global head of connectivity, SunGard’s global trading business

Come Trade with Me

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A version of this blog post was originally published by the Financial Times.

Recently, I traveled to Madrid. I booked a flight on British Airways and found myself flying… Iberia. Of course these days these two “national carriers” are part of the same company, listed primarily on the London Stock Exchange and Bolsa y Mercados Espanoles, the Madrid exchange.

The Madrid and London stock exchanges are both over 150 years old and fiercely independent. They used to be among scores of independent stock exchanges around the world, all existing to serve their local markets with listings of companies from their country or local area. But increasingly independence is the exception, not the norm, for stock markets.

Like airlines, when countries from Austria to Zimbabwe took pride in having “national carriers,” having your own stock market was a calling card for a nation, even a region. Just as the economics of airlines have prompted alliances no-one could have conceived of – Air France KLM, for example – the economics of stock markets are increasingly leading to a shake-out of the industry.

And just like with airlines, the traditional players are being challenged by low cost entrants who are shaking up the perceived business model by stripping it back to the basics of what traders want from a market. For every Easyjet or SouthWest Airlines, there are multilateral trading facilities (MTFs) such as BATS-Chi X or hungry new entrants, like the Intercontinental Exchange (ICE).

Hardly a week goes by without another deal or alliance being struck among exchanges. The partnerships change all the time creating the most unlikely bedfellows. But in reality all they are doing is following the money.

We are often told that we live in a global world. What happens in Sao Paulo can move markets in Shanghai. This means that traders can be in any location they choose – and these choices are dictated by the availability of skilled labor, the nature of the tax regime, regulations and probably where hedge fund managers want to send their kids to school. From that location they want to trade in any security anywhere in the world. Their choice of market is not predicated on any national loyalty – they will go where there is the best opportunity, the most liquidity, the lowest costs and the least hassle.

As a result you have seen an increasing flow of companies listing on stock markets outside their home territory – from Israeli technology companies on NASDAQ to Kazakh miners on the LSE and Manchester United, an English football club with a Scottish manager, listing in New York where “soccer” is at best a minority sport. Even when a company has its primary listing in its home country, you will often find that the investor community and the majority of trading happen in other places.

Like airlines, national exchanges have had to adapt from being near monopolies in their home markets to being relatively small players in an increasingly global marketplace. They have had to invest in systems and infrastructure to compete and yet still see a large amount of their business being taken by rivals. Against this background it is not surprising that they want to huddle together or face being picked off by global consolidators, worse- altogether forgotten and obsolete.

Over the last few years we have seen multiple alliances in other parts of the world come to fruition. Euronext in Western Europe should regain some autonomy following from the very likely takeover of its parent company by ICE, while NASDAQ OMX in the Nordics, ASEAN in South East Asia, CEESEG in Central & Eastern Europe, and MILA in Latin America have all emerged as important trading blocks, each operating with a subtly different market model.

A fresh crop of new entrants are emerging who reflect the financial strength of markets previously not considered to be worthy of consideration. Moscow shows how, with government backing and strong momentum, a fragmented market can be consolidated to create a credible emerging financial center, fighting for Russian stocks listings that previously would have gone to London or New York. Both the Warsaw and Istanbul exchanges are emerging with similar ambitions.

Where will it end? I can see a few major groupings of markets emerging over time. It is hard to see more than two or three exchange groups in Europe.  The lessons from the airline industry are there to see.

vice president, SunGard’s capital markets business

Regulatory Changes to Shadow Banking Bring Market Participants into the Light

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A version of this blog post originally appeared in Securities Lending Times (p 16).

The overarching mandate of financial reform is to mitigate the potential risks associated with systemically important financial activities and institutions. Statutory authority has purposely reserved an abundance of discretionary authority for the regulators to capture and reconfigure processes that have “an effect upon,” covered activities.

As a means of exercising this reservation of authority, rule-makers as well regulatory-framework-setting bodies now seek to target shadow banking.

For instance, the Financial Stability Board (FSB), which itself does not have rule-making authority yet is considered a persuasive advisory body concerning international standards within the financial system, seeks to “mitigate the spill-over effect between the regular banking system and the shadow banking system.”

Additionally, the Financial Stability Oversight Council (FSOC), which has rule-making authority under Section 120 of the Dodd-Frank Act, seeks to enhance and substantively modify the shadow banking space. The FSOC has concluded that the current state of shadow banking contributes to systemic risks. As a result, it now seeks to address the perceived bank-like activities that pose risks by subjecting shadow banking, and related activities such as money market mutual funds, (MMFs), and securitization activities to more onerous oversight.

Changes are coming to shadow banking

Shadow banking, which arguably provides a valuable funding conduit that supports real economic activity, broadly covers credit intermediation, liquidity optimization and maturity transformation involving entities and activities outside of the traditional banking system. Shadow banking may include securitization activities such as origination, or alternatively, wholesale funding through MMFs.

For example, MMFs, which had approximately $​3.​1 trillion in assets under management as of December 31, 2012, provide a substantial portion of the short-term funding available in the capital markets and are an integral part of shadow banking.

The regulators purport that MMFs generally lack loss-absorption capacity and are susceptible to runs. The FSOC and the Securities Exchange Commission (SEC) propose substantive rule changes that constitute the second regulatory enhancement since 2010. The present rule related to MMFs seeks to incorporate a variable value calculation that would replace the traditional fixed valuation.

Specifically, the proposed regulatory enhancements call for a mark-to-market (MTM) variable net asset value (NAV) as opposed to the fixed NAV used currently. The migration toward a variable NAV, which values the asset(s) at the current available market price, calls for supporting automation that would allow investors to monitor and contemplate risk and valuation changes in the MMF’s assets through a data-driven dashboard.

Additionally, the credit risk retention rule under Section 941 of the Dodd-Frank Act, which supplants Section 15G to the Securities Exchange Act of 1934, requires securitization sponsors to retain a portion of the credit risk and an economic interest in the assets they securitize.

According to the rule, securitization sponsors may retain credit risk in a number of ways. Since the manner and method in which risk retention is accomplished remains discretionary, based on certain limitations, firms are then faced with a technology challenge. That is, the flexibility of the rules in light of the heterogeneity of products and market participants provides a robust business case for automation. Accordingly, sponsors, or other market participants with independent technology processing capabilities, may achieve compliance with the risk retentions requirements in Section 941, or alternatively, may leverage the analytics in other ways.

Still, shadow banking will continue to evolve

Shadow banking takes a variety of forms, which are continuously evolving despite the regulatory scrutiny of these activities. From a regulatory monitoring perspective, authorities intend to cast a wide net, potentially subjecting all non-bank credit intermediation activities that might arise to new rules.

From a regulatory policy perspective, the proposed rules likely require enhanced automation processes for all covered shadow banking activities that involve credit intermediation, liquidity optimization and maturity transformation. This is true because enhanced transparency almost always requires connectivity reconfiguration and quantitative capabilities.

It is important to note that the FSOC and FSB regulatory objectives are not merely minor revisions to existing regulatory structures, but substantial changes in the ways that shadow banking will be regulated globally.

The ambiguity of these directives and outstanding reservations of authority given to regulators should prompt a call-to-action for shadow banking participants – including buy-side beneficiaries – regarding necessary automation advancements to support these industry changes.

When Every Penny Counts, Firms Must Operate Smarter Through Deeper Data Analysis

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The full version of this blog post originally appeared in Wall Street & Technology. It also appeared on Bank Systems & Technology.

Today’s economic environment has become increasingly difficult, forcing executives and managers to analyze expenditures and business practices with more scrutiny in an effort to remain profitable.

In addition to the expense of creating and maintaining an effective cost identification and management solution, broker-dealers are faced with the issue of the integrity of its results. Most financial services firms today are engaged in multiple businesses across global markets and with a magnitude of clients and business partners. Each new profit conduit is also an opportunity to add expense.

In order to identify profitability and cost savings, firms must manage large and disparate data sets housing transaction details, market timing and circumstances, and relationship details. The task of collecting, mapping and then parsing multiple data sources for accuracy is a big challenge. Even if a company has the ability to manage the data sets, there is a level of sophistication and depth that few market participants have achieved to date.

It is becoming increasingly important for firms to have access to a solution that can deliver a complete overview of costs via an integrated model across accounting and the front office. It should allow for a deep dive into disparate data sets to better handle alpha and cost attribution, and help improve trading decisions based on real-time analytics and granular data. This system should also then deliver the right information to buy-side clients to efficiently measure performance.

With the right access to and view of cost-related data, firms can give themselves a competitive advantage and operate smarter in today’s difficult markets where every penny counts.

While you’re here…

senior vice president, Astec Analytics, SunGard’s capital markets business

Lewis on Lending: A Bubble Fit to Burst?

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This blog post was taken from the Astec Analytics Securities Lending Focus for April 2013.

In the early 18th century, the bursting of what became known as the South Sea Bubble broke many fortunes. The East India Company, riding high on the global dominance of the British Empire, issued huge quantities of highly priced stock to hungry investors who believed the company’s monopoly on South American trade could not fail.

Unfortunately, they were wrong, and their clamor for the shares blinded them to the fundamental weaknesses of the company. A sudden realization burst the bubble, and the shares became worthless almost overnight. I am not, of course, directly comparing certain countries’ debt issuance with that of incompetent 18th century industrialists, but there is a certain similarity in the desperation of investors seeking safe places to put their money and the resultant bubbles in prices such actions create.

The price of debt issued by certain governments has been pushing at record highs recently, with the U.S. and Japan among them. Commonly, it is occurring where there are active “asset purchase” practices in place supporting demand for their debt, but there has to be a limit and at that point we will likely see a correction. The correction may of course be a slow deflation, with prices falling back steadily and corresponding yields rising to more normal levels. However, a more dramatic bursting of the bubble could have much worse implications for the markets and investors.

Securities lending volumes have certainly been on the rise in the debt of certain countries, which could indicate a movement of sentiment and the build-up of short positions poised to take advantage of a fall in prices if and when it comes. Shorting is, of course, not the only reason to borrow securities and government/sovereign debt of certain nations will attract greater demand as the need for high-quality collateral increases under new market regulations coming into force.

Over the coming weeks, we at SunGard’s Astec Analytics will be looking at these movements in greater depth to try and separate the demand to borrow high-quality collateral from those that may be borrowing debt that, possibly like the stock of the East India Company, is inflated beyond its true and fair value.

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.

market analyst, Astec Analytics, SunGard's capital markets business

It Started with Tulips, but is the Bond Market the Next Big Bubble?

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A version of this blog post originally appeared on Forbes.

It started with tulips, went through corn and technology, and most recently hit property and cheap money. I am of course talking about bubbles. Not the type children play with and people write songs about, but the kind that, when they burst, can cause financial havoc.

The word “bubble” is bandied about all too often. There seems to be a constant fear that any price rise could become a short-sharp-shock. The latest in this long line up are bonds. Junk bonds, investment-grade corporates and even U.S. Treasuries – the classic ‘no-risk’ investment option – all seem to be reaching new heights.

Low interest rates and stimulus efforts from the U.S. government and Federal Reserve have brought U.S. yields to record lows. Add to this a fast flow of cash away from riskier equities and into the perceived safe haven of bonds, and maybe there is a case to be made that these fixed income securities are starting to get overheated.

Is this a bubble? If prices slowly retreat rather than burst, overheating like this isn’t usually defined as a bubble. So then, does this increase in demand for bonds look set to pop?

Looking and analyzing securities lending data from SunGard’s Astec Analytics may offer us some insight. If people have started to increase short positions in bonds, this at the very least represents growing concerns that prices may not rise forever, nor yields keep on falling. But could the accumulation of short positions actually precipitate the collapse of the bubble? If people are betting it will burst, could these positions represent the pin that will do the popping?

There has also been a growing sentiment that the U.S. Fed may start to rein in its stimulus efforts, when, and if the economy recovers. Any such move would likely see interest rates rise and demand for bonds, particularly Treasuries, fall. An unexpected announcement from Ben Bernanke, or even a European Central Bank or the UK’s MPC, would most likely act as a ‘pin.’

So what does the Astec Analytics securities lending data show? Are traders taking bets against bonds? Does this mean a burst is on the cards, or does it suggest selling pressure (both short and closing longs) may exert an influence at a more gradual pace?

Looking at the number of borrowed securities over the past year, we can see a distinct difference between implied shorting activity on U.S. corporate bonds, Treasuries and U.S. equities.

While the cash U.S. equity markets made steady gains during 2012 and early 2013, the number of shares borrowed saw only mild increases and generally held at fairly steady levels – a pattern we often observe when the short side of the market believes the price gains are ‘appropriate,’ or have the potential to continue.

The bond market on the other hands shows two fairly distinct patterns – corporates undergo increased borrowing in the first half of 2012, up around 25%, falling back and then bouncing once again in 2013; Treasuries see almost the exact reverse, with borrowing levels declining in the first months of last year, then climbing higher only to pull back again during the start of 2013.

Comparing corporate bonds and equities in the cash market, we have already observed a similar pattern. Both have been gaining over the past 12 months as some confidence surrounding the economy and prospects of individual firms has begun to build.

Companies have found it ever easier to issue debt at low interest rates as demand for their bonds has been strong. Likewise the very real threat of junk-graded companies defaulting on their debt has started to subside from the levels feared last year.

The one difference then is what has been happening recently; while both corporate bonds and equities have continued to climb in 2013, the increase in short interest in bonds has started to outstrip that of the stock market. An increase in short interest in line with climbing prices (when other factors are not an influence) is a pattern we see when short sellers are skeptical of the price move, and believe the securities to be overbought. Here, those on the short side seem to be making bets that corporate bonds will fall in a way shares will not. Is this a bubble?

Moving to Treasuries, their borrowing volumes seem to suggest a pattern all their own. As U.S. sovereign yields fell lower on bond buying and low interest rates, Astec Analytics’s data suggests short selling the bonds began to climb as early as May of 2012. Although at that point, the idea that Treasuries were in a bubble saw little speculation, the perceived pessimism probably began to surface thanks to an improving economic situation and increasing likelihood that the Fed would eventually curb its enthusiasm for stimulus measures.

In this case then, the lending data for the past few months suggest the exact opposite with regard to corporates – short positions may have been building over the previous year, but most recently those on the short side seem to be more skeptical that a bubble has formed, or at least that a bubble would pop any time soon.

Unlike corporates, this also fits in with the long side for U.S. sovereigns. While it is true that Treasuries are holding near record-low yield levels, the second half of last year saw rates creep slowly higher. The yield on the benchmark U.S. 10-year, for example, was as low as 1.4% in June 2012, and so it could be argued the current 2% level actually represents a fairly significant increase.

This easing of demand for Treasuries may be the key point. Rather than the short-sharp-shock needed to burst any bubble, Treasuries have seemingly been undergoing a slowing of demand, a release of air if you will, that may reduce the risk of any actual pop.

So then, is the bond market experiencing a bubble? This may be a matter of opinion, and depends mostly on what one defines as a bubble. A bubble is generally only called a bubble after it bursts, in which case the lending data seems to suggest that short sellers believe corporate bonds may be ready for such a hit.

With Treasuries on the other hand, the story may not be as clear cut. Although any move by the U.S. government to ease stimulus measures would certainly have a massive impact on sovereigns. Astec Analytics’s data seems to suggest much of this turnaround in policy is already being “priced in” to one extent or another.

One should also consider how far ‘ahead’ on the long side short sellers are. If each side is offering fair value, then the risk of the bubble bursting is reduced. If, however, the short side is overly cautious (or optimistic, depending on the perspective), then Treasuries may still be set for a deeper drop than one might think. As of yet, though, the lending data seems to suggest this may at least not lead to a burst to the extent many now fear.

product manager, Valdi, SunGard's capital markets business

Limit Up-Limit Down: Where’s the Limit?

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This blog post originally appeared on Advanced Trading and in the John Lothian Newsletter.

On April 8, 2013, the new Securities and Exchange Commission (SEC) rule Limit Up-Limit Down, aka Rule 608, will go into effect in the attempt to lessen volatility in the equities market. Limit Up-Limit Down was passed on May 31, 2012 to “address extraordinary market volatility market wide.”  At the time of the ruling, the Single Stock Circuit Breaker rule was in place to address market volatility, but was not consistent across the market. Limit Up-Limit Down will eventually replace the Single Stock Circuit Breaker in its entirety as it is rolled out in two phases over 2013 with the complete roll-out expected to be complete by September 2013.

To understand why this new rule has come about, one needs look no further than the events of May 6, 2010, known as the “Flash Crash.” During the Flash Crash, the market nose-dived at record rates in a very short time; within only 20 minutes, the market had dropped nearly 1000 points.  Almost as fast, the market gained back nearly 600 points.  This type of incident is ripe for conjecture and philanthropic thought about how to stop another Flash Crash event from taking place again.  Unfortunately, the ‘why’ is generally overlooked, as seems to be the case again today, where once again firms are sent scurrying to comply with a new regulation.

As technology has advanced, the markets have relied more and more on electronic trading, which coincidentally has led to some of the most significant market events in recent times.  This has put an unnecessary burden on a vast majority of firms, who, in an already fragmented market with withering profit margins, now must spend more on compliance.  The costs of running a business are becoming astronomical and firms are feeling that burden.

Now it seems obvious that the Flash Crash and similar instances before and after were accelerated by high-frequency trading (HFT) and rogue algorithms. High-frequency traders profit from the smallest arbitrage opportunities available. These arbitrage opportunities cannot be spotted quickly enough by humans, so these traders rely on technology, co-location hardware, and high-tech algorithms to find, analyze, and react to the information with little to no human interaction. There’s little regulation in place for monitoring and reacting to rogue algorithms today. This all begs the question: why has the SEC chosen to develop a rule that doesn’t necessarily address the root of potential market volatility issues?

What will happen as HFT firms migrate to other asset classes and instruments where the Limit Up-Limit Down Rule does not exist?

With the advent of this new Limit Up-Limit Down rule, the onus is on broker-dealers to have a system in place that will not allow executions to occur outside the set price bands nor quote outside the price bands, and will monitor for executions that might occur during a halt after a limit state has been enacted for more than 15 seconds.  Broker-dealers will also need to have access to this market data to truly understand the price band movements and how this may impact their resting limit orders.

In the end, it feels like this rule is a blanket oversight that fails to tackle the real issue around extraordinary market volatility, the rise of high frequency trading and rogue algorithms. When it comes to Limit Up-Limit Down, when will the regulators realize their limits?

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

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Enterprise Risk Management and the Vernal Equinox

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A version of this blog post was originally published by Markets Media.

In a time long forgotten, seven days before the third full moon of the year, a drum beats a slow and terrible accompaniment to the death march of the sacrifices to a god whose satisfaction is needed to guarantee a good harvest and the survival of the tribe for another 12 months. As the mid-afternoon sun moves through the sky, the deity himself appears – a winged snake – and makes his way down the steps of the temple built to honor him. At the base of the temple, a carved statue of Kukulkan’s head meets the shadowy shape of his body, bringing together his astral and physical form. At that moment, the human sacrifices are made, and the people pray in terrified silence that it is enough.

An eon later, and March 20 sees the 2013 vernal equinox, signifying the end of winter and the astronomical start of spring. This annual event carries with it echoes of legends and rituals from ancient cultures that have direct relevance to our approach to financial risk management today.

Within the Mayan city of Chichén Itzá lies the pyramid temple of Kukulkan, a deity who took the shape of a winged serpent. On the vernal (and autumnal) equinox each year, the god can be seen descending the temple steps in the form of light and shadows, meeting his own carved head at the base. This astonishing feat of architectural design is generally thought to be associated with Mayan agricultural rites. There is also pictorial evidence of the god overseeing human sacrifice.

Photo via worldmysteries.com

What is striking about the pyramid, the visage of the ancient god and its linkage to a successful agricultural season, is that in many ways this is similar to the development and build out of much modern enterprise risk architecture.

Just as the Maya structured their lives and rituals around balancing risks which included not angering their gods, financial firms of today must also use risk assessment as a key decision-making tool. The basic purposes and aims of a modern risk system being:

  • Allow the risks being taken by the firm, both market and credit, to be understood by the risk management department
  • Enable the CRO, or whoever is responsible for developing the overall risk appetite, to see that the defined risk-taking aims are being adhered to
  • Empower the risk takers, the portfolio managers or traders, to understand the impacts of their positions on both their and the institution’s risk profile
  • Ensure that all regulatory requirements are fully met with regards to risk management

The danger comes when the regulatory needs overshadow the other considerations, and the creation of those numbers becomes the only end-point of the system. This, essentially, creates a large, often dislocated system where the firm will:

  • Run all parts of the system once the trading day has finished
  • Combine those results and produce a series of regulatory reports and numbers
  • Allocate capital in accordance with those numbers and reports
  • Sign off for the day

As long as there are no unexpected catastrophes throughout the following period, and the regulatory numbers are supplied, the risk system is presumed to be working. In many ways, this is exactly the situation accepted by the Mayans, where a technically brilliant design created a result that would be verified by a successful harvest, regardless of the scientific non-connectedness of the temple equinox event to the actual agricultural outcome.

Of course, in the case of financial risk management today, one required outcome is met entirely. The regulatory requirements could be said to be the most important, as without them, the firm’s ability to perform its business is threatened. The key to understanding regulatory requirements, though, is that they are primarily designed to ensure that the financial system is protected from specific bank failures, not to protect individual institutions from failing.

Regulatory reporting is a result of the positioning of the bank. While referred to in the reports, risk appetite and the adherence to that appetite tend to be secondary considerations. The risk appetite is a forward-looking plan of action, designed to ensure that in a business where financial risk-taking is the core business, there is a C-suite control of the activity, and a grass-roots understanding of that strategy. Any enterprise-wide risk system should see the regulatory reporting as a starting point for deeper analysis and understanding.

The Mayans focused on appeasing and venerating the winged serpent god Kukulkan, and did so by creating an awe-inspiring pyramid and making human sacrifices. Of course, with the value of hindsight and more modern farming knowledge, we know this approach cannot guarantee or even improve the chances of a good growing season. Financial failures also bear out that simply calculating and correctly reporting risk numbers to regulatory bodies cannot guarantee financial stability.

It is always a risk to be in awe of technical achievement and to mistake that achievement for success in the overall task. It is a necessity, when architecting a risk system, to bear in mind the full scope of the requirements of the system.

These system requirements include the ability to define the risk appetite within the C-suite, and for the risk takers to work within that appetite. Analysts and risk takers need to be able to explore both regulatory and non-regulatory measures in pursuit of the adherence of the risk appetite. That can only be achieved by taking the most granular approach possible, and building, through user-defined aggregation, a series of answers to risk questions that include but are certainly not limited to regulatory reporting. Once those questions are being asked, there is a natural feedback loop that develops through the firm, enabling both a validation of the risk production and the development of a risk culture.

Technical architects should aim for greatness, for systems that are fast and accurate, and for systems that create and strengthen the cultural nervous system of risk-taking organization. The priests and the architects of the temple of Kukulkan at Chichén Itzá achieved technical greatness, but focused solely on veneration. On March 20, 2013, as the winged serpent makes its way down the pyramid constructed in its honor, we should make sure that we are looking at our enterprise risk systems with greater importance and through a wider angle lens.

senior vice president, Astec Analytics, SunGard’s capital markets business

Lewis on Lending: Oh, for Some Good News!

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This blog post was taken from the Astec Analytics Securities Lending Focus for March 2013.

Last month I stated that I wanted to find some good news to include in Focus, but I am sorry to say that I have failed on this occasion. More doom and gloom could well be on the way.

In original drafts of the Financial Transaction Tax, securities lending and repo transactions had been exempted – in the latest drafts, this has changed, and a tax of 0.1% will be applied to one leg of each trade – i.e. the first exchange of lent securities and collateral will attract a 0.1% levy on both parties, but the return of the loan will be exempt.

There is much more talking to do around the clarification of how this charge will be applied – for example, will all payments and returns of collateral throughout the life of the loan be taxed in the same way? – but in its very basic form, there is a significant chance that these charges will be applied by early in 2014.

One may say 0.1% or 10 basis points does not sound much, but 10bp is substantial when you compare it to the returns most funds earn from securities lending programs. Adding such a tax to an already embattled industry would drive more participants away and the knock-on impact on market liquidity, efficiency and price spreads has been well documented.

Tax is not free money; such levies will either strangle the industry by having significant negative impacts to the wider market or it will simply change the economics of the market. In the latter case, all securities will be more expensive to borrow, and returns to investors and beneficial owners will fall as a result as these costs will need to be passed on to them – margins in the securities lending industry certainly cannot support such a levy.

The law of unintended consequences looms large over this particular piece of legislation and its development from draft to full legislation is something that the industry will watch and no doubt lobby hard on over the coming months.

While you’re here…

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.