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Third Party Calculation Agents

Third Party Calculation Agents have become more prevalent in the past years. Companies that run the strategy/index calculation as an outsourcing partner for the investment banks. This may not seem of great interest for the end client at first glance; however, there are some benefits to such an approach.

The calculation agent has very broad and discretionary powers. Banks that aim for a sustainable business will not abuse them, but there obviously is a conflict of interest. This excerpt is from the risk factors of an equity structured note.

If the calculation agent is the same entity as the guarantor and the issuer is an affiliate of the guarantor, potential conflicts of interest may exist between the calculation agent and the purchasers.

From a control point of view, it is an improvement to have an impartial third party involved calculating levels. It is true that the banks pay Third Party Calculation Agents, but this is a systematic process that can be verified, unlike CDO ratings for example.

The Third Party Calculation Agent can also provide some help/consulting on best practices for exception handling and some quality control for the rules to less experienced strategy providers.

In big and experienced investment banking operations, these advantages may not count for much, as they normally already follow best practices. Nevertheless, with the proliferation of smaller banks releasing Trading Strategy Indices, the potential for quality control as part of the work of Third Party Calculation Agents could grow.

For most clients, the existence of calculation agents other than the investment bank providing the investment strategy may not be significant enough to influence any investment decisions. Very sophisticated clients sometimes have to set up their own calculation spreadsheets, this could also be an area where Third Party Calculation Agents can leverage their knowledge and offer consulting services.

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Trading Strategy IndicesTrading Strategy Indices or Algorithmic Indices (TSI) or algorithmic indices or algos have become very popular in the past decade. Indices on anything from equities, rates, credit, FX, commodities and even volatility have been offered to qualified investors.

 

Technically, these strategies have a lot of similarities with traditional (beta) indices, such as S&P 500 or DJUBS. But their focus is typically less on representing a certain market, but rather on generating returns. They are segmented in enhanced beta and alpha strategies. The lines can be blurry at times though.

 

Unlike CTAs and managed futures which have trading systems that can be fine tuned and re-calibrated at any point in time, Trading Strategy Index rules are set in stone and cannot be changed once they are published.

 

There are several reasons for the proliferation and success of such strategies: On the supply side there are investment banks, that typically do not have an asset management licence and cannot offer discretionary management to their clients. So Trading Strategy Index based products became a welcome way to tap the asset management market with a new product. The fee structure is also often more akin to Mutual Funds or Hedge Funds and allows banks to generate ongoing revenue streams.

 

Selling products with 3rd party asset managers does happen sometimes, but this is not the normal focus of their sales force and often puts the investment bank into an unwanted competing position with their asset management division.

 

On the demand side sophisticated clients may want to have access to very specific trading strategies, without having to set up extensive execution and monitoring operations. Especially real money investors are often not keen on setting up complex futures trading operations that require a full time trader to watch and roll the positions. Trading Strategy Indices can also allow clients to access markets that they may not be able or willing to directly trade in. Also when clients started to get a better grasp of some of the more simple trading strategies applied by hedge funds, they were seeking for ways to access them at lower costs.

 

In a world where many hedge funds are still charging “2% + 20%” or “1.5% + 15%” there is ongoing demand for products that apparently offer similar risk and returns at a fraction of these costs.

 

The strategies employed cover a wide range. Some incorporate simple strategies, such as momentum, some offer a tweak on standard indices and others run complex optimisation strategies.
Clients looking to get exposure to Trading Strategy Indices, find a large offering of various strategies in different asset classes and different wrappers. This blog aims to provide some clarity in this topic.
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