have some pretty complex structures on our books, primarily interest rate swap-related products such as inverse floaters, index amortizing swaps, dual index swaps and other debt products with embedded caps and floors," says Narayan.

Home loan banks can use Principia to value such transactions and decompose them for structuring and hedging purposes, she adds.

Narayan was a member of the federal home loan bank steering committee that was formed nearly two years ago to carry out the joint derivatives system evaluation project. This team undertook an extensive review of the participating banks' organizational structures and systems environments. It then formally defined the home loan banks' requirements in a request-for-proposal that was sent out to around 20 systems vendors, she says.

Around 12 vendors responded to this document. Six were chosen for a second round evaluation based on the banks' refined set of requirements. The project team then visited three shortlisted systems vendors at their head offices before making their final decision. Although she declines to name the short-listed systems, Narayan did say that offerings from C·ATS Software, Renaissance Software, Kamakura Associates, LOR/Geske Bock and Infinity Financial Technology were originally considered.

Principia Partners was officially registered as a limited liability company in January 1995 by 11 original members of Republic National Bank's derivatives trading and systems groups. However, development of the Principia Analytics System began in 1990 at Mercadian Capital, a derivative products trading company that was initially backed by the U.S.-based New England Mutual Life Insurance Company.

Many of Principia's 14-strong staff originally came together at Mercadian. This group worked together to develop a Unix-based system that would support all Mercadian's derivatives operations, including trading, decision support and processing. Republic took over Mercadian in 1993 – the systems group remained intact at its new parent and continued to develop Principia's functionality and architecture.

"From the outset one of our key design goals was to build a unified valuation framework within the system so that all products were being looked at from a consistent conceptual framework," explains Woodward Hoffman, head of Principia's technology development. "It's critical to know that you're comparing different products on the same basis."

Few Details

In late 1994, this group negotiated its departure from Republic. They left the bank on amicable terms, according to Adams. She declines to provide any further details regarding the Principia team's departure from Republic. In particular, Adams declines to comment on whether the group compensated the bank in return for rights to the Principia system, or whether the bank has taken an equity stake in the venture.

The Principia system continues to be used globally by Republic for integrated front-to-back office derivatives trading and risk management systems support, according to Adams.

She says that no one factor could be singled out as the primary reason behind Principia's founders leaving Republic to launch their new venture. After building a profitable global derivatives trading organization at Republic Bank, the group's founders were looking for new business opportunities, she says.

'Competitive' Pricing

By late 1994, Principia's founders believed that the market timing was right for their application to compete favorably with rival offerings. Despite industry rumors that Principia charges considerably less than rival vendors, Adams says the system is marketed based on its functionality and performance and that it is priced "competitively" with other similar highend Unix-based derivatives systems.

The Principia Analytics System was built using objectoriented design techniques and is coded entirely in C++, says Hoffman. Starting out fresh in 1990 was a big advantage for the developers, he adds, as the system contained no legacy code.

The development team designed a proprietary software layer that integrates Principia's objects with its underlying Informix database. This interface has also proved to be an advantage for the vendor in the long run, says Hoffman.

Not Much Middleware

"There wasn't much in the way of such middleware available in the market at the time we began building Principia," he comments.

"So we developed a fair amount of proprietary technology to manage object persistence. It's proved to give us a tremendous amount of flexibility over the years in terms of enabling us to keep with current product innovations," he says.

"We're always expanding the product's scope, adding new features and refining what exists. It's sort of a philosophical maxim in this market that when a product stops evolving and growing, it dies," adds Hoffman.

Principia Partners

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Principia Debuts Its Derivatives System at Eight Home Loan Banks

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