Complex Derivatives Tamed

Paris - September 2, 2002 - Banks serving institutional and corporate clients often compete on their ability to provide high value-added solutions. The design of such solutions drives financial innovation and frequently translates into complex financial products. The challenge for wholesale banks is to deliver tailored solutions within the window of opportunity, while controlling costs and risks.

According to Mr. Alvise Munari, London-based head of European structured products at Goldman Sachs, quoted in Risk (July 2002, page 22), "the number of participants in the exotic [equity derivatives] market has more than doubled over the past year." A widening range of financial institutions is therefore confronted with the challenge of designing, pricing, and processing complex derivatives.

Complex derivatives present two significant business challenges:

• Communication. Banks and their customers lack a concise, precise, and complete description standard for complex products. Natural language (e.g., English) documents exchanged between market participants, such as term sheets and confirmations, are often incomplete or ambiguous, and expose banks to significant legal and operational risks. A formal product description tool is needed to improve communication between parties and to help "debug" legally binding natural language documents.
• Process Automation. Competitive intensity in capital markets often decreases as the volume of transactions in a new class of financial instrument exceeds a certain level. Beyond that threshold, banks that rely on manual processes generally face rising costs and operational risks. Consequently, banks risk losing business precisely at the point where competition recedes and margins become more attractive. In order to compete in markets characterized by such "winner takes all" dynamics, banks need to commodify new products as quickly as possible. This can be achieved by building systems that decouple contract definitions and processes. A process is a task such as pricing or operational management that manipulates contract definitions.

Computer models aiming to encapsulate the definitions and behavior of financial instruments have been developed by banks and vendors in recent years. Many of these initiatives did not meet expectations for complex derivatives because the resulting models lack a crucial property: sophisticated contracts cannot be assembled from a small set of simple elements that processes know how to manipulate, regardless of the contract's complexity. This means that the introduction of a new financial instrument requires that all processes be reprogrammed for this instrument.

One solution to this difficult problem comes from programming language theory, a discipline that, until now, has had little interaction with the world of financial derivatives. The authors of the first paper that draws insights from the study of programming languages to describe and process financial contracts are Simon Peyton Jones of Microsoft Research in Cambridge, Jean-Marc Eber of LexiFi in Paris, and Julian Seward of the University of Glasgow. The paper entitled "Composing contracts: an adventure in financial engineering" received the Best EAPLS (European Association for Programming Languages and Systems) Paper Award at the PLI 2000 Conference (Principles, Logics, and Implementations of high-level programming languages) held in Montreal in September 2000.

One of the authors, Jean-Marc Eber had been developing the idea of a formal contract language for nearly ten years at Société Générale, a leading French bank. In April 2000, he founded LexiFi in Paris to create the Modeling Language for Finance (MLFi), a programming language for describing financial contracts. MLFi was awarded the Software Product of the Year Award 2001 by Risk, an influential publication in the area of financial trading and risk management.

MLFi accurately describes sophisticated capital market, credit, and investment products. MLFi captures the essence of financial contracts with a set of less than twenty core constructs or "primitives" that may be used to both describe and manage complex derivatives. By decoupling contract definitions and processes, MLFi simplifies the development of structuring, trading, back office, document processing, risk management, e-business, enterprise application integration (EAI), and data warehousing solutions.

About LexiFi

LexiFi provides software and services that enable financial institutions to structure, price, and process complex financial products. LexiFi has developed the Modeling Language for Finance (MLFi), a precise formalism that exhaustively describes sophisticated capital market, credit, and investment products with a limited set of core constructs. LexiFi's award-winning offering allows banks, securities firms, and buy-side organizations to keep pace with financial innovation, while controlling costs and risks.