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vice president, risk solutions, SunGard's capital markets business

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Risk Management: Making Sure the Tail Doesn’t Wag the Dog

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This blog post originally appeared on TabbFORUM.

Risk can and should be seen as the core of a financial institution. The management of risk has become an industry in itself, led in turn by regulatory drivers, technological advancement, trading floor developments and quantitative research. In this blur of evolution, it is easy to lose sight of exactly what is required of the risk department, and it is worth taking a step back to refocus on what is important.

There has always been a risk function. The key to that function is ensuring that the firm takes risks commensurate with the risk objectives as spelled out by the management of that firm, and that there is sufficient liquidity within the organization to withstand those losses that are reasonably foreseeable.

When risk management was primarily concerned with prudence in granting loans and investment diversification, there were challenges – but these were generally well understood, to the extent that many of the quantitative methods used by funds without derivative exposure are more than 30 years old. The use of derivatives, however, introduced the need for a new level of analytics, started as an offshoot of the trading desks themselves, and moving through being a trading strategy to becoming the central plank of the regulatory reporting requirements across the world. These requirements now include:

  • VaR (and various VaR derivative measures, such as VaR Shortfall)
  • Stress testing
  • Tail analysis
  • Sensitivity analysis
  • Liquidity stress testing
  • Potential future exposure
  • CVA

The essence of the risk management function though, remains the same, ensuring that risks are in line with what is now known as the “risk appetite” and that there is sufficient liquid capital available to mitigate losses that will inevitably occur as a result of taking those risks. This is fundamentally a human activity, a fact that can become lost within the overgrown architecture of many modern risk infrastructures. The first step to re-establishing the function as an efficient, people-led one is to understand how badly planned technological deployments hamper that intention.

The key barriers to risk efficiency are:

  • Too many disparate data sources leading to risk analysts spending much of their time ensuring that various systems have produced results and aggregating those results (a process that in itself often leads to significant loss of accuracy).
  • Black-box processes make the validation of the risk results difficult to check. This is a particularly thorny issue, as results indicating no issues do not attract the same level of attention as results pointing to potential breaches of risk limits. Given the potential impact to the business, these investigations are conducted in pressurized situations.
  • Regulatory reporting has increased in response to the crises that have hit the financial world, from Barings collapse to the recent credit crunch. As regulators seek to protect the system from individual firm failure, the amount of time spent complying with the rules has risen exponentially.

The dichotomy is that the need for technology has never been greater. The power and speed available now should enable risk systems that allow risk management to view, analyze, understand and communicate risk profiles in a way that promotes their function far above regulatory compliance and (back) into trading and portfolio strategy. To achieve this, the technological stack must enable certain core capabilities.

  • Processes that can be automated should be both automated and subject to audit and reporting – manual aggregation leads directly to operational risk. Communication systems and protocols now exist that enable almost any systems to speak to each other, with reporting and feedback available. As long as reporting on these systems exist and are available as standard daily outputs, there should be little to no human involvement in data aggregation.
  • Risk reporting should allow for “deep dive” investigation of the risk profile by risk analysts – this should be one of the core activities of the department and should allow sources of risk to be identified, whether those sources are related to the risk-generation process itself…
  • Trade representation
  • Market data
  • Risk methodology

…or actual trading positions affected by:

  • Individual, identifiable trades or positions
  • Risk factors impacting the portfolio as a whole
  • Risk management should be able to communicate both the risk position and the risk appetite across the organization – along with risk investigation; this should be the main activity for the risk department. It is exactly this communication that creates the platform for the chief risk officer and the board to determine the risk appetite itself, and to express that appetite in the terms and language of the risk reporting. It is equally important that the risk takers are kept informed of the same risk positioning in order that they use the risk system and its results as a critical input into decision making.
  • Risk management needs the ability to make trade corrections on an intraday basis. In order to achieve the level of credibility required for risk to become a strategic tool, when errors in the input data are discovered, they must be corrected and the risk made accurate. The correction capacity for the risk analysts has to be built, in a compliant way, into the risk architecture.

The current technology makes the above possible, with the recent increases in computation speed, data storage capacity and quantitative sophistication all available to complement online reporting and communication. In short, the technology has finally caught up with the needs of the industry – as long as existing, inefficient infrastructure and the regulatory pull on resources allow for what is available to be deployed intelligently across the organization.

Risk management, as a central financial function, has never enjoyed as high a profile as it does at the moment, but it also has never had the barrage of issue to deal with simultaneously. As long as the technical designers remember that the technology must empower the human activity that is risk management, then the outcome can and should be truly effective and credible risk structures acting as the nervous systems of the firms they exist within.

vice president, risk solutions, SunGard's capital markets business

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Beware the Ides of March: A Warning about Central Clearing from 44 BC

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This blog post was originally published by DerivSource.

In March of 44 BC, Gaius Julius Caesar was killed on the steps of the Forum of Rome – before his ambition to centralize power in the Republic, removing the checks and balances of Roman politics, could be fully realized. It is striking that the date for mandatory clearing is set for mid-March 2013, and there are clear parallels to March 15, 44 BC, better known as the Ides of March.

Crossing the Rubicon

In present day, the road to mandatory clearing began in the aftermath of the credit crisis, and is a central plank of the Dodd-Frank Act and plays a role in many new market reforms across the globe. In essence, its ambition is to remove the systemic risk created by the multitude of opaque bilateral agreements and collateral agreements characteristic of the OTC derivatives market previously. The solution the regulators devised was to take the largest pool of derivatives and to have their trading, clearing and margin/collateralization run centrally through central counterparties, whose overall level of financial health and liquidity could be better tracked by the regulatory bodies.

This backdrop is remarkably similar to the situation in ancient Rome, as a system designed around democracy and accountability had become mired in dishonesty and strife, as Sulla and Pompey fought for supremacy in the most powerful city-state in history. Caesar’s decision to cross the Rubicon River with his legion intact, essentially an act of insurrection, was seen by many, including Caesar himself, as the only way for Rome to maintain its lofty status on the global stage.

I came, I saw, I conquered

In both cases, the battle was fought and the victors were named. In the U.S. financial markets, swaps will be cleared centrally beginning in mid-March 2013 for all institutions with notional trading of 8bn or above, as well as some smaller specialized trading vehicles where the activity is deemed risky.

The margin will, in part be decided by each CCP using a VaR-based method, replicating the method previously used to calculate regulatory and economic capital. This margin is calculated by the CCP, and while member futures commission merchants can dispute the amount on behalf of themselves or their clients, it is not a bilateral collateral dispute as has been the case, but a notional dispute. The margin requested by the CCP must be paid.

Again, there is an echo from the move from republican to imperial rule of the Roman Empire. Caesar and his supporters saw that Rome had become weak and that it needed stronger, more centralized leadership, which in theory would remove the corruption of the elections but would retain a senate as a nod towards the system that had served the Republic through its massive expansion.

Experience is the teacher of all things

What lessons can be learned from the violent demise of one of the most celebrated tacticians in history?

Seismic changes, regardless of intent, need to carry the mass market with them. In Gaius Julius Caesar’s case, the political change was too dramatic for the senate, and it was to be his heir Octavian who would become Rome’s first emperor.

In the case of central clearing, there are the means available for the FCMs and their underlying clients to replicate, validate and maintain a check on their required margins. As long as such remedial actions are taken, the switch to a systemically safer swaps market in the twenty-first century should be considerably less painful than the change from republic to empire in Rome 2050 years ago.

senior product specialist, SunGard's capital markets business

For a Competitive Advantage, Firms Require Integrated Compliance and Surveillance Systems

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In the wake of a long series of high-profile international failings in market conduct and outright fraud, the Hong Kong capital markets are today under increased scrutiny to ensure trading in the region remains fair, transparent and orderly. The key overarching objective in Hong Kong – and around the world – is to ensure investor trust remains high.

A few incidents that have touched the region recently are high-profile anti-money laundering failings at international levels, suspected collusion in the process of setting interbank interest rates, and identified failings of monitoring and reporting positions.

Whether the resulting regulatory action is a fine or a criminal prosecution, individuals, firms associated with those individuals, and the firms themselves that are found guilty are subject to not only financial damage but reputational damage as well. The press is increasingly monitoring and reporting any suspected and confirmed misconduct within the industry. Ultimately, they also provide fuel to the movement to clamp down and excessively regulate the whole industry.

Another trend is also emerging: customers are increasingly asking a firm about its compliance policy and processes before deciding to commit to long-term and/or large-scale investment services. After all, you don’t want to find that your investments are involved in scandalous insider trading or used by the firm to finance expensive fines.

FIND OUT: What is effective surveillance?

Clearly, there is now a business case for actors within capital markets to invest in efficient surveillance systems.

Compliance solutions must be able to analyze a firm’s trading activity and the effectiveness of its trading strategies, ensure that trading activity falls within regulatory frameworks, and comply with corporate ethics of the company. The system also needs to be integrated with other compliance tools – such as pre-trade risk, social media surveillance, staff dealing and customer due diligence – to give a complete picture of regulatory risk and the ability to demonstrate a comprehensive approach. Finally, firms need a strong compliance and regulatory function. This will also help them demonstrate their corporate responsibility to employees, regulators and the public.

Compliance systems must demonstrate enough flexibility, performance and capacity to cater for future regulatory changes and business requirements, including the anticipated growth in the amount of data that needs to be processed in real time.

For the visionary organization, a well-functioning and integrated compliance and surveillance solution is becoming an important opportunity to get ahead of the competition and – perhaps even more importantly in today’s climate – also a way to demonstrate a company’s full commitment to corporate responsibility and engagement in the evolving regulatory landscape.

After all, how can anyone properly participate in the regulatory legislative process if they don’t fully understand market activities and trends, including their own firm’s contributions? This is true for participants, market venues and regulatory authorities alike.

vice president, SunGard’s capital markets business

Why the EU’s Rejection of EMIR is an Explicit Endorsement of Dodd-Frank

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This blog post was originally published on FOW.

The EU rejection of EMIR on February 5, 2013 is specifically directed at non-financial companies, such as airlines, agriculture firms and other corporates that use derivatives to hedge against commercial activities. The ruling likely provides much-deserved relief to non-financial hedgers by modifying, reducing or potentially eliminating a threshold-based clearing obligation.

Under the European Markets Infrastructure Regulation (EMIR), Article 10 prescribes that where a non-financial counterparty takes positions in OTC derivative contracts and these positions exceed a defined clearing threshold; the non-financial counterparty must notify authorities and clear all future derivatives. In essence, the non-financial counterparty is “knocked-in” to mandatory regulations based exclusively on volumetric considerations.

This rejected knock-in schedule which effectively changes the status of a non-financial end-user to a more substantively regulated entity is at odds with similar Dodd-Frank provisions under U.S. law.

Under Dodd-Frank, the end-user exception is less prescriptive and generally allows bona-fide end-users to maintain their status regardless of any notional-based threshold. That is, end-users using swaps to hedge or mitigate commercial risk will generally not be required to clear their swaps even in the instance that a certain threshold is breached.

Compared to EMIR, the Dodd-Frank end-user provisions provide for more trading certainty by allowing end-users to maintain their status as end-users perpetually, based on activity-based analysis rather than an aggregate notional value perspective.

Another issue that was explicitly rejected by the EU was the aggregation of thresholds that would knock end-users in to a compulsory clearing regime by combining all asset classes. This proposed requirement was likely the most contentious. The asset class aggregation proposal contemplates significant burdens onto firms that are at risk of implementing systems to account for only a de minimus activity in one asset class just because its activities in another asset class have exceeded certain notional limits.

The EU’s rejection of the technical standards, as it relates to commercial hedge activities, now provides market participants with more clarity that the rules should be, and are being harmonized across borders to avoid regulatory arbitrage. More significantly, market participants now have additional regulatory clarity based on their status, such as Dodd-Frank prescribes, as opposed to extreme variability and uncertainty, as was proposed in EMIR and now rejected by the EU.

This is an important development. The stage is now set to harmonize the cross-border application of the end-user clearing exception. For example, end-user market participants, or alternatively, their agents, will likely move quickly to implement hedge strategy operational processes, including data collection of inter-affiliate swaps, swap guarantee accounting and straight-through reporting, while maintaining consistency of a perpetual status.

vice president, SunGard’s capital markets business

Are Your Collateral Management and Hypothecation Methods Ready for Prime Time?

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This blog post was originally published on TabbFORUM.

For many sell-side capital markets participants, collateral management has emerged as the most profound business requirement of 2013. For the buy-side, and depending on the final rules and participants’ functional capabilities, collateral optimization may be one of the most prolific revenue opportunities presented in years.

This opportunity is apparent because while global regulatory mandates are changing (or have changed), certain customer asset protection and segregation requirements explicitly allow counterparties to contractually control the velocity and impact of their pledged collateral. This is significant because contractual control over collateral may transcend to cost reductions for collateral pledgers as well as enhanced revenue channels for those who conduct lending, facilitation, prime and transaction services.

Taken together, collateral optimization and collateral management are different opportunities viewed through the same lens. The greatest challenge of mutualizing the instant opportunity is the ability to conduct proper and perpetual cost-benefit analysis that appropriately weighs the buy-side collateral management levers with the sell-side regulatory-driven constraints. In other words, collateral optimization is a function of measuring and contemplating whether hypothecation, control and related waivers are worth the implicit costs.

What is Hypothecation?

Hypothecation refers to the pledging of collateral to secure an obligation. For example, hypothecation occurs when a hedge fund pledges and posts eligible collateral to its prime broker to secure a trading portfolio, with or without rights to borrow against these secured assets.

Beyond the direct collateral posting and collection phase (hypothecation), comes the potential for a subsequent re-use of the pledged assets. This process is known as rehypothecation, and refers to the re-use or re-pledging of the subject collateral. There are practical implications of rehypothecation that include both risks and benefits.

Rehypothecation Benefits and Risks

On the benefit side, participants share economic incentives to enter into facilitation, prime and transaction services that permit the commingling and rehypothecation of posted collateral. This contemplates additional revenue opportunities for the prime broker by leveraging the client’s pre-pledged collateral assets for the purpose of backing the broker’s own trades and/or borrowing activities. In turn, the pledger benefits through reduced capital or transaction costs, and likely more economically favorable borrowing or transaction terms.

Therefore rehypothecation has good business justification, but the benefits are not without certain risks. For instance, rehypothecation necessarily involves the commingling of client assets because in order to leverage the assets, a service provider, for instance a prime broker, must have a security interest in and a contractual right to re-pledge.

In addition to the pledger’s waiver of certain rights, namely commingling and subordination, rehypothecation includes other risks including a potential default, insolvency, or the inability to return the pledged assets based on systemic risks within the rehypothecation chain. As a result of this balancing, visibility of all relevant collateral should be managed through a collateral optimization engine and be capable of reconciling the cost benefit paradigm in addition to the requisite inventory, valuation and collaboration functions.

The Rules Create the Potential Opportunity

On its face, hypothecation rules as they relate to swaps and security-based swaps have become more prescriptive through the enactment of the Dodd-Frank Act (DFA). Generally the DFA rules have either banned or significantly impaired rehypothecation by: (i) requiring customer account segregation, (ii) mandating disclosure and invocation of collateral rights; and (iii) mandating explicit limits on rehypothecation and/or investment.

For example, the Securities Exchange Commission’s (SEC’s) rule 18a-4, which applies to security-based swap dealers (with 15c3-3 applicable to broker-dealers), stipulates that a security-based swap entity’s non-covered entity counterparties’ can elect to have collateral segregated at an independent third party custodian, or alternatively, waive the right to collateral segregation altogether. Waiver also presumes a subordination agreement which relinquishes some or all priority claims and contemporaneously avoids a capital charge onto the security-based swap entity. Without these contractual waivers, the security-based swap entity may be disincentivized to provide certain collateral transformation or preferential lending arrangements – so each participant should appropriately and independently analyze its position.

Regarding cleared swaps, legal segregation with operational commingling (LSOC) generally prohibits a futures commission merchant (FCM) from permitting a lien on cleared swaps customer collateral that it holds. The prohibition would logistically restrict the FCM’s ability to rehypothecate the customer’s collateral. However, on October 17, 2012, the Commodity Futures Trading Commission (CFTC) provided interpretive guidance that explicitly allows a cleared swaps customer to grant a lien, or be induced to grant a lien or security interest in its pledge collateral. This is significant as the regulators have guided the marketplace with generalized restrictions, yet have contemplated the foreseeable circumstances where market participants utilize technology automation to analyze the cost benefit of collateral optimization on a case-by-case or counterparty basis.

Both instances of regulatory action by the SEC and CFTC seemingly endorse a “right to contract” perspective that allows and even encourages participants to independently model rehypothecation risks and benefits by using automation.

Automation is the Key to Survival

Ultimately, it is necessary for all participants considering rehypothecation, or any aspect of collateral waiver, as part of an underlying collateral management or optimization strategy to consolidate automation across business lines and asset classes. This accomplishes a true cost-benefit justification. Both buy-side and sell-side firms are moving toward automating collateral pools and portfolios, trade reconciliation, and valuation; including real-time liquidity monitoring and account segregation as distinct opportunities.

vice president, collateral management, SunGard's capital markets business

2013 Agenda: Central Clearing, Collateral Optimization, Initial Margins

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This article was originally published on FOW.

We all know that the regulatory tsunami of Dodd Frank, EMIR and Basel III is causing a fundamental change in the financial industry and to both buy-side and sell-side business models. With many of these changes coming into effect in 2013, great strain will be put on people, processes and balance sheets. Now is the time for a comprehensive look at how firms are adapting to this new reality and what their main priorities are for driving change and investment.

To put some structure around this aim, SunGard, in conjunction with the specialist risk management consultancy, InteDelta, conducted a study.  The study which was focused primarily on collateral management and optimization, investigated the readiness of the industry when it comes to impending regulatory change, the key priorities driving investment in infrastructure, and the changes to buy-side and sell-side firms’ businesses.

We set out to find answers to some pertinent questions, including:

  • What are the key priorities driving change and investment in collateral management practices? How do these priorities differ across buy-side and sell-side firms?
  • To what extent do firms feel that their collateral management capabilities are sufficient to successfully support their business in the future?
  • How are firms addressing initial margin calculation and what are the drivers affecting this issue?
  • How far advanced – or not – are firms with regard to collateral trading and optimization?

As we expected, some of the key findings validate our thinking. Others were more surprising.

On the whole, what we do know is that there remains much work to be done for most firms to get in place the infrastructure to handle the fundamental changes about to hit the OTC derivatives market and the knock-on effects on repo and securities lending.

So what is really keeping firms up at night?

Central clearing, initial margin, and collateral optimization are high on everyone’s agendas, as expected. Most investment so far has been tactical, to merely tick the compliance boxes. It appears most firms still have much strategic work to do, particularly on the sell-side. In particular, only 10% of respondent firms feel their systems and processes are complete in their ability to support the combined cleared and non-cleared model, and most are building out their OTC clearing capabilities from the existing bilateral collateral management function. Furthermore, only 21% said they have “fairly advanced collateral optimization solutions” in place. Findings like these are cause for some worry, as the regulatory clock keeps ticking and firms will only have so much time left to prepare.

Where does your firm fall on the collateral optimization, initial margin and central clearing preparedness spectrum?

CLICK HERE TO DOWNLOAD THE REPORT OF FINDINGS FROM THE SUNGARD-INTEDELTA 2012 GLOBAL COLLATERAL MANAGEMENT SURVEY.

trading and client connectivity, SunGard’s global trading business

European Equity Trading: Research and Regulation Collide

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This blog post originally appeared on TabbFORUM.

Tabb Group’s new report, “European Equity Trading 2012/2013: Changing the Rules of Engagement,” highlights some issues that we must hope politicians will note during their review of the MiFID regulations.

It’s no exaggeration to say that Tabb’s research profiles an equity market in crisis ─ arguably one that is dysfunctional in some important respects. “Lit book” trading volumes have again fallen sharply in 2012, and there has not been a correspondingly large increase in dark pool trading. So the predicament, as it appears to most buy-side firms, is one of vanishing liquidity. And the buy-side’s primary concern – as reported to Tabb – is how and where to find what liquidity is left.

There are worrying signs of a self-reinforcing downward spiral, so one objective of regulatory change should be to stop or even reverse this trend. Good liquidity, after all, usually implies tight price spreads and the best results for end investors – the people whose interests the MiFID regulations are intended to serve.

The market fragmentation unleashed in 2007 hasn’t helped in this respect, as it has spread the thin post-crisis trading across an increasing number of platforms. In the absence of a consolidated tape of traded prices, fragmentation has also posed another challenge to the buy side: a serious lack of market transparency. This, at least, looks likely to be rectified with MiFID II.

But can MiFID II help with the liquidity crisis?

At the moment, it does not look likely. Even if we put aside the threat of a minimum resting time for orders ─ which may not appear in the final regulation ─ MiFID II has worrying implications for liquidity. A central finding in the new Tabb research is that block trading is in decline, with traders instead choosing to slice large orders via algorithms and then trade many of those small slices in dark pools. It’s clear that asset managers are increasingly finding this the safest and most efficient way of implementing buy and sell decisions in major portfolio adjustments.

But the broker crossing networks and dark multilateral trading facilities (MTFs) that support this mode of trading will not be allowed to do so after the implementation of MiFID II as it’s currently drafted – MTFs and “systematic internalisers” will have pre-trade transparency waivers only for “large in size” orders. So, who knows where those fugitive smaller orders will get executed? When we consider this factor alongside the constraints on market-making activity implied by the MiFID II drafts, it seems clear there is potential for a further downturn in liquidity.

Elsewhere in the Tabb Group report, it’s positive to see the increasing focus on execution quality and the rising usage of transaction cost analysis (TCA) in measuring it – often with multiple systems now being used for cross-checking. But the liquidity concern remains: if new regulation causes further volume reductions, then the market impact of larger orders will grow and those detailed TCA reports could make for depressing reading.

So let’s hope that MiFID’s apparent mantra of “transparency at all costs” is moderated, before the costs become too high.

vice president, SunGard’s capital markets business

U.S. Banks: Hello to 2013, Goodbye to Basel III?

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This blog post was originally published in Wall Street Letter.

Industry participants that oppose the onerous and complicated requirements of Basel III may succeed in permanently eliminating a U.S. implementation. Although it is likely that enhanced capital and risk standards, as mandated by the Dodd-Frank Act (“DFA”) will be implemented, they may however, depending on certain pending initiatives, be prescribed through government and industry collaboration.

In response to a request by industry participants, the U.S. federal banking agencies, on November 9, 2012, released a joint release indefinitely delaying the January 1, 2013 U.S. implementation of Basel III.

Basel III, which was drafted by the Bank for International Settlements and endorsed by the G-20, is a comprehensive regulatory reform intended to improve the banking sector’s ability to absorb shocks arising from financial and economic stress and to improve risk management, governance and transparency in the banking sector. Although considered highly authoritative, Basel III standards are adopted and implemented by each member country, and are not universally legally binding. In the U.S., statutory authority, such as the DFA, supersedes a Basel III-type directive.

Although industry participants have asserted the complexity of many of the final rules including new risk-weights and excessively burdensome recordkeeping requirements on smaller banks, the relief granted was expressly based on the industry’s lack of understanding of the rules and additional technology requirements.

The reason for the delay granted by the banking agencies is significant because if the delay is strategically leveraged with a pending congressional bill, which stipulates performance objectives rather than behavior modification as a basis for adequate regulation, the stage is set to permanently oust Basel III, and its intricate requirements, from the U.S.

The saving grace for industry participants opposed to Basel III may be a little-known bill titled the Independent Regulatory Analysis Act, (“IRAA”).

If passed, IRAA will provide an unprecedented authority to influence policy and rulemaking functions of regulatory agencies, and would constitute an expedient limitation on the authority of regulators to promulgate rules. IRAA purportedly seeks to create a check and balance approach to the promulgation of excessive, redundant and overly burdensome regulations. Non-statutory regulatory directives such as Basel III would likely qualify for independent review under IRAA.

The Basel III delay is a manifestation of contemplated additional or burdensome technology requirements. Industry participants should react by promoting internal models that measure and manage capital adequacy, risk management, governance and transparency – all of which are prescribed under the Collins Amendment to the DFA.

The Collins Amendment, which is a provision within DFA, effectively sets a capital floor and establishes minimum leverage and risk-based capital requirements for insured depository institutions, bank and thrift holding companies and systemically important non-bank financial companies that are not quantitatively lower than were in effect on the date of the DFA enactment. The result is the imposition of more stringent capital requirements on financial companies, as well as swap dealers and non-bank financial companies deemed to be a potential systemic risk. Given that Basel III and the Collins Amendment conflict in some instances, in the U.S. divergent issues will likely favor the Collins provisions.

Some argue that the predecessor of Basel III, known as Basel II, contemplated erroneous and insufficient standards of internal modeling to compute risk-based capital requirements and has imminently failed to provide adequate protections. Therefore, the enhanced Basel III requirements are necessary to account for capital exposures that have previously caused an adverse effect on the U.S. economy.

Conversely, the indefinite delay of the U.S. implementation of Basel III together with the pending congressional mark-up of IRAA indicates that now is the time for Basel III opponents to promote broad and simplified alternatives to calculating risk-weighting and sensitivity that is substantially similar to the pre-existing allowance of internal models for counterparty credit exposure, operational risks, margin lending, and repo-style transactions.

While you’re here…

solution specialist, SunGard’s capital markets business

Prime Services: Is Your Business Ready for 2013?

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This blog post originally appeared on TabbFORUM.

Though hedge funds and the prime brokerage industry have not escaped the turbulence of recent years, they are both in relatively good health as we approach the end of 2012 and look ahead to 2013.

In the aftermath of the global credit crisis, hedge funds and their investors began to concentrate on counterparty risk and their exposure to service providers. Many hedge funds, if large enough, began to spread their positions across multiple prime brokers. At the same time, the larger firms’ appetite for offering prime brokerage services to small hedge funds was diminishing. This presented opportunities for some of the smaller firms and created an opening for new prime services entrants to the market.

Today, hedge funds have become some of the most important customers to many banks and brokers, whether they offer prime brokerage services or not. Many of the larger hedge funds will be paying substantial fees and commissions to their brokers and financiers.

At the same time, competition for business between prime brokers has become even more tightly contested, and the demands from hedge funds continue to grow and change. Add to this the proposed and implemented regulatory changes across the globe, and it is unsurprising that prime brokers are seeking new ways to differentiate the service levels they provide.

Meeting these new demands is expensive and time-consuming for even the largest prime brokers. Much of this is due to the nature of the prime brokerage systems being used today; many are a conglomeration of legacy systems, vendor point solutions and in-house development. Meanwhile, the clients and businesses these systems support have become ever more sophisticated and varied.

Today, we are seeing a transformation of the prime services business model. Both the demand, and the available services, are moving from an all encompassing one-stop-shop model to one with a number of different flavors of prime service provider, whether they be prime brokers, prime custodians or boutique offerings handling specific aspects of the operational support.

As the world covered by prime service providers expands, the need for a multi-asset class core system which is smartly designed and volume insensitive has only increased. For instance, aside from the requirement of 24-hour support, the provider must provide a consolidated view of the clients’ business for both reporting and internal risk assessments. At the same time, clients are now more demanding of a consistent level of service in all locations.

The challenge for all of these firms participating in prime services supply is the same: how best to connect different parts of the firm and different services and systems in a consolidated offering to their clients? With the right system in place, firms will be better positioned to react with speed to changes in client and regulatory demands. The ability to provide a consistent level of effective, global client service supported by an efficient, consolidated technology platform can be a key differentiator in today’s increasingly competitive industry.

With industry changes and new challenges mounting for prime services providers, I suppose the biggest question of all is: is your firm ready for 2013?

While you’re here…

vice president, risk solutions, SunGard's capital markets business

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Risk Management: Yippee Ki Yay, Rogue Traders

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This blog post originally appeared on TabbFORUM.

The holiday season is upon us, and with it comes a slew of reruns of classic holiday films along with the annual financial reporting season and its attendant analysis of institutions’ risk management capabilities. Seemingly unrelated? Actually, the two are inextricably linked via one of the greatest holiday season films of all time: Die Hard.

At its heart, the Die Hard franchise is a veritable case study in risk management, with stress testing and the role of an “on-the-ground” risk manager front and center.

What closely aligns the film series with practical risk management are the recurring themes of:

  • Distraction – Typically the villains engage in a more elaborate “meta plan” which fully occupies the law enforcement agencies, while they (the villains) concentrate on a far smaller, and often simple robbery
  • Automation – The law enforcement agency moves through a tried and tested “playbook” in response to the more elaborate plan, which leaves the underlying crime being committed largely undetected until it is too late

This has always struck me as being exactly the situation risk managers face. Typically, when risk tolerance breaches are detected, there is a reasonably automated response, which runs something along the lines of:

  1. System alerts a breach
  2. Breach is identified to risk-taking area (trading, portfolio management, etc.)
  3. Risk-taking area refute the basis of the breach (bad data, incorrect trade representation, bad risk models, etc.)
    1. Risk analysts scramble to check data inputs and re-validate models
    2. Risk-taking area continues with the position
    3. Risk finally (re)prove those elements in doubt
    4. Position is closed by risk-taking area
    5. Profits were made (or losses were incurred) on a position that was out of risk tolerance

It is not reasonable to suggest that every time a trader or portfolio manager doubts the risk reporting they are, in fact, using the system to maintain an out-of-compliance open position, but there are certainly cases where this is the case and even when not the case, the risk of losses from a position that was identified as out of tolerance exists and needs to be addressed.

The only way that this (deliberate or accidental) distraction play can be beaten is to start with a more transparent base for the results. This means that when the breach is identified, the underlying parameters of that breach are also identified. This would include:

  • Trades, and the representation used by the risk engines, shown in the risk reports
  • Market data used to calculate the risk disclosed within the risk reporting
  • Back-testing of risk models shown within the risk reporting

Once these areas are made open for scrutiny, it becomes much harder to simply send the risk analyst back to the risk department to check their data, and far more likely to initiate a discussion regarding the underlying cause of the risk tolerance breach. Of course, opening up the models for scrutiny can create more initial negative feedback, but does result in a far more bought-in and well-grounded risk architecture.

But back to the film. Die Hard is not just a well-made warning against distraction and automated responses. Perhaps its greatest contribution to the genre of risk management is in its attitude to stress testing.  The first, third and fourth in the series are particularly striking in this regard. It is interesting how the stress testing within the films magnifies with each installment:

  • Robbery of bond certificates using law enforcement protocols around hostage-taking to guarantee the “fail-proof” safe will open
  • Robbery of gold bullion using law enforcement protocols around threatening multiple schools, in New York to guarantee no police interference
  • Theft of electronic financial records using law enforcement protocols around an organized cyber-attack, on the US infrastructure, to avoid detection of actual crime

Each of these stress tests is dynamic and designed to test the infrastructure to failure. Each uses the technology and incentives of the time and each shows holes in the fabric of the risk management in place. These are textbook descriptions of what a financial institution’s stress tests should be designed to do.

Note that this is not the same as regulatory stress testing, mandated by the system to test that system’s resiliency, but more about ensuring that the practical risk management in place in a financial services firm is robust enough to detect, and flexible enough to operate, at the practical level, to be effective during an unexpected event. Determining exposures and risk sources at the tail in a high pressure situation should be within the remit of a risk management system.

The final lesson of the franchised powerhouse is the need to maintain human control. Notably, it is Bruce Willis’s hard bitten cop who initiates the override of the automated response and takes control of the situation, thwarting the underlying crime. This is a subtle yet compelling message to risk managers.

Risk management architecture and tools are just that: tools. They should aid the risk management, but to be truly effective, risk managers need to understand the underlying rationale for the tools, the underlying math of the risk engines and the underlying purpose of the risk management department itself.

If they can do that, they should rarely find themselves “in the wrong place at the wrong time.”

While you’re here…