Jul 16, 2013

Comprehensive Risk Management of OTC Derivatives: A Tricky Endeavor

The Dodd-Frank rules implemented earlier this month have left Wall Street participants once again abuzz regarding the impact of the financial overhaul, with ever-more swaps being routed to central clearing houses.  With approximately $650 trillion in today's global swaps market, along with regulation and implementation continuing to drive up the cost of derivative operations—it's no surprise that related risk management best practices are still keeping many market practitioners up at night.

As regulators continue their quest to make the financial markets 'safer,' the timing couldn't be better for the Professional Risk Managers' International Association's (PRMIA) recent panel event discussion, Advancements in Risk Analytics, hosted at New York City's Harvard Club. The roundtable discussion addressed many of today's pressing concerns, including the growing importance of the need for firm-wide holistic risk management programs.

Panel participants—including roundtable moderator, Sol Steinberg, Vice President of Valuation & Risk at LCH Clearnet, Paul Rowady, Senior Capital Markets Analyst at TABB Group, Denny Yu, Vice President and Product Manager of Risk at Numerix, and Bikram Singh, former Global Business Head of OTC Derivatives Services at Citibank—were all in agreement that firms must continue to evolve their own best practices.

The Universe of Market Analytics is Growing Exponentially

In his keynote remarks, Mr. Steinberg kicked-off the discussion with an observation about how the universe of market analytics is growing exponentially and emphasized the importance of today's advancements in risk analytics. The discussion that followed shed additional light on pricing and practices, given the new clearing mandates taking effect for the buyside. He talked about how central clearing is unavoidable and procyclical: when risk increases, so do related margin requirements.  So how can broker-dealers maximize capital efficiencies? This paved the road for the discussion ahead. Mr. Steinberg touched upon other hot topics, such as the importance of liquidity and funding risk analytics—in addition to collateral optimization analytics, central counterparty (CCP) basis risk metrics, initial margin analytics and counterparty assessment analytics.


Panelists from left to right: Bikram Singh, Former Global Business Head of OTC Derivatives Services at Citibank, Denny Yu, Vice President and Product Manager of Risk at Numerix, Paul Rowady, Senior Capital Markets Analyst at TABB Group and roundtable moderator, Sol Steinberg, Vice President of Valuation & Risk at LCH Clearnet

 Welcome to The Data Visualization Era

Paul Rowady was next up at the plate, and he enthusiastically welcomed everyone to the data visualization era. When asked by an audience member, "What exactly is data visualization?," he described it as converting data into pictures or visual metaphors so market participants could absorb data more easily. The other panelists all agreed upon the importance of data visualization, given the need to interpret the vast and ever-increasing amounts of data volumes that will need to be consumed in the coming years. Mr. Rowady also reiterated the importance of the need for centralized, enterprise-level risk analytics. Like other panelists, he emphasized the need for breaking down the siloed approach to risk management and for enhancing the fluidity of 'the flow'—from front-to-back office and back-to-front. Not surprisingly, his research also indicated an uptick in risk management investment amongst financial institutions.

The Increasing Cost of Derivatives Operations

Next, Denny Yu of Numerix in his discussion on Advancements in Risk Analytics, highlighted current industry trends—including how regulation and implementation have led to the increasing cost of derivatives operations. He also discussed how central clearing will continue to offer both challenges—and opportunities. Mr. Yu reiterated how with the roles of front and middle offices continually evolving, practitioners must also continue to evolve best practices. He also cited the new trend in which many banks and buyside institutions are beginning to break down the silos to review metrics across the front and middle office for pricing, capital and regulatory measures.


Denny Yu addresses risk management best practices at New York City's Harvard Club


The Bottom Line: Economic Value Add/True Profit & Loss

Mr. Yu addressed the major analytics changes due to multi-curve pricing, CSA optionality and the widespread use of valuation adjustments—including credit value adjustment (CVA), debit value adjustment (DVA) and funding value adjustment (FVA.) He talked about what's been on every practitioner's mind in the OTC business: how all of these adjustments, in addition to additional transaction costs, impact the bottom line—profit and loss.

It was very enlightening the way Mr. Yu outlined the comprehensive measures for OTC derivatives at the trade or portfolio level, as demonstrated in the chart below:


The following example illustrates the impact of these additional costs, and the bottom line EVA or True P&L.


Risk: The Seven Point Framework

Next on the agenda, Bikram Singh, former Global Business Head of OTC Derivatives Services at Citibank, outlined what he calls the seven point framework around risk. After several years on the front lines, Mr. Singh has been contemplating just how complex the new ecosystem is going to be.

He even joked about how risk professionals will have 'solid job guarantees' over the next few years.  He reiterated the idea that data is going to be extremely important going forward, including: flow, extraction, synthesizing, putting together reports and data interpretation.

So, how does one really evaluate risk across the organization? Mr. Singh's answer included these seven points outlined below:

Point 1. Market Risk

New regulations mandate daily measurement of market exposure. The second component within market risk includes having timely and reliable valuation data, which must be derived from and verified from sources independent of the business trading unit. Models must be independently validated by qualified independent persons. In addition, reconciliation of P&L from valuations with the general ledger must occur at least once each business day.

Point 2. Credit Risk

This includes daily measurement of overall credit exposures to comply with counterparty credit limits, monitoring and reporting of violations of counterparty credit limits performed by personal that are independent of the business trading unit, regular valuation of the collateral used to cover exposures, collateral management and safeguarding of collateral.

Point 3. Liquidity Risk

This would include the daily measurement of liquidity needs, impact on price, application of appropriate collateral haircuts and the impact on market and credit risk.

Point 4. FX Risk

This includes the daily measurement of the amount of capital exposed to fluctuations in the valuation of foreign exchange and would include safeguards to comply against adverse currency fluctuations.

Point 5. Legal Risk

This includes a good risk management program with a sound legal basis for transactions and netting agreements, documentations, and a customer relationship management (CRM) system around legal documents with counterparties put into place.

Point 6. Operational Risk

Operations is 'a choke point', if you don't have correct data flow across the front, middle and back office. Firms should have secure systems with accurate scale and capacity, which should also be independent from the business unit. There should be safeguards in place, along with the reconciliation of all systems within the firm.

Point 7. Settlement Risk

This includes the establishment of standard settlement instructions with each counterparty. Here, we should also note the overall importance of a holistic risk management program.

Readiness Assessment: Managing Risk Is Always Going to Be a Tricky Endeavor

How ready was everyone in the room across the landscape? It should be noted that after each point, Mr. Singh requested to see a show of hands from the risk professionals in the room to observe if their particular organization was ready—or at least thinking about the above points? Overall, what we observed was that the majority of market participants are not fully prepared for the complexity of this undertaking. Mr. Singh concluded by emphasizing the need to look at these points in totality—from a very macro-level. "Behavior modification is always the most difficult variable," concluded Mr. Rowady.

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