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Hedge funds derivatives boom will drive fresh IT spending

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US brokerage firms will generate USD 33.2 billion from derivatives related revenue in 2006 as the rapidly growing market catches up with the cash market.

US brokerage firms will generate USD 33.2 billion from derivatives related revenue in 2006 as the rapidly growing market catches up with the cash market.

According to new research from TowerGroup, Wall Street has made record profits from derivatives and structured products in the first three quarters of 2006.

‘We are seeing enormous demand for derivatives from the buy-side, particularly relative to hedge funds, following the relaxation of restrictions on using derivatives for managing money,’ said Dushyant Shahrawat, research area director of the Securities & Capital Markets research service at TowerGroup.  ‘Yet, for many, the derivatives market remains an enigma that is both overly-complex and difficult to grasp.’

Shahrawat continued: ‘Playing the derivatives game requires a strong balance sheet for structured products, ability to execute and process trades, talented and innovative people to generate ideas for clients, and a strong cash business as support. Brokerage firms that will succeed in the market will have the vision to combine cash and derivatives under the same management, so expertise is leveraged across products and clients can be serviced across the entire capital structure.’
TowerGroup this week published three reports on the topic: ‘Derivatives 101: A Crucial Primer’; ‘The Derivatives Revolution: Trends, Brokerage Offerings and Future Growth’ and ‘Technology in Derivatives: Poised for an Extended Period of Growth’.

TowerGroup believes the derivatives market is currently at the tipping point, on its way to coming into its own as an asset class. The notional value of derivatives globally grew to USD 270 trillion in 2005 from USD 98 trillion in 2000. Over the next three years, TowerGroup expects buy-side derivatives usage to explode, bolstered by the shift to electronic trading, search for alpha, and more accommodating regulations (such as changes to ERISA and the adoption of Prudent Investor Rule), which allow derivatives usage in pension funds and institutional money management.

Highlights of the research include:

  • TowerGroup estimates between 8-10% of U.S. sell-side revenue in 2006 will be driven by derivatives.  This growth will have enormous implications for the technology decisions sell-side CIOs make in forthcoming years. TowerGroup estimates derivatives related IT budgets at sell-side firms will grow rapidly over the next few years already evident in the derivatives rearchitecture projects currently underway on Wall Street.
  • Derivatives are energizing the agency brokerage business and Wall Street firms have been leading their buy-side and hedge fund relationships with derivatives offerings. TowerGroup research indicates that brokerage firms are aggressively bolstering their derivatives staff and expertise which is reflected in derivatives personnel salaries going up by 30-40% over the last 2 years.
  • Globally, there is enormous disparity in derivatives usage. Not surprisingly, U.S. and European firms lead usage over rest of the world, followed by Japanese institutions. Yet TowerGroup believes the fastest growth area for derivatives globally will be seen in emerging markets.
  • TowerGroup estimates global IT spending in derivatives will grow 18% annually over the next three years – much faster than the 4-6% for equities and fixed income. Top areas of spending will be risk management, processing and pricing/analytics.

Background note:
TowerGroup is an advisory research and consulting firm focused on the global financial services industry. Headquartered near Boston in Needham, Massachusetts, and with offices in North America, Europe, and the Asia-Pacific region, TowerGroup serves a global client base.

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