Solutions: Risk & Analytics

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Risk, Baseball and a Brand New Year of Opportunity

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This blog post was originally published on TabbFORUM.

It’s 2013. The days are lengthening again, and the risk world is facing an environment that is more concrete, while remaining every bit as challenging as it was before the millennium became a teenager.

The challenges faced by risk departments everywhere are well known, and include rafts of new regulations from Basel and Dodd-Frank, and data sets including the recent financial crisis, pointing to very likely high volatility in the months and years ahead, central clearing making calls to the risk management quant teams, and a low inflation/interest rate state continuing to cause anxiety in the pension world. With such a backdrop, it is easy to see risk management as an exercise in compliance at the lowest cost, but as Brad Pitt playing Billy Beane in the baseball movie “Moneyball,” demanded of his staffers: Are we asking the right question?

It is true that risk can be seen as simply calculation of “buffer capital” in the form of regulatory capital, margin, or collateral, depending on the underlying activity, but this crucially ignores the management aspect of “risk management.”

A couple areas in the financial markets illustrate this point well.

On the buy side there are the pension funds, where risk management has traditionally been based around performance and volatility tracking of fund managers against their benchmarks. Essentially, this meant that the risk management itself was really only addressing the risk of poor manager selection, rather than exploring the deeper risks of the fund as a whole. This view of risk is changing, however, as many funds face being under-funded against their liabilities as returns dry up and pensioners live longer than originally accounted for.

The question becomes one of calculated excess risk, often with derivatives being used to leverage the fund, and risk budgeting being used to allocate that excess. In a nutshell, risk budgeting involves:

  • Understanding the risk, or possible loss profile, of the benchmark of the overall pension fund. VaR or conditional VaR (VaR shortfall) is most typically used as the risk metric
  • Determining a level of risk, or increased level of possible loss, that the fund is willing to take on, to make up any underlying funding deficiencies
  • Allocating the excess risk to the underlying managers who run the assets for the fund

So far so good, but the situation is complicated by the fact that many funds use external managers who operate against alternative benchmarks. This means that for the fund to be well managed, and the risks fully understood, the central risk managers also need to understand:

  • The risk or potential loss profile of the fund benchmark (i.e. the fund assuming that it was invested exactly against its benchmark)
  • The risk or loss profile of each external manager’s benchmark (again the amount of the fund allocated to that manager, assuming investment to be exactly in line with the benchmark)
  • The basis or allocation risk between the aggregate external benchmarks and the fund’s official benchmark (this is the risk associated with the selection of the external managers themselves)
  • The risk or potential loss profile created by the external manager’s investment choices, or the stock selection risk (this is measured between the actual external portfolio and the external manager’s benchmark)

The risk budgeting itself is a mix of selecting managers with riskier benchmarks and then allowing those managers the latitude to actively increase their risky positions against their own benchmarks.  The two elements have to be taken together, and once they are, the risk profile of the fund, using well tested risk methodologies, can be fully understood, and used to actively control the increase in overall fund riskiness, in search of higher returns to make up funding gaps.

This type of risk-based fine tuning transforms risk departments from performance measurement departments into active risk controllers, adding considerable value to the business at a time when it is desperately needed. In this instance, the right question is really about solving an under-funding issue, rather than a risk management one.

On the sell side, the adoption of VaR-based margining by central clearing venues opens up many opportunities for risk practitioners to actively add value to their firms. These would include:

  • Ability to calculate the optimum venue, margin-wise, for any new trades to be cleared
  • Full control of regulator-required “independent margin”
  • Margin minimization using futures, where allowed, to offset cleared OTC trades

In both cases, on the sell side and on the buy side, risk is actively enabling informed decision making and empowering those who choose to use it in that way. Both are simply asking a different question to the original, “How do we cope with the latest requirement?”  In the case of pension funds, we are asking how best to solve the under-funding problem, and in the case of central clearing, we are asking how best to profit from the new environment. In both cases, the use of well understood risk management techniques is the answer.

In what should be an interesting year for risk managers across all sectors, the first step begins in looking afresh at the problem, seeing the opportunity and ‘getting on first base’ with the solution.

Happy New Year!

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Risk Management: Conferences, Convergence and Catastrophe

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This blog post was originally published on TabbFORUM.

Late October 2012 saw an RMA conference on risk management in Dallas, the annual FIA conference in Chicago, and a catastrophic natural disaster in and around New York. While these were separate events with very different impact levels, all three were connected by the complexity of modern risk management, what it means, and how its outputs can be understood and used.

Dallas

Conversation at the Risk Management Association event in Dallas was focused largely on developing, implementing and managing a risk appetite within a financial institution. This tackled from multiple angles, including liquidity risk, market risk and credit risk. The recurring theme of the discussions was the difficulty in developing a framework that works both top-down from an enterprise-wide risk tolerance perspective, and bottom-up from an individual risk contributor’s perspective.

Risk appetite definitions ranged across benchmarked “active” risk budgeting (VaR against benchmarks), economic capital, collateral and funding costs, VaR and VaR shortfall. As has been noted before, it is interesting that in the aftermath of a financial crisis which saw VaR receive critical attention, its use is expanding into bilateral calculation of collateral and central clearing margins.

Chicago

It was those same central clearing margins that took center stage at Chicago’s Futures Industry Association conference. As a business more used to exact calculations built on lot sizes and observable prices, the relative complexity, convexity and simulation-based margining of interest rate swaps are causing many to strengthen their technical architecture and approach. As the single largest OTC derivative class heads to the margin model, FCMs and their clients are becoming familiar with historic simulation, decay factors and look-back periods. At the same time, the margin posted is looking more and more like an alternative for economic capital, even using the same techniques to generate the number.

The VaR number itself, of course, is essentially predicting the minimum loss that would be expected to happen at the specified percentile. For example, a 99th percent VaR predicts the minimum loss that should be expected to happen once in every hundred days.

New York, New Jersey, and Neighboring Areas

As the conferences in Dallas and Chicago were happening, the tri-state area of New York, New Jersey and Connecticut were actually experiencing a devastating weather event.

The parallels between a VaR calculation and this “perfect storm” are as inescapable as they are shocking. Defined variously as a tail event or a 2.33 standard deviation event, the VaR cases are typically characterized by multiple loss-causing events occurring within the same simulation. This is a low percentile by definition, but has an extremely large impact. In terms of what faced the northeast U.S., a high tide and a hurricane create the worst possible outcome for the shoreline areas. Here, risk management hits closer to home.

Risk management is a control function that mitigates, to a degree, the impact of the extremes. It is also a fact that events deep in the tail are often uncontrollable.  It was with shock that reports of Hurricane Sandy’s effects were viewed, and with a sense of humility that the aftermath restorations are being tackled.

Risk can often be seen as a dry academic subject, as more theory than reality, and the discussions in Dallas and Chicago could lend weight to that opinion. However, the events in the tri-state area graphically and violently demonstrated that tail events do happen, and enormous damage can be caused when extremes collide.

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Cage Goes in the Water. You Go in the Water. Shark’s in the Water.

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This blog post originally appeared on TabbFORUM.

In the 1975 summer smash Jaws, a rogue shark terrorizes a summer town. In addition to being responsible for more aquaphobia and galeophobia (the fear of sharks) than any other film in history, it does highlight different responses to a problem. Much of the film is set on board the Orca, highlighting the tension between an old-school captain and a scientist who is keen to make sure that “non-rogue” sharks are left in peace. The bemusement of the boat skipper at the scientist’s willingness to jump in the water with the sharks is emphasized by the singing of an old shanty after most of the two men’s encounters.

The comparison comes to mind when reading that a CRO has been appointed at Knight Capital. While I am claiming no specific knowledge of Knight Capital’s particular situation, it is clear that the announcement of a CRO role at any firm would convey a sense that the institution is taking its risk controls very seriously, and implies that a C-level appointee will be tasked with instilling a more culturally based risk attitude across the firm. Although this is usually the case – and certainly may be with Knight – there are also occasions when the net effect is a person receiving the same risk reports as before, but they are now called “Chief Risk Officer” instead of head of market or credit risk.

There are some risk managers who seem to truly believe in being in the water with the sharks, with or without a cage. Those folks will typically have the risk function in or near the middle of the trading or portfolio management areas, and are more interested in actively engaging in strategic and tactical discussions than producing increasingly detailed reports. Key to this engagement is the CRO’s willingness and capacity to debate the risk numbers, what they mean, and the models used to create them. Typically this debate results in some changes on the risk side, but supports a far more bought-in stakeholder group. Further, in this scenario, the floor-level understanding of risk evolves quickly into expectancy that risk is represented in strategic discussions at all levels.

The language of risk should really become the language of a financial institution. This can only happen if looking through the risk lens adds value to those in charge of taking risk and enables senior management to express the firm’s strategy and outlook in risk-based terms. It is important that this goes beyond simply risk-adjusting returns in order to control incentives. The risk numbers have to actively add value. And when that value is added and understood, the cultural shift will follow.

So, as we read about the growing number of CROs in financial services, we should pay more attention to the language used to express the future direction of the firms with those new members of the C-suite. Are they simply paying a bounty to a weatherworn fisherman and putting up a “beaches are open” sign, or are they actually in the water, in the cage, with the sharks?

…Farewell and adieu to you fair Spanish ladies…

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A Different Kind of Wall Street Board Meeting

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Friday August 17, 2012 sees a most unusual board meeting in downtown New York. Representatives from the largest banks on Wall Street, private equity firms, and Main Street gathered at Pier 40 for what may be the most cordial coming together of year. I am lucky enough to be at the event.

It is, of course, the start of the 2012 SEAPaddleNYC, a 26½ mile stand up paddle board race around the island of Manhattan, taking in the Hudson, Harlem and East Rivers, ending at the foot of the historic Brooklyn Bridge. Board shorts and bikinis replace the suits and dresses that each racer would normally be wearing on a weekday morning, allowing the investment bankers, traders, risk managers and others to mingle and chat as they await the 8:00 a.m. start.

Especially interesting is the intersection of professional and private life, and specifically how well the risk advice we give out to financial firms is applied in this most practical of situations.

To begin, we can look at the top-down view of the event and consider what risks we should be concerned with, their potential outcomes and how to mitigate them.

This would start with fitness. This is far and away the highest risk category considering that the race entails:

  • Standing in the mid-summer New York heat for up to eight hours (the time it took me last year!)
  • Paddling consistently for the entire duration of the circumnavigation of the island
  • Being in three reasonably fast-flowing rivers throughout the event

The concept of not being able to complete the race introduces the possibility of the worst case outcome, drowning.

The only answer here is to never underestimate the risk and the undertaking, and to train for several months beforehand. This is very similar to marathon training, and effectively requires that the total training miles covered is a multiple of the miles in the actual event. That in turn means putting in “on water” miles in the summer midday sun for many weekends prior on top of daily gym sessions. The easy-to-overlook piece is the “in exercise monitoring” of your own physical state and the recognition of the onset of exhaustion before it prevents your ability to at least make the river bank.

However, fitness will get you so far. Proper equipment is the second essential risk mitigation. The boards themselves come in two flavors; those designed for surfing/ leisure and those designed for racing. For shorter races of six or seven miles, the surf boards will suffice, but for distances of ten miles or more, a racing board that is flat, wedged-shaped (to cut through swell), and light is essential. I participated in the same event last year using a surf board, and this was the main reason for my eight-hour finish time.

The third risk consideration, in terms of the intangibles, is understanding the environment. This relates to understanding the tidal gates between rivers, and knowing when certain milestones have to be reached before the flow against the paddler will result in furiously “standing still” at maximum, muscle-sapping effort. A race strategy has to be built around those flows, and success can only be achieved by working within them, not against them. Rivers around New York all have different ebb and flow times, but these can be worked out mathematically from the Battery Park high tide. Paddling without this knowledge is akin to investing in a product with no idea of the risk factors inherent in that product.

In the paddle board race, there are things that can be controlled, but there are also risks that are completely outside of our control, which include water state and weather.

While a river has reasonably predictable flows, the quality and state of that water is highly dependent on upstream factors such as sewage spillage (an example of which occurred just nine days before this race). The key is to understand what has happened to the water recently, and what the consequences are for contact with and drinking of the affected water. If the risk is a direct contact risk, then the only prudent thing is not to compete, , but if the risk is in the drinking, then carrying your own water supply (with a one way valve!) and being disciplined not to allow any river intake on the inevitable spills will mitigate this effectively.

Weather also poses some interesting questions to the risk-aware racer. What weather is dangerous, and what weather makes the event untenable? Heat is dangerous, but carriage of water and sunscreen should prevent it being a deal-breaker. Thunder and lightning are something else. Actual lightning versus possible lightning becomes a paddler’s choice (and a test of faith in forecasters probabilities), while sheet lightning versus streak lightning becomes the on-water difference between an interesting light display in the clouds and a terrifying odyssey.

In the end, as with all risk analysis, the object is not to remove all risk, but to understand the risks involved and to proceed or not, with those risks in mind. Part of the fun is taking the risk, just as investment banking can be seen as a collection of monetized risks, but the key is to minimize the risks that can be minimized, and to take on the others in the most calculated way possible.

Now, bring me that horizon!

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

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Pension Funds Becoming More “Active” in Risk Management

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Right now, there is a noticeable change occurring in the approach to risk management on the buy side, particularly within the pension fund area.

Traditionally, pension funds have been measured against a few core metrics. These include duration, where the duration of the fund would roughly match the weighted average payout of the underlying pensioners, future and present; and benchmarking, where the benchmarks that were used would be selected on the average age of those same underlying pensioners and would be geared towards growth (equities) or cash liquidity and capital conservation (bonds). The core objective would be to protect the capital value of the contributions from loss and inflation, and to achieve a growth that would enable the provision of an annuity at retirement age that was appropriate for that time, and the expected draw time of that retiree.

Market changes are challenging this traditional approach.

First, the increasing longevity of the pension draw has put pressure on the pension funds, in the same way that it has various state pension plans, to fund current pensioners with current contributions, making the capital protection and growth of those contributions more difficult.

Second, the sell side of the capital markets has become increasingly volatile, which has caused risk managers to focus not just on the core fund remit, but on the absolute risk faced by the fund. It is this which seems to drive much of the segment’s move towards more sophisticated risk analytics, systems and approaches.

Consequently, across the buy side, we are seeing more:

  • VaR-based absolute risk management
  • Risk budgeting, or active risk management
  • Counterparty credit risk analysis

The move towards VaR-based analytics is interesting as it shows a determinedly more forward-looking approach to risk than simply comparing results with benchmark allocations (the traditional CAPM model), and illustrates some of the concerns that risk managers and their boards have regarding the market-based risk faced by the funds.

Recent market turmoil has put pressure on the liquidity of the funds, in the sense of trading liquidity and most importantly in terms of the fund valuation and the ability to create future cash flows based on the capital value, i.e. paying the current retirees from the current contributors. This is forcing more creative and arguably more aggressive investment strategies, including an increased risk of derivatives and non-capital markets assets, such as real estate and infrastructure.

Traditional “relative risk” measures based on allocation and CAPM models are not well suited to measuring the risk in these types of strategic environments, so the funds and their respective risk management groups are moving towards techniques and methods more associated with sell-side risk, such as VaR and tail risk analysis. Of course the benchmarks are still at the heart of the fund management, but the relative measures are less around simple allocation and more skewed towards active risk and risk budgeting where the VaR itself is the basis of the relative calculation and the excess risk represented by that active number is allocated across assets and fund subdivisions.

This analytics style is accompanied by increased focus on expected shortfall (losses beyond the VaR threshold), multi-asset stress testing and deeper quantitative analysis around the VaR distributions of the underlying asset classes and their correlations with each other.

On the credit risk side of the equation, there is a generalized concern around issuer and counterparty risk, and the correct pricing of that risk. This brings advanced measures such as PFE (potential future exposure) and CVA (credit valuation adjustment) into play. These have no real benchmarking relevance, but do have a potentially large impact on the financial stability and future liquidity of the fund.

This is a major change within the pension fund industry which in turn means that it is a major change to the financial industry, given that public and large corporate pension funds’ assets under management are routinely above 100 billion, and can run close to 300 billion for the very large funds.

Moving to this new level of risk management sophistication requires investment in systems and technology, as well as in people who can properly understand, explain and apply that technology. The most challenging issue – as always with risk management – is the change in the internal mindset of the various stakeholders, from board members to portfolio managers. Successful enterprise risk management, whether at a pension fund or an investment bank, requires that a risk-based view is taken of strategy and control, and that risk becomes a cultural keystone of the organization.

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I Saw a Werewolf with a Chinese Menu in His Hand

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This blog post originally appeared on GARP – Global Association of Risk Professionals.

The late, great Warren Zevon sang about werewolves living it up in his sardonic 1978 classic “Werewolves of London.” It seems there may be more metaphorical truth to this song than meets the eye.

In his recently published book, The Hour Between Dog and Wolf: Risk Taking, Gut Feelings and the Biology of Boom and Bust (Penguin Press), John Coates brilliantly explains how physiological reactions to success, stress, threat and opportunity may be at the heart of the excesses that accompany, and can even define, the tail ends of financial peaks and troughs. A former Wall Street trader, Coates has some fascinating ideas for how a working understanding of this intersection of neuroscience and finance could benefit the risk management of investment banks, as well as the health of the risk takers themselves.

080712_JohnCoates_BookCover
Former Wall Street trader
John Coates’ new book
focuses on the intersection
of neuroscience and finance.

The book itself contains a large amount of hard science, centering on the body’s unconscious reactions to change in the immediate environment and how that in turn, via the natural production of hormones and steroids, dictates the conscious reaction to the situation. It also shows, as a working example, how this plays out on a trading floor, where such reactions can have an impact on both the health of the firm in question, and within the overall financial system.

I Saw a Werewolf Drinking a Piña Colada at Trader Vic’s

The results of various experiments make for truly interesting reading, with daily P&Ls being positively correlated to startling testosterone levels, but, for risk management, the further increase in testosterone that the very success generates, and the subsequent increasing tolerance for risky behavior that follows it. The book describes the euphoric rush at the peak of a successful trading day in a bull market, as a “point that traders and investors feel the bonds of terrestrial life slip from their shoulders and they begin to flex their muscles like newborn superheroes.”

This observed behavior is counterpointed by the economic theory typically employed in the same banks, which assumes rational behavior from market participants, and begins to highlight where the two views diverge, creating the volatility and exuberance seen at the height of a boom. Moving easily between neuroscience, philosophy, pop culture and financial market behavior, Coates highlights differences between the ideal (rational) and the actual (potentially irrational) trading behaviors.

Equally important is the bodily reaction to underperformance and its ability to dictate a highly risk-averse state of mind. Again moving through the subconscious to the resultant conscious reaction, it illuminates the situation at the bottom of a bad day, and how body can initiate instinctual reactions to stress, leading at the extreme to an inability to act at all.

He’s the Hairy-Handed Gent Who Ran Amok in Kent

The book concludes with a number of ways that such knowledge could be used to strengthen risk management, from hiring policy through active trading-floor risk management. The key lies between two core elements: the testosterone levels of the trader; and the trader’s ability to deal with spiking levels of uncertainty.

The first point would seem to indicate that when bringing together a cluster of younger (less experienced in dealing with stressful conditions) men (higher testosterone), and spiking that cocktail with an environment of monetary and cultural reward, short-term performance is likely to increase the severity of tail events. A more diverse mix of gender and age is likely to dilute this significantly. It is also important to recognize and intercept extreme physiological responses, and suggestions include both longer-term incentive schemes and a more pastoral management of success and failure through the cycle.

These are excellent ideas, but it is also important to employ a risk monitoring system that tracks individual traders’ successes and failures, including higher and lower P&Ls on specific positions and trades, which would logically seem to be early indicators of their subconscious drivers.

All in all, Coates’s book is a must read for risk managers who would like to progress their firm’s risk culture beyond end-of-day reporting.

While you’re here…

  • Read more expert insights on risk management.
  • Explore SunGard’s enterprise risk management solution, Adaptiv.

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

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SURVEY SAYS: VOLATILITY RISK A MAJOR HEADACHE FOR US FINANCIAL FIRMS

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When considering current industry views on volatility risk, it should be noted that traditionally, profitability of trading and investment banking fed on volatility. The terms “volatility” and “risk” can almost be used interchangeably; good risk management could be defined as effectively managing the varying levels of uncertainty from an expected outcome. The greater the uncertainty of an outcome, the greater the risk (or higher chance of loss), the higher the required risk premium; this is the standard risk equation.

What is most striking about the results from “Vulnerability to Volatility Risk – a Global Challenge,” a survey conducted by the Economist Intelligence Unit for SunGard, is the level of worry, particularly in the U.S., from firms around their vulnerability to volatility risk, with more than half the respondents expressing concerns over their firm’s ability to withstand increasing volatility risk over the next three years.

I see two core reasons that could be underlying this risk-centric headache, particularly in the short term: regulatory response to volatility and/or sovereign instability.

Regulatory Response to Volatility

Regulatory responses to increasingly uncertain markets have significant impact on financial firms, which is evident in the survey results. The expected regulatory response to crisis or potential crisis is to protect the system itself, rather than the firms within it. This is normal and particularly in the U.S., much of the post-crisis talk has been around prevention of systemic risk. In essence, the goal is to force liquidity buffers, collateralization and risk-driven capitalization to levels where a firm’s default is only the firm’s default and not a ‘black hole’ in the financial cosmos, into which multiple other firms are pulled. But the increase in capitalization and collateralization has the impact of removing working capital and market liquidity, which hurts smaller firms the most. They are aware of this regulatory side effect: the survey shows these firms are the least confident.

We also find that the order of risk-based worries goes market, then regulatory, then credit. This is fascinating, since it could mean that regulatory reforms are seen as effective in terms of preventing crisis contagion (reducing credit risk), through higher capitalization and collateralization, but that simply meeting those regulatory requirements becomes a more significant worry. Furthermore, the effect of those regulations being met could reduce capital flow through the market to the point that market valuations, based as they are on liquid flows and values, become more volatile as liquidity is reduced.

Finally, the cost of ‘protecting the system’ results in a reallocation of budget that would otherwise go to ‘protecting the firm.’ This can also be seen in the EIU-SunGard survey, where firms see their current level of stress testing as inadequate, and their preparedness for a more volatile environment as poor at best. However, the fact that respondents tend to feel that their investment in the future state was adequate speaks to the fact that investment in protecting the firm is being drawn from other, more profitable, activities, and should be read in conjunction with the feeling that shareholder value could fall victim to the volatility climb.

Sovereign Instability

In terms of sovereign risk, it is also interesting to reflect on the last few decades having been a remarkably stable platform for European and U.S.-based financial firms. Sovereign risk had been seen as effectively non-existent in these regions, and so a pretty effective risk reward framework had been in effect in terms of investment outside the region (horizontally) and in terms of emergent technologies and industries (vertically), across both core and emerging markets.

What has happened more recently has destabilized this platform. With the U.S.-led crisis of 2008, the ongoing euro zone crisis, and increased political risks in some emerging markets, it is challenging to determine which tremors have their epicenters at the global level, and which at the local. Most risk systems are not configured for such analysis, and even for those that can be, the inputs are less scientific and more based on guesswork, increasing the uncertainty of the result.

Such responses were made within the “Vulnerability to Volatility Risk – a Global Challenge” survey, which also points to the poor opinion of the current stress testing state, as against the more optimistic expectation of the future state (where such schisms are likely to be embedded as standard stresses).

It is also clear, from the EIU-SunGard survey, that senior management teams are becoming more focused on the risks increasing volatility poses to shareholder value and their firm’s health. This is likely a consequence of regulatory pressure and, more importantly, the fact that the recent crisis exposed how vulnerable, to volatility, financial firms within developed markets had become. For some time, the escalating effect certain risky activities could have in a crisis had been less understood or even acknowledged. That has clearly changed.

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THE STATE OF LISTED DERIVATIVES

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2011 saw the highest volumes ever recorded across the world’s listed derivatives markets. Despite some quieter early months in 2012, the longstanding volume growth trend still appears to be in place, led by the surge in commodity trading and by booming currency futures volumes. Several factors continue to drive this trend: wider buy-side market awareness, particularly in emerging markets, more flexible investment mandates at many firms, and the need to hedge against persistent cash market volatility.

But look more closely, and things don’t seem quite so rosy. Deal sizes are shrinking, driven in part by growth in the use of algorithmic trading strategies, and client demands continue to grow for DMA and algo access to an increasing number of global exchanges. Coping with these amid rapid changes in market conditions, such as the commodities boom, and in increasingly competitive conditions, is clearly no rest cure. And trading and clearing costs for the brokerage community remain relatively high: the pricing pressures due to inter-market competition in equities have not yet translated to the world of derivatives, with its proprietary contracts and vertical trading/clearing silos.

Adding to these direct business pressures, in the wake of the global financial crisis the derivatives sell-side is also receiving unprecedented levels of regulatory attention. The largest issues are of course those associated with global regulators’ drive to push OTC business onto electronic platforms and central clearing. As the OTC and exchange traded markets become more alike, we can expect significant impact on the way that brokerage firms structure themselves to address their clients and interface to trading venues. But while we wait for these changes to take effect, the primary regulation-driven focus in most exchange-traded brokerage businesses is on risk management.

This former Cinderella area of business operations is now central. Derivatives position risk forms part of firm-wide considerations, but two core issues are specific trading room concerns:

  1. Pre-trade risk management traps some major risks – including many erroneous and/or limit-breaking orders – at the most appropriate time: before they hit the markets. Responding in some cases to direct regulatory demands, many firms are extending and tightening their electronic pre-trade controls, with latency considerations ultimately determining how much it is practical to do before sending an order to market.Guidelines published by FIX Protocol Limited, recently updated and extended to cover futures and options, are a useful contribution to developing best practices. In Europe, the 2012 ESMA Guidelines for automated trading engines are also relevant: fortunately for firms striving to stay in compliance, the ESMA risk management requirements are broadly consistent with the FPL recommendations.
  2. The biggest issue in commodities is of course position limits. While legal tussles continue over the Dodd-Frank/CFTC rules, implementation may be required by year-end 2012, and we await ESMA’s crafting of the MiFID 2 principles into new European regulations.Full compliance with the CFTC rules in their current form implies assessing real-time global positions in a range of commodities: this will be very demanding for U.S. firms trading internationally and across multiple listed and OTC markets. There must be concerns about potential regulatory arbitrage as long as these rules are not applied worldwide.

Keeping up with all of this change is not easy. But it’s not only about compliance: it is enabling risk managers to win budget and resources for projects that they have long thought important or even necessary. The end result, one hopes, will be fewer concerns about business survival if we face another market meltdown.

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head of product management, Adaptiv, SunGard’s capital markets business

FULL STEAM AHEAD TO A NEW BEGINNING?

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This blog post originally appeared on FOW.

The rapid response to the financial crisis initiated by the G20 has led to a plethora of new regulations which sometimes seem like a never-ending series of sticky plasters trying to patch up a leaky hull. No sooner has one leak been fixed (think Stressed VaR or Incremental Risk Charge) than another springs forth (think CVA or Wrong-Way Risk). Inevitably in times of crisis and emergency this approach is needed to steady the ship, but shouldn’t we also be trying to steer a course to a safe harbor?

This seems to be the thinking behind the Basel Committee on Banking Supervision’s latest consultation document entitled “Fundamental review of the trading book.” The aim of this review is to set a consistent framework within which to think about regulatory capital and, despite the name, it touches upon the banking book as well as the trading book.

The suggestion that will inevitably grab the most headlines is the proposal to replace VaR (Value at Risk) as the main measure of market risk with ES (Expected Shortfall). Although controversial, this has many practical and theoretical advantages. The main stated benefit is that whereas VaR provides a lower bound on extreme losses (“you’ll lose at least this much, but we can’t say how much worse it could get”), ES tries to quantify what dangers lurk in the tail of the loss distribution (“this is the average of the really bad losses”).

However since ES relies on much the same simulation framework as VaR, it still suffers from some of the other drawbacks, such as the assumption that looking into the past can tell you something about the future. Also, back-testing ES (i.e. trying to judge whether your model is in fact good at predicting the future) is a lot more complex than back-testing the simpler VaR concept.

Some other proposals, such as introducing liquidity assessments into market risk measures, seem particularly prescient in the light of recent multi-billion dollar trading losses in illiquid credit default indices. However it seems unlikely that the traders taking on those positions didn’t know that there was finite liquidity available, and so the question is whether or not a liquidity indicator would have led to risk management overruling the trading desk’s strategy.

Probably the most significant proposals from a long-term perspective surround the boundary between the trading book and the banking book. One of the major issues of the financial crisis was the ability of banks to arbitrage between the two books; the tightening up of rules about where assets are accounted for can only help. Since interest rate risk is a pillar 1 item for the trading book but a pillar 2 item for the banking book there is more work to be done, but getting a comprehensive and consistent framework across all areas of risk is one way to ensure our banks weather future storms better than they managed the recent ones.

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

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THE BUZZ AT PRMIA’S BIRTHDAY BASH

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This month saw the Professional Risk Managers International Association (PRMIA) celebrate its tenth birthday in style at the Marriott Marquis in New York’s Times Square at its inaugural risk conference, sponsored in part by SunGard.

Even with the credit crisis behind us, ongoing issues with euro zone sovereignty risk, Basel III, the Volcker rule, the failure of MF Global, and the move to central clearing proved that there was plenty to talk about at the event. And if 2012 had not been eventful enough so far, J.P. Morgan’s announcement of a $2 billion loss on the eve of the conference both highlighted the profile of risk management and guaranteed a buzz at the party.

With the JPM news so fresh, speculation was high as to the root of the issue, with plenty of debate over whether risk management had failed, been ignored or experienced a miscalculation. The same three possibilities were equally discussed during the MF Global case earlier in the year. Conferences focused on risk management often delve into the status of risk management within larger financial firms, but rarely have such stark examples acting as fuel to the fire.

Of course, there were also more forward-looking discussions around dealing with regulatory reform and any unintended consequences thereof. A key area of discussion for the PRMIA audience was central clearing. Among the potential issues that could arise were concentration and liquidity risks within specific clearing exchanges, and the dramatic rise in the amount of collateral/margin required to conduct derivatives trades. The role of FCMs and their attendant business models also tail-ended those same debates.

The ongoing conversation about whether VaR or Expected Shortfall is the more effective risk metric was high on the agenda, as delegates pondered the usefulness of the two. In general, participants agreed that VaR/stressed VaR works for the capital calculations but that both measures should be looked at internally for prudent risk management, along with other tail-orientated risk measures and stress tests.

The plight of the euro zone was next on the hot topic list, as risk managers from across the U.S. and beyond discussed the theoretical and practical implications of sovereign risk in the developed European markets, the impact these have on credit spreads and default correlations, and how best to reflect political risk in underlying risk calculations and estimates.

The PRMIA audience also discussed the Volcker rule, both in terms of absolute compliance and monitoring of hedging and market making activities, as well as the equally worrisome effect on liquidity in the absence of prop trading. Interestingly, potential Volcker-led liquidity issues led back to the question of which risk measure (VaR/ES) can be best adjusted to reflect lower liquidity environments, the need for liquid central clearing, and the associated cost of margin/collateral.

There were also presentations on risk culture, model validity and enterprise-wide liquidity, operational, market and credit risk. Of course, these are all topics that in less stressed times could be top-of-mind at a risk conference, but were here relegated to bit players on a larger stage.

At the PRMIA conference the conversations were all different, yet connected. After 10 years of challenging risk management, it was a great way to celebrate. There has never been a stronger need for forums like this where risk professionals from across the industry can discuss, argue, share and move forward with peer-agreed best practice in a financial world that seems intent on challenging the resolve and commitment of risk departments everywhere.

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