Financial Plumbing

Open-source’s impact on quantitative finance

Originally published in the September/October 2012 issue

Financial services software is typically very large, very complex, and requires a lot of people with deep and in-demand skill sets to build and test it. Because of these high barriers to entry, what has resulted is little innovation or new vendors in the risk and trading analytics space. Most of the key solutions in the market are legacy systems from the early 1990s, and a staggering 46% of IT spend goes to in-house development.

The key development in approaches to risk analytics today is the adoption of software under an open-source license: it is free to download and use, and does not require a commercial contract with any user. Yet this approach provides all of the functionality that users would expect from a sophisticated, production-grade risk analytics platform. As such, there is increased interest from investors who share a vision of radically disrupting the quantitative finance market.

Last month, OpenGamma closed a $15 million Series C investment round led by ICAP plc. This is significant progress for the company, and similar providers, as it raises awareness around the crucial implications open-source poses for the hedge fund world at large.

Impact on investors and risk space
Limited partners (LPs) are squeezing hedge fund fees, and it’s much harder for most strategies to deliver significant alpha when global interest rates are hovering around 0, than it was 10 years ago. As a result, hedge funds are looking for cost reductions in every part of their operations. They can no longer justify bloated IT infrastructures, or building and maintaining expensive in-house systems. More to the point, many hedge fund portfolio managers task their IT departments with one goal: build a Tier-1 investment bank-grade trading and risk infrastructure without the Tier-1 IB annual costs.

Open-source is a natural solution to this challenge: it is perfect for ‘plumbing’. Instead of rebuilding what everyone else is building without gaining any proprietary value, hedge funds can optimise their IT spend and aim at the 5% to 15% of the technology stack that is specific to their trading strategies and helps generate alpha – their ‘secret sauce’. Open-source can handle the rest.

On the other hand, regulators and partners are all demanding more clarity on risk management and the underlying numbers. Traditional black-box solutions simply don’t work any more. In the context of risk management, open-source means that every calculation, and the code behind it, is transparent. Not only canthe user see the underlying code behind all calculations, they also have complete freedom to change the code to fit their requirements. No more questions as to what goes on inside that box, and how the risk numbers are calculated. When everyone knows what happens under the hood, users can feel confident trusting the results they get out of the system (and not just have to take a vendor’s word for it).

Ultimately, an open-source de facto standard for quantitative finance will ease reconciliation between the front and middle offices. In an ideal world, the number the trader sees before he executes a trade is guaranteed to be consistent with the number that the risk manager sees the day after. There is no more arguing back-and-forth over whose number is correct.

For many of those reasons, one of the key maturity signals that LPs look for in choosing hedge fund managers is the quality and source of their risk infrastructure; firms that have outsourced that part of their technology stack have often been seen as lower in the maturity curve than firms that have invested in-house, for many of those reasons. The combination of the maturity of a technology stack, the sophistication of models, and the transparency for firms is now perceived favourably by the next generation of LPs.

Fundamentally, if done right, open-source leads to better software. Open-source benefits from an ethos of shared knowledge and continuous development. This means that bugs are identified and fixed faster and, because of the open discourse of the projects and open nature of the communities around them, decisions are more democratic. A vibrant community can contribute much more value than a single vendor. Naturally, building and nurturing this community is key to the success of any open-source company.

Impact on hedge funds
As hedge funds continue to assess available open-source technologies, a few key components should be considered: asset class coverage, robust GUI tools, pre-built risk models, trade data connectors, and hosted services. Until now, the active adopters have been sophisticated hedge funds in the market (more than $1 billion in assets). Satisfying the portfolio and risk managers at these types of funds proves the technology really works. However, open-source vendors should also look toward a cloud-based/SaaS (Software as a Service) offering suitable for smaller hedge funds, or those without in-house IT teams. When these releases are available, they’ll have the same responsibilities: the same technology, backed by the same software, as used by the most sophisticated market participants, with a seamless upgrade path.

As with any open-source project, resources are necessary for hedge funds to independently evaluate the product. This means improving documentation and communication channels, as well as developing training packages. Some firms take at least a year to do an initial implementation; and the goal should be a 10-minute download-to-joy experience. All of this allows the user to get familiar with the platform without being subjected to endless sales calls – unless they want to be, of course.

For any open-source company, remaining independent, and truly open, is paramount. Customers greatly value the neutrality and transparency that open-source players contribute to the industry. Open-source vendors (OpenGamma included) need to be extra vigilant to not sacrifice any of the areas users want them to support in the technology ecosystem – from market data, to trade processing bridges, to integration with back-office and portfolio management systems – regardless of external investors. OpenGamma’s investors, ICAP included, believe in this vision and potential customers should continue to see us work with all firms, including ICAP competitors.

The pace of change in the markets shows no signs of slowing down. Hedge funds are required to react to changing market requirements,new regulations, and new investment strategies faster than ever before. The flexibility offered by open-source technology is the perfect answer to this challenge.

Kirk Wylie is co-founder and CEO of OpenGamma, a London-based company providing open-source software for trading and risk analytics. Wylie is a Silicon Valley veteran and has spent a number of years working on risk management technology in the financial services industry.