Article
December 3, 1998: Financial Products
Principia Partners on the FAS Track
The ramifications of FAS No.133 — the US Financial Accounting Standards
Board’s derivatives and hedge accounting standard — have not
yet been fully recognized or embraced by a significant proportion of the
US corporate market. Or by many enterprise-wide risk management systems
providers for that matter. And of those firms which do recognize the ramifications,
just how many are fully prepared is a question Principia Partners LLC is
dealing with on a daily basis.
"As we launch a whole new sub-ledger to address regulatory requirements, we see that FAS 133 is becoming an overwhelming priority," says principal Theresa Adams. "A day doesn't go by that we don’t get a call to ask how our system complies with the standard. We see it as being our priority at least throughout 1999, if not throughout the following year."
Indeed, the polemic surrounding the application and implementation of FAS 133 has created such a diversion in the world of derivatives users and providers over the last few years, that many appear to be still coming to terms with the mere notion of its existence.
"Educating our current customer base to meet these huge regulatory requirements is a major focus of the firm," Adams adds. Fellow principal Brian Donnally agrees: "I don’t think our competitors are geared up for FAS 133. So many of them are concentrating on the euro and Y2K," he adds. "But we think we’re fairly unique in both our ability to handle FAS 133 — to cope with the accounting issues — and also to handle the mark-to- market aspect. The accounting-oriented firms can’t cope with the mark-to-market needs, and vice versa. We have the client base that requires this combination."
In focusing on both the new US and UK accounting rules, the firm is indeed tailoring to fit its client profile. "In general, end-users and smaller dealers are our target market," says Donnally. Principia numbers among its clients many corporate users, major US insurers with assets totaling more than US$250bn, as well as regional banks — as opposed to focusing on the major broker-dealer community.
"We do deal with some of the larger banks in terms of the risk manager who wants to validate his own trading system for existing derivatives activity," says Donnally, however. "Wall Street knows that building proprietary systems is costly. The mandate and time won’t be there to develop a system. So where a structured products desk, for example, wants outstanding independent analytics, yield curve and vol analysis, that’s where we can be of use." In this kind of situation, using independent analytics removes the conflict of interest which exists when bonuses are being paid based on what valuations are given.
PAS for FAS
Principia Analytic System (PAS), the firm’s front-to-back office trading and portfolio management solution, includes a complete set of risk management tools to value interest rate, fx and equity portfolios, and to evaluate risk under expected, historical and stressed conditions.
Donnally supplies a large part of the trading expertise at the firm. He previously managed global trading activity at Republic National Bank of New York, where he held responsibility for pricing and hedging the bank’s interest rate, currency swap and swaption portfolios. Principia uses a wide range of sources for its pricing and hedging tools, culled from Donnally’s extensive experience in the industry. These are then aggregated to present PAS clients with numbers which are representative of where the market really is, rather than where a single bank or operator indicates it is.
This catholic approach to source materials is particularly useful in the increasingly topical area of credit risk management, where disparities in valuations can be wide. As indeed can disparity of valuation methods.
Says Donnally: "We have incredibly powerful credit risk management functionality, which until recently has taken a second seat to our other risk management tools. But with the recent hedge fund problems, there is an increasing urgency in getting credit risk analytics that cover the full spectrum of products on a common platform."
PAS offers not only fully integrated market and credit risk management capabilities, but also various methodologies. According to Adams: "A lot of people are looking at alternative ways of assessing risk. For example, on the bank side — as counterparties to the hedge funds — a number like VaR may have really meant something to a risk manager. But traders never really managed by that number. No one number is the ‘be all and end all’. It takes a combination of factors. I think many risk managers who have been scrabbling around the Street are saying that a measure such as VaR can’t possibly cover all exposures," she adds. "They are now being more vocal and looking for more variety in risk management evaluation — which is where we come in."
"Risk management teams are also going to have to become much more quantitative and much more accountable," says Adams. "The principles of trading will shift and encompass the risk management function and force them to analyze on a more integrated basis."
Donnally applies a point germane to the post-LTCM hedge fund crisis to the markets in general: "The recent hedge fund debacle pointed out a common risk associated with dealing with all counterparties, which was that the situation was exacerbated because the fund was so leveraged. You have to look at all the elements of risk — for example, term structures of vols, interest rates, etc. Yes, it would be wonderful if you could look at a standard VaR for all these things but it’s just unrealistic. What our system does elegantly is manage all the areas of risk inside a portfolio — not just deltas or vegas. Risk management must be far more encompassing in order to get into the heart of where risks lie."
"We are very strong on credit spread risk management and the ability to identify the various term structures of credit spreads," adds Donnally. "Across credits, across markets, and across products."
The Basic Principals
Principia is now a finely honed version of its original incarnation. Adams, who is the firm’s marketing guru, Donnally, and the third principal of the trio, its product development expert, Woodward Hoffmann, were joint founders with John Sampson, Kenneth Sullivan, and Jeffrey Weinstock. All met up under the aegis of Drexel Burnham Lambert, where Sullivan managed mortgage-backed securities research, high grade fixed income research and interest rate products trading. Each of the six held key posts in one or more of these areas.
Sullivan left to form Mercadian Capital in 1990, a proprietary trading operation to which all of Principia’s founding principals migrated. The firm’s business was later administered out of Republic Bank.
The six formed Principia in 1995, by which time the PAS system had already been under development for several years. Adams, Donnally and Hoffman subsequently bought out the interests of the three other founders, who returned to full-time fund management.
"The restructuring allows all of us to focus our energies and resources exclusively on activities of greatest interest," said Sullivan at the time. "John, Jeff and I will concentrate on fund management, while Theresa, Brian and Woody work to expand the market for Principia’s extremely powerful software." Mercadian Capital management is a Principia client.
Customers Care
Among its recent signors, Principia counts Federal Farm Credit Banks Funding Corporation, People’s Bank, and two of the aforementioned large insurance companies. And among its longer standing users, National City Bank. Indeed, the latter cited its long-term use of PAS as a key component of its success in marketing derivatives and risk management strategies to its middle market clients.
According to Anthony Crisalli, senior vice president and managing director of the structured and derivatives product group at NatCity Investments. "The growth in our business in the last two years has been dramatic, and that is the result of our own marketing and educational efforts with customers, and the ability to give people in our organization access to excellent tools. PAS has great functionality, provides us with the reports we require, has the execution capabilities to handle the volume of business we have generated, and is supported by a company which is extremely responsive to our needs."
On the fate of Principia’s chosen industry, Theresa Adams says: "There have been a fair number of mergers and acquisitions. But we still see ourselves in a different niche, given our focus on the end-user market. In general, the vendor community is not addressing end-users. To the extent that our competitors focus on larger derivative dealers, it leaves us free to zero in on our customer base."
COPYRIGHT NOTICE: Financial Products, 3rd December 1998 © Metal Bulletin plc 1998 All rights reserved. No part of this publication (text, data or graphic) may be reproduced, stored in any data retrieval system, or transmitted, in any form whatsoever or by any means (electronic, mechanical, photocopying, recording or otherwise) without obtaining Metal Bulletin plc's prior written consent.